As more retail investors flock toward online brokerages, whether self-directed broker-dealers or robo-advisers, regulators are likely to cast a more critical eye on digital investing tools, experts say.
A recent $70 million enforcement action against fast-growing online brokerage Robinhood Financial and a potential $200 million fine for Charles Schwab Corp.’s robo-adviser platform, shed light on heightened transparency issues the Securities and Exchange Commission and Financial Industry Regulatory Authority Inc. may keep closely on their radar.
Robo-advisers have experienced a meteoric rise since their debut in 2008. Assets managed clocked in at $460 billion in 2020 and are predicted to grow to $1.2 trillion by 2024, according to a white paper by Plaid. Schwab Intelligent Portfolios, for one, has experienced a 51% year-over-year increase in client assets at $64 billion as of the end of March, according to the company’s 8-K filing.
Accounts at online brokerages, too, skyrocketed during the pandemic with more than 10 million new brokerage accounts opened in 2020, according to J.D. Power. Robinhood snatched 27% of all new do-it-yourself account openings, more than any other firm.
At this point, SEC Chairman Gary Gensler can no longer ignore the digital advice space, said Kurt Wolfe, an attorney at Quinn Emanuel Urquhart & Sullivan.
“So far, enforcement actions against robo-advisers have really focused on low-hanging fruit — like advertising or disclosure issues that might apply to any RIA,” Wolfe said. “But we haven’t yet seen a case against an online broker or robo-adviser that really hits at critical questions about where these platforms fit in the securities regulatory landscape.”
NEW ERA FOR DIGITAL INVESTING
In this new age of digital investing tools, the key question could be how the SEC will address the question of what constitutes customer service versus licensed financial advice.
“The lines used to be fairly brightly marked, but there are now a lot of tools and platforms that exist in a gray area,” Wolfe said. “The SEC will have to think carefully about where those firms and services fit in the regulatory space. We could very well see new rules or guidance in the not-so-distant future.”
The SEC released a robust set of guidance in February 2017 spelling out what robo-advisers need to disclose, like fees the platform collects even if they are indirect. Yet the environment has changed rapidly in recent years and issuing new guidance for both robo-advisers and online brokerages is a seminal piece, said Douglas Kamin, managing director at Foreside Financial Group.
While business models and regulatory allegations are completely separate, the one similarity for both Schwab and Robinhood are around customer education and communication, said Sophie Schmitt, senior analyst with Aite Group.
“Schwab positioned their offering as superior because of the absence of an AUM fee and Robinhood positioned options trading as available to anyone with insufficient risk disclosures and investor education,” she said. “The Robinhood failures seem to me to be more egregious, so it’s interesting that the fine is lower than the one being levied on Schwab.”
Schwab’s possible $200 million fine will help push not just robo-advisers but the financial advice industry as a whole towards increased transparency, said David Goldstone, manager of research and analytics at Backend Benchmarking. To start, firms need to review how their robo-advice product generates revenue.
“If it is generating revenue from cash holdings in the portfolio, payment for trade order flow, holding proprietary funds or other methods outside of a management fee, then the marketing materials and disclosures need to be reviewed to ensure that clients fully understand the full costs of the service,” Goldstone said.
Investors aren’t charged a fee on the Schwab platform, but they do incur expenses charged by the underlying ETFs, some of which are proprietary. The service would also direct a client’s funds into cash, ranging from 6% to 22.5%, depending on a client’s risk profile.
While it is difficult to quantify how much the large cash allocation at Schwab has held back the growth of clients’ portfolios, a high cash allocation creates a cash drag on a portfolio, Goldstone said.
“Over a long time period, even a relatively small impact on the growth of a portfolio can make a significant difference in the value of that portfolio when that growth is compounded over years or decades,” he said.
In Robinhood’s case, the blurry line between offering users customer service versus financial advice is growing thicker, and the startup’s compliance program is likely struggling to keep up, Kamin said.
Robinhood has made it clear that its financial adviser recruits will not be used to provide financial advice, rather, customer service. Yet Robinhood’s IPO filing does note its investment education tools could subject the firm to additional risks as it cannot guarantee it won’t be construed as constituting investment advice or recommendations by customers or regulatory agencies.
“Robinhood has service reps, but have the employees making those field phone calls been trained as to what they can or cannot do or say?” said Kamin. “Does the person doing the reviewing and monitoring have the expertise to understand what words are considered prohibited by the SEC?”
Like other online brokerages, Robinhood decided on speed to market rather than building a platform that ensured it met basic legal and compliance obligations at federal and state levels, said Peter Dugas, executive director at Capco.
“Whether they’re an online broker or robo-adviser using an algorithm to make determinations on investment advice, firms should be ensuring proper policy procedures, disclosures and specific requirements to how the investment advice is being delivered, as well as how it’s consumed,” Dugas said.
With SEC Chair Gary Gensler, who has signaled that he wants the agency to hold robo-advisers to the same standards as other investment firms, Dugas said to expect the new regulatory leader to move effectively and quickly to enforce rules that hold institutions accountable.
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Andrew is half-human, half-gamer. He’s also a science fiction author writing for BleeBot.