Can You Use P2P Loans to Provide Finance To Others?

The FCA and others have become concerned that some people or firms may be borrowing money on peer-to-peer lending platforms and using that money to provide finance to others without being authorised to do so, rather than borrowing solely to finance their own activities. 

So the Treasury proposes to clarify when a person or business can borrow on a P2P lending platform without needing to be authorised to 'accept deposits' by amending the 'business test' for deposit-taking as explained here.

For the sake of argument, let's just accept that a 'loan' can be a "deposit"; that borrowing on a P2P lending platform can involving "accepting" a deposit; and no potential exemptions apply. The question is whether this is being done "by way of business".

The current test merely says that a borrower will not be 'accepting deposits by way of business' if the borrower doesn't hold himself out as accepting deposits on a day-to-day basis; and any deposits are accepted only on "particular occasions".

This is considered too vague to be helpful in the P2P lending context, so the government proposes to add a specific carve-out for the situation where:

• the acceptance of deposits is facilitated by an authorised P2P lending platform;
• the borrower is not a bank or 'credit institution' (as they are already in the business of accepting deposits) or other type of regulated person (who would need to add the permission to accept deposits);
• the borrower is not carrying on the business of accepting deposits (which is obviously kind of circular, but another provision will say that if the borrower uses the capital or interest on the funds solely to finance other business activity carried on by the borrower (not a third party), this will be evidence that the borrower is not carrying on the business of accepting deposits);
• the borrower does not hold himself out as accepting deposits on a day to day basis, other than as facilitated by the P2P lending platform.

The key element in the context of borrowing on a P2P lending platform is that the borrower's use of the loan proceeds is to finance that person or firm's own activities, as opposed to being used to provide finance to others.

Of course, this post is for information purposes only and does not constitute legal advice.

FCA Weighs In On #InitialCoinOfferings

The Financial Conduct Authority has just published its thoughts on "initial coin offerings" (ICOs), the issue of cryptographic tokens or 'currency'. There is already a wide variety of purposes for ICOs, making them much harder to classify than your typical stock market "initial public offering" (or IPOs) with which some people seem to be equating them.  The FCA has also provided links to guidance from: 

• the U.S. Securities and Exchange Commission, 
• the Monetary Authority of Singapore, 
• the Canadian Securities Administrators, 
• the People’s Bank of China and 
• the Securities and Futures Commission of Hong Kong.

Many additional risks also arise from the fact that the nature of the 'coins' or cryptographic currency and whether there is a market for those - quite apart from the purpose for which funds are being raised and/or invested in - as well as the distributed ledger in which they and related transactions are based. We are a long way from the usual stakeholders (like regulators) understanding and engaging with the new technology, let alone standardising any kind of process for doing ICOs as 'efficiently' as IPOs or even traditional technology projects (hopefully more so!).

I have no reason to think ICOs won't necessarily become fairly commonplace in due course, but it's appropriate for the regulators to be treading cautiously at present - although they should be supportive of genuine attempts to innovate in this area and engage positively with issuers while warning investors of the risks.

Here's a helpful ICO 'tracker' from CoinDesk.

 

Humans At The Heart of FinTech

My article on this theme has been published by the Society of Computers and Law in connection with the IFCLA conference, where I participated on a panel discussing disruptive technology in financial services. 

It is interesting to see how people's belief in the 'efficient market' and appeals to the authorities for help when things get out of hand is playing out in the context of the Ethereum project and the DAO!

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. 

FCA Consults On Rules for Banks' #SME Loan Referrals and Credit Data

The Financial Conduct Authority is consulting on rules relating to banks' obligations to release information about credit performance to credit reference agencies; and the referral of their rejected small business loan applications to 'designated finance platforms'. 

The proposals are in Chapter 6 of the FCA's current quarterly consultation.

The FCA will have a limited supervisory and enforcement role in relation to these obligations.

The consultation ends on 5 August 2015.

Big Day For Providers Of #AlternativeFinance To #SMEs

This morning, the British Business Bank began the process of creating a market for small business loan applications that the banks decline to fund, as well as opening up the banks' credit data to improve credit scoring for small business borrowers. 

Specifically, the BBB has called for expressions of interest from firms wishing to become either a designated finance platform, to whom banks must offer to refer any small businesses whose loan applications are rejected.

