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New research by Tom Baker lays out guidelines for regulating robo advisors

November 27, 2017

With the advent of automated financial products, consumers can get quotes for a mortgage, find a health insurance plan, or get help planning their financial future. But with these tasks now able to be conducted by computer programs, new research co-authored by Penn Law’s Tom Baker investigates how regulators should handle these new technologies.

The article, “Regulating Robo Advice across the Financial Services Industry,” was co-authored by Baker and Benedict G. C. Dellaert of Erasumus University Rotterdam and is forthcoming in the Iowa Law Review.

Baker is the William Maul Measey Professor of Law and Health Sciences and a preeminent scholar in insurance law. His scholarship explores insurance, risk, and responsibility using methods and perspectives drawn from economics, sociology, psychology, and history. One of his most recent projects was serving as Reporter for the American Law Institute’s Restatement of the Law Liability Insurance, an effort to definitively define the field.

With the growth of automated financial advice services, also known as “robo advisors,” consumers have new tools for choosing investments, banking products, and insurance policies. These robo advisors have the potential to provide higher quality, more transparent financial advice at a lower cost than human financial advisors, Baker and Dellaert explain.

They also note that emergence of these programs doesn’t eliminate a role for people in the financial industry. “People design, model, program, implement, and market these automated advisors,” they write, “and many automated advisors operate behind the scenes, assisting people who interact with clients and customers.”

Throughout their essay, the authors use the example of the “well-designed robo advisor” to examine the benefits and detriments of automated financial services.  “This is not because we believe that robo advisors necessarily will be well designed,” they write. “Indeed, we believe the contrary.”

“While robo advisors have the potential to outperform humans in matching customers to mass market financial products, they are not inherently immune from the misalignment of incentives that has historically affected financial product intermediaries,” they state. “A robo advisor can be designed to ignore those incentives, but many consumer financial product intermediaries that develop or purchase robo advisors are subject to those incentives. It would be naïve to simply assume that intermediaries will always choose the algorithms and choice architecture that are best for consumers, rather than those best for the intermediaries.”

In addition, robo advisors pose new risks — they “may entrench historical unfairness and promote a financial services monoculture with new kinds of unfairness and a greater vulnerability to catastrophic failure than the less coordinated actions of humans working without automated advice.”

These programs present new challenges for regulators, Baker and Dellaert write, and an open discussion between legal and financial scholars, as well as experts in other relevant disciplines, is necessary protect the integrity of financial markets.

The traditional goals of regulation are competence, honesty, and suitability, the authors explain. A well-designed robo advisor should meet those goals as well as a human advisor — though they are careful to emphasize “well-designed” — but regulators will need to quickly develop the expertise to assess just what “well-designed” means.

“The smart thing for regulators to do is to start developing the necessary capacities now, when they stakes are lower, and when consumers are still sufficiently uncertain about robo advisors that some firms may actually welcome the legitimization that could accompany independent certification of the quality of robo advice,” they write.

Baker and Dellaert propose a regulatory “trajectory” rather than a regulatory agenda. First, regulators must gather information to assess the capacities that their agencies must develop through a systemic, interdisciplinary assessment, then they must develop those capacities.

As of now, they note, there is no formal inter-agency coordination in the United States on financial technology, and that coordination is even less developed on the global stage.

“While there is no evidence that this lack of oversight and coordination has caused harm yet,” Baker and Dellaert write, “it almost certainly will in the future, as the market simply cannot be counted upon to be self-correcting when robo advisors grow in scale to the point that they reshape financial product markets.”

The benefits of regulation will very likely exceed the costs, they conclude, “because the very same returns to scale that make robo advisors so cost-effective lead to similar returns to scale in assessing their quality. Coordinating that effort is a logical and important role for our expert financial services regulators. It is time for them to develop the necessary expertise.”