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News May 21, 2018 Issue

Technology: IAA Urges Treasury to Recommend a Principles-Based Approach

As new technologies and networks proliferate among advisory firms and other non-bank financial institutions, many will require regulation, but will that regulation encourage innovation, or stifle it? The Investment Adviser Association, in a recent letter to the Department of the Treasury, urged the Department to support innovation by recommending and encouraging regulators to adopt regulations that are principles-based.

Principles-based regulations generally avoid the prescriptive instructions that many advisers and other financial entities find problematic. The use of principles-based standards typically allow those regulated to determine the methodology of compliance in achieving required goals.

"To allow for the industry to keep up with and harness changing technology, regulation must [emphasis IAA] be principles-based," the IAA said in its 11-page April 25 letter, which it posted on its website last week. "Prescriptive rules become quickly obsolete and, because they often fail to anticipate novel uses of technology, they invariably act as a roadblock to innovation. In the area of quickly developing financial innovation and technology, broad uniform standards are likely to be more effective than rules."

Ropes & Gray counsel David Tittsworth said that the IAA’s call for a prescriptive-based approach when it comes to regulation of technology "resonates strongly with me, in part because of the general principles-based approach of the Advisers Act. I also agree that prescriptive rules can become outmoded as technology advances and changes quickly and may actually impede meaningful and effective regulation in the long run."

"The theme that runs throughout the IAA letter in regard to the needs of the investment adviser community is, ‘We need to innovate, so please don’t give us over-prescriptive regulations,’" said Mayer Brown partner Adam Kanter. "‘We need room to grow. Don’t box us in.’"

Treasury Department reports

The IAA sent its letter following two meetings with Treasury Department officials, the first in January in regard to providing investment advice through the use of digital platforms, and the second in April in regard to how advisers are exploring technology to enhance the client experience and relationship, streamline back office functions, and provide business efficiencies.

The meetings are part of Treasury’s preparations for its fourth and final report addressing the U.S. financial system. Each report focuses on an aspect of the system. The first three addressed, respectively, depository institutions (banks, savings associations, credits unions and more), capital markets (debt, equity, commodities and derivatives, among others), and the asset management and insurance industries (ACA Insight, 11/6/17). The fourth report will address non-bank financial institutions (i.e., investment advisers), financial technology and financial innovations.

General principles

Among the general principles that the IAA recommended to the Treasury, in addition to regulations being principles-based, were the following:

  • Regulations and standards should be "technology-neutral and not based on the presence, absence or type of technology;
  • Regulatory focus should continue to be on investor protection and market integrity and efficiency, while supporting and facilitating exploration of financial innovation; and
  • Regulators should expressly support financial institutions taking a reasonable, risk-based approach when assessing, implementing and applying technology to their businesses.

Use of technology

The IAA’s recommendations to Treasury in regard to existing technologies included the following:

  • Digital advice. "It is important to underscore that the use of technology by digital advisers to offer investment services does not change the regulatory environment in which they operate, nor does it change the types of investments (e.g., asset classes and investment strategies) that they offer their clients," the IAA said. The association said that any recommendations that Treasury makes in this area should support the approach set out in past SEC guidance and that they should be principles-based and apply to all advisers.
  • Distributed ledger technology. Treasury should adopt "a measured approach" by focusing on the promise of this technology, "which, we believe, could revolutionize financial services," the IAA said. "We believe that DLT has enormous potential to create operational efficiencies in a number of different areas, including, for example, in areas of recordkeeping and in the trading and settlement of investments. Treasury should encourage these developments and work with the financial industry to map out a regulatory approach that will facilitate exploration and innovation."
  • Cloud services. The IAA urged the Department to encourage regulators to issue updated guidance that would make it clear that "no law or regulations prohibits the use of the public cloud. They also should make it clear that regulated entities may employ cloud services – directly or through their service providers – provided they develop effective oversight mechanisms designed to ensure that customer data and critical operations are protected."

Modernization of existing regulations

The IAA has already called for modernizing a number of existing rules, but used the opportunity provided by the Treasury’s need for input to note technological reasons for certain rules to be updated. For instance, it noted that in regard to Rule 204-2, the Books and Records Rule, the SEC should make it clear that digital ledger technology and cloud services may be used to store records. For Rule 206(4)-2, the Custody Rule, the IAA advised Treasury that regulators need to understand new and evolving structures for custody and cryptoassets.

The IAA also raised concerns regarding the need for modernization in regard to data breach and cybersecurity regulations and personally identifiable information.

In regard to modernizing existing rules, Tittsworth said that the rules in question "have developed cobwebs over time and would benefit from a fresh look that recognizes and acknowledges developments in financial technology."