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Alternative Lending: A regulatory approach to Peer-to-Peer lending

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Alternative Lending

THE PEER-TO-PEER INDUSTRY GREW 177%

BETWEEN 2012-2013

The industry

DOUBLES in size

every year

More than

5,000 SMEs HAVE RAISED FUNDS THROUGH ALTERNATIVE FINANCE INTERMEDIARIES BETWEEN

2011-2013

P2P lending platforms

are the

LARGESTFORMS OF MODERN FINANCE IN THE UK

A regulatory approach to Peer-to-Peer Lending

THE UK’S LARGESTPeer-to-Peer operators match£80 million in loans per month

91%of the SME lending market

is dominated by the

big 5 banks

SME funding gap over the next five years:

£191BILLION

£84BILLION

The US, the UK and China

MAKE UP

96%of the overall financial return

Crowdfunding market:

OTHERS

4%UK

17%CHINA

28%US

51%

£80million

ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEER–TO–PEER LENDING 3

Introduction

Before taking over the regulation of the consumer credit market from the Office of Fair Trading on the 1 April 2014, the Financial Conduct Authority published a policy statement on its regulatory approach to firms operating online Crowdfunding platforms. As part of the government’s plan to promote alternative forms of finance, the FCA has adopted a balanced solution that seeks to protect both investors and an industry that is seen to be key to the growth of small and medium sized enterprises.

Nicholas HardingLending Works

1 April 2014: FCA takes over regulation of Consumer Credit from the OFT

April 2014: FCA to publish paper on key risks in the market in order to establish intervention priorities

1 October 2014: FCA will start considering applications for full authorisation from firms with interim permission

1 April 2016: Full FCA consumer credit regime will come into effect replacing the interim permission regime

2019: Department for Business, Innovation and Skills and HM Treasury to carry out post-implementation review reform

2019: FCA to complete a review of retained CCA conduct requirements and develop rule-based alternatives

“We strongly believe that the FCA regulation

is fantastic for the industry as a whole, not only will it

encourage best practice, more importantly, it will promote trust and consumer security

amongst investors and borrowers.”

4 ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEER–TO–PEER LENDING

The importance of alternative lending channels

Traditionally, UK businesses have heavily relied upon banks to meet their funding needs. It is estimated that 91% of small and medium sized enterprises (SME) seek funding from the UK’s largest five banks. Historically, the lack of alternative funding options has proven a hindrance to such businesses.

Nevertheless, since the financial crisis, and despite political efforts, SMEs struggle to access the finance they need. The Breedon Report, which examined the financing of UK SMEs, concluded that in the next five years there will be a finance gap of between £84 billion and £191 billion1. Although the report did not identify a single solution to this problem, it established that raising awareness about alternative finance methods would be key.

The term alternative finance commonly comprises any form of finance provided by non-banking entities. It is thought that these innovative funding methods will have a crucial role in the creation and survival of SMEs. The government acknowledges the importance of the funding gap and has adopted various measures to promote lending. Currently, it is consulting on whether to take legislative action to help match SMEs that have been rejected for loans with challenger banks and alternative finance providers who are looking to offer credit.

Amongst the alternative lending possibilities, the Crowdfunding sector has drawn particular attention due to its exponential growth and its crucial role providing SMEs with access to finance. Crowdfunding platforms provide a medium by which businesses and individuals are able to seek flexible financing options from an array of sources, predominantly via online platforms. There are numerous forms of Crowdfunding:

some are charitable donations that provide intangible benefits; others, such as equity Crowdfunding and Peer-to-Peer lending, do offer financial returns.

The importance of these funding methods was acknowledged by the Parliamentary Commission on Banking Standards which stated that: “Peer-to-Peer and Crowdfunding platforms have the potential to improve the UK retail banking market as both a source of competition to mainstream banks as well as an alternative to them (…) The emergence of such firms could increase competition and choice for lenders, borrowers, consumers and investors2.”

Lending platforms were originally regulated by the Office of Fair Trading (OFT); however, since 1 April 2014 they are regulated by the FCA. The Regulator shares the government’s desire to make these alternative forms of finance more secure and accessible. Christopher Woolard, the FCA’s Director of Policy, Risk and Research recently stated: “Consumers need to be clear on what they are getting into and what the risks of Crowdfunding are. Our rules provide this clarity and extra protection for consumers, balanced by a desire to ensure firms and individuals continue to have access to this innovative source of funding 3.”