In addition, the BBB is seeking information from credit reference agencies that would like to receive credit data held by banks on small businesses to increase the reliability of SME credit scoring for non-bank lenders.

Feedback on FCA Project Innovate Workshops

The Financial Conduct Authority has published its summary of the feedback it received in relation to its proposals to support innovation in financial services ("Project Innovate").

A striking aspect is the negative, limited view of innovation from established, regulated firms, compared to small innovators and non-regulated firms. This seems to underscore how protected the existing providers have been from external competition to date.

Worth providing feedback on the summary, and any solutions to problems identified.

Following the Financial Innovation Lab session in May and the Project Innovate session I attended in August, I still recommend a short 'small firms registration process' that would allow all new firms to enter the market more quickly and operate under certain thresholds before going through the lengthy full authorisation process if they can succeed in growing (as for small payment/e-money institutions).

UK Remains Calm Over Virtual Currencies

Despite the ECB's recent attempt to "discourage" EU financial institutions from trading or holding virtual currencies, the UK Chancellor has explained that the UK will conduct its own investigation into the potential for virtual currencies, like Bitcoin, to encourage innovation in the financial sector, while also considering the risks and how best to mitigate them. 

This perfectly illustrates the common law adage that 'the law must follow commerce', as opposed to the civil law view that the State should first prescribe whether and how business should be done - a distinction that Eurocrats really need to understand. As George Osborne noted: 

"it is only by harnessing innovations in finance, alongside our existing world class knowledge and skills in financial services, that we'll ensure Britain's financial sector continues to meet the diverse needs of businesses and consumers here and around the globe".

 

Entrepreneurs: Help The FCA Help You!

Great news: the Financial Conduct Authority is continuing its efforts to support innovation in financial services, and is offering both entrepreneurs and innovative firms the chance to sense-check its approach.

Following the session with the Finance Innovation Lab in May and its June announcement of Project Innovate, the FCA has just issued a mercifully short consultation paper on its plans and arranged a series of summer workshops on:

• how entrepreneurs can get authorised more efficiently; 
• figuring out how non-regulated businesses can engage with the FCA in an Innovation Hub to help them collaborate with regulated businesses while avoiding the need for regulation; and 
• how regulated firms could engage with innovative firms and the FCA via the Innovation Hub.

Specific questions on which the FCA also welcomes your answers before 5 September are:

1. Is there anything about the regulatory system that poses particular difficulties for innovator businesses?
2. What practical assistance do you think the Incubator could usefully provide to small innovator firms?
3. Do you think it would be useful to establish an Innovation Hub function?
4. What criteria should we use in order to focus our resources on ‘genuine, ground-breaking’ innovation?
5. Do you have any other feedback or suggestions about Project Innovate?

This is a fabulous opportunity for everyone in the UK's FinTech sector to help the FCA improve its authorisation and guidance processes to support new businesses, so please get involved.

FCA Announces #ProjectInnovate

Hard on the heels of the Transforming Finance workshop, the FCA announced in a speech by CEO Martin Wheatley last week that it will support innovators by: 

• providing 'advice on compliance' to firms who are developing new models or products advice so they can navigate the regulatory system;

• looking for areas where the system itself needs to adapt to new technology or broader change – rather than the other way round; and

• launching an incubator to help innovative, small financial businesses ready themselves for regulatory authorisation.

The umbrella term for these initiatives is "Project Innovate". I look forward to hearing more about it, including contact details etc.

How The FCA Could Support Innovation And Diversity In Financial Services

Hats off to the Financial Conduct Authority for hosting and participating in The Finance Innovation Lab's recent workshop on Transforming Finance. It was an excellent, productive discussion and seems likely to help drive helpful change. For the sake of transparency, here are my notes/thoughts (unattributed, on the basis of Chatham House Rules).

The FCA board is interested in how the financial services market can be 'disrupted' in ways that are positive for consumers and small businesses. There is a new awareness of how regulatory uncertainty can be a barrier to entry/growth; and the need to get better at recognising the harm that comes from stifling good initiatives.

Key aspects of beneficial disruption include, innovation, diversity, and competition. There is evidence that competition within markets alone is insufficient, and can actually drive mis-selling (e.g. banks competed to sell PPI). Increasing diversity is also necessary, to enable competition amongst different business models and services in the same market. This requires the FCA to consider how firms outside the regulated markets are delivering better consumer outcomes, as well as firms within the regulated markets.

