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, 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.

Regulatory arbitrage

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 peer-to-peer lending 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 a single borrower’s macro loan in peer-to-peer lending. This means the exposure to risk is shared between investors. To mitigate the risk of borrower default, platforms will often maintain a ‘Provision Fund’ which takes a percentage of borrower returns and stores them in a safeguard. The FCA states investors pay into this fund when investing capital, ‘Since all investors on the platform pay into the provision fund’. This seems inconsistent with the manner in which (major) UK platforms operate.

The implication from the FCA 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.’ Assuming the provision fund capital is taken as a percentage of the borrower APR, and not from the investor interest rate, then the investor’s interest will not be affected.

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 fore of all major P2P platforms in the U.K. There is not 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 capital and/or interest 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 this can be problematic.

The regulator is concerned with the risk being handed from exiting investor to 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 securitizing P2P loans. The regulator’s will monitor the performance of these securities whilst also assessing the relationship between P2P platforms and 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)? Understandable concerns, of course.

In saying that, institutional funding improves liquidity on platforms and invites the broader wealth management sphere to access this market, something the FCA stimulated by granting permissions to IFAs April 6th to recommend P2P products to their clientele.

Peer-to-peer lending players’ input required

The FCA require feedback and insight into the following:

• 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.

Download the FCA’s invitation document for more information on what they intend to review, and the questions laid out which industry players can provide responses to by September 8th 2016. All in all, the industry is highly cooperative when it comes to regulation. A robust regulatory framework is what sets UK alternative finance apart from many of its counterparts. Forging a strong, working relationship with the FCA and instilling confidence in investors are two primary factors peer-to-peer lending will endeavour to continue improving upon.