1 Breedon Report: “Boosting Finance Options for Businesses”2 Parliamentary Commission on Banking Standards: “Changing Banking for Good” (57)3 The FCA outlines how it will regulate crowdfunding: http://www.fca.org.uk/news/the-financial-conduct-authority-outlines-how-it-will-regulate-crowdfunding


FCA’s regulatory approach to Crowdfunding

The FCA’s policy statement, published in March 2014, does not propose fundamental changes from its original Consultation Paper (CP 13/13). Firms holding an OFT licence should have applied for interim permission before 1 April 2014.

Those organisations that did not complete the application by the 1 April, will need to apply for full authorisation and will be unable to conduct Crowdfunding activities until they are authorised. The Regulator has decided to maintain the polemic distinction between investment-based Crowdfunding and loan-based Crowdfunding (or Peer-to-Peer lending).

Investment-based Crowdfunding consists of investing in businesses by buying ‘unlisted securities that are hard to value independently or sell on a secondary market’. The FCA considers that, given the high risks that investors face by investing in ‘non-readily realisable securities’, they should only be promoted to individuals that understand their inherent dangers or to those than can cope with the potential financial losses, that is: professional clients, retail clients who are advised, retail clients classified as corporate finance or venture capital contacts and sophisticated or high net worth investors. Those retail clients that are not provided with investment advice will need to pass an ‘appropriateness test’ and certify that they will not invest more than 10% of their ‘net investible assets’ in these products.

Investment-based Crowdfunding firms were given a transition period to comply with the new rules. While many are choosing to implement the changes to ensure compliance immediately, they will become mandatory from 1 October 2014. Nevertheless, by imposing investment restrictions, the Regulator has been accused by entrepreneurs of taking the ‘crowd’ out of Crowdfunding. Conversely, Peer-to-Peer lending, which consists of financing businesses and loans with contributions from a large number of sources, has been subject to lighter regulation.

Vince CableSecretary of State for

Business, Innovation and Skills

“Small and medium-sized businesses need access to a

diverse range of finance options, including non-bank lending. These new forms of finance are still small in scale today but they should, over

time, bring additional choice and greater competition to the

lending market.”


New rules and capital requirements

The FCA’s approach to Peer-to-Peer lending platforms is much lighter as they are considered to be lower risk. The Regulator’s rules can be summarised as follows:

The FCA has decided to recalibrate its volume-based financial resources requirements to reflect economies of scale in extremely large organisations. The Regulator has proposed a transition period: Until 31 March 2017, the fixed minimum prudential requirement will be £20,000. From that date, the minimum requirement will increase to £50,000. Transitional arrangements will not apply to OFT-regulated organisations until they become fully authorised.

Platform operators will have to create programmes that ensure loans can be managed to maturity in case of platform failure. The Regulator has decided not to impose stringent requirements for the arrangements that firms must have in place. Nevertheless, firms are expected to have appropriate systems and controls depending on their customer needs and their business model particularities.

Lenders holding client money will need to apply the existing client money rules contained in the Client Assets Sourcebook (CASS). The application of the regime will entail additional reporting requirements for CASS medium and CASS large firms. However, Peer-to-Peer lenders will not be subject to these measures until October 2014.

The Regulated Activities Order and the Financial Promotion Order have been amended; therefore, lending websites and details of loans will be considered as financial promotions. The rules require firms to ensure investors have enough information to make informed investment decisions and that all communications are fair, clear and not misleading. The Regulator didn’t mandate specific disclosures placing the onus on firms. These rules, considered to be essential for consumer protection, have been applicable since 1 April 2014.

Loan-based Crowdfunding platforms will be subject to the FCA’s dispute resolution rules. Moreover, in order to assist with market monitoring, organisations will need to submit regular reports on their financial position, the client money held, complaints and the loans arranged each quarter.