Greater transparency around fees, incentives and conflicts of interest allows excessive fees to attract competition and/or disintermediation; and the removal/re-alignment of perverse incentives and conflicts of interest.  

FCA could foster innovation with: 

• a 'sandbox' for entrepreneurs/innovators to consider how new models might be impacted by rules - this could include an online method for extracting all the rules in the Handbook that relate to a certain product or activity; 
• pre-authorisation workshops to coach firms through the evolution to authorsiation and obtain feedback on problems and potential improvements; 
• a shortened, small firms registration process that would allow new entrants to operate under certain thresholds before going through the lengthy full authorisation process (as for small payment/e-money institutions);
• a small firms unit made up of staff from each of the FCA's main 'silos' to ensure joined-up focus on innovation and diversity, consistency, fairness and positive discrimination in favour of sensible initiatives.

The regulatory/policy environment needs to be more open and accessible. We need to know which staff are responsible for what. The FCA tends to draft its rules and communicate in its own unique language, rather than in the language of the markets it regulates or even the same terms used in directives/regulations it is supposed to implement. It also needs to 'get out more', and participate in more forums involving firms, trade bodies, policy officials from relevant departments (e.g. Treasury and BIS) and the European Commission. There should be more public roadshows, roundtables etc - perhaps the FCA could host an annual, wider version of the P2P Finance Policy Summit that was run in December 2012? The consultation process should more positively discriminate in favour of those outside the incumbent firms, it should be more socially networked with a more widely telegraphed timetable. In this context it would also be helpful for the FCA to keep a register of who is lobbying it (e.g. as Ministers must disclose). There should be a body to scrutinise what the FCA (and HMT) is consulting on and how the consultation process operates.

The FCA views the market through the lens of products, and types of firms and their activities, rather than from the standpoint of the customer and how the customer can be empowered to achieve their own financial outcome. The customer is seen as victim, whereas the tide of technology and innovation is delivering greater control to the customer (e.g. over personal data - and financial transactions are just another type of data).

The FCA needs to participate in the debate over the best means of credit creation - should we separate banks' role in money creation from their role in actually allocating credit? Should we strip banks of their role in creating money altogether, as covered by Martin Wolf recently. 

How do we distinguish genuine innovation or invention from merely incremental changes to existing models/products? New rules should be tested for their potential impact on diversity, innovation and competition.

The Financial Services Consumer Panel and Smaller Business Practitioner Panel should have specific obligations to consider the above issues, as well as the interests of alternative finance providers and civil society more generally.

Interested in your thoughts!

Could The FCA Do More To Foster Innovation In Financial Services?

Previously I've suggested that two things are choking the flow of money to people and small businesses who need it: broken regulation and perverse incentives. So it's important to give some credit for work on both fronts.

Financial regulation remains overly complex, but at least some reforms have been made to welcome innovation and competition at the retail level. And the recent budget showed the government is keen to ensure that ISAs and pensions encourage people to put their eggs in more than one basket. The FCA has also done some impressive research into insurance add-ons.

However, for this momentum to be maintained, financial regulation must become even more welcoming of innovation and competition - and much simpler and transparent for everyone to understand. So here are seven suggestions:

