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The UK Financial Conduct Authority Looks to Update Rules for Loan Based Crowdfunding which is “Increasingly Complex,” Opens New Consultation

Investment Crowdfunding Rules Deemed Satisfactory.

The UK Financial Conduct Authority (FCA) has finally released its long awaited post-implementation review of crowdfunding regulation. As has been widely rumored for quite some time, the FCA is looking to adjust rules governing loan based crowdfunding, also labeled peer to peer lending, while leaving the equity side, a more simple business model, largely unchanged. The FCA states they are “largely content with the regulatory framework in place for investment based crowdfunding platforms.”

The FCA announced a new consultation regarding proposed changes stating the agency has observed an evolving sector of online lending with some loan based crowdfunding models becoming increasingly complex.

Additionally, the agency said they had witnessed some “poor business practices” in the P2P sector. While some P2P lenders have more robust controls in place others are deemed inadequate and in need of “significant improvements.”

Gillian Roche-Saunders, a partner at the law firm of Bates, Wells & Braithwaite in London and a leading regulatory consultant in the Fintech sector, had this to say about the FCA review;

“Today’s announcement shows a real u-turn from that very initial assumption in 2013 that P2P lending was the simpler of the regulated crowdfunding models. The FCA has truly looked under the bonnet of the industry and identified three sub-strata of lending platforms along with ancillary services that create very different experiences and risks for consumers. This will be the foundation of a much more sophisticated and targeted supervisory approach from the regulator.“

Christopher Woolard, who overseas the competition mandate at the FCA, issued a statement alongside the review;

“When we introduced new rules for crowdfunding, we said we’d review the market as it developed. We believe that loan-based crowdfunding can play a valuable role in providing finance to small businesses and individuals but it’s essential that regulation stays up to date as markets develop. The changes we’re proposing are about ensuring sustainable development of the market and appropriate consumer protections.”

As a regulator, the FCA is regarded as a sector leader when it comes to facilitating Fintech innovation. It’s light touch, principles based regulatory approach, has been a vital variable in the growth of online capital formation. The UK crowdfunding sector is, in many ways, the most robust in the world.

The FCA most recently completed a review of crowdfunding rules in 2016. At that time the agency stated;

“Our focus is ensuring that investor protections are appropriate for the risks in the crowdfunding sector while continuing to promote effective competition in the interests of consumers. Based on our findings to date, we believe it is necessary to strengthen investor protection in a number of areas. We plan to consult next year on new rules to address the issues we have identified.”

The delayed review by the FCA has been expected for quite some time with the expectation that peer to peer lending would receive targeted scrutiny.

As defined by the UK, crowdfunding takes two forms:

  • Loan-based crowdfunding – usually called peer-to-peer (P2P) lending. People and institutions use these types of platforms to lend money directly to consumers or businesses, to make a financial return from interest payments and the repayment of capital over time.
  • Investment-based crowdfunding – these are platforms where investors can invest directly in businesses by buying investments such as shares or debentures.

Breaking this down further, the FCA identifies three main categories:

  • Conduit Platforms – The investor picks the investment opportunities and the platform administors the loan or investment arrangement.
  • Pricing Platforms – The platform sets the price but the investor picks the underlying loan or investment
  • Discretionary Platforms – The platform sets the price and chooses the investor’s portfolio of loans to generate a target rate – this is only seen in the P2P sector.

The review document recognizes the differences between loan based and “investment-based” crowdfunding stating these differences have influenced their “calibration” of the regulatory framework. The FCA also acknowledges the importance of online capital formation but this benefit must be balanced with the intrinsic risk:

“Crowdfunding can be an important alternative source of finance for companies and consumers. The sector also provides an alternative investment opportunity for investors. However, investment through crowdfunding is not without risk, because of the exposure to the underlying asset that is created, and in some cases because of the complexity of the investments offered. Where such risks are not adequately managed or understood, harm to consumers and to market integrity can arise.”

Siting specific examples of concern, the FCA pointed to the following areas of loan based crowdfunding;

An extreme example sited by the FCA is of a lender (investor) being exposed to opaque offerings, including a case where an investor was receiving less than 3% return on a loan generating 30% interest thus the platform was keeping 27% return. The FCA also states that some P2P loans are incorrectly priced where the interest rate paid is not being matched to the risk of the loan.

These concerns have heightened the FCA’s sensitivity to their investor protection mandate.

Proactive v. Reactive

The FCA says that losses and defaults within the P2P sector have been muted but caution that this sector of Fintech has “not been through a full economic cycle.”

“When economic conditions tighten, losses on loans and investments may increase. The sector has not yet been through such a tightening and so the resilience of the P2P business models observed remain relatively untested.”

The increasing complexity of the online lending sector requires additional risk management mandates, according to the FCA. The choice is to demand more stringent controls or for platforms to simplify their business model.

The UK Peer to Peer Finance Association (P2PFA), the representative organization for most of the leading P2P lenders, issued a statement in response to the review.

Paul Smee, current P2PFA Chair, said his Association has has always maintained that all investors lending through a peer-to-peer lending platform need to be clear about the performance of the platforms on which they invest.

“That is why P2PFA members have set out and signed up to Operating Principles which give a gold standard for disclosure. We are pleased that the FCA’s proposals endorse the idea of full disclosure,” stated Smee. “There is a lot of detail in this document, and we will be working through its implications, to ensure that the eventual regime is practical, proportionate and allows for the development of a healthy and competitive market in peer-to-peer lending. Peer-to-peer lending needs to make its full contribution to the growth of the UK economy and we will be working to ensure that new regulatory requirements do not get in the way.”

While the P2PFA has set a high standard of operation for its members, not all UK platforms have agreed to these principles and joined the group. Additionally, the P2PFA welcomed the need for transparency and disclosure along with wind down plans for platforms.

The investment crowdfunding sector, frequently called equity-based, came away with a fairly positive review. Luke Lang, co-founder of Crowdcube issued the following statement;

“After comprehensive consultation with the industry, the FCA has made the right call in finding that the existing regulatory framework for investment-based crowdfunding platforms is fit for purpose.”

The UK investment crowdfunding segment has endured little fraud since the sector became a regulated sector of finance.

The proposed changes by the FCA seek to adapt the ways in which the loan-based crowdfunding model has morphed during the past few years. The proposals include:

Julia Groves, Partner and Head of Crowdfunding at Downing LLP – and former Chair of the UKCFA, welcomed the FCA’s decision to carry out a further consultation as helpful to sector growth. She said this was indicative of the agencies commitment to instilling greater transparency and accessibility – something Downing Crowd has been calling for.

“It’s unsurprising to us that the FCA review is clearly focused more on the loan-based area of the market (P2P lending), given the lower levels of disclosure and the lack of transparency offered by some P2P platforms … But to survive in the mainstream, the industry needs to help both investors and their advisers understand where the different types of crowdfunding sit on the risk scale compared to other traditional investments,” shared Groves.

The FCA is requesting feedback to the consultation by 27 October 2018 before publishing rules in a Policy Statement later this year. The review is a must read for regulators and industry participants around the world.

See below.


 

The FCA review:  Loan-based (peer to peer) and investment based crowdfunding platforms: Feedback on our post implementation review and proposed changes to the regulatory framework.

 

Questions in the FCA paper

a)  gather sufficient information about the borrower to be able to competently assess the borrower’s credit risk,
b)  categorise borrowers by their credit risk in a systematic and structured way, and
c)  price the loan so it adequately and fairly reflects the credit risk determined in a)? If not, please explain why.

 

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