UK Continues To Clear The Path For Growth Of Alternative Finance

Draft legislation has now been published to allow bad debt relief for investors in peer to peer loans, in addition to the new Personal Savings Allowance announced in the Summer Budget.

These measures are among those that address the key regulatory problems and perverse incentives that have been preventing the flow of finance to people and businesses who need it and improved returns to savers and investors. The first regulatory initiative was to regulate P2P lending, announced in 2013; while the first step in addressing incentives was to include P2P loans in ISAs - first announced in 2014.

In introducing the latest incentive measures the government says it remains "determined to increase competition in the financial sector, where new firms such as P2P platforms can thrive alongside the established players and compete to offer new and improved services to customers. This new relief will create a level playing field for the taxation of income from P2P lending when compared to the taxation of traditional forms of retail investment available from those established players."

The government's commitment is critical, given that the financial system is now less diverse than before the financial crisis blew up in 2008. Few bank reforms have actually taken effect - and some are being watered down. Recent fines and scandals also reveal little change in mainstream financial services culture from that described in the report of the Parliamentary Commission on Banking Standards and most recently in the damning report into the failure of HBOS.

From 6 April 2016, individuals investing in certain P2P loans will be able to set-off the losses they incur from loans in default against income they receive from other P2P loans, when calculating their savings income for tax purposes. 

In addition, under the Personal Savings Allowance announced in the Summer Budget 2015, the first £1,000 of savings income will be exempt from tax for basic rate taxpayers and the first £500 for higher rate taxpayers. An individual’s PSA will apply to interest they receive from P2P lending after any relief for bad debts. 

The Innovative Finance #ISA

The Treasury has announced the details of its commitment to extend tax-free Individual Savings Accounts (ISAs) to include peer-to-peer loans from 6 April 2016, effectively adding a third basket for your nest eggs. The enabling regulations will be published later this year. In the meantime, the government is also consulting on adding certain 'crowd-investment' instruments to ISAs in due course.

From April 2016, there will be a new "Innovative Finance ISA" in which individual investors will be able to hold P2P loans (formally known as 'article 36H agreements' in article 36H of the FSMA (Regulated Activities) Order 2001, and "P2P agreements" in the FCA's Handbook).

Advisers will be able to advise on P2P loans within the scope of their existing FCA advisory authorisation.

For ease of administration, each P2P lending platform is likely to become the ISA Manager for the Innovative Finance ISA that covers P2P loans agreed on its platform. 

P2P platforms (and other relevant ISA managers) will not be required to enable customers to sell their loans or to move their loans to another platform. But platforms may, if they wish, facilitate the sale of loans on their own secondary markets (as some do already) and enable the transfer of the cash proceeds to another ISA manager - indeed customers must be able to withdraw un-lent cash withdrawn within 30 days. However, it won't be possible for you to transfer only part of the money you subscribed in that tax year.

The different rules for P2P loans mean that they won't qualify for Junior ISAs or Child Trust Funds, which are less flexible than adult ISAs.

Adding Peer-to-Peer Loans To #ISAs

The Treasury is consulting on how to implement the government's decision to allow us all to hold peer-to-peer loans within our Individual Savings Accounts (ISAs). This is revolutionary because it increases the range of assets that can be held in ISAs - increasing diversification and therefore the value of the ISA portfolio - and significantly improves the visibility of where your investment money ends up (as I've argued for some time). Adding P2P loans will also change the way ISAs and ISA managers operate, which raises the various questions that the Treasury is consulting on (set out below). This post explains the difference between P2P lending and investing in funds typically held in stocks and shares ISAs, and addresses the main issues outlined by the Treasury.

What are peer-to-peer loans?

Peer-to-peer (or 'P2P') loans are just simple loans agreed directly between lender and borrower. There is no bank or fund manager in the middle, and the operator of the platform on which the loans are agreed is not a party to the loans.

How is P2P lending different to investing in funds?

Perhaps the best way to understand the difference is by starting with the role of the fund manager as opposed to the P2P platform operator. In simple terms, a fund manager collects money paid by investors in return for 'units' in the fund, and then controls the investment of that money in its own name (or that of the fund entity) - so the manager controls the management of the money or other assets in the fund, not the investors,.

However, the operator of a P2P lending platform enables many lenders to lend small amounts of money directly to many different borrowers, and then simply administers the individual loan contracts in accordance with their terms.  So the lenders on a P2P platform, rather than the platform operator, keep control over the management of their money and loan contracts. This is a key reason why P2P loans are a fundamentally different asset class to units in investment funds.

What does this mean for ISA managers?

These differences present a challenge for today's ISA managers - whose job it is to enable you to invest using your annual ISA limits, and keep track of those for HMRC.

Currently, when you buy units in an investment fund through an ISA manager, the manager adds your order to many other orders that it receives and then buys the total number of units in the investment fund in its own name. Each unit is standardised with the same price/value and issued by the same entity. The manager then records how many units it bought on your behalf in its own systems. You have no direct contract or any other link with the investment fund at all.