1. Tailored rulebooks: By the FCA's own admission, about 10% of the rules spread throughout its giant, ever-expanding 'Handbook' are relevant to each regulated activity. But the FCA does not gather the relevant rules into 'tailored' rulebooks, as the FSA used to do. That means everyone must waste time and resources wading through the 90% of rules that don't apply to their given activity. But it's worth noting that the FCA still maintains the helpful “Approach” documents that explain its separate regimes for e-money and payment services. Why not adopt this same 'approach' in other areas?
2. Registered small firms option: The FCA authorisation process involves 6 to 9 months' work in advance of filing, at an estimated cost of £150,000 per firm (see note 10 from this Treasury/Cabinet Office workshop). It then takes another 3 to 12 months to become authorised, depending on the permission required. This makes funding the launch of a new financial service very expensive compared to an unregulated service, and the slow time to market increases the risk of failure (ironically). A 'registered small firms' option already exists in relation to e-money and payment services, and would reduce the cost and delay of market entry for firms preparing for full authorisation. It should be brought in more broadly.
3. Client-money banking platform: Many authorised firms are obliged to 'safeguard' their clients' money by keeping it separate from their own funds in 'segregated' bank accounts. UK banks can be particularly slow and uncooperative in opening these accounts, which delays time to market. This, along with the recent financial and IT problems amongst UK banks, suggests it might be wise to 'ring fence' segregated accounts on a separate platform, possibly under the supervision of the new Payments Regulator.
4. Small Investor Option: Any web designer will tell you that the more 'clicks' you put in the way of a consumer, the less likely it is the consumer will go through a process. So 'dialogue boxes' that require people to certify things or take tests to invest in bonds or shares will also deter them. That's a barrier to the adoption of new 'crowd-investment' services, which many people might prefer to try out with small amounts. In fact it's far easier to gamble on lotteries and bingo than it is to invest. So allowing people to be invited to invest up to, say, £250 in debt securities or shares per project on authorised crowd-investment platforms with a clear, fair and not misleading description of the risks, but without any form of certification, advice or appropriateness test would seem appropriate (see the French proposals for crowd-investment).
5. Platform-level regulation: current financial regulation operates on the basis of different types of activity related to certain types of legal instrument, regardless of the customer experience. However, the online 'marketplace' model is now being applied to many different types of financial service, enabling people to transact directly with each other in relation to payments, savings, loans and investments, for example. Insurance and other services will likely follow down this path. This offers the chance to removing doubt and duplication by regulating common operational risks with a single set of rules at the platform level, with relatively few extra rules for different types of instruments or different types of activity being financed.
6. FCA 'Sandbox': coupled with the registered small firms option, the FCA could maintain a more dynamic focus on innovation and competition if it offered a dedicated space or channel for evaluating new services - both inside and outside the regulated sphere - which would also help it decide whether to flex its rules to suit.
7. Seek solutions from outside the existing market: the FCA should not assume that every innovation is designed to circumvent the existing regime to the detriment of customers. There are plenty of entrepreneurs who have spotted opportunities created by poor banking and are trying to increase transparency and reduce costs. So where the FCA is aware of existing consumer detriment or other market problems, it could present these to the market in open 'innovation workshops' - similar to those fostered by the Treasury/Cabinet Office - and/or release them into its 'sandbox'.

Your thoughts?

Draft Peer-to-Peer Lending Regulations

The draft regulations enabling the Financial Conduct Authority to regulated peer-to-peer lending have been published for parliamentary approval (see Articles 36H-I). There have been some changes to since the previous version in the March consultation to remove certain issues. The more detailed FCA rules should be out with a further consultation paper in September/October.

Basically, your platform is 'in scope' for FCA purposes if it enables loans to which individuals are a party as lenders and/or borrowers (either on their own or as a member of an unincorporated association or a partnerships of two or three). However, there is an exception in the case of borrowers, where either the lender provides the borrower with credit of more than £25,000 or the loan is entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower. 

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.

Presentation on Regulating Alternative Finance

Here's my presentation from Monday's very well organised ACCA Alternative Finance Conference 2013.

Videos of the presentations are now available on the ACCA’s Alternative Finance site.

Regulating peer to-peer and alternative finance - sdj from Simon Deane-Johns

Submission To Parliamentary Commission on Banking Standards

In the interests of transparency, I've embedded below my submission to the Parliamentary Commission on Banking Standards.

Submission to commission on banking standards sdj 08 02 13 final from Simon Deane-Johns

You Want Another 'Clarion Call' To Regulate Crowd Investing?!

On Monday, Lord Sharkey and Baroness Kramer proposed a 'probing amendment' to the Financial Services Bill to add "The activity of establishing, operating or winding up a crowdfunding scheme" (see here, from column 832). In support of this, Lord Sharkey cited the example of the US JOBS Act and the fact that most new jobs are created by small businesses. He also cited a report by the Association for UK Interactive Entertainment (UKIE). Oddly, however, in declining to support the latest amendment, Lord Sassoon said (at column 835), "there has been no clarion call from industry for more regulation." This appears to arise out of some confusion over the meaning of the term 'crowdfunding', which is being used in some circles to refer to all direct finance platforms, regardless of whether they facilitate donations, lending or investment in debentures and shares.

