“Robo Advisory” has huge chances to win on buzzword-contests related to Fintech-services that they will disrupt current business models. But what are the services, “Robo Advisors” offer and why should they make a significant difference?
What is “Robo Advisory”?
The term Robo Advisory is not known to the law. As with many business models, which have emerged with advancing digitalization, Robo Advisory services are not yet independently regulated by the legislator. Nevertheless, as such services gain importance, the competent authorities – particularly BaFin in Germany – and the legislator are becoming more and more aware of the particularities of the Robo Advisory business model.
Therefore a useful description of Robo Advisory was developed by BaFin and the Boston Consulting Group in an extensive study on Big Data and Artificial Intelligence (cf. “Big Data meets artificial intelligence”). Therein Robo Advisory is described as:
- (Retail) asset management or intermediation products
- with a fully automated customer interface
- that use algorithms to determine
- (and, where applicable, manage portfolios)
- based on customer information.
The characteristics of Robo Advisory
This description presents two particularities that describe Robo Advisory: Firstly, Robo Advisory takes place primarily in the sectors of reception and transmission of orders, portfolio management and investment advice. Secondly, Fintechs offering Robo Advisory products focus on the process of communication between client and investment advisor/ portfolio manager or person or entity that transmits an order. Robo Advisors are therefore something like a second wave after the digitalization of trading, which is already significantly automated.
How are Robo Advisors regulated?
The services branded as “Robo Advisory” vary to a huge extent. Therefore the one regulation for Robo Advisory does not exist. As with many digital services in the field of financial regulation, within the assessment of financial regulatory implications the competent authorities “translate” the relevant business model to the existing laws and regulations.
Mainly, the services offered by Robo Advisors do qualify as “investment services” within the meaning of MiFID II. Investment services within the meaning of MiFID II are defined to be “financial services” in the German Banking Act. Persons or entities that intend to offer financial services on a commercial scale do require a licence by BaFin.
Pro’s and Con’s of Robo Advisory
So what are the advantages and the disadvantages of Robo Advisory?
Let’s start with a few problems:
- The algorithms behind the customer interfaces are still relatively simply structured. According to the words of BaFin/Boston Consulting: “However, many [Robo Advisory services] tend to involve comparatively low levels of BDAI complexity at the moment.” The less complex the algorithms are, the less individualized the services are at the end for the customer.
- The understanding of the specific risks of Robo Advisory services is still very low. Therefore, the president of the BaFin, Felix Hufeld, addressed rhetorically: “Must the oversight soon define supervisory standards for self-learning systems?” (the full statement is available here).
- The existing regulatory framework is developed on an “analogue” basis. The legislator had the picture of the customer sitting in front of the investment advisor/ portfolio manager and being handed out all the information required. Obviously these two different angles tend to be problematic.
On the contrary, Robo Advisory has its advantages. These may include:
- Robo Advisory services are typically (much) cheaper for the customer. Therefore they give customers access to financial services which were not previously accessible at all or only available to a limited extent. Best example: Portfolio management.
- In theory algorithm based investment strategies may lead to a more individualized portfolio management for the customer. More complex algorithms – even if programmed for thousands of customers – could be more customized than products developed before.
Regulation for the digitalized financial industry is still in its early development. On a European level the EU is still developing its “FinTech Action Plan” which shall facilitate the opportunities for Fintechs in the EU. The revision of the Capital Requirements Directive/Capital Requirements Regulation and the proposed prudential framework for investment firms may lead to an easier access for Robo Advisory services within the EU.