Just as with many other sectors of the economy, the securities industry has experienced a fast-coming barrage of changes to the business of investing, most of all in emerging technologies.
Investment Advisers may have ignored the changes in technology several years ago, but those who provide investment advisory services can no longer avoid the fact that clients’ portfolio needs have evolved, and they may fail to act in the best interest of their investors should they overlook it.
However, there are some important factors to consider when incorporating new types of assets into clients’ portfolios and steps to take to mitigate risks.
Emerging Technologies (Artificial Intelligence, Cryptocurrencies/Digital Assets)
Investors are actively seeking to add emerging technologies, especially Artificial Intelligence (AI) and cryptocurrency, to their portfolios. Rightfully so, as these technologies continue to prove that they are more than a passing trend. For example, industries such as healthcare, education, manufacturing, and even finance have all integrated the use of AI into business practices, and cryptocurrencies are becoming more mainstream as even major retailers begin to accept this alternative form of payment.
Investment companies, advisers, and others managing investment portfolios understand the importance of offering clients these options. However, with governments poised to push more regulation in the next few years and the added strain of regulating bodies in the securities sector, advisers are well advised to practice caution.
Investing in emerging technologies can yield high returns, but it also carries heavy risk due to market volatility.
Smart investment advisers who have added such assets to their clients’ portfolios understand the importance of diversification, keeping the long-term goal in mind, and limiting quick returns. In addition, they understand the importance of considering the potential issues that come with such investments and must account for bias, clients’ data privacy, transparency, and other ethical considerations.
The SEC and Emerging Technologies: Potential Issues
Investment companies, investment advisers, broker-dealers, and others in the advisory space who are managing or contemplating adding emerging technology assets in areas such as AI or cryptocurrencies to their clients’ portfolios should understand the associated risks.
The SEC has kept a sharp eye on the use of AI in investment management, watching for potential issues such as client data privacy, bias, and failure to provide transparency. In addition, although several proposed regulations are still waiting to be passed, the SEC has not hesitated to take enforcement action against those in the investment management industry. To learn more about the SEC’s approach to AI adoption in the industry, please read our previous Risk Management Tip: AI Regulation in Finance and Securities.
For practitioners managing portfolios that include AI and other tech assets, risk management becomes even more important to address potential issues surrounding evolving technologies such as these.
AI, especially Generative AI, which learns from existing patterns to create new similar data, carries several major risk factors that can arise in the absence of diligent oversight, including data bias, plagiarism, and data manipulation, as well as other major ethical issues. It is therefore of utmost importance that those who manage investment portfolios that include Generative AI must develop or update current risk mitigation processes and procedures to address these potential risks.
In addition, portfolios that include digital assets or cryptocurrencies offer investors many advantages but carry several risks that must be taken into consideration in risk mitigation efforts, such as challenges with valuation since investments like these have no tangible assets tied to them.
Those already managing or considering adding such investments to their clients’ portfolios should take extra measures to address transparency, security, and privacy concerns, as well as develop vigorous protocols on prevention and response to cyber security issues.
Form ADV Considerations for Emerging Technologies—Cryptocurrencies
Investment advisers who already manage or are contemplating adding digital assets and cryptocurrencies to their client portfolios face unique challenges when it comes to compliance.
Advisers must display competency in investing in cryptocurrencies since these types of assets are speculative and are not regulated or controlled by any authority. Advisers must attain client acknowledgement that they have been informed of the risks involved in such investment strategies.
Furthermore, advisers managing or planning to manage crypto assets designated as ‘securities’ must do so with a qualified custodian and adhere to the existing Custody Rule put forth by the SEC. The rules for crypto assets that do not qualify as ‘securities’ are unclear. In this case, one viable option is to categorize such assets as ‘funds’ and follow existing rules in place when completing Form ADV.
Jacko Law Group, PC works with seasoned trailblazers in the investment advisory space. We assist them in developing and maintaining a robust and up-to-date compliance program that not only protects them from violating current regulatory requirements but readies them for upcoming changes.
If you currently manage cryptocurrencies, AI technology, or other emerging technology assets for your clients or are considering adding these types of investments to your clients’ portfolios, we encourage you to speak to one of our team members by contacting us at 619-298-2880 or by emailing firstname.lastname@example.org.