But on a P2P platform, you agree many small loans directly with lots of other people for the purposes specified, and different platforms tend to specialise in different types of loans (personal loans, working capital for small businesses, commercial property etc). Everyone's holding is different, even though some lenders end up lending to the same borrower. You also directly agree the platform's fee, if any, which may be waived in some cases (sometimes the borrower pays the fees, for tax reasons, leaving the lender with just the net income).

So existing ISA managers will probably need to make systems changes to enable it to track your own unique holdings of P2P loans in your ISA, and it seems likely they'll want to see a lot of demand before they do so. Accordingly, to meet demand for P2P loans in ISAs it's likely that the operators of P2P lending platforms will become ISA managers in their own right.

What does this mean for ISA rules?

You will probably be able to withdraw P2P loans from ISAs without having to sell them and take the cash.

ISA assets can typically be transferred between ISA managers, but that isn't practicable between different P2P platforms, so it's likely that any transfer would only work by selling the loans and transferring the cash directly to the other ISA manager. However, the Treasury is not sure whether to require this, as it could discriminate against platforms that do not have ready secondary markets for the loans agreed on their platforms. Another reason not to insist on transferability is that even if there were a secondary market, there could be a delay in finding a buyer for the loans, as opposed to just waiting for them to be repaid; and a 'forced' sale could mean a low market price, even from a market-maker or underwriter.

The Treasury is also interested in arrangements for continuing to manage P2P loans in ISAs in the event that the P2P platform operator ceases to qualify as an ISA manager, similar to the FCA requirements for administration of loans in the event that the operator ceases to trade.

The Treasury is still not sure whether to allow P2P loans to be kept in their own ISA or in a stocks and shares ISA. However, assuming P2P platforms are likely to need to become ISA managers in their own right, it would seem unduly onerous to make them apply for the extra FCA permissions required to offer other investments available through stocks/shares ISAs. So I'd suggest that there will need to be a third 'P2P loans ISA', or at least the ability for platform operators to offer a stocks/shares ISA that is limited only to holding P2P loans.

The Treasury expresses some concern that P2P lending on behalf of children through Child Trusts Funds (CTFs) or Junior ISAs could mean that the parent or guardian and not the child will be the one who understands the business activity or loan purpose of the business/personal borrower. But this is no worse than investing in a managed fund where you don't know the precise mix of the constituent stocks/shares or even the actual issuers and therefore their businesses or use of proceeds.

Finally, the Treasury believes that title to P2P loans made via CTFs and Junior ISAs would need to be held by the ISA manager or some third party, as loans made by minors are not enforceable (as a matter of contract law).

Those Treasury questions in full:

1. In relation to the proposals generally, what necessary set-up costs (one-off costs) would be necessary for your business to arrange peer-to-peer loans meeting the proposed eligibility requirements for ISAs? What would be the estimated ongoing annual costs of doing so?
2. Do respondents agree that the government’s proposed approach provides sufficient clarity as to which peer-to-peer loans will be eligible for ISA inclusion?
3. Do respondents agree that the proposed regulatory requirements strike the correct balance between investor protection and a proportionate regulatory regime?
4. Are existing ISA managers considering offering peer-to-peer loans alongside other ISA eligible investments? What factors may affect this decision?
5. Are firms operating peer-to-peer platforms considering seeking authorisation to act as ISA managers if the government permits this? What factors may affect this decision?
6. Do respondents have any concerns regarding FCA-authorised firms operating peer-to-peer platforms being allowed to act as ISA managers? If so, what are they?
7. Do respondents see any risks arising from firms operating peer-to-peer platforms approved as ISA managers not being required to have legal ownership of peer-to-peer loans held within ISAs?
8. Are there any drawbacks to the proposed withdrawal procedure for peer-to-peer loans? If so, what are they?
9. If the transfer requirement is applied to peer-to-peer loans – do respondents foresee any risks or detriment for consumers resulting from the proposed modification of the current ISA requirements? If so, what are these?
10. Following the sale of the peer-to-peer loan and transfer instructions from the investor, what would be the most appropriate time period within which the cash realised should be transferred?
11. Is the proposed modification to transfer requirements t likely to present any difficulties or administrative obstacles for ISA managers (including those receiving transfers)? If so, what are these?
12. What are respondents’ views on requiring the existence of a secondary market in order for a peer-to-peer loan to qualify for ISA eligibility? Would such a requirement provide a useful degree of reassurance to investors?
13. Would a requirement to offer a secondary market pose any problems or difficulties for peer-to-peer platforms and if so, what are these? Could secondary market arrangements of this type be easily defined?
14. Do respondents think that a guarantee of a sale at market value within a given period would be desirable in addition to the proposed requirement of a secondary market?
15. Is there merit for investors in requiring that there must be a mechanism by which loans can be sold at market value within a given period? What period should this be, taking account of the times taken at present to achieve sales on existing secondary markets?
16. Are there other ways in which to facilitate transferability, besides those described above? If so, how might these work?
17. Overall, do respondents feel that the benefits to investors from applying transfer requirements to peer-to-peer loans held in ISAs outweigh the possible risks of doing so?
18. Do respondents have suggestions as to how loans held within ISAs could continue to be managed by an ISA manager in cases where either a firm operating a peer-to-peer platform collapses and they were acting as ISA manager, or where such a firm becomes ineligible to act as an ISA manager following removal of its FCA permissions?
19. How important is it that investors should be able to mix peer-to-peer loans with other eligible investments within their ISA in a single tax year? Do respondents believe most investors wishing to place peer-to-peer loans into an ISA account will additionally want to invest in other types of non-cash ISA investments within the same tax year?
20. Would a third ISA type be helpful in alerting investors to the different rules which will apply to peer-to-peer loans within ISAs? Overall, would a third ISA type aimed specifically at alternative finance products such as peer-to-peer loans be a good thing – and if so, why?
21. What potential difficulties or challenges might the creation of a third ISA type present for savers, investors, ISA managers or others?
22. If the government decides not to introduce a third ISA type, how can we best ensure that customers are clear about the special characteristics associated with peer-to-peer loans, for example that they are not covered by the FSCS, and that they may be difficult to liquidate?
23. Do respondents have any concerns about offering a tax advantage where loans made by or on behalf of children might be made without knowledge of the intended recipient(s) or usage of the loaned funds? If so, what are they?
24. Do respondents agree that if peer-to-peer loans are made eligible for CTFs and Junior ISAs, these loans should be in the legal ownership of the ISA manager? If not – what alternative approach might be considered?