Prudential requirements:

Protections in case of firm failure:

Client money rules:

Dispute resolution and reporting requirements:

Disclosure rules:


It is important to note that investments via Peer-to-Peer lenders will not be covered by the Financial Services Compensation Scheme (FSCS). The Regulator expects firms to disclose the lack of coverage and its consequences to potential investors. The FCA considers that the prudential requirements and the arrangements in case of firm failure should be sufficient to protect investors. Nonetheless, the possibility of including these alternative lenders within the FSCS remit will be reconsidered in 2016.

Lending platforms suffer from all the risks associated with credit provision, including money laundering and terrorist financing. The Joint Money Laundering Steering Group has published draft guidance for these type of firms relating to their compliance with anti-money laundering regulations.

Volume-based capital requirements(Applicable from 2017)

0 to £50 million 0.20%

> £50 million to £250 million 0.15%

> £250 million to £500 million 0.10%

> £500 million 0.05%

Nicholas HardingLending Works

“Appropriate

prudential requirements are critical for our industry.

We believe that higher capital requirements than those initially

proposed by the FCA could be beneficial; they would help prevent the failure of

businesses and increase our credibility”.


International approach to Crowdfunding

The Peer-to-Peer lending market remains a relative newcomer in terms of global credit provision. While growth is encouraging, particularly in the UK, USA and China, the proportionate share of credit markets remains small.

Market share Crowdfunding market 2013However, due to its growth potential, policy-makers are demonstrating an increasing appetite to regulate the sector, both to mitigate risk and encourage customers to make use of the alternative funding options the industry provides. Striking the perfect regulatory balance is not easy, and while policy approaches vary from country to country, a certain degree of harmonisation is likely to be necessary due to the prospective cross-border nature of the Crowdfunding industry.

In the US, the largest Peer-to-Peer lending market, platforms must follow an arduous regulatory process. Each lender needs to be regulated by the Securities and Exchange Commission (SEC) at a Federal level, and register the loans they originate. These businesses receive the same treatment as a public company, therefore they have to comply with high disclosure requirements: their finances, loan origination and practices are public. Peer-to-Peer and Crowdfunding activities are not permitted in certain states, hence state approval is necessary too. Those platforms that want to operate in more than one state can either become a public business or apply to each state separately.

China

US

UK

OthersSource: Iosco

28%

51%

17%

4%

As in the UK, equity Crowdfunding has certain limitations. Sophisticated investors can only deposit 5% of their annual income. This limit goes up to 10% when the annual income is over $100,000. The SEC is considering extending these rules to retail investors.


Conversely, China, another Peer-to-Peer giant, has not regulated the Crowdfunding industry. The lack of regulatory guidance and tighter monetary conditions resulted in the failure of nearly seventy Peer-to-Peer lending websites at the end of 2013. Although they only represent a small fraction of the circa 1000 Peer-to-Peer platforms currently operating in China, the collapse sparked concern in Europe and the US. As a result, the Chinese Central Bank assured that it will provide closer supervision and stressed that illegal lending practices, such as investing clients’ funds in financial products, can result in death penalties.

The European Commission (EC) recently issued a report discussing the long term possibilities of the Crowdfunding industry to complement traditional sources of finance. The Commission considers that Crowdfunding can ‘contribute to building a pluralistic and resilient social market economy’ and sustains that burdensome and premature regulatory action could hinder the industry’s development. The EC will conduct a detailed study in 2014 in order to better understand national European regulation and explore the possibility of launching a harmonised solution.

Regulatory regime

Description Countries

UK model Platforms need approval from the FCA to operate

United Kingdom

Exempt market/ unregulated through lack of definition

P2P is either an exempt market or there is a lack of definition in legislation

Brazil, China, Ecuador, Egypt, South Korea, Tunisia

Intermediary regulation

Regulates P2P lending platforms as an intermediary, which requires registration and other regulatory requirements

Australia, Argentina, Canada and New Zealand

Banking regulation Regulates P2P platforms as banks

France, Germany, Italy

US model Requires registration of the platform with the SEC and state authorisation

United States

Prohibited Both P2P lending and equity Crowdfunding are banned

Japan, Israel

International regulatory regimes

Source: Iosco


Conclusion

Initial reactions to the FCA’s rules have been broadly positive, many precepts are a close reflection of the Peer-to-Peer Finance Association code of conduct. Nicholas Harding, founder at Lending Works, confirmed: “We strongly believe that the FCA regulation is fantastic for the industry as a whole, not only will it encourage best practice, more importantly, it will promote trust amongst investors and borrowers.”

