Of Card Payments, Consumer Protection, SMEs and Merchant Aggregators

Consumer advocates have raised the issue of some uncertainty about which credit card transactions benefit from the statutory right to pursue the card issuer if a merchant makes a misrepresentation or breaches the contract for sale of an item (see the April article from MoneySavingExpert). Many do not realise that the uncertainty arises from arrangements that enable small businesses to accept card payments, overlooking important benefits to SMEs and consumers alike. If SMEs (which represent 99% of UK businesses) cannot accept card payments, consumers may find it less convenient to deal with them, threatening their livelihoods and over half the UK's new jobs, while also reducing consumer choice and competition for large retailers. The statutory right is also subject to exceptions that mean the transaction might not be covered anyway. Yet cardholders still have 'chargeback' rights under their card terms, which are more generous and involve less hassle than making a statutory claim.  So, my own view is that the benefit of enabling small traders to offer their customers the convenience of paying by card outweighs the potential lack of a statutory claim against the card issuer, because the cardholder has the greater comfort of being able to initiate a chargeback anyway. 

Statutory Rights

Consumer credit transactions that involve the borrower (e.g. a credit cardholder), the creditor (e.g. a credit card issuer) and a supplier (merchant) under the same agreement benefit from a provision of the Consumer Credit Act (CCA) that makes the creditor liable for any misrepresentation or breach of contract relating to the sale of the item (section 75). Various exclusions apply. For instance, it only covers items over a £100 up to £30,000 and it does not cover or must be more than Another provision covers transactions where the credit agreement did not directly involve the supplier but was specifically linked to the sale of a specific item (section 75A). Again, however, there are exceptions and it only applies to transactions for an amount exceeding £30,000 up to £60,260, so it is unlikely to be relevant to card transactions.

Chargeback Rights

Under rules governing the operation of the card schemes, such as MasterCard, card transactions can be reversed or 'charged back' in various cases including cardholder dispute within 180 days of the transaction. This right is wider than the statutory right under section 75 of the CCA because it applies to debit card transactions as well as credit card transactions, and the reasons for initiating a chargeback go well beyond the scope of the statutory right (see the list of reasons on page 54).

Merchant Aggregators

Card schemes operate by enabling issuers to issue payment cards that can be presented to participating merchants, who send the transaction data to an 'acquirer' who then obtains payment from the relevant card issuers via an 'interchange' process run by the card scheme operator. 

Typically, the merchant must have a direct contract with an acquirer, but that is expensive to set up and administer in the case of small merchants. 

So to give cardholders the convenience of being able to pay small merchants, the card schemes allow approved intermediaries (MasterCard calls them "Payment Facilitators", for example) to represent  small businesses more efficiently and cost effectively under a single contract with the acquirer, enabling those 'submerchants' to accept card payments where their annual transaction volume is less than $1m or local currency equivalent (increased from $100,000 a few years ago). WorldPay, the UK's largest card acquirer, explains its aggregator program here, for example; and MasterCard has a global list of approved Payment Facilitators by region.

In addition, department stores and e-commerce marketplaces may be treated by the card schemes as the merchant, where the obligation to pay the price of an item offered by a third party seller is satisfied by paying the store or marketplace operator rather than the seller directly. Where problems arise in that context, even though section 75 claims would not be possible, the cardholder typically has the right to either use the marketplace's own dispute resolution and compensation process or, in any event, to initiate a chargeback (large third party sellers will also have their own returns and complaints resolution and compensation process). Such 'master merchant' relationships are also important channels for small businesses to gain access to larger markets, again improving convenience, consumer choice and competition.

The point in all these cases is to weigh the benefits to consumers of convenience, increased choice and competition - as well as the benefits to SMEs who are able to access a wider market, grow and create more new jobs - against the loss of the relatively narrow rights under section 75 compared to chargeback rights and other remedies.

P2P Lending Goes Global: FinTech Credit v OldTech Credit

Twelve years after the launch of Zopa and the peer-to-peer finance sector finally gets its first report from the Bank of International Settlements (BIS), the central bank of central banks. The report is surprisingly positive, given financial regulators' preference for the status quo. Basically, they believe that change increases risk and increased risk is bad, so innovation is both risky and bad. Similarly, they're fond of shoe-horning innovative services into existing regulatory frameworks without seeing that the innovation may itself be exposing and/or solving flaws in that system. At any rate, the banking situation must be pretty dire for the industry's global beacon to produce a positive report on alternatives...  But in the the interests of time I want to ignore the positives and answer a few criticisms:

Is P2P lending "procyclical"?

No.

In fairness, the BIS report only suggests that P2P finance represents the "potential for ...more procyclical credit provision in the economy", but I still disagree that this is a feature of the model.

Bank lending itself is procyclical, which is to say that banks lend lots of money when the economy is booming, yet try to protect their balance sheets when times are tough and we need credit the most. In fact, this was such an alarming feature of the recent/current financial crisis that BIS itself introduced capital rules that it thought would force banks to become less procyclical. Recently, moreover, the BIS's own Basel Committee reported that these rules are proving ineffective. They think there is too much bank credit available and/or the quality of creditworthiness is in decline.

If that's the case, then we really are in trouble, since UK banks have been lending progressively less to real businesses, and we aren't exactly in the grip of an economic boom...

