The regulator’s paper has been created as the first step in the crowdfunding post-implementation review process. The paper, including questions to be answered by the industry, can be downloaded here.
FCA Crowdfunding Review
The FCA has called for input from key players in UK Crowdfunding, two years on from regulation of the industry in 2014, in a co-operative effort to review the rulebook. This includes peer-to-consumer and peer-to-business lending (loan-based crowdfunding), as well as equity crowdfunding (investment-based crowdfunding). Focusing on peer-to-peer lending (P2P), a market which has an accumulative value of over £6bn in 10 years and £2.7bn in 2015 in secured and unsecured loans, this review is a welcome step for the industry; an industry which cites transparency as a pivotal factor in its success.
The FCA determines that:
The sector has evolved considerably in the last two years, and now offers a number of different propositions from those in the market two years ago. We have potential concerns about some areas of the market and would like to explore them further in this year’s review. This paper therefore also sets out our initial thinking on areas where it might be appropriate to adjust the rules.
In financial terms, arbitrage consists of ‘the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices.’ In this instance, the FCA’s concerns stem from the P2P market adopting regulations and potentially using them to exploit other areas of the investment market; a blurring of the lines, effectively.
There are potentially blurred lines between loan-based crowdfunding and other business models, such as asset management.
Market Developments Raise Concerns
The FCA goes on to list a number of areas within loan-based crowdfunding that must be addressed. Here are a couple of critical assumptions to be reviewed:
1. ‘Broader pool of credit risk’
Typically, dozens of investors will make micro loans to compile a borrower’s macro loan in peer-to-peer lending. This means the exposure to risk is shared between investors. Diversification is a primary risk mitigating procedure employed by P2P platforms. But, the “pool of credit risk” calls into question a platform’s vetting and underwriting capabilities. If subprime loans are being written to compensate for a lack of borrower appetite, or simply the platform’s screening and approval processes are not very strict or robust, then the credit risk could be broadened and result in a large number of borrowers defaulting on their loan commitments.
When the arrangement is between the lender (investor) and the borrower, with no FSCS coverage, this risk is amplified. P2P platforms have recourse to recover defaulted loans, in the form of asset liquidation, but also safeguards like provision funds which take a portion of borrower repayments and store them to be used in the event of a default (at directors’ discretion) further protect investors. However, the FCA review suggests the provision fund exposes all investors to the same level of risk irrespective of whether they are invested in the defaulted loan. The implication is that if the provision fund depletes to cover borrower defaults, ‘each investor on the platform has some indirect exposure to the risk of other loans on the platform in which they may not themselves be invested.’
2. ‘mis-match of products/investment products look like 30-day notice savings accounts’
Liquidity is an important factor in peer-to-peer lending, one which is placed at the forefront of all major P2P platforms. There is not an established secondary market to trade products and transform P2P loans into a cash asset. Peer-to-peer platforms make it clear that if an investor wants access to their invested capital they will have to ‘sell-out’ to a new investor on the platform. With large, mainstream platforms like RateSetter this can be a quick, 10-minute process. For smaller platforms with greater illiquidity this can be problematic.
The regulator is concerned with the risk being handed from the exiting investor to the new investor, which could suggest loan-based crowdfunding platforms are practicing ‘regulatory arbitrage with banking business, without being subject to the same consumer protection requirements’ such as minimum liquidity reserves.
3. ‘Changes in investor base’
Nesta identified 30% of peer-to-peer loans in 2015 as being institutionally funded. This comes as no surprise when major P2P platforms such as Zopa, RateSetter and Funding Circle are partnering with banks and securitising P2P loans. The regulator will monitor the performance of these securities whilst also assessing the relationship between P2P platforms, institutions and retail investors. Are institutions given favourable treatment? Do they get to review loans before less experienced, less sophisticated retail investors do (for example)?
In saying that, institutional funding improves liquidity on platforms and invites the broader wealth management sphere to access this market.
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Peer-to-Peer Industry Players’ Input Required
The FCA requires feedback on the following major points:
- Perception of risks and knowledge gaps from industry experts.
- Consequence of Brexit? EU and UK regulatory framework – how will UK regulations be affected.
This will inform and design the research conducted by the regulator as it seeks to address concerns that have surfaced in the last two years.
Representatives of peer-to-peer lending have been quick to support this invitation to contribute to the review process.
Peer-to-Peer Finance Association Chair, Christine Farnish, CBE, commented on the review:
Peer-to-peer lending platforms have a proud record of embracing regulation. The Association’s platforms are committed to the highest standards of business practice – including ensuring that consumers and businesses considering investing or borrowing are fully aware of the risks and rewards of peer-to-peer lending – which are embodied in our Operating Principles.