BaFin

Robo-advice - Automated investment advice in supervisory practice

Date: 01.09.2017

In the course of increasing digitalisation, companies are offering financial instruments online with ever greater frequency. For such investment services, the same requirements essentially apply as for services provided in-branch or over the phone. This is also the case for investment advice. If providers give investors the opportunity to inform themselves in a personalised manner about financial instruments, to compare different offers and to effect securities transactions, this may fulfil the definition of investment advice. This applies even more when there are additional service aspects that the user understands to be advice.

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The automated distribution of financial instruments and similar digital services – also known as robo-advice – generally meet the definition of investment advice and therefore require authorisation under banking or industrial law (only available in German). If such authorisation has not been granted or if the associated follow-up requirements of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG - only available in German) or of the German Industrial Code (Gewerbeordnung – GewO - only available in German) are not satisfied, the providers expose themselves to a considerable legal risk. Even though many new offers are currently coming onto the market, it is therefore not worthwhile to launch a robo-advisor for the sake of speed which tries (in vain) to avoid having to fulfil the requirements applicable to investment advice. Instead, the providers should make use of the opportunities offered by new media to provide full investment advice with the authorisation and under the supervision of BaFin and therefore make a contribution towards the creation of a consumer-friendly market environment.

This article is intended to help providers assess whether they meet the definition of investment advice. In terms of potential investment advice, the models currently on the market have in common that, based on the information entered by the customer, a result is created which can range from the recommendation of an individual security through suggestions on portfolio structure (with or without a recommendation) right up to a neutral listing of different financial instruments. The article follows this standard procedure based on the three typical steps of "exploration", "recommendation" and "content of the recommendation" and highlights the explanations on the definition of investment advice using practical examples.

The definitions of investment broking, of contract broking and of portfolio management on the other hand – which are sometimes also marketed under the term "robo-advice" – are not dealt with here. In case of doubt, providers should seek a binding, individual assessment from BaFin.

DefinitionInvestment advice

Section 1 (1a) sentence 2 no. 1a of the German Banking Act (Kreditwesengesetz – KWG - only available in German) defines investment advice as "providing customers or their representatives with personal recommendations in respect of transactions relating to certain financial instruments where the recommendation is based on an evaluation of the investor's personal circumstances or is presented as being suitable for the investor and is not provided exclusively via information distribution channels or for the general public". It is BaFin's duty to examine whether a robo-advisor fulfils the legal criteria for investment advice on the basis of the actual range of functions it offers. It is completely irrelevant whether the provider indicates by way of a disclaimer that the service they offer does not constitute investment advice.

First step: exploration

Investment advice is a personalised investment service which is typically based on an assessment of the personal circumstances of the customer. In order to generate results, robo-advice tools draw on information entered by the customer. The customer usually enters their information after being prompted. The information is entered in one or more steps, at the end of which the actual recommendation is made. To start off, for example, basic personal information such as the age, occupation and investment objective of the customer are requested, followed by basic information on the desired investment, i.e. the investment horizon, investment amount and monthly savings amounts and, to finish, personal details such as the customer's knowledge, experience and risk appetite.

Not every circumstance about which the service provider requests information, however, constitutes a personal circumstance for the purpose of investment advice. The investment amount and monthly savings figures, for example, are generally not considered to be personal circumstances. Nevertheless, in terms of BaFin's administrative practice the number of personal circumstances about which information is requested is irrelevant for the definition of investment advice. It is sufficient if information on just one personal circumstance is requested. Therefore, a tool which merely asks the customer to state their desired investment horizon and the amount they wish to invest before making a recommendation of an investment in a fund selected on the basis of the investment period is also to be considered an investment advice tool. The objective relevance of the circumstance about which information is requested is equally immaterial. Thus the criteria for investment advice can already be fulfilled by requesting information on the customer's age or by asking them to indicate their desired investment horizon or their risk appetite.

DefinitionPersonal circumstances

For the purpose of investment advice, personal circumstances are criteria which the customer has to be queried on in order to assess suitability. These include the customer's knowledge and experience, investment objectives, financial situation as well as risk appetite and – as a result of the amended European Markets in Financial Instruments Directive II (MiFID II) – in the future their ability to bear losses, too. In addition, all other individual factors are also considered which may be significant for the investment service, such as the customer's age or matrimonial property regime.

Even if the customer does not explicitly provide any information, they may still impart information on their personal circumstances to the provider. If they can choose for example between strategies, the names of which allow one to deduce their riskiness, they are already disclosing their risk appetite through their choice – e.g. if the customer has to decide at the beginning of the procedure for one of the three model portfolios "Defensive portfolio", "Balanced portfolio" or "Speculative portfolio". The sorting of a product list based on features such as "Recommended investment horizon" or "Suitable for: retirement provision/wealth-building/short-term profit" constitutes the implicit querying of personal circumstances.

Mere repetition of product names on the other hand does not constitute a querying of personal circumstances even if the names include components which may suggest such circumstances, for example "Fund XY Defensive" (risk appetite) or bond "Medium Term" (investment horizon).

Second step: recommendation

In order to meet the definition of investment advice, it is crucial whether the result generated by the robo-advisor has the character of a personal recommendation. If the provider offers the customer information in a neutral manner, this does not constitute a recommendation. This applies, for example, to the provision of a search function which selects an existing product offer on the basis of purely objective product features. This is the case, for instance, if a search engine limits an extensive choice of products based on predefined criteria such as return on investment, maturity, product/investment class or securities identification number (ISIN, WKN, etc.).

