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US Senate report warns of AI risks in hedge fund trading

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US federal financial regulators are lagging in their oversight of hedge funds’ use of AI for trading decisions, posing a serious threat to market stability, according to a report by FedScoop. 

A new 45-page report from the US Senate Committee on Homeland Security and Governmental Affairs, led by Michigan Democrat and US senator Gary Peters, highlights that recent regulatory actions and the current federal legal framework inadequately address the evolving use of AI in the financial services sector, including by hedge funds. 

The authors, who interviewed representatives from the SEC, CFTC, Federal Reserve, Financial Industry Regulatory Authority and Financial Stability Oversight Council, wrote: “The report also finds that the risks of future impacts resulting from AI use in investment decisions go beyond potential harm to individual investors and could have an impact on wider financial stability.” 

 The report underscores the rapid adoption of AI in the financial services sector, particularly among hedge funds, which manage over $5tn in assets in the US. While data analytics has long been used to inform trading decisions, the report notes that AI and machine learning amplify traditional industry risks, potentially triggering “uniform movements by significant numbers of investors”, and that existing safeguards may not adequately protect against such “herding” behavior. 

Federal regulators’ efforts to mitigate AI-related risks are still “in their infancy”, the report states, and are not sufficiently coordinating their efforts. SEC chairman Gary Gensler has warned that a financial crisis triggered by AI is “nearly unavoidable” within the next decade, while both the SEC and Commodity Futures Trading Commission have started examining AI’s uses and risks in investment vehicles, but clear regulatory guidance is still lacking. 

“Despite these recent steps, regulators have yet to fully clarify how existing regulations apply to hedge funds’ use of AI in trading, and there are no established baseline standards specifically on the use of AI for trading purposes,” the report said.  

The report urges the SEC and CFTC to advance measures to address these risks, such as creating standards and guidelines for how hedge funds define trading systems that use AI; establishing operational baselines for hedge funds’ AI use; and developing a risk assessment framework. 

The report, which involved interviews with hedge funds Citadel, Renaissance Technologies, Bridgewater Associates, AI Capital Management, Numerai and WorldQuant, also revealed a lack of consensus regarding when to intervene with the technology, risk classification, definitions of various terms and the hedge funds’ overall AI strategies. 

In an email to FedScoop, Bryan Corbett, president and CEO of MFA, criticised the report as “overtly-political” and argued that alternative asset managers use technology to generate returns for a diverse set of investors including pensions and endowments, and that current market practices are well-established and beneficial. 

He added: “This partisan report fails to recognise long-accepted current market practices which serve investors and enhance market efficiency.” 

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