Compare this to the rise of P2P lending. We started Zopa in 2005 when the 'spread' between high bank savings rates and cheap credit was actually very narrow (heavily subsidised by PPI revenues) - yet proved that lending directly between humans without a bank in the middle produced a better deal for both lenders and borrowers. This is why P2P lending has become ever more popular since 2008, while banks have sat on the sidelines waiting for the good times to roll. Lenders get higher interest on their money, diversify risk by lending to lots of people and businesses who are starved of bank loans - apparently leaving the banks with leaner opportunities...

But I believe the banks have simply chosen to chase higher yielding loans and other assets because their cost base does not allow them to make money serving the better risk customers.

Indeed, the BIS report acknowledges that banks have "left room" for platforms that enable people to lend directly to each other "by withdrawing from some market segments" after the financial crisis (which, I'd like to emphasis, still hasn't ended).  The report notes that P2P lending equated to 14% of gross bank lending flows to UK small businesses by 2015... only 5 years after the launch of the first P2P business lending platform.

So, P2P finance is actually counter-cyclical by its very nature.

The real issue, perhaps, is what happens when banks start being able to offer better interest rates and cheaper loans. Yet Zopa's early experience shows the new platforms will still be able to compete successfully (especially because those PPI cross-subsidies are no longer available: refunds and compensation have now reached £26.9bn, according to the FCA!).

Is it likely there will be a 'run' on P2P lending?

No. Far from seeing a potential 'run' on P2P lending platforms by lenders trying to get their money out, many platforms are seeing excess lender demand due to continuing low yields on bank deposits (not to mention high fees on investment products). Zopa, for example, has been closed to new lenders for some months, even while seeing record borrower demand, yet still plans to offer P2P lending within Innovative Finance ISAs. Everyone is chasing yield, not just the banks. But, again, the early experience shows that the rates will still be more attractive if and when banks are able to offer higher rates to savers, because they need fatter margins than P2P platform operators.

Meanwhile, the P2P model has expanded from consumer and small business loans into car finance and commercial property loans. But so far the regulators have protected banks against head-to-head competition for other forms of finance, such as retail sales finance or mortgages, through lack of reform to arcane procedures dictated by consumer credit and mortgage regulation and refusing to allow longer term finance to be supported with short term loans - which banks are allowed to do all the time.

So, rather than a run on P2P lending, we're more likely to see successful P2P lending operators adding a bank to their group, at the same time as expanding their existing P2P offerings. In other words, a twin-track attack on Old Tech banks and banking models.

Will P2P lending help solve problems with banks' legacy systems?

No.

There's no doubt that this BIS report and the regulatory obsession with 'FinTech' generally, springs partly from regulators' fervent wish that OldTech banks will simply take advantage of the latest trend to rejuvenate their systems for the longer term.

But there are many reasons why established retail banks won't do that - and will continue to passively resist regulatory edicts to do so. That's why the UK government had to impose the open banking initiative (not to mention sharing business credit information and declined loan applications); why the Bank of England has opened up the Real Time Gross Settlement system; and why PSD2 regulates a new class of  third party 'account information' and 'payment initiation' service providers.

Why won't the banks renew their legacy systems to save themselves? For starters, they don't actually have legacy "systems" so much as separate bits of very old kit connected manually by employees holding hands with electrical chord between their teeth using their own spreadsheets. So the shiny new government-mandated open banking interfaces will likely be connected to computers that aren't really party of any type of integrated "system" that, say, a Google engineer might recognise.

Aside from that insurmountable IT challenge, bank management teams are simply not incentivised or empowered to think about the long term, and all their key decisions are made (after a very long time) in committee to avoid personal blame.

So it's more likely that the aspects of 'banking' which are within the scope of P2P lending will gradually drift away from banks altogether, while activities outside that competitive scope will need to be reinvented by others, including new banks, from the ground up.

Will traditional banks launch their own P2P lending platforms?

Probably not.

Some have bought shares in such platforms and others have actually lent their own funds on P2P lending platforms. But that's a long way from allowing their depositors to lend directly to their borrowers.

That's because bankers make their money by keeping savers and borrowers separate of each other and treating deposits as their own funds. 

It's high time regulators admitted this to themselves and got on with the job of supporting more transparent, fairer mechanisms for allocating people's spare cash to other people who need it.

Is P2P lending an "originate-to-distribute" model?

No.

Here, again, P2P lending is a reaction away from this type of model and is transparent enough to reveal attempts to introduce it. BIS says that "originate-to-distribute" refers to the fact that neither the primary lender nor the operator of the platform retains any ownership or interest in the loan that is agreed. But this does not fully describe the model or its potential hazards.

The "originate-to-distribute" model may have that basic feature but the point is that it's driven by a market for secondary instruments (bonds and other derivatives) that are based on underlying loan contracts, where demand in that secondary market has outpaced the supply of loans. In that case, loans may start to be originated solely to support the secondary market. This transpired in the context of the sub-prime mortgage crisis, where investment banks arranged bond issues in a way that effectively concealed the poor quality of underlying loans. From their own problems with undertaking due diligence, they knew that the underlying loan data was hard to find and in many cases unreliable (hence the related 'fraudclosure' issue of investors foreclosing on mortgages they could not prove they owned). That's why the banks involved have since been paid billions in fines and compensation towards the repayment of bailouts (at least in the US).