DefinitionObjective product features

Objective product features include such basic information as the type and characteristics of the financial instrument, its price, the associated costs, yield and other product features required by law or by contract such as termination rights and subordination. Similarly, key figures calculated without any scope for discretion such as price to earnings ratio, volatility and Sharpe ratio – absolute risk-adjusted growth – are to be considered purely objective. The same applies to all information which the provider must make available under the law, including, for example, the risk class in the Key Investor Information of a fund and, in future, key figures from the basic information required under MiFID II.

According to the corresponding Guidance Notice (only available in German), a recommendation can be deemed to exist if the investor is advised that a particular action is in his/her interests. The threshold between pure information and the provision of advice is passed if the provider adds distinct features to its offer or develops product features into criteria which are intended to help the customer make their choice. This is the case, for example, if the provider prepares a scale of risk categories which it has created on the basis of its own assessment. If, on the other hand, it uses the rating of a recognised agency, this is usually an adequately objective product feature.

The choice of products underlying the service offered can also establish the character of a recommendation. By pre-selecting the products, the provider can control the search result and considerably narrow down the scope of potential results. Here, the scale of this narrowing down is crucial. If the pre-selection is made on the basis of objective criteria and includes a suitably large number of financial instruments, it does not constitute a recommendation.

In addition, the recommendation made must be "personal". This criterion means that the recommendation must be based on an analysis of the personal circumstances of the customer or is represented as being suitable for them. This is the case, for example, if the information provided by the customer in relation to their risk appetite has a noticeable effect on the composition of the portfolio suggested.

Even if the customer information is in fact not taken into account, the recommendation made may still be deemed personal – in particular if the customer has the impression that their personal circumstances influenced the recommendation made. This impression can arise by the mere request of information on the customer's personal circumstances, even if the portfolio suggested in the end in fact always contains the same instruments or includes instruments selected at random irrespective of the information provided by the customer.

Third step: content of the recommendation

In order to meet the definition of investment advice, the recommendation must also relate to transactions in specific financial instruments. In addition to buying/subscribing for and selling/restitution, the exchange, redemption and underwriting of a financial instrument are all deemed transactions. Holding a position and the execution or non-execution of rights conferred by a financial instrument are also considered to be transactions.

An example: the provider gives the investor the option of an automated portfolio analysis. At the end of the analysis, the tool recommends reducing individual positions in order to avoid cluster risks; at the same time, a recommendation is made to buy alternative products. The remaining portfolio positions are labelled "unproblematic". In addition, the customer is reminded that they should exercise a conversion right by the specified date, because, in the opinion of the provider, the shares of the issuer will perform well in the future. Along with sell recommendations to avoid cluster risks, the provider therefore also makes explicit hold recommendations in relation to the remaining portfolio positions by labelling them as unproblematic. The suggested alternative products constitute buy recommendations. The reference to timely conversion is also a transaction recommendation.

In terms of meeting the definition of investment advice, it is irrelevant whether the recommended transactions can be directly executed within the tool or directly after the recommendation is made – or indeed whether one can purchase financial instruments at all from the provider. Investment advice is therefore also deemed to be provided if the robo-advisor suggests a portfolio structure with specific financial instruments which the customer can only purchase from a third-party provider or implement in the context of an asset management agreement.

The definition of investment advice requires that a recommendation is not just generic but instead relates to specific financial instruments. The recommendation of particular funds or individual shares – for instance by way of an ISIN – is always specific for the purpose of investment advice. Naming general product categories such as "shares" or "funds", as part of an abstract suggestion on portfolio structure for example, is not specific enough. When making its assessment, BaFin considers both the number of available products as well as the granularity in terms of the narrowing-down process.

This too can be illustrated by way of an example. The tool recommends the following portfolio structure: 30 per cent shares, 50 per cent bonds, 20 per cent funds. The proportion of the portfolio to be made up of shares is merely narrowed down by industry (technology, pharmaceuticals and car manufacturing). For the proportion to be made up of bonds, the customer can choose from a wide range of directly purchasable corporate bonds while for the funds element of the portfolio only ten diversified mixed funds are available. In this example, the recommendation of "technology shares" or "bonds" is not specific enough whereas the mention of "technology shares in the MDAX" on the other hand only includes around 20 securities and therefore would constitute a specific recommendation. The recommendation of "funds", while being vague in and of itself, is made more specific by the fact that only ten products are available to be chosen – i.e. ten specific financial instruments are recommended.

NoteLinks on the topic

Exception: public recommendation

There is one important exception in this context: if the recommendation is provided solely through information distribution channels, in particular through the media, or is announced to the general public in some other way, this does not constitute investment advice. This exception applies especially in the case of advertising measures if, for example, a specific financial instrument is advertised in a newspaper as being suitable for risk-sensitive, long-term oriented investors.

In the case of robo-advice, however, the service provided is usually one which is only addressed to individuals – even if it is typically performed over the internet. Even from a technical point of view, the individual user of the robo-advisor is personalised to facilitate the storage and processing of their details during the process. The recommendation which results from the advisory process is thereby also only made available to the individual customer.

Author

Pawel Grischuk
BaFin Division for Supervision of Compliance with Rules of Conduct, Investor Protection Private & Foreign Banks

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