As disruptive technologies become increasingly embedded within the private funds industry, a joint JTC and K&L Gates roundtable discussion looked at how regulators are responding.
Despite the hype around new Artificial intelligence (AI) tools (i.e. Generative AI, Large Language Models, etc.), most private funds – for now – are using the technology to perform only a limited number of tasks.
“Use cases for Generative AI across the industry have mainly focused on improving the investment decision making process through digesting and summarizing vast amounts of data about companies, markets, risks and opportunities,” said Jeff Drinkwater, Senior Director of Institutional Client Services at JTC.
Other firms are also turning to AI for more low-key support, such as drafting reports or refining emails.
While these particular use cases do not appear high risk, regulators are starting to scrutinize the technology due to concerns around its unmeasurable potential and associated privacy, security, transparency and ethical considerations.
The US Securities and Exchange Commission (SEC), for example, had proposed new rules for investment advisers and broker dealers on how they use Predictive Data Analytics (PDA), which includes AI and other technologies.[1]
Some firms are using PDA, which produces detailed analytics based on vast quantities of data (i.e. customer data, market data, etc), to better customize their services for certain clients.
However, the SEC is becoming increasingly alarmed about PDA black box technology, warning it could lead to potential conflicts of interest emerging between managers and investors.[2]
Under the SEC’s proposal, firms would need to have procedures and written policies in place to prevent any conflicts of interest from materializing.
Nonetheless, critics argue that the SEC’s proposed PDA rules are too broad.
“The proposal seeks to restrict technology from doing what salespeople have been doing for years, namely making a prediction and trying to find ways to bring investors on board and into their funds,” said Rick Lake, Lecturer at Boston University’s Digital Business Institute and Founder of consultancy firm Narrative Alpha.
While the private funds industry may not be making the most of AI, the technology is still evolving at an unprecedented pace. “The use cases for emerging technologies like AI are rapidly evolving. I can see this making it critical for regulators to stay abreast as they consider regulations in this dynamic backdrop,” a point made by Rahul Shukla, Managing Director at Kroll.
This is echoed by Lance Dial, Partner at K&L Gates. “The SEC is trying to be proactive about AI, which is why they are introducing these PDA rules. The biggest problem facing regulators is that we do not know what AI is going to look like in a year’s time.”
Notably, after the roundtable, the SEC indicated in its regulatory agenda that the PDA rules would be revised and reproposed.
Dealing with cyber-crime – how regulators can help
As technologies like AI become more ubiquitous, so too do the risks, especially cyber-crime.
Financial services is widely considered to be one of the sectors most vulnerable to cyber-crime. Over the last 20 years, the International Monetary Fund (IMF) calculates that the financial services industry has suffered over 20,000 cyber-attacks, incurring costs totalling $12 billion.[3]
According to IBM, each successful hack costs a financial institution $5.9 million on average.[4]
This has forced regulators to intervene, with the SEC – as part of its recently updated Cyber-Security Risk Management Rules – proposing new cyber-security governance requirements for investment advisers.
Under the proposed rules, firms would have to report significant cyber-security incidents to the SEC, disclose information about cyber-security risks and incidents to clients and prospects, and maintain records on their cyber-security risk management rules and incidents.[5]
“Cyber-security is an increasing area of concern, and there is merit in having rules or common standards in place, which can help institutions, large and small, understand what is required of them. That said, it is easy for regulators to become overly prescriptive, and create significant costs for emerging managers, which may end up having a disproportionate impact on those with fewer technology resources,” said Jamie Peterson, a Director at Iron Road Partners, a professional services firm.
Driving ahead with regulations
As new technologies and risks emerge, regulators are having to take action. A pragmatic and sensible approach by US regulators will be essential if the private funds industry is to remain competitive and grow its asset base even further.
If you’re interested in discussing this article further, or finding out about JTC’s private funds offering, please get in touch with Jeff directly.
[1] K&L Gates – August 16, 2023 – A New Frontier: The SEC Addresses Artificial Intelligence (And A Whole Lot More)
[2] K&L Gates – August 16, 2023 – A New Frontier: The SEC Addresses Artificial Intelligence (And A Whole Lot More)
[3] World Economic Forum – May 15, 2024 – Global financial stability at risk due to cyber-threats, IMF warns. Here’s what to know
[4] Finextra – February 9, 2024 – The state of Cyber-crime in the financial sector
[5] Eisneramper – May 30, 2024 – SEC’s Cyber-security Risk Management Rules for Funds and Advisers
