Search This Blog

Wednesday, 5 September 2012

FSA Note On Crowd Investing

In response to various comments and queries, I've reviewed the FSA's recent note to consumers on 'crowdfunding'. The FSA's note is actually quite a positive sign, although it's worth clarifying a few aspects discussed below. These relate to terminology and the policy context, the wider audience, opportunities for everyone to diversify, the potential for secondary markets and another means of protecting customer funds.

Here one has to sympathise with the FSA. Alternative finance platforms are springing up all over the country and the FSA no doubt feels obliged to say something helpful about those closest to its remit. Yet it is only empowered to supervise the current regulatory framework, which is ill-suited to the sort of innovation that crowd investing represents. The Treasury, which is responsible for producing the regulation that governs the FSA's remit, has been dragging its heels somewhat on this front. Even the US has beaten us to the punch by cutting a swathe through its byzantine securities legislation to provide a more proportionate regime to support crowd investing.

So in these respects the FSA's note is also helpful in illustrating the need for proportionate regulation that the alternative finance industry has been calling for to enable the responsible growth of non-bank retail financial services. The note is also perhaps a sign that the FSA acknowledges the need to look beyond the regulated markets when considering whether there is adequate innovation and competition within them.

Terminology and The Policy Context

I've previously discussed the various meanings of the term 'crowdfunding' and the policy context here. The FSA's note initially states that "crowdfunding involves a large group of people contributing money to support a business, individual or campaign." But that would encompass a wide array of situations that surely aren't in scope, including ordinary donations to charities, buying shares on a stock exchange and perhaps even retail sales. Accordingly, later in its note the FSA qualifies the statement by adding that crowdfunding investors will usually receive shares in the business or project they contribute to..." pre-purchase goods to be produced or "...receive a reward like a t-shirt or mug". I read this to mean that the FSA is referring to both 'crowd-investing' as well as the original form of 'rewards-based' crowdfunding that I've discussed previously. But that's not to say these activities are necessarily regulated by the FSA - indeed the FSA later points out that "almost all crowdfunds are not authorsed by [it]" - though it can be a complex undertaking to determine what is in or out of scope.

What is perhaps missing, however, is the primary point of distinction between crowd investing and traditional forms of investment. Crowd investing involves a marketplace comprising a crowd of consumers and/or small businesses on both sides, whose direct interaction is faciliated by a neutral platform operator. In other words, members of the crowd are engaging with each other on the same platform, rather than a single financial institution offering its own products to its customers. This phenomenon partly reflects the 'Web 2.0' or 'social media' trend that has also 'democratised' the retail, entertainment and other consumer-facing industries. In the investment context, it most often involves contributing relatively small sums of money you would be prepared to lose, in order to finance the activities of people and businesses whose success might benefit you, your community or society generally, but on terms that could also give you a financial return in that success. Other key differences between various types of crowdfunding models (in the broader sense) and traditional financial services are explained in Annex 1 to this note on regulatory reform.

Wider Audience

The FSA's note is primarily an explanation for consumers acting as investors, rather than an explanatory note to the people or businesses who see crowd investing as a way to raise funds, or to the platform operators who facilitate the interaction between the two. Again, this perhaps misses the point that crowd investing comprises a marketplace with a crowd of consumers and/or small businesses on both the investing side and the receiving side.

But the note does helpfully point out that "for businesses, crowdfunding can be a useful way to gain direct access to investors and finance that more traditional investors, venture capitalist or lenders are not prepared to offer."

That's putting it politely, as you might expect. Aside from the Web 2.0 trend, another reason for the growth in peer-to-peer finance models is that banks, pension funds and other traditional investors whom the FSA does regulate are continuing to conserve capital or offer finance on terms that are unduly onerous, while charging savers and investors high fees and/or failing to offer a decent return. This intransigence suggests that it's down to entrepreneurs and private investors to connect the dots between low returns on savings and the opportunity to fill the SME funding gap of £26bn - £52bn over the next 5 years, or the annual social sector finance gap of £0.9bn - £1.7bn.

Opportunities To Diversify

The FSA says that "crowdfunding could make up part of a diversified portfolio, especially for sophisticated investors." I do not read this to necessarily mean "sophisticated investors" in a regulatory sense (e.g. under the Financial Promotions Order). Even so, this begs the question why only 'sophisticated investors' should enjoy the benefits of the reduced investment risk that goes with maintaining a diversified portfolio beyond "mainstream investment products". People seen as 'ordinary' investors are proportionately suffering much more from a lack of opportunities to diversify than those who are more wealthy or finance professionals (if that's any proxy for 'sophisticated'). ISA and pension rules incentivise the concentration of funds into assets that are providing little return and generate high fees for institutions. Ironically, in rejecting calls by the Breedon Taskforce for broadening the ISA scheme the government highlighted the problem by confirming that 45% of the adult population is herding into the same narrow range of asset classes.

That's not to say that any old asset should necessarily qualify for ISAs and pensions, and I agree that the risks in such investments should be clearly explained to investors, along with the benefits. As I've said repeatedly, simplicity and transparency as to both the benefits and the extent to which you risk losing money are critical to the process of making financial services more consumable, but we need a more facilitative approach to that process. Policy-makers must recognise that crowd investing has its genesis in the trend towards greater transparency and consumer control, not less. Operators are trying to simplify financial services and make them more transparent and accessible to all. Legacy financial regulation is one of very few hurdles in the way of that trend, yet entrepreneurs are responsibly calling for more proportionate regulation rather than some kind of unregulated free-for-all.

Secondary Markets?

Interestingly, the FSA points to the inability to sell many crowd investments as a risk associated with crowd investing (which perhaps misses the point of crowd investing in the first place, as discussed above). Yet, ironically, current regulation renders the development of such secondary markets impracticable. So the fact that the FSA has called this out as a risk suggests that efficient means of secondary trading on crowd investing platforms may be permitted as a benefit to consumers in future.

Protection of Customer Funds

The FSA says you should "find out how your money is protected if the business, project or even the crowdfunding platform collapses - in particular check whether the business has appropriate cash reserves or even insurance supporting if it fails." This is true. While the very nature of 'investment' is that you may lose your money if a company or project you invest in does not succeed, it should also be made clear to you from the outset. But when considering what happens to your uninvested funds if an unregulated crowd investment platform collapses, it's worth mentioning that the platform operator might legitimately choose to hold funds received from customers in trust in a separate bank account, designated as holding customers' funds with the bank's acknowledgement, so that those funds do not form part of the operator's assets and would not be available to the operator's creditors if the operator were to fail. The operator may also make arrangements for the ongoing administration of investments in the event that it ceases to operate.

At the end of its note the FSA adds that "We are also concerned that some firms involved in crowdfunding may be handling client money without our permission or authorisation, and therefore may not have adequate protection in place for investors." However, its important to clarify that 'handling client money' is not a regulated activity in its own right. The FSA's client money rules only apply where the provider is both authorised by the FSA and subject to the FSA's own client money rules. So this does not mean that firms who are legitimately operating outside the FSA's remit (or who are FSA-regulated but not subject to the FSA's client money rules), cannot choose the other ways of protecting their customers' funds described above.

Finally, it's worth clarifying that even FSA-authorised firms may fail to follow the right procedures to protect customer funds, thereby potentially undermine the protective effect of the arrangements (as alleged in the case of Lehman Brothers and MF Global). In January 2011, the FSA also fined Barclays Capital £1.12 million for "failing to protect and segregate on an intra-day basis client money held in sterling money market deposits" over an eight year period.

The point is that even the most intense regulation will not remove investment risk entirely.

Image from Lattice Capital.

No comments:

Post a Comment