Submission on New Model for Retail Finance

Set out below are both the initial summary and my full submission to the Red Tape Challenge and the BIS Taskforce on Non-bank Finance. I'm very grateful to the colleagues who contributed, as mentioned in the longer document.

In its invitation to submit evidence of ‘red tape’ that is inhibiting the development of ‘disruptive business models’, the Cabinet Office notes the example of Zopa, “a company that provides a platform for members of the public to lend to each other, who found that financial regulations simply didn’t know how to deal with a business that didn’t conform to an outdated idea of what a lender is…” 

This paper demonstrates that financial regulation similarly fails to deal with a range of non-bank, direct finance platforms (“Platforms”) that share some of the key characteristics of Zopa’s person-to-person lending platform (see Annex 1). Accordingly, financial regulation is failing to enable the cost efficient flow of surplus funds from ordinary people savers and investors to creditworthy people and businesses who need finance. In particular, as further explained in Annex 2, the current regulatory framework:

• generates confusion amongst ordinary people as to the basis on which they may lawfully participate on alternative finance Platforms (even though some are licensed by the Office of Fair Trading);

• creates legal and regulatory issues that vary greatly depending on the structure of Platform and instrument adopted, particularly where investment is for return, rather than by way of donation (without return) to a good cause. This means that detailed legal advice is needed for any Platform and this is itself a barrier to entry for some schemes which may not pose any significant risk to the public. Platforms may also require a level of regulatory authorisation which may be inappropriate, again considering the low level of risk to the public.

• does not make alternative finance products eligible for the usual mechanisms through which ordinary people save and invest (as explained in Annex 2), and the inability to deduct bad debt before tax and the tax on interest charged to cover bad debt exposes individual participants on Platforms to much higher ‘effective tax rates’ than their applicable statutory rates (see Annex 3);

• discourages ordinary savers and investors from adequately diversifying their investments;

• incentivises ordinary savers and investors to concentrate their money in bank cash deposits, and regulated stocks and shares;

• inhibits ordinary savers’ and investors’ from accessing fixed income returns that exceed long term savings rates;

• inhibits the development of peer-to-peer funding of other fixed term finance (e.g. mortgages and project/asset finance); and

• protects ‘traditional’ regulated financial services providers from competition.

These regulatory failings could be resolved by creating a new regulated activity of “operating a Platform”, for which the best-equipped regulatory authority would be the Financial Services Authority (as replaced by the Financial Conduct Authority). In tandem, or as alternatives, there could be exemptions based on size of investment or risk (e.g. some schemes or platforms may involve minimal investment in what is sometimes a socially useful venture); lesser regulation/authorisation within existing classes of regulated activity (as for small payment services providers or small e-money issuers) ; or the official endorsement of self-regulatory codes (as banks enjoy in relation to the Banking Code, for example). Direct and indirect incentives that selectively favour incumbent banks and investment funds should also be recognised and modified to balance the competitive landscape. Detailed regulatory changes are explained in Annex 4. 

Regulation of the platform would be independent of any regulation that may apply to the type of product offered to participants on the platform (e.g. loans, trade invoices, debentures to finance renewable energy and lending for social projects, as noted in Annex 1). However, exemptions from regulations governing financial promotions and offers to the public could be granted for instruments that are offered on Platforms. 

Proportionate regulation that obliges Platform operators to address operational risks common to all products would also enable economies of scale and sharing of consistent ‘best practice’, and leave product providers and other competent regulators to focus solely on product-specific issues (e.g. consumer credit, charitable purposes). Similarly, participants on such Platforms do not need to be treated as if they are participating in the course of a ‘business’ if the Platform itself meets all the compliance requirements that a business of that kind would otherwise have to meet. 

Given the established nature of the financial regulatory framework and the dominance of incumbent banks in the provision of debt finance to individuals and small businesses in particular, it is unrealistic to assume that new business models will thrive without some alteration to the regulatory framework to enable rapid market entry and to facilitate strong, responsible growth.

Alternative finance briefing paper simon deane-johns 27 01 12

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You Want Eggs With Your Privacy Regulation?

Well, the EuroZerozone may be disintegrating, but the European Commission is certainly doing its best to cement over the obvious cracks in the single market fantasy. Now we need more regulation of... privacy.