But, as the name suggests, P2P lending - at least in the UK - involves a direct loan between each lender and borrower on the same platform, where the data concerning the loans is available to the participants, including lenders who may receive assignments of loans already made on the same platform. The visibility of the loan performance data and reputational impact for the platform operator if all goes wrong limits the temptation to conceal the original credit quality or performance of the loan.

So, BIS's assertion that P2P lending represents the same model or suffers from the same potential for moral hazard is not right.

It is possible for a lender to ask a P2P platform to provide it with access to some less creditworthy borrowers to achieve a higher overall yield, perhaps even with a view to selling the resulting loans to other lenders or even securitising them; but even if you deem that to be 'originate-to-distribute', the 'moral hazard' is not there because the data is readily available for all to understand the lesser quality or performance of the loan.

The BIS report cites the Lending Club 'scandal' in 2016. But, ironically, Lending Club is not based on a genuine P2P lending model at all, because the SEC refused to allow direct 'peer-to-peer' loans without full security registration requirements (just ask Prosper!). So the regulators forced the US platforms to operate the same securitisation model that the banks pioneered in the sub-prime crisis... We abandoned attempts to launch the direct P2P model in the US because this model is nothing new - as well as being cumbersome, convoluted and expensive. But even there the relevant 'scandal' was 'only' that when selecting a portfolio of loans to issue bonds to the relevant investor, Prosper selected some loans that did not meet the investor's specified criteria. Not great where the data is available, but the point was that the problem was spotted quite quickly because the relevant data was readily available, so the loans could be re-purchased by the issuer.  

The report also cites the problems at Trustbuddy, in Sweden, but the problems there were again detected early by new management looking at the collections data, who promptly alerted the authorities; and Ezubao, in China, which was a ponzi scheme operated between July 2014 and December 2015 that was detected quite quickly - certainly faster than Madoff's activities in the supposedly heavily regulated US investment markets.

It is worth acknowledging, however, that there is always scope for something to go wrong. This is why the UK P2P lending industry pushed for specific regulation of P2P lending from 2011; and highlights why regulators should stop their hand-wringing about innovation and get on with the job of adapting to change.

Financial Authorities Need A Fresh Approach To Innovation

The application of the latest technology and business models to finance ("FinTech") is sparking a debate about the role of regulators and their approach to innovation. Senior officials advocate no change, citing various experiments and distinct innovation teams or projects of their own. But the financial system will fail to keep pace with the demands of the broader economy unless a culture of encouraging innovation is embedded throughout our regulators.

Financial innovation is hog-tied to the past. Regulators are conditioned to view innovation through the lens of current services and rules, rather than to consider it afresh. New services are sidelined into policy silos, where they are 'shoe-horned' into existing rules. Regulators seem reluctant to concede that new services reveal shortcomings in existing models and or that they should drive a change in regulatory approach. 

For example, Mark Carney, Governor of the Bank of England, has said that the Bank of England takes "consistent approaches to activities that give rise to the same risks, regardless of whether those are undertaken by "old regulated" or "new FinTech" firms."  This is because, he claims, "following a raft of post-crisis reforms, the Bank’s regulatory frameworks are now fit for purpose."  

Whose purpose?

Do banks adequately serve their customers?

Do they operate within the law? 

The UK's banks are a constant source of scandal, and frequently incur vast fines and compensation bills for misconduct.  New problems emerge constantly, and on a giant scale. Their role in Russian money laundering is perhaps the latest example. Many of the post-crisis reforms are also yet to take effect in the UK. The critical "ring-fencing" of retail and investment or 'casino' banking, for example, has been watered-down and won't take effect until 2019 - more than a decade after the financial crisis began - while Donald Trump is busy unwinding such reforms in the US. Whether such national initiatives will even be effective in a global system is still unclear.

Despite its name, "FinTech" represents not only the application of technology but also (usually) a customer-oriented commitment to either improve existing financial services or create alternatives that are aligned with customers' requirements. Yet the Bank of England approaches such innovation in the banking sector by asking:

• Which FinTech activities constitute traditional banking activities by another name and should be regulated as such? Systemic risks associated with credit intermediation including maturity transformation, leverage and liquidity mismatch should be regulated consistently regardless of the delivery mechanism.
• How could developments change the safety and soundness of existing regulated firms?  
• How could developments change potential macroeconomic and macrofinancial dynamics including disruptions to systemically important markets? 
• What could be the implications for the level of cyber and operational risks faced by regulated firms and the financial system as a whole?

This is not just a UK phenomenon. When it comes to assessing the application of technology to the financial system Sabine Lautenschlager, Vice-Chair of the Supervisory Board of the European Central Bank, also advocates "same business, same risks, same rules." 

Sabine says that "customers want to extend their digital life to banking; they want banking services anytime and anywhere." Yet she points to three "potential futures" for 'banking', none of which acknowledges the benefits of innovation. The only 'benign' scenario she considers is the one where banks "team up with" new entrants (or "fintechs"). A second scenario involves fragmentation into regulated and unregulated activity - nothing new, as the unregulated 'shadow banking' sector was already at the vast, pre-crisis levels in 2015. A third is that "fintechs" might be "swallowed up by big tech companies" making the banking market "more concentrated, less competitive and less diversified" (as if banking isn't already!). But the big tech companies already have regulated financial subsidiaries (mainly offering retail payment services under EU carve-outs from the banking monopoly), and their presence in the market automatically makes it less concentrated, more competitive and more diversified.