At Last: ISAs Go To Work!

Readers of this blog will be familiar with my rants on ISAs. So you can imagine my delight that the Chancellor has finally announced an the extension of the scheme:

"To further increase the choice that ISA savers have about how they invest, ISA eligibility will be extended to peer-to-peer loans, and all restrictions around the maturity dates of securities held within ISAs will be removed. The government will also explore extending the ISA regime to include debt securities offered by crowdfunding platforms."

In addition, from 1 July 2014 ISAs will be reformed into a simpler product, the ‘New ISA’ (NISA), with an overall limit of £15,000 per year. You will be able to hold cash tax-free within your Stocks and Shares NISA (if your provider allows it). And you'll be able to ask NISA providers to switch your money between cash-NISAs and Stocks and Shares NISAs.

As explained here, these changes offer a huge boost to the real economy, because savers will be able to lend their 'dead' savings directly to each other and to small firms to help fill the funding gap left by the banks. At the same time, savers will improve the value of their investments, not only by diversifying into a new asset class, but also one that provides a decent return.

Hats off to the government and the Treasury for putting in the work to turn this situation around.

Why Our ISAs Don't 'Work'... Yet.

The Treasury consultation on expanding the ISA scheme provides a fresh opportunity to put our savings to work and boost economic growth at the same time.

What's wrong with ISAs?

The “Individual Savings Account” (ISA) rules encourage us to put £11,280 a year into bank cash deposits and a limited list of regulated bonds and shares by making the returns tax-free.

Last year the Treasury estimated that about 45% of UK adults have an ISA, with a total of £400bn split about equally between cash and stocks/shares.

But in 2010 Consumer Focus found that cash-ISAs were only earning an average of 0.41% interest (after initial ‘teaser’ rates expire). They also found that 60 per cent of savers never withdraw money from their account; and 30 per cent see their ISAs as an alternative to a pension. 

Yet the banks don't use this cheap £200bn very wisely. In fact, only £1 in every £10 of the credit they create is allocated to firms who contribute to economic growth (GDP) and 60% of new jobs. In other words, lending to businesses is just not our banks' core activity, even though we also guarantee their liabilities. They earn more by financing consumption and speculation in financial assets. They've even taken £9.5bn under the so-called "Funding for Lending" scheme, and lent even less than before...

So we need the ISA scheme to encourage people to put their ISA money - and the country - back to work.

That means adding alternative asset classes that provide a decent return by financing the real economy, such as those generated on peer-to-peer lending and crowd-investment platforms.

Why hasn't this been done already?

The Treasury has previously resisted calls to do this on two occasions over the past few years. Their defence has been that ISAs are popular, simple to understand, relatively low risk and peer-to-peer platforms are not regulated (see here at para 14 and here at page 13).

But on neither occasion did the Treasury acknowledge the risks posed by the huge concentration of ISA cash in low yield deposits. Or the potential benefits of enabling savers to make some of those funds available to consumers and small businesses at lower cost and far higher returns - especially given that peer-to-peer default rates have proved to be very low.

The regulatory concern also appears to have been misplaced. Banks have clearly demonstrated that regulation affords no guarantee that consumers will be treated fairly. And peer-to-peer platforms, which are already partly regulated by the Office of Fair Trading, have been requesting broader regulation for several years. As a result, the Treasury has begun consulting on plans for more comprehensive regulation by the new Financial Conduct Authority from 2014.

All of that means the latest consultation on adding new assets to the ISA scheme is a golden opportunity to convince the Treasury to let us put our savings to work. 

Let's not miss it.