As with everything else that Brussels churns out, this breakfast had its origins in the primordial soup of the "Social Dialogue" and various talkfests that are helpfully identified by the city in which they were discussed. This time around something seems to have happened in Stockholm in 2009, for example. At any rate, you'll be so impressed by the rich pedigree of the grandly named:

"Proposal for a
REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL

on the protection of individuals with regard to the processing of personal data and on
the free movement of such data (General Data Protection Regulation)"

that you'll gratefully submit to the wisdom of our European overlords.

As for me, I just can't wait to roll my sleeves up and get to grips with the detail... the "right to be forgotten", "data portability", "data protection by design and by default", the logging/reporting of personal data security breaches, personal data processing impact assessments, prior consultation and regulatory consent for potentially risky processing; not to mention enhanced internal controls, enforcement and compliance burdens, including the appointment of a data protection officer.

No, really.

Honest.

Just as soon as I've got my head around the idea that "Consent shall not provide a legal basis for the processing, where there is a significant imbalance between the position of the data subject and the controller" (Article 7(4)).

How can we really be sure there has been consent to anything?

Should Central Banks Supervise Facebook Credits?

This is an interesting question that I've been keeping an eye on for sometime now. Forbes is the latest media outlet to wonder whether Facebook Credits are going to be deemed systemic and somehow in need of regulatory supervision. They cite estimates that Facebook Credits total "$470 million of revenue in 2011, or about 11% of Facebook’s total business."

Financial regulators haven't been terribly interested in Facebook Credits because they merely constitute 'closed loop' stored value, rather than 'open-loop' stored value or 'e-money'. The line of demarcation is somewhat open to conjecture, but as explained below it seems likely that the Facebook Credits programme (as currently configured) will remain outside the scope of regulation. However, Facebook could decide to make things really interesting by 'opening the loop'  to become a full-scale e-money issuer...

When you buy Facebook Credits you're really just buying a 'claim code', like you would a music download, and that code is redeemable for purchases of items on the Facebook.com platform. The code is purchased from and redeemed by the same Facebook entity (if you're a resident of or have your principal place of business in the US or Canada, it's Facebook, Inc., otherwise, it's Facebook Ireland Limited). This means the suppliers of items you buy don't actually redeem the Facebook Credits themselves. Instead they rely on Facebook to process that transaction, and the suppliers receive only 70% of the price of the items sold, after Facebook deducts its commission or fees. The terms and conditions also make it clear that the 'credits' aren't able to be re-sold or transferred to anyone outside of Facebook. All of this means Facebook Credits are 'closed loop' stored value.

Typically, the European Commission has been the most aggressive in trying to comprehensively regulate e-money (and everything else!). That's largely arisen from efforts to break open the continental 'banking monopoly', starting with retail payments. As a result, issuing e-money in the European Economic Area (EEA) is a regulated activity under the second 'E-money Directive', and its use in retail payment transactions is covered by the Payment Services Directive. The two directives have been implemented in the UK by The Electronic Money Regulations 2011 and the Payment Services Regulations 2009. Essentially, this creates a framework within non-banks can be authorised to process retail payments.

Key regulatory requirements related directly to E-money include official authorisation/supervision, minimum and ongoing capital requirements and the need to safeguard (insure or segregate) money corresponding to outstanding E-money. “Electronic money” is defined as:

"...electronically (including magnetically) stored monetary value as represented by a claim on the electronic money issuer which—(a) is issued on receipt of funds for the purpose of making payment transactions; (b) is accepted by a person other than the electronic money issuer; and (c) is not excluded by regulation 3;" [my italics].

Parking the various issues with the real meaning and scope of "payment transactions", it's clear from the relevant terms and conditions that Facebook Credits are not accepted by anyone other than the relevant Facebook entity. Technologically speaking, it also seems likely that none of the suppliers of items purchased with Facebook Credits would be able to recognise and redeem the unique claim codes. Furthermore, both of the regulation 3 exemptions are relevant in the context of Facebook Credits:

"3. (a) monetary value stored on instruments that can be used to acquire goods or services only—

(i) in or on the electronic money issuer’s premises; or
(ii) under a commercial agreement with the electronic money issuer, either within a limited network of service providers or for a limited range of goods or services;"

which is generally referred to as the 'limited network' exemption; and a 'digital goods' exemption (which also applies to services) for:

"...(b) monetary value that is used to make payment transactions executed by means of any telecommunication, digital or IT device, where the goods or services purchased are delivered to and are to be used through a telecommunication, digital or IT device, provided that the telecommunication, digital or IT operator does not act only as an intermediary between the payment service user and the supplier of the goods and services."