The ECB's overall concern seems to be that banking will become less profitable, causing existing players to cut spending on risk management.  But a preoccupation with the impact of innovation on  legacy players dooms the sector to over reliance on legacy firms and inefficient models that effectively require super-normal profits to operate. Mark Carney also points out that concerns about banks cutting corners to keep up with more nimble competitors should not constrain innovation, but is instead a matter for the central bank "to ensure prudential standards and resolution regimes for the affected banks are sufficiently robust to these risks."

The ECB has some strange views on what constitutes risks.  It is said to be inherently risky, for example, that P2P lending platforms are "securitising the loans they originate from their platforms". That maybe how such programmes work in the US, but over there a regulated lender makes a regulated loan and sells it to a listed entity that issues bonds under an SEC-registered prospectus. So any problems are happening right under the noses of the relevant authorities. In the UK, the lenders are free to securitise their portfolios - and several have - but that is not the role of the platform operator. Again, however, this involves regulated activity, both at P2P platform level and through the offer and listing of the relevant bonds.  The regulators are already implicated.

"Robo-advice" is also said to create the risk of investors 'herding' into the same positions at the same time, yet this already happens among regulated fund managers (and banks).  

Risks associated with 'cloud' services and outsourcing of data storage are also cited by the ECB, but these are not new risks at all, or even exclusive to financial services.  

Indeed, what regulators seem to miss is that many of the technological advances that are finally being applied to financial services under the "FinTech" banner have been applied to other sectors for over a decade.

This is not to say that new models are necessarily 'good' or effective. It can also take some time for risks to emerge.  The 'lessons' of the past and the resulting regulatory 'tools' and solutions must not be forgotten, and the old models need to be managed along side the new. But those old models and the rules they require should not be the only lens through which all innovation is analysed. New services must also be viewed afresh.

EC Boils Consumer Law Ocean On Eve of #Brexit Referendum

Perfectly timed to coincide with a peak in frustration with EU red tape, the European Commission has just published its plan to ruin everyone's summer consultation on the 'fitness' of six consumer directives, and is also busy reviewing a seventh (the Consumer Rights Directive):

• Unfair Contract Terms Directive 93/13/EEC;
• Consumer Sales and Guarantees Directive 1999/44/EC;
• Unfair Commercial Practices Directive 2005/29/EC;
• Price Indication Directive 98/6/EC;
• Misleading and Comparative Advertising Directive 2006/114/EC;
• Injunctions Directive 2009/22/EC.

Try to avoid falling asleep in the sun!

Will this result in less red tape? I could hazard a guess, but we won't really know until it's too late. The Commission reports its findings in mid-2017.

Revenge Of The Trilogues

They sound like something from a sci-fi horror movie, but the Trilogues are actually already among us. In an excellent article, Vicky Marissen, MD of PACT European Affairs, has explained how these "three-way discussions" have moved further and further away from their rightful place in the latter part of the ordinary European legislative procedure and are now being used informally as a legislative shortcut - something the new EU agreement seems likely to make even worse.

Relying more on trilogues means that about 90% of EU legislation is adopted on first reading without any genuine legislative debate; and secondary legislation is being used to kick more sensitive cans down the Rue du Luxembourg. Indeed, trilogues are now happening within just a few days of each other without publishing the changes agreed, so it's impracticable for those outside the trilogues to follow or attempt to engage in what is really a closed debate. This was a frequent problem in the course of agreeing the new Payment Services Directive, for example.

The recent EU institutional agreement on better regulation won't fix this, as the Commission is able to use its participation in trilogues to (wrongfully) assume the role of legislator - note that its proposal for better regulation didn't even mention the word "trilogue" and merely stated that "The three institutions will ensure an appropriate degree of transparency of the legislative process, including of trilateral negotiations between the three institutions." If anything, that agreement promises more informal trilogues:

"Where appropriate, the three institutions may agree to coordinate efforts to accelerate the legislative adoption process, both during each institution's internal preparatory steps and during the inter-institutional negotiations."

Not only does this increasingly closed shop raise the risk of poor, ill-considered drafting that creates costs for the broader community, but the mere perception of an opaque process also widens the gap between EU legislators and EU citizens - a gap that is already wider than the one between national legislators and their citizens.

The EU's legislative process needs to be more transparent than national processes, not less, if the EU is to be respected or seen as a Good Thing.

I'm amazed the Brexit fans aren't sounding the alarm over this...

Oh, wait, no I'm not. The Brexit 'debate' is pure politics, not connected to anything real.

RegTech Bottleneck?

The UK's Financial Conduct Authority is rightly proud of its Innovation Hub, Regulatory Sandbox and new "RegTech" approach, which includes "managing regulatory requirements more efficiently, and... how we can best support developments and potentially adopt some RegTech solutions ourselves."

But the figures suggest that either more resources are required or there has to be a quicker route to market for new firms.

Of 413 requests received as at February, about 215 firms (52%) obtained support from the FCA's Innovation Hub. But only 39 firms (18%) have either been authorised (18) or are going through the approval process (21).  And in a recent statement defending its record on processing applications for authorisation by P2P lending platforms, the FCA said that it has only processed 8 of 94 applications received (about 9%).

Something is gumming up the works!