This is in fact the third amendment that relates to peer-to-peer or direct finance platforms, the first pair of amendments having been debated on 18 July (see columns 325 to 332). All three are really part of the same debate insofar as they share common types of operational risks, regardless of the type of instrument available on the platform. In that earlier debate (at column 330), Lord Sassoon confirmed that "changes being made as part of the Bill under Clause 6 would make it legally possible to bring direct platforms into scope." From the immediate context, he seemed to be only referring to peer-to-peer lending, since that amendment deals with "Rights under any contract under which one person provides another with credit". However, this should also permit regulation of crowd investing in other debt insturments (debentures), leaving open the question of whether equity-based crowd investing can be definitively brought in scope. 

Lord Sassoon said the financial regulatory framework is flexible enough to enable crowd investing, and he says the FSA's note on crowd investing shows that the matter is in hand. But he did add, rather tellingly, that "industry standards and further FSA and FCA guidance may have an important role to play in future." 

That seems an unnecessarily cryptic reference to the Government's recent response to the Red Tape Challenge on challenger businesses, which is why the suggested lack of a 'clarion call' seems rather odd. That Red Tape Challenge indeed yielded a 'clarion call' from industry for proportionate regulation to clear the way for various forms of direct finance. Follow-up submissions produced in consultation with various platforms dealt with both crowd investing and peer-to-peer lending, as did submissions in support of the July amendments in the House of Lords. 

And, as the government's creation of a cross-departmental working group suggests, there is a lot of work yet to be done in response to that call.

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.

Unpacking The Term "Crowdfunding"

The term "crowdfunding" is being used a lot in legal circles these days, but it can mean a number of different things to different people - from many people buying shares in a single company to any form of peer-to-peer financing or donations. So for the sake of clarity I thought I'd explain my own understanding of the different types, as well as the overall policy context.  

Terminology

In its broadest sense, 'crowdfunding' describes a key impact of Web 2.0 on financial services (as discussed over on Pragmatist, and in print here). It's one aspect of the same trend towards greater consumer control that has swept through retailing, entertainment and so on. The critical point of distinction between the various forms of crowdfunding and 'traditional' forms of finance is that crowdfunding involves a finance marketplace comprising consumers and/or small businesses on both sides, whose direct interaction is facilitated by a neutral platform operator, rather than a single financial institution offering its products to its customers. Other key characteristics are set out in Annex 1 to this note. But when the term 'crowdfunding' is used in this broad sense, one should bear in mind that it actually encompasses a range of very different models, involving very different legal instruments, with very different legal and regulatory outcomes, as discussed below.

'Crowdfunding' first gained currency to describe 'rewards-based' peer-to-peer platforms like ArtistShare and Kickstarter.com, which were designed to raise money from many people to fund many small budget projects via the internet without infringing US laws that control the offer of 'securities' to the public. On those web sites, eligible people are enabled to post 'pitches' seeking funding for a project (e.g. to start a monthly magazine) in return for a 'reward' of some kind (e.g. a monthly copy of the magazine for a period). There is a range of similar platforms in the UK (e.g. Peoplefund.it, Crowdfunder and those mentioned here).

Independently of rewards-based crowdfunding, peer-to-peer platforms have also emerged in the markets for personal loans and small business loans. This activity was first called 'social lending', then 'person-to-person lending', 'peer-to-peer lending', 'P2P lending' and more recently 'crowd lending'. Examples include Zopa, Ratesetter and Funding Circle in the UK and, say, Comunitae in Spain. The peer-to-peer lending model has also been adapted to enable many people to fund numerous small businesses in developing countries, which is referred to as 'micro-finance' (e.g. Kiva, MyC4). When applied in the domestic not-for-profit or charity sector, the peer-to-peer lending model tends to be referred to as 'social finance' (e.g. Buzzbnk).

However, the term 'crowdfunding' has acquired a more formal regulatory meaning over the past year or so, as a result of the successful campaign in the US to introduce the JOBS Act to allow the crowdfunding model to be used in situations where 'securities' are the reward (Title III of  the JOBS Act is called the Crowdfund Act). This is apt to cause confusion outside the US, because the US Securities Exchange Commission has a broader interpretation of what constitutes a 'security', and narrower exemptions from the scope of its securities laws, than the UK and many other jurisdictions.