The digital goods exemption is pretty clear cut, and probably applies to most of what Facebook Credits are used for. But being able to pay for a trip to the movies, as Forbes reports occurred in the US last summer, would likely fall outside the EU digital goods/services exemption if it occurred in the European Economic Area. So that puts pressure on the extent to which Facebook can claim to be a "limited network" of service providers or only providing access to "a limited range of goods or services". And if that exemption fell away, we'd be back to whether a participating merchant could be deemed to be 'accepting' Facebook Credits. 

The meaning of "limited" is left undefined in the legislation, probably to give the authorities a broad enough discretion to act where they think it's necessary or appropriate. However, the ordinary dictionary meaning does not equate to 'small', 'narrow' or 'few', so the size of the programme of itself shouldn't be a problem.

Nevertheless, it seems that the scope, scale and growth of the Facebook Credit programme is continuing to provoke policy discussion about its regulatory status, particularly as to whether there are systemic grounds on which Facebook should be segregating customer funds related to oustanding stored value and whether it has some kind of unfair cost advantage over authorised E-money institutions.

I discussed the policy issues related to operational risk, safeguarding and competition concerns in the context of other limited network offerings during the UK consultation on the introduction of the 2011 regulations. Incredible as it may seem, I think these will recede as the eventual scale of 'proper' E-money issuance will gradually grow to vastly exceed the quantity of Facebook Credits in issue - unless Facebook decides to enter the E-money market itself and go 'open-loop'. Now that would be interesting.

Red Tape Challenge Submission - Summary

In its invitation to submit evidence of ‘red tape’ that is inhibiting the developmentof ‘disruptive business models’, the Cabinet Office notes the example of Zopa, “a company that provides a platform for members of the public to lend to each other, who found that financial regulations simply didn’t know how to deal with a business that didn’t conform to an outdated idea of what a lender is…” 

Financial regulation similarly fails to deal with a range of non-bank finance platforms that share some of the key characteristics of Zopa’s person-to-person lending platform. Accordingly, financial regulation is failing to enable the cost efficient flow of surplus funds from ordinary people savers and investors to creditworthy people and businesses who need finance. In particular, the current framework: 

1. generates confusion amongst ordinary people as to the basis on which they may lawfully participate on alternative finance platforms (even though some are licensed by the Office of Fair Trading); 
2. does not make alternative finance products eligible for the usual mechanisms through which ordinary people save and invest, exposing lenders to higher ‘effective tax rates’; 
3. discourages ordinary savers and investors from adequately diversifying their investments; 
4. incentivises ordinary savers and investors to concentrate their money in bank cash deposits, and regulated stocks and shares; 
5. inhibits ordinary savers’ and investors’ from accessing fixed income returns that exceed long term savings rates; 
6. inhibits the development of peer-to-peer funding of other fixed term finance (e.g.mortgages and project/asset finance, and even short term funding of invoices); and
7. protects ‘traditional’ regulated financial services providers from competition. 

These regulatory failings could be resolved by creating a new regulated activity of operating a direct finance platform, for which the best-equipped regulatory authority would be the Financial Services Authority (as replaced by the Financial Conduct Authority). Regulation of the platform would be independent of any regulation that may apply to the type of product offered to participants on the platform (e.g. loans, trade invoices, debentures to finance renewable energy and lending for social projects). Proportionate regulation that obliges platform operators to address operational risks common to all products would also enable economies of scale and sharing of consistent best practice, and leave product providers and other competent regulators to focus solely on product-specific issues (e.g. consumer credit, charitable purposes). 

Similarly, there is no reason why products distributed via these platforms should not also be eligible for the usual mechanisms through which ordinary people save and invest, such as ISAs, pensions and enterprise investment schemes.

I'm off to Number 10 today to discuss these issues, and will be submitting a more detailed paper in the coming weeks, both to the Red Tape Challenge and the BIS Taskforce on alternative business finance. I'm interested in any comments you may have.