Financial regulators are "three or four steps behind" technological innovation — and that gets dangerous," argues Andrew W. Lo, finance professor at MIT Sloan School of Management and director of the MIT Laboratory for Financial Engineering, in an interview with ThinkAdvisor.
The "biggest challenge" for regulators is trying to keep pace with the years-long pick-up in tech innovation, says Lo, who is on FINRA's Economic Advisory Committee.
Financial regulation is just one area of his current research.
For another, he is a principal investigator at the MIT Computer Science and Artificial Intelligence Laboratory.
Time magazine named Lo one of "the 100 Most Influential People in the world" in 2012.
Co-founder of the tech-driven QLS Advisors, he is on the board of biopharmaceutical company Roivant Sciences.
His newest book is In Pursuit of the Perfect Portfolio, co-written by Stephen R. Foerster and published in August.
In the interview, Lo cites the necessity for "additional oversight" of robo-advisors because of their inherent risk, which the typical retail investor isn't prepared to manage.
He also discusses new technologies, like cryptocurrencies, which are difficult to monitor and regulate, he says.
Lo's AI research focuses on "artificial humanity," which he calls "a second-generation AI."
"Until we have an algorithmic understanding of how humans would likely behave [in market downturns], you're never going to have truly intelligent software," he contends.
This involves incorporating into algorithms investors' "freak-out factor," as he terms it, and their "pain point."
ThinkAdvisor recently interviewed Lo, speaking from his office at MIT. The conversation embraced what regulators are doing to try to avoid another devastating financial crisis and his research on systemic risk, which is about how the financial system's subcomponents are interconnected and how that affects risk.
The professor is also studying the financial impact of impact investing and is at work on a framework for "discharging fiduciary duties" when shareholders, plan sponsors or plan participants are interested in making such investments.
Here are highlights of our interview.
THINKADVISOR: The SEC has found that many financial advisors haven't been supporting the best interest regulation, Reg BI. Do advisors need more regulation?
ANDREW LO: Regulation has to be done very carefully because when you over-regulate markets, you create unintended consequences that can take years or decades to undo; in some cases, you can never undo them. So you have to proceed cautiously.
However, in the area of robo-advisors, we need to understand what the systemic implications are, particularly because you're dealing with retail investors, and not all of them are prepared to fully understand and manage the kinds of risks that come with robo-advisors.
So I do think that additional oversight is necessary there. But that will require a fair amount of study before we can implement the proper regulations.
The SEC has also found broker-dealers who were seemingly ignoring Reg BI and even offering risky and more costly products. Your thoughts?
It's a growing problem because financial markets are becoming much more complex, and financial services are now being offered by a number of new entities that may not look like your traditional financial institution.
In fact, that's the whole point of fintech — to be disruptive in providing services to individuals at lower cost in unconventional ways. That's creating challenges for regulators to keep pace with.
Regulators need more resources to address these issues and deal with them. The budgeting process [needs] to reflect the new realities of market complexity.
Such as?
Cryptocurrencies are a case in point. Many of the players are not your traditional broker-dealer. These exist both onshore and offshore in ways that are very, very difficult to monitor and regulate.
The SEC and CFTC [Commodity Futures Trading Commission] are both looking at this very carefully, as are a number of the Feds [Federal Reserve banks].
This is a good example of where the technologies move so quickly that it's not even clear what the right answer is — never mind that we don't have the answers yet.
What's the biggest challenge for regulators?
The main issue is the pick-up in the pace of technological innovation.
Over the last 20 years, the speed of innovation in technology has greatly increased. It's been going great guns.
Historically, regulation has been one or two steps behind. Now they're maybe three or four steps behind, and that gets to be dangerous.
Regulators are definitely making progress and have hired a number of people at the SEC and the CFTC that have the kind of experience to be able to address some of the technological advances.
But [keeping pace] is the biggest challenge right now.
What are regulators doing to try to prevent another financial crisis like the one in 2008?
They're collecting a lot more data than they used to and are trying to keep track of it in a more systematic fashion.
The Office of Financial Research is a new agency that was [established] precisely to focus on the data-collection problem and monitoring emerging risks to financial stability.