Prior to the JOBS Act, the SEC required an individual or small business borrower to comply with the same formal registration requirements for entering into a simple loan contract via a public web site that a major corporation must follow when offering its shares, bonds or debentures to the public. So US-based peer-to-peer lending programmes have had to be registered with the SEC at great expense and require a financial institution to act as an intermediary (e.g. Lending Club, Prosper).

But in the UK and many other jurisdictions such heavyweight requirements are applied to more complex debt instruments (bonds and debentures) and shares ('equities'). As a result, peer-to-peer lending (or 'crowd lending') using simple loan contracts has been established outside the scope of securities or investment regulation in the UK since Zopa launched in 2005 (later joined by Ratesetter and Funding Circle).

However, peer-to-peer models that involve shares and debentures ('crowd investing') have proved a lot more awkward to implement, given that traditional financial regulation is more intense in connection with those instruments. Exemptions have been more liberal than in the US (at least pre-JOBS Act), although fiendishly complex and expensive in time and money to interpret. As a result, there is a growing political consensus that the UK would also benefit from a US-style regulatory overhaul in this area. And it is in the context of this policy debate that use of the term 'crowdfunding' is most at risk of generating confusion between 'crowd investing' and other forms of  'crowdfunding' in the broader sense.

Policy Context

While 'crowd investing' is perhaps most under the regulatory spotlight currently, there are some common issues and operational risks across all types of 'crowdfunding' in the broadest sense (though less so with rewards-based crowdfunding). All types of plaforms involve a similar technological and operational 'architecture of participation'. And they all meet some difficulty under traditional regulation - and the more intense that regulation is, the more complex it is to innovate, launch, operate and grow. Small changes can trigger significant regulatory requirements, increase costs and inhibit marketing. Tax incentives favour products offered by traditional institutions and inhibit the ability of ordinary savers and investors to diversify.

As a result, the operators of both peer-to-peer lending and crowd investing platforms have been calling for proportionate regulation at the platform-level to enable rapid, responsible development, regardless of the type of instrument available on the platform. This process began when the leading UK peer-to-peer lenders launched the Peer-to-Peer Finance Association in July 2011, proposing a set of Operating Principles to address typical operational risks. They and several crowd investment operators have also participated in various government and private sector forums. The social finance sector has since added its support, with leading charity lawyers Bates Wells & Braithwaite citing the development of these types of platform as a necessary step in the development of social investment (which was also endorsed by the government-funded Community Shares Unit). And a meeting of wide variety of European industry participants took place in June 2012 to discuss the need for EU regulation. 

In the meantime, economic reality has also increased the pressure for clear and proportionate regulation to enable alternative finance. Banks and other traditional investors continue 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. There is a dawning recognition that it's down to entrepreneurs and private investors to connect the dots between low returns on savings and the fact that SMEs face a funding gap of £26bn - £52bn over the next 5 years, or that social sector organisations face an annual finance gap of £0.9bn  - £1.7bn. 

Against this backdrop, there have been numerous UK government reports and recommendations on the need to encourage the creation and development of both peer-to-peer lending and crowd-investing, with the weight of emphasis depending on the focus of the relevant initiative. These include the Cabinet Office's Red Tape Challenge on disruptive business models; NESTA's "Beyond the Banks" report; the Breedon Taskforce report (which the government largely accepted); Andrew Haldane's speech on forging a common financial language; and Lord Young's report to the Prime Minister on the start-up and development of small business. 

However, there has been little concrete action from the UK Treasury, prompting the debate of various amendments to the Financial Services Bill in the House of Lords. In essence, these amendments seek both greater engagement by the authorities in encouraging innovation generally, as well as specific regulation to encourage the growth of peer-to-peer models for a range of different instruments.

By way of comparison, it's interesting to note that the JOBS Act was the product of a US Presidential initiative in January 2011 which received bi-partisan support in the US Congress, and the new law was signed by the President on 5 April 2012.

Image from Lattice Capital.

FAQ on Crowdfunding Amendments to the Financial Services Bill

Today, the Financial Services Bill is being discussed in Committee Stage in the House of Lords. Set out below is an explanation I prepared on the amendments to the Financial Services Bill proposed (at 114) as a basis for promoting more effective competition in the interests of consumers and small businesses in the regulated financial markets, including the establishment of a new authorisation regime for direct finance platforms - or 'crowdfunding'. 

FAQ on proposed amendments of Financial Services Bill sdj 260612

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