14 Apr 2016

Regulating digital financial product advice consultation paper released

by Narelle Smythe, Matthew Daley, Welton Chan

Licensees are encouraged to make a submission so the "Providing digital financial product advice to retail clients" Regulatory Guide is as facilitative and helpful as possible.

On Monday, 21 March 2016, ASIC released Consultation Paper 254 Regulating digital financial product advice that included a draft Regulatory Guide Providing digital financial product advice to retail clients. The release is a welcome development. The provision of digital advice has the potential to grow rapidly as an accessible, trusted and low-cost service which is affordable to retail clients.

However, while welcome, the draft Regulatory Guide does not deal with some of the key regulatory issues impacting on digital advice, including the extent to which digital advice is general or personal advice; and while it sets out certain minimum ASIC expectations relating to scaled advice and the best interests duty, it leaves open critical questions in relation to how to appropriately scale the advice in light of the best interests duty.

The Regulatory Guide builds on existing ASIC guidance and regulatory concepts. Key issues covered include:

  • the organisational competence obligation for digital advice licensees;
  • the ways in which digital advice licensees should monitor and test their algorithms; and
  • the minimum steps digital advice providers should take to comply with the best interests duty when providing "scaled advice" (personal advice that is limited in scope) to retail clients.

Organisational competence obligation

ASIC has proposed that digital advice licensees must have at least one responsible manager who meets the training and competence standards as set out in Regulatory Guide 146: Licensing: Training of financial product advisers.

Currently, the Corporations Amendment (Professional Standards of Financial Advisers) Bill 2015 is under consultation and if it is enacted, higher training and competence standards will apply to advisers. ASIC expects these standards will then be applied to digital advice licensees, meaning the responsible managers must meet the standards in that Bill, including:

  • meeting the higher training and competence standards (ie. have a degree or equivalent qualification, pass an exam, complete a professional year and undertake continuing professional development); and
  • complying with the proposed ethical standards (that is, comply with a code of ethics and be covered by an approved compliance scheme).

Adequate human resources

Licensees are required to have adequate human resources to provide the financial services authorised by its licence. To satisfy the human resources requirement in respect of digital advice, ASIC expects the licensee to have at least one person who has:

  • an understanding of the technology and algorithms used to provide digital advice. ASIC also expects the licensee to have people within the business who understand the rationale, risks and rules behind the algorithms underpinning the digital advice; and
  • the appropriate skills and experience to thoroughly review the quality of the digital advice provided.

Monitoring and testing digital advice algorithms

As part of establishing and maintaining an adequate risk management system, ASIC has indicated ways in which licensees who offer digital advice to retail clients should monitor and test their algorithms. In particular, ASIC has indicated these licensees must:

Design and testing algorithms

  • have appropriate system design documentation that clearly sets out the purpose, scope and design of the algorithms including decision rules or decision trees which display decisions and their possible consequences;
  • have a documented test strategy which includes test plans, test cases, test results, defect resolution (if relevant), and final test results that explain the scope of the licensee's testing of algorithms;

Changing algorithms

  • review and update algorithms whenever there are factors that may affect their currency such as market changes and changes in the law, have appropriate and secure processes for managing any algorithm changes, and be able to control, monitor and reconstruct any algorithm changes over a seven year time-frame;

Dealing with algorithm errors

  • have controls and processes in place to suspend the provision of advice if an error within an algorithm is detected; and

Reviewing the performance of algorithms

  • have in place adequate resources, including human and technological resources, to monitor and supervise the performance of algorithms through an adequate and timely review of the advice provided.

Providing scaled advice in the best interests of clients

The following requirements are some of ASIC's minimum expectations to assist digital advice providers in providing scaled advice that is in the best interest of clients. Digital advice providers should:

  • explain to the client from the outset the scope of the advice; that is, what advice is being offered and not offered;
  • require the client to actively demonstrate that they understand that the advice they are seeking is within the scope of advice offered, for example, by requiring the client to acknowledge the scope of advice being offered or the client to answer questions to actively communicate that the advice they are seeking is within the scope of the advice offered;
  • at key points in the advice process, inform (not through wordy disclaimers or fine print) the client about the limitations and potential consequences of the scope of advice; and
  • throughout the advice process, inform the client about key concepts, risks and benefits associated with the advice being provided.

The Regulatory Guide, however, does not provide additional guidance on how to appropriately scale the advice in light of the best interests duty. In addition, ASIC expects all personal advice to be scaled to some extent. The Regulatory Guide does not provide, for example, further guidance on the extent to which digital advice is general or personal advice. As providers build profiles of hypothetical investors, providers may not need to collect personal information from customers. This leaves a question as to whether a reasonable person might expect the provider to have considered one or more of the customer's objectives, financial situation and needs.

ASIC has also indicated that digital advice will not be suitable for some clients and it will closely scrutinise situations where all clients have been provided with digital advice. ASIC expects digital advice providers to:

  • use a "triage" process where clients for whom the advice being offered is not suitable, or who want advice on a topic outside the scope of advice are filtered out; and
  • take the necessary steps to inform their clients about the limitations and key concepts of the digital advice being provided, in particular where the potential consequences of their decisions are significant.

Reviewing advice

ASIC expects digital advice licensees to:

  • use human advisers to review samples of digital advice. Reviews should be conducted by assessing all the information (as opposed to using a "tick-a-box" approach) and using a human reviewer's judgment in assessing the quality of digital advice provided;
  • initially conduct frequent reviews of digital advice and exercise heightened scrutiny when any change to an algorithm is made. Recommended scrutiny includes running test scenarios to test the quality of advice provided; and
  • regularly monitor and test algorithms through periodic and random advice reviews.

When dealing with errors, licensees are expected to:

  • understand that suspension of an algorithm alone is unlikely to sufficiently rectify the problems (with the defective advice) and licensees may also need to lodge a breach report with ASIC; and
  • take additional steps to review advice that may be defective. ASIC expects licensees to remediate clients who have suffered a loss as a result of the defective advice being provided.

Effective communication

As there is no human adviser directly involved in providing digital advice, ASIC has stressed the importance of digital advice providers to carefully consider their website design, digital communication and digital disclosure through a user-focused approach which places the client's needs first.

Next steps

As an accessible, trusted and low-cost service, digital advice offers significant benefits to customers. ASIC has released the draft Regulatory Guide for comment. Licensees are encouraged to make a submission in order to assist in making the Regulatory Guide to be as facilitative and helpful as possible. If you would like to make a submission, you must do so by 16 May 2016.

Our Banking and Financial Services team can assist you to understand the impact of the draft Regulatory Guide and make a submission.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.