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other, who found that financial regulations simply didn’t know how to deal with a business that didn’t conform to an outdated idea of what a lender is…”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.
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