In its statement on the P2P lending process, the FCA bravely claims that it is "taking a proportionate approach to regulation, recognising the need for consumers to be adequately protected and have the information they need". It has a deadline of 12 months to decide on applications (actually 6 months for complete applications). But it's not like these firms are trying to flout the law - they have willingly approached the FCA for approval. Indeed, the P2P lending industry spent years lobbying for regulation of the sector, which was introduced by the Treasury in early 2013 and took effect on 1 April 2014. Yet since then the FCA's figures suggest that over 40 new firms have applied to enter the market and 42 of them are unable to trade because their application to do so is yet to be approved. Another 44 firms are still relying on their interim permission by virtue of being licensed under the previous regulatory regime, and therefore (ironically) cannot offer the new Innovative Finance ISA because they are not yet fully authorised.

How many firms are able to persist against these regulatory headwinds remains to be seen, but the approach seems neither proportionate nor worthy of the FCA's ambition to foster innovation and competition for the benefit of consumers. So far, the traditional players remain pretty safely sheltered behind the FCA's regulatory wall.

Something must be done.

Either the FCA needs more resources or it must adopt a more expeditious approach to granting regulatory approval - a mechanism that allows firms to begin trading more quickly under certain thresholds, for example, as is the case with small payment institutions and small e-money institutions. Indeed, payment services firms enjoy their own regulatory regime (with a 3 month turnaround time for complete applications); and the P2P industry lobbied for that regime to be used as the basis for regulating their platforms - an approach which the French and Spanish have since adopted and the European Banking Authority supports.

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. 

Isle of Man Goes Crypto-Crazy

I'm indebted to my colleagues in the Isle of Man for pointing me to the IoM's recent Designated Businesses (Registration and Oversight Act 2015, which imposes various registration and anti-money laundering requirements on distributed ledger technology. Do we have a poster-child for how regulation of new technology can go way too far?

The IoM compliance obligations are aimed at: 

"the business of issuing, transmitting, transferring, providing safe custody or storage of, administering, managing, lending, buying, selling, exchanging or otherwise trading or intermediating convertible virtual currencies, including crypto-currencies or similar concepts where the concept is accepted by persons as a means of payment for goods or services, a unit of account, a store of value or a commodity;"

This seems likely to be counter-productive, to say the least, given that the 'currency' aspect of distributed ledgers is often merely there to reward the 'miner' or processor of transactions or events that occur on the ledger, regardless of whether those events are themselves financial in nature - financial services being merely one of many different potential applications.

So, should every business on the IoM that uses, or might wish to use, distributed ledgers register with the authorities and introduce AML controls on everyone it deals with, just in case? Maybe so...

Two specific points to make:

1. ‘convertible virtual currencies’ are defined more broadly than one would expect:

“including crypto-currencies or similar concepts [neither term being defined, except by what follows…] where the concept is accepted by persons as a means of payment for goods or services, a unit of account, a store of value or a commodity”, 

Most definitions of a ‘currency’ require all these criteria to be met, not just any one of them. Imagine what would happen to the US Dollar, for example, if suddenly it was not accepted as meeting just one of the above criteria...  Indeed, for this reason many people disagree that Bitcoin - the most widely used form of 'crypto-currency' - is still nothing more than a commodity.

In addition, none of the typical exemptions under payment services regulations seem to be imported here. To take but one relevant example: consumer loyalty/rewards programmes are typically exempt on the basis that the rewards are only accepted as a means of payment within a 'limited network'. Do the local authorities really want every business participating in a loyalty scheme on the Isle of Man to register and apply AML controls just because the scheme involves distributed ledger technology? Maybe so...

2.  Similarly, the list of activities that trigger the relevant compliance obligations would seem to cover a vast array of potential services and their providers/users - recognising that these are distributed ledgers to which all computers running the protocol have the same access. Again, just think of consumer loyalty programmes as you go through the list:

the business of issuing, transmitting, transferring, providing safe custody or storage of, administering, managing, lending, buying, selling, exchanging or otherwise trading or intermediating...

Even payment services regulation, for instance, exempts technology services that support transactions without the service provider handling funds. And the whole point of the ledger is that no intermediary is actually handling funds - its all happening peer-to-peer amongst machines - indeed perhaps everyone's device is handling the funds. Furthermore, there will be instances where access to a distributed ledger is just one element of a wider system - as in the car-rental example, or tracking shipping containers - and it may not be clear to everyone that a distributed ledger is involved if it's just to share the location or state of a vehicle or container.

Still, the Isle of Man's approach might at least be useful in demonstrating how regulation in this area can go too far...

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.

Need To #Crowdfund Your US Launch? Try Reggae...

... er, that should read "Reg A". 

I'm indebted to Anna Pinedo and Jim Tanenbaum for pointing out that the SEC has finally done its job under Title IV of the JOBS Act. As they carefully explain in a recent Mofo Alert, the amendments to Regulation A that take effect in about 90 days time will enable private US and Canadian companies to raise up to $50 million in a 12 month period. That entity could be the holding company for a UK start-up, for example, or possibly the US subsidiary of a UK start-up, so long as it has a genuine US establishment - you know, real people and office equipment and a decent coffee machine. 

Existing shareholders may also sell reasonable amounts of stock as part of the offering. 

