Brussels Proposes Free Movement For Crowdfunding

The European Commission has proposed a crowdfunding regulation that would enable cross-border peer-to-peer business lending and investment-based crowdfunding. Rather than interfere with national regimes, the regulation is intended to enable platforms to apply to ESMA for an EU "label" or right to operate throughout the EEA on conditions that are more proportionate than some of the harsher national regimes (e.g. those applying MiFID). 

The regulation would not apply to platforms that facilitate consumer loans/mortgages or donation/reward-based crowdfunding, or to platforms that are already authorised as investment firms. There would be a limit of €1m on the total amount of each fundraising.

The Regulations would require effective and prudent management; complaints handling; management by people with appropriate skills and professional experience; the detection and prevention or management of conflicts of interest. There are also rules on outsourcing and client asset safeguarding. There would need to be an initial appropriateness assessment for each investors, and a "key investment information sheet" for each investment opportunity. Communications would need to be "clear, comprehensible, complete and correct." Secondary trading would need to occur via a "bulletin board" on the platform rather than a "trading system".

It is not clear when the Regulations might be made final, but they would take effect just over 12 months after publication.

All very much academic for UK-based platforms, fundraisers and investors if Brexit goes ahead...

#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.

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?

FCA's Response And Final Rules On Crowdfunding

The FCA today published its response to its recent 'crowdfunding consultation'. 

In essence, the paper merely justifies why the FCA has refused to alter its earlier proposal. Accordingly, all the previous criticisms still apply... [sighs].

This won't be terribly welcome news, but at least crowd-investment platforms now know they can market to a restricted area of the 'crowd', if not everyone.

And, following Friday's release of the consumer credit rules that also apply to 'P2P agreements', peer-to-peer lending platforms now have the two rulebooks they need to begin preparing for the first wave of regulation in 25 days' time, followed by full regulation from 1 October.

Response to EC Consultation on Crowdfunding

New Years' Eve marks the deadline for responding to the European Commission consultation on crowdfunding. 

The response page is here (scroll to "How to Submit..."). You can respond as either a citizen or an organisation. I chose the citizen option as I was responding in a personal capacity rather than on behalf of any client. The compulsory questionnaire (embedded below) took about 20 mins to complete. It gave me the option to upload a document and I chose yesterday's response to the FCA consultation.

Have your say! ;-)

Response to EC crowdfunding consultation Dec 2013 from Simon Deane-Johns

Response to FCA Crowdfunding Consultation

I have embedded below my personal response to the UK Financial Conduct Authority's consultation on rules for regulating peer-to-peer lending and crowd-investment platforms, submitted today.

Interested in any thoughts or feedback you may have.

Response to FCA crowdfunding consultation simon deane-johns - final from Simon Deane-Johns

A PSD Passport For P2P Lending?

I was interested to read the overview of European national laws that might apply to various types of peer-to-peer finance ('crowdfunding'), published this week by the European Crowdfunding Network (ECN). It's fair to say that the UK is somewhat more advanced in its decision to specifically regulate, but it's proving fairly easy for other member states to catch up - principally via payment services regulation.

While self-regulation of the peer-to-peer lending in the UK borrowed heavily from the UK's implementation of the Payment Services Directive, no one suggested that a peer-to-peer lending platform was actually a payment service (in my view, it's out of scope, or otherwise exempt in several respects). Whereas, the peer-to-peer foreign exhange platforms, such as Kantox (in the UK) and Currency Fair (in Ireland) did take advantage of the PSD as a regulatory basis for their activities.

The EU passport rights that authorised payment institutions enjoy are obviously important for a foreign exchange platform, but less so for lending - due to the challenges in establishing a cross-border market for consumer credit.

Until now, that is.

Unfortunately, the FCA has been rather heavy-handed in its approach to the regulation of peer-to-peer lending, particularly in terms of financial promotions, client money rules and the red tape deterrent requirement for anyone 'lending [to consumers] in the course of a business' (whatever that means) to hold their own consumer credit authorisation, in addition to the platform. In other words, the FCA ignored pan-European calls for a PSD-like approach and has instead opted to import the activity into its investment regime. The French, on the other hand, are consulting on a PSD-based approach, although they have proposed some ridiculously low limits and appear to restrict the volume to the €3m per month to stay below the threshold for fully authorised payment institution status (where a passport would be available), which need to be lifted if it is genuinely going to enable P2P lending, especially to SMEs. 

The ECN overview reveals that other member states appear to be all over the place on the question of whether platforms fall within the scope of the PSD. Some commentators suggest the payment element of P2P lending is in scope, in which case that aspect should be outsourced, or that the platform operator become registered as a small payment institution or fully authorised as a payment institution (or become appointment as a PSD agent). Others suggest that P2P lending may be in scope but exempt under the commercial agents exemption.

Interestingly, however, the European Commission has proposed a new Payment Services Directive (PSD2), which it would like to finalise by Spring 2014. PSD2 is still somewhat flawed, sure, but even in its current form it would seem more proportionate than what the UK is proposing in relation to P2P lending. Including P2P lending within its scope would also provide the Commission with an opportunity to clarify that, so long as the platform is authorised, lenders (payers) should not also need to be authorised under the Consumer Credit Directive - to enable businesses to lend to consumers and other businesses.

Any port in a storm...

FCA Crowdfunding Consultation

The FCA has today published its crowdfunding consultation, covering both crowd investment in equities and debt securities (which the FCA calls 'investment-based crowdfunding'), as well as the lender side of peer-to-peer lending ('loan-based crowdfunding'). The borrower side of loan-based crowdfunding was covered in the FCA's consumer credit consultation earlier this month. The consultation paper will be of interest not only to platform operators, but also to those looking to raise or contribute funds in a bid to escape bank products, in particular.