The Regulator acknowledges that higher consumer protection comes at a price. So far, it has published two cost-benefit analyses which indicate that the rules will result in certain companies leaving the Peer-to-Peer industry and that compliance costs will be permanently higher for those that survive. Increasing costs and new industry entries may result in market consolidation.

While the estimated £840 million that will be lent by alternative finance providers in 2014 only represents 2% of annual UK business lending, this amount has grown at a rate of more than 90% year-on-year. Peer-to-Peer lenders are often described as ‘game-changers’; not only because of the seductive rates they offer, but because both borrowers and investors are captivated by their speed and simplicity.

More importantly, the industry benefits from Government support. In March, it was revealed that Peer-to-Peer lending was to be included within the tax-free ISA allowance. According to one of the biggest market participants, the announcement represents a crucial moment for the industry. Lending platforms believe that it is a great

opportunity to lobby for increased sharing of credit information with banks, although this would require a considerable softening of attitudes from traditional lenders and increased collaboration with alternative finance providers.

The lack of competitiveness in the lending market causes concern among policy-makers globally. Many countries see the benefits of supporting alternative forms of finance. Nevertheless, the inherent risks that Peer-to-Peer lending entails cannot be disregarded. Although default rates in the industry are currently low, the data can be misleading: most of these platforms were established in the last three years; therefore the majority of their loans have not reached maturity yet. Market participants expect regulation to prevent the failure of alternative lending institutions, which would have a disastrous reputational effect; Nicholas Harding, added: “Appropriate prudential requirements are critical for our industry. We believe that higher capital requirements than those initially proposed by the FCA could be beneficial, they would help prevent the failure of businesses and increase our credibility.”


Vince Cable Secretary of State for Business, Innovation and Skills

Despite most lending platforms having robust credit checking systems in place, some would like the Regulator to be more prescriptive about the quality of the technology and the competencies of the individuals running these businesses. The long term effects of the regulatory approach adopted by the FCA is yet to be seen, for now the future of the Peer-to-Peer lending world is full of possibilities which include the development of innovative payment methods and the smart use of big data. The rate of growth, both in value and maturity, of the alternative lending industry is unprecedented. The manner in which these businesses have adapted to initial regulation paints a positive picture for the future prosperity of a sector with a major role to play in the Financial Services industry of the future.

“We need to see

more small, innovative, alternative banks and non-banks. There are many new

financing models which have been created, such as Peer-to-Peer lending,

which have taken off like wildfire. I am now beginning to encounter

companies around the country which would have gone under

were it not for Peer-to-Peer lending.”

“Peer-to-Peer lenders are often described as

‘game-changers’; not only because of the seductive rates they offer, but because both borrowers and investors are

captivated by their speed and simplicity.”

© 2015 Grant Thornton UK LLP. All rights reserved.

‘Grant Thornton’ refers to the brand under which the Grant Thornton member firms provide assurance, tax and advisory services to their clients and/or refers to one or more member firms, as the context requires.

Grant Thornton UK LLP is a member firm of Grant Thornton International Ltd (GTIL). GTIL and the member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services are delivered by the member firms. GTIL does not provide services to clients. GTIL and its member firms are not agents of, and do not obligate, one another and are not liable for one another’s acts or omissions.

This publication has been prepared only as a guide. No responsibility can be accepted by us for loss occasioned to any person acting or refraining from acting as a result of any material in this publication.

grant-thornton.co.uk

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Grant Thornton UK LLP @GrantThornton

Tarun MistryPartner, Financial Services Corporate FinanceT (0)20 7728 2404E [email protected]

Gareth MillerAssociate Director, RegulatoryT (0)20 7865 2863E [email protected]

Jake Wombwell-PoveyFinancial Services Corporate FinanceT (0)20 7865 2569E [email protected]

Peter LandersHead of Consumer FinanceT (0)20 7865 2792E [email protected]

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