And eligible investors include 'the crowd' - provided they each limit their purchases to no more than 10% of the greater of their annual income or net worth (with a similar limit for non-accredited corporate entities). 

It should also be possible to combine a Reggae Reg A offering with private offering, if you really, really need the extra money.

FCA Goes Social

The Financial Conduct Authority has made a huge effort to shrug off the image of its predecessor, and its latest guidance on social media and customer communications is another case in point. The FCA goes to far greater lengths than the FSA to understand the activities that it's regulating, and it has properly recognised the benefits to firms using the social media, not just the risks. There are some big concerns in here. But overall it's a helpful steer on how to market financial services in the social media, rather than just another regulatory minefield.

Now, about those 'big concerns'...

The word "consent" does not appear in this document. Nor do the words "data protection". The word "privacy" appears once, however, in a footnote which helpfully refers to the Information Commissioner's guidance on Direct Marketing. That's really the only nod to the many other requirements that application developers need to consider when producing financial services - something we've been focusing on intently at the Society for Computers and Law, for example. That's a particular concern, when section 1.8 of the guidance recommends "the use of software that enables advertisers to target particular groups very precisely" without so much as a footnote. If this is a tip to use Big Data tools, cookies and so on to engage in behavioural targeting of advertising, then firms will need a lot more help if they are to expected to do so appropriately.

Of equal concern is the FCA's decision to 'gold-plate' its guidance to the level of compliance required by the European directives on consumer credit and mortgages - another example of the European "regulatory creep" that blights the UK's landscape and is the source of so much talk of a "Brexit":

"The same constraints do not exist in other areas, but we think it is important to adopt a common approach across all the sectors we regulate, and across all media. To do otherwise would create a more complex and less certain regime, which would impose additional costs and which firms and consumers would find more difficult to navigate."

The problem with this approach is that not only do UK officials have a tendency to over-comply in this fashion, but they also take a literal approach to the interpretation of European law, rather than the purposive approach that European law itself dictates. So the UK invariably implements European edicts far more restrictively than, say, Greece or even France (historically the country most sued for failing to implement European laws, but here's the league table). 

Another problematic area is the guidance on using an image to convey a risk warning where a character limit would make it impossible to include it as text. While appearing to recommend this approach, the FCA then points out (on page 8) that Twitter settings, for example, allow users to ensure that images appear as a link, rather than being automatically displayed. So, risk warnings or other required information cannot appear solely as an image where such user features are present. This is explained a little more in section 7 of the Annex, which also mentions that some social media services limit the amount of text in images or crop them in unpredictable ways... In other words, images are not really much of a solution, even though they feature heavily throughout the FCA's examples.

Retweets and other sharing of financial promotions by customers and employees is another area for firms to consider a bit more carefully. There is some discussion of that (under "Other regulatory issues" on page 11), but it's obviously at the core of why firms would use the social media over traditional advertising channels. Basically, you can't rely on your employees to do the dirty work for you, at least not in the course of their employment (a slippery slope); and just because they or your customers are prepared to make a claim, doesn't mean that the firm can share it with impunity.

While it's refreshing that the FCA does not consider a tweet, for example, to be a real-time promotion, it doesn't mention the use of instant messaging features, or direct messaging. Although the guidance does mention that a customer 'following' a firm's account or 'liking' its material does not amount to an express request to receive real-time promotions to get around the ban on 'cold-calling'.

Finally, record-keeping is a key concern here. As the FCA points out (on page 14), you can't rely on the social media platforms to retain a copy of your promotional material. So firms need to have their own records of tweets etc., and the related compliance sign-offs.

No doubt the FCA's guidance will evolve in the light of these concerns over time - not to mention the guidance from the Information Commissioner!

EBA Sees #Payments Regulation As Best Model For #P2Plending - Updated

When the UK peer-to-peer lending industry began calling for proportionate regulation in 2011, we pointed to payments regulation as the ideal model. By the end of 2012, about 30 firms from across Europe signed an open letter calling for that approach to the regulation of crowdfunding generally. And that was the thrust of my response to the EC consultation on the topic. After all, these marketplaces are all basically payment platforms that enable the wallet-holders to agree to lend or invest money rather than just pay it. They have far more in common than there are differences.

Unfortunately, the UK authorities were determined to apply the existing investment rules to the P2P model, with consumer credit rules adapted to cover loans to individual borrowers and some small businesses. So instead of a dedicated set of regulations dealing with common operational risks among all platforms, with some extra rules to cover different types of instruments, we ended up with rules sprinkled all over the giant FCA Handbook.

Since then, however, the French have opted to apply payments regulation to P2P lending, and last week the European Banking Authority suggested a similar approach.

Of course, the additional attraction to payments regulation is that it is the subject of a 'maximum harmonisation' directive that allows for passporting throughout the EEA far more easily than under investment regulation.

If I were a betting man, I would put good money on the EBA's approach eventually winning out, with the real battle being fought over whether there should be any restriction on the amount that individuals should be able to lend [see update below]. The UK, France and Spain have each taken different approaches to this question. I'm glad to say that the UK has been the most pragmatic in recognising that platforms will struggle to generate enough liquidity without the possibility for some individual investors to lend significantly more than others to any one borrower, particularly in the SME lending markets. As I mentioned in the context of the recent European crowdfunding conference, my sense is that French and Spanish platform operators will realise this problem as they try to scale...

