Regulatory Bulletin: FCA – Call for input to the post-implementation review of the FCA’s crowdfunding rules

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  1. Introduction

The document published by the FCA is about some of the recent developments across the crowdfunding sector and a number of potential concerns highlighted by the FCA.

New rules by the FCA for the regulation of crowdfunding platforms came into force in 2014 and the regulatory framework is to be reviewed and changed accordingly in 2016.

The FCA plans to visit all firms who operate peer-to-peer lending platforms to collect evidence on potential risks and address any knowledge gaps. The information and results obtained from these visits, and any responses received by the FCA, will then be used to adjust the regulatory framework on crowdfunding platforms.

 

  1. Context

Crowdfunding is a way in which people, organisations and businesses (including start-ups) can raise money through online portals to finance or re-finance their activities.

Crowdfunding platforms are the portals that act as brokers between parties looking to invest and parties looking to raise money.

FCA gained responsibility of regulating the consumer credit market in 2014, which covered crowdfunding platforms and peer-to-peer lending platforms. When crowdfunding involves a financial promotion or arranging investment deals, regulation has always been applicable.

Investors in crowdfunding platforms are exposed to risks such as capital risk, liquidity risk and default risk but are not eligible to claim against the Financial Services Compensation Scheme (FSCS). The FSCS provides compensation to customers if a financial services firm ceases to operate – part of investor protection.

 

  1. Market size and growth
  • In 2015, an estimated £2.7bn was invested on regulated crowdfunding platforms, compared to an estimated £500m in 2013.

crowdfunding Fig1

  • Nine firms are fully authorised to offer loan-based crowdfunding platforms and 88 firms seeking full authorisation.
  • Equity-based crowdfunding has grown in 2015, Figure 2, but still small in comparison to the £16.7bn sales of investment funds in same year.crowdfunding Fig2
  • Growth in debt securities on crowdfunding platforms has increased, with the figure rising to £6.2m in 2015.
  • In regard to Figure 1, 41% of capital was used to finance real estate lending in 2015. Similarly, in regard to Figure 2, 26% of investments were made in real estate companies in 2015.

 

  1. Current regulatory approach

If the lender is an investor in the course of business, such as an institutional investor, then the regulated credit agreement is subject to requirement of the Consumer Credit Act 1974. The lender must also be an FCA authorised individual, in regard to consumer credit, to lend through peer-to-peer platforms. The lender and the credit agreement must also comply with the rules of the FCA’s Consumer Credit sourcebook (CONC).

If the lender is not in the course of business, then the credit agreement is still a regulated credit agreement but the lender does not need to be FCA authorised.

If the borrower in the lending agreement is an individual, as defined in the Consumer Credit Act 1974, the credit agreement must be a regulated credit agreement.

To bridge the gap and protect borrowers, the FCA introduced new rules in the Consumer Credit Sourcebook for peer-to-peer platforms.

Any promotions of loan and equity peer-to-peer investments must be fair, clear and not misleading.

Consumers interested in lending must have access to clear information and the basic consumer protection rights, which include client money must be protected and firms meet minimum capital standards, including resolution plans.

 

  1. Recent market developments

Investor offerings

An emerging feature of platforms is the pooling of credit risk. This, in some cases, means platforms are also operating investment schemes. This makes the business model of platforms crossover to those of asset management, which the regulatory regime does not account for and might need to be changed in the near future.

Maturity mis-match products

A borrower may want to borrow capital for a loan period of five years but investors have the option to withdraw their money after a 30-day notice period. Therefore, this creates an expectation gap and the risk of investors withdrawing money means liquidity reserves need to be increased. Some peer-to-peer platforms know expectation gaps exist but are not fully prepared for the risk and so, the FCA needs to understand each situation where this arises.

Investor base changing

Institutional investors are increasing as they made up 26% of business loans and 32% of consumer loans in 2015. The FCA want to investigate if institutional investors and retail investors are being treated the same, if retail investors are taking on more of the risk and also, if any conflicts of interest are managed properly by peer-to-peer platforms.

Also, people can invest in peer-to-peer platforms with Innovative Finance ISA wrappers and with pension money, potentially increasing the investor base further.