[updated as follows on 18 March 2015]

The battle over the restrictions around who should lend on P2P lending platforms, and how much, seems to flow from the mistaken belief by some authorities (the EBA included) that 'loans' are somehow 'debt securities'. Ironically, in its discussion of why investor type restrictions might be extended to simple loans, the EBA opinion underscores why that should not be the case - and indeed isn't the case in the UK.

For instance, in summarising the risks to lenders involved in P2P lending, the EBA, states (at para 28) that "the assessment of an investment opportunity requires a profound analysis as well as a thorough understanding of the project or business of a potential borrower." Yet making a loan does not equate to an 'investment' opportunity (and you would have thought that a banking regulator could fully elucidate the difference).

A loan is just a debt - which is a simple enough concept for anyone to grasp. It chiefly involves 'credit risk', not 'investment risk'; unlike bonds, for example, which are typically held for investment purposes rather than simply to earn interest (hence the focus on bond 'yields' rather than the interest rate or 'coupon').

The EBA later refers to the need for "explanations about a project, financing mechanisms and other investor education material", which also seems to misunderstand the straightforward nature of credit. Later still, the EBA states that P2P lending "usually means that lenders enter into loan agreements with a borrower which is, in many cases, a start-up enterprise." But that is certainly not the case in the UK, where such companies typically turn to equity investors who are looking for a share in the growth of a business, rather than simply the repayment of their capital plus interest. A subsequent discussion of "investment advice" and "investment recommendations" also highlights the EBA's mistaken assumptions about the essence of P2P lending. It's almost as if someone simply substituted "loan" for "equity" in a section about equity-based crowdfunding platforms.

This mistaken classification of lending as an investment is doubly ironic, given that the EBA is responsible for policy related to payments, banking, savings and loans and not securities (which is ESMA's territory). In fact, were it not for the EBA's view that payments regulation is the best fit for regulating the common operational risks of P2P lending, I would suspect the it of trying to limit competition with the banking sector by pushing P2P lending into the investment world. Yet, somewhat weirdly, when it comes to the section on credit risk the EBA suggests that platforms might be "required to cooperate with a bank, either in the way that the bank processes the assessments [of creditworthiness] on a professional basis or takes over any credit risk by contracting with each borrower directly." Which also ignores the fact, of course, that banks are busy walking away from the markets now served by the P2P lending platforms!

The EBA is also being somewhat disingenuous in suggesting that P2P lending platforms should carry out criminal records checks on borrowers - an extremely time-consuming, personally intrusive and costly process that not even banks are required to undergo when making loans. Compliance with anti-money laundering regulations, PEP/sanctions screening and membership of industry anti-fraud databases are adequate and proportionate controls for screening borrowers. Likewise, P2P lending platforms do not represent any greater source of risk to a lender's personal data than many other types of business, and data protection law should govern this type of risk, as it already requires appropriate IT and information security controls.

Overall, one is left with a nagging concern that, while it has made the best choice of regulatory frameworks for controlling the common risks associated with P2P lending, the EBA has not really engaged properly with the concept or the sector. Let's hope that changes soon.

FCA Spotlight On How Consumers Deal With Money

Source: Audio Visual Excellence

Consumer Spotlight is the FCA’s view on how UK consumers deal with money and financial services, including the capabilities and potential vulnerabilities. It describes ten consumer segments, and reveals the data the model is built on.

The tool is intended to help the FCA identify the risks consumers face, and the protection required.

Charts show how each segment responded to questions in a survey of over 4000 consumers. Filters reveal characteristics, attitudes and behaviours associated with different group of consumers (e.g. inertia, risk appetite and impulsiveness). This can help firms design products and communications that "work well for different, specific consumers."

The FCA's model is said to differ from firm's models because it incorporates "some data not commonly collected in commercial models, such as vulnerability characteristics and financial capability." However, I wonder if another difference is that some firms treat evidence of vulnerability and financial capability as a reason to target a segment, rather than avoid it...

While firms would be wise to at least consider the data when designing products and communications, the FCA warns that:

"The data is based on consumer recall and self-reported behaviour and attitudes; it is not validated against other sources. Consumers may not know the answers to questions. Other industry data may be gathered in different ways or for different purposes, making direct comparisons difficult... Although it may inform a firm's thinking and planning, the model is not designed for commercial development. We do not intend to enable firms to profile their own customer base using the model for their own commercial benefit."

#Crowdfunding the EU

Suddenly it's all go on the EU crowdfunding front.

I'm still digesting last week's ESMA opinion on crowd-investing and the advice on how to regulate it, which is to be followed by the European Banking Authority's view on the regulation of P2P lending.

It's too early to expect anything conclusive - both ESMA and the EBA say they are merely supporting the Commission in its broader efforts to embed crowdfunding in a range of policy areas - but it's good to see official recognition of the benefits of crowdfunding, as well as the risks, and some sunlight on the highly technical challenges to accommodating the new business models. Let's hope they consider how any changes will impact customer experience, marketability and the need to scale these platforms quite quickly.

In addition to regulatory reform, it would be great if the EU agenda could evolve to include realigning traditional tax incentives to boost personal investment in new asset classes.

More on the detail soon!

Thoughts On The Growth Of EU #Crowdfunding

I've just spent a fascinating few days at the ECN Crowdfunding convention in Paris this week discussing the development of crowdfunding across the EU. The main focus was on regulation, since that is perceived as being the key difference from country to country. But of course there are other factors involved and these were also covered in the presentations. In particular, crowdfunding is a huge marketing challenge, given the vast advertising budgets of mainstream financial services providers and customer inertia. There are also many perverse incentives and implicit subsidies favouring the traditional financial models. I helped explain such problems in a recent submission The Finance Innovation Lab to the Competition and Markets Authority on retail/SME banking, for example.

A European twist on the scale and nature of the competitive problems was emphasised by an early presentation from our hosts, BpiFrance, a state financial institution targeting traditional funding at SMEs. It has 2000 staff in 37 offices and arranged funding of €10bn for 3500 French SMEs in 2012 alone. So not only do French crowdfunding platforms face a banking monopoly, but they must also compete against direct public programmes. With that kind of competition, it's little wonder the French crowdfunding market is only a twentieth the size of the UK! Thankfully, Bpi appears to have switched to supporting the development of many new private platforms, rather than trying fund plug the French SME funding gap all by itself - rather like the strategy adopted by the British Business Bank.

Of course, the SME funding gap is not exclusive to France. Christian Katz, CEO of SIX, the Swiss stock exchange, explained that the EU's 23 million companies face a funding gap of 2 trillion over the next 5 years. Yet only 11500 have access to the public markets. Currently, SMEs are creating 1 job for every 5 that big companies are eliminating. In other words, the companies that create the jobs are starved of access to working capital.

This kind of problem is not simply financial, and Joachim Schwerin, Policy Officer, DG Industry & Enterprise gave an excellent presentation on Friday explained how Crowdfunding features in five of the EC's key policies for stimulating economic growth:

• Improving access to finance, especially for SMEs;
• Financing projects that have found it hard to obtain traditional finance
• Boosting the digital economy
• Increasing the level of entrepreneurship, which is completely lacking in many EU countries; and
• Enhancing democracy, by enabling people to mobilise their savings to produce financial returns, rather than always having to trust their funds to banks and other traditional intermediaries that may not actually have their interests at heart.

Joachim outlined plans for extensive guidance to SMEs on types of crowdfunding via the EC's "Access to finance for SMEs" portal, highlighting the opportunities for SMEs rather than just focusing on the risks to investors. So watch that space during early 2015.

Many delegates were pressing Joachim to outline an EU regulatory timetable, but he was right to point out that this is premature. He confirmed that the EC is still in listening mode, which is as refreshing to hear now as it was in October. Regulation does not create markets, as the EC has discovered in its regulation of consumer credit and contract law. Indeed, it is plain from the recent French law and German proposals that regulating without an understanding of the market could kill them altogether.

For instance, the French authorities have limited participation in P2P lending to individuals who may only lend up to €1,000 per project/borrower. The authorities say this is necessary to ensure that lenders diversify the total amount they lend. This seems harmless enough until you realise the marketing challenge faced by someone starting a brand new P2P platform who cannot rely on a few large lenders to fund the bulk of early loans, or to step in where liquidity is scarce from time to time. Yet in more developed markets there is no evidence that lenders fail to diversify. In the latest UK market study Nesta has found that 88% of lenders say they engage in P2P business lending because they think diversification is important, which is supported by the figures:

"The average P2P business lending loan size is £73,222 and it takes approximately 796 transactions from individual lenders to the business borrower to fund a listed loan, with the average loan being just £91.95. P2P business lenders have, on average, a sizeable lending portfolio of £8,137 spread over a median of 52 business loans."

As a result, project-by-project caps are not a feature of the regulation of P2P lending in the UK, nor the rules allowing wider retail participation in crowd-investment. These regulations only took effect in April 2014, well after these markets were firmly established, well understood, and were able to benefit from the credibility that proportionate regulation can bring without being strangled by red tape.

Finally, it was interesting to hear Christian Katz's recommendations to help ensure the success of crowdfunding in the EU, based on how stock exchanges have developed:

• Clear, common terminology;
• Code of conduct - especially promoting transparency - e.g. disclose the details underpinning credit ratings;
• Platform stability/availability;
• Fund recovery - safeguarding customer funds and how to get money out;
• Cross-border - don't ignore potential that the Internet brings;
• Positioning crowdfunding - e.g. as a source of pre-IPO funding (under €5m).

Each of these points merits a post in its own right, but an EU code of conduct would seem to be a good way to focus market participants on achieving them. The team at ECN presented some early thoughts. Clearly the code will need to be consistent with applicable national laws and accommodate all the different types of crowdfunding. It should also be negotiated by the CEOs of platforms, as they understand the development plans for their own businesses better than the lawyers and the policy staff. Such codes have already been agreed by the leading participants in more developed markets. For example, the Peer-2-Peer Finance Association (P2PFA) has developed Operating Principles specific to P2P lending, and the UK CrowdFunding Association (UKCFA) has produced its own code of practice to accommodate donation-based and investment-based crowdfunding.

While it is possible that specific enabling regulation may be necessary in some countries to initiate the ability to establish dedicated crowdfunding platforms (e.g. allowing normal loans to be concluded on such platforms, rather than only participation loans, or lifting the €100,000 limit on equity crowd-investment in Germany, for example), the EC's approach of allowing platforms to develop in line with self-regulation seems the wiser than rushing to regulate in detail.

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!