Consumer credit

As the types of crowdfunding platforms have increased, the range of credit agreements offered have also increased. In some cases, loan-based crowdfunding firms are pressurised to relax creditworthiness checks.

Current regulation states, there is ‘dual regulation’ between investors and borrowers. The investor, if lending in the course of business, must meet the requirements of the Consumer Credit Act 1974 and the consumer credit sourcebook applicable to lenders. Therefore, the lender must assess the borrower’s creditworthiness. Now, the assessment of creditworthiness needs to be checked if it is sufficient enough given the different types of platforms available.

Mortgages

Some peer-to-peer platforms are considering moving into residential mortgage contracts market, which at the moment is a non-regulated lending activity and investors would have no protection.

Firms systems and controls

As the loan-based crowdfunding market is evolving, the FCA is constantly monitoring the sector and believes that firms’ market risks are high. There is a risk that firms’ infrastructure, systems and controls are not sufficient enough to keep up with competition and the market.

Prudential requirements

Loan-based crowdfunding firms must hold a minimum amount of capital (prudential requirement) to ensure they can withstand any future financial market issues. The fixed minimum requirement of capital required has increased to £50,000 and is taken into consideration when a firm is seeking FCA authorisation.

Client money rules

Money that goes from lenders to borrower and vice versa is ‘client money’ and so, loan-based crowdfunding firms must follow the rules in the FCA’s Client Assets sourcebook to give client protection. The FCA is ensuring all loan-based crowdfunding firms are complying with the client money rules.

Pooling

Some firms have developed investor pooling into their business model and therefore must be subject to the same requirements as asset management firms, who manage regulated pooled investment funds.

Standards of disclosure

Information firms provide to potential investors must be accurate, balanced and sufficient for the investor to understand the nature of the investment and the risks associated. The information must also be fair, clear and not misleading therefore letting investors make investment decisions for themselves.

Guidance on the types of disclosures firms must provide have been outlined by the FCA, but there is concern about how loan-based crowdfunding firms are giving information to potential investors and so this is to be reviewed by the FCA.

Financial promotions

Many loan-based crowdfunding firms are not being compliant when displaying financial promotions, particularly on social media. Some firms believe the FCA rules on social media promotions are ‘excessive and too strict’ and therefore the FCA plans to review these rules.

Investor understanding

The FCA is considering making loan-based crowdfunding firms check their potential investors against certain criteria to test their knowledge or experience with the risks involved.

Competition

Loan-based crowdfunding platforms compete with other financial institutions, such as banks and consumer credit firms, for funding and lending opportunities. The advantages for loan-based crowdfunding platforms are the low operating costs and the opportunity for smaller firms to access capital. As there is competition between financial institutions, it improves customer service and gives customers a better deal.

Wind-down plans

Current FCA rules mean that loan-based crowdfunding platforms must have a resolution plan in place to keep loan repayments on-going, even if the platform collapses. The FCA plans to check how robust these plans are and if the rules need tightening.

Financial Services Compensation Scheme (FSCS)

If a firm operating a loan-based crowdfunding platform fails, investors are not covered by the FSCS. The FCA decided the FSCS should not cover peer-to-peer platforms, as the regulatory costs to investors would be higher than the potential loss to investors.

Loan-based crowdfunding firms would only be covered by the FSCS if the firm were FCA regulated, the claimant is eligible to claim, the claim is related to an activity that is covered by the FSCS or the firm has a civil liability to the claimant.

The FCA is planning to review how the FSCS is funded and whether the current situation is sufficient following market developments and growth.

Non-readily realisable securities

Crowdfunding platforms also typically sell certain types of equities and debt securities that are not listed on regulated stock markets but can carry significant risks. These securities can be sold over the Internet and other media, and the FCA has rules of how and to who these financial products are promoted.

Given the significant risks associated with these financial products, firms must follow marketing restrictions and conduct appropriateness tests on potential customers. Although, there are currently no specific FCA rules on how to perform the test.

Due diligence

The FCA has not set out specific due diligence rules by which crowdfunding firms must follow, as currently either firms or investors can carry out research of potential investments. However, the FCA are concerned because investors may not be able to assess different levels of risk and firms may not have robust systems and controls in place to mitigate the risk of financial crime. Therefore, the FCA may introduce minimum due diligence standards where a firm’s business plan is reviewed by a third party.