The FCA is clearly aware of the general anxiety that any rules it makes should not exclude the 'crowd'. But based on the FCA's summary of its proposals, in my view it has not struck the right balance (called for by the industry last December) for the reasons below. In summary:

• The proposals seem to land quite heavily on peer-to-peer lending (perhaps partly because investment-based platforms are already subject to the investment regime). While in principle the FCA has followed the thrust of the P2PFA's Operating Principles (which was based on payments regulation) the decision to bring simple P2P loans into the investment regime will make it substantially more expensive in time and money to establish a platform. The costs of ongoing compliance will also increase, though largely through the undue complexity of the investment regime, rather than any substantive change in how operational risks are managed. In addition to potentially discouraging entrepreneurs from establishing a platform, the red tape requirement for a lender to be authorised, in addition to the platform, where 'lending in the course of a business' on a platform may discourage business and institutional participation, especially without clarity on where compliance responsibilities lie given that the lender's own operational systems aren't involved at all. There is little proportionality according to the relative risks associated with different types of loan (e.g. unsecured prime, secured, short term high rate and so on). However, there is some good news in that the FCA seems to advocate the introduction of a 'secondary market', where platforms don't already operate one, without apparent restrictions on how these should operate or whether one could participate without first lending into the 'primary market'.

• The proposals for investment-based crowdfunding do at least allow for wider 'retail' participation than the FCA has seemed to support to date. However, people will be asked to certify that they will not invest more than 10% of their 'net investible portfolio' in unlisted shares or unlisted debt securities (excluding their primary residence, pensions and life cover), and they face an 'appropriateness test' if they aren't investing on advice. So it will still be much easier to stick a tenner on a pony, where the house always wins, rather than to back a local business in support of the economy. The risks that the FCA points to in justification for this can all be explained transparently on websites. But who in government will take responsibility for the strange inconsistencies in the way we are allowed to use our money?

Comments are due by 19 December, and it would be best to get involved. The FCA plans to review the overall crowdfunding regime again in 2016, so it could be a long wait before any problems missed will be rectified...

Loan-based crowdfunding

Firms operating loan-based crowdfunding platfroms are to be regulated from 1 April 2014 as ‘operating an electronic system in relation to lending’ (under article 36H of the Regulated Activities Order). The FCA is aware of about 25 firms in this category.

The FCA sees loan-based crowdfunding as "generally of lower risk than that made via investment-based platforms" although it sees the potential for innovation that may bring higher risks, so will keep the sector under review. For the time being, however, the FCA is consulting on:

• minimum prudential requirements that firms must meet in order to ensure their ongoing viability (£20,000 to £50,000 minimum capital and a further 0.3% to 0.1% of volumes on a scale of £50m to £500m);
• the requirement for firms to take reasonable steps to ensure existing loans continue to be managed in the event of platform failure;
• rules that firms must follow when holding client money, to minimise the risk of loss due to fraud, misuse, poor record-keeping and in the event of a firm's failure;
• rules on the resolution of disputes, and
• reporting requirements for firms to the FCA in relation to their financial position, client money holdings, complaints and loans arranged.

It is reassuring that all these issues (other than FCA reporting obligations), have long been addressed by the Peer-to-Peer Finance Association in its Operating Principles. However, those were modelled on payment services regulation (under the Payment Services Regulations 2009), whereas the FCA proposes to apply more or less the full weight of its retail investment regulation on the sector for little real benefit. For instance, the effect of the voluminous client money 'sourcebook' ('CASS') is not terribly different to payment services segregation requirements that would only need to be tweaked slightly). Firms might decide to outsource the handling of client money to other authorised firms, rather than accept the additional red tape that CASS creates (as investment-based platforms tend to do).

Unfortunately, too, the FCA interprets the Consumer Credit Directive to mean that any person or firm lending in the course of business via loan-based crowdfunding platforms will need to be authorised as they are carrying on a regulated activity. That interpretation is inconsistent with the FCA's view that such a person is actually an investor in loans, rather than a lender, but may be driven by the use of the word 'creditor' in the Directive. Moreover, such dual authorisation makes no sense, given that all the operational activities associated with the marketing, creation and servicing of the loans takes place in the platform operator's systems, rather than the lender (even where that lender is, say, a bank). In other words, the lending is being done in the course of the platform operator's business, not any business being run by the lender. Responsibility for compliance in such circumstances is not clear. How is a business lender supposed to comply with consumer credit rules when it is not directly advertising, processing loan applications or servicing the loans? Further, the FCA (like the OFT) declines to give any guidance on what it means to be 'lending in the course of a business', other than to refer to its existing guidance around the 'business test'. Early case law cited in HMRC guidance on this topic, however, requires an assessment of the operational reality which in this case suggests lenders on loan-based crowfunding platforms are not lending in the course of a business operated by them but in the course of a business of the platform operator.

In my view, the FCA's interpretation of the Consumer Credit Directive is another example of UK officials failing to take a purposive approach to interpreting EU law and needlessly creating a rod for our own backs. I doubt very much whether the purpose of the Directive was to ensure dual regulation in the context of loan-based crowdfunding.

Notwithstanding the 'low risk' classification, the FCA plans to treat investments on loan-based crowdfunding platforms largely as it does other designated investments (though there is no guidance on what distinguishes a 'loan' from 'debt securities' in the FCA's view). So rules that apply to firms arranging transactions in designated investments will therefore also apply to firms running loan-based crowdfunding platforms. As a result, such firms will have to comply with two separate FCA rule books - one for borrowers ("CONC"), and one for lenders (now to be called 'investors') ("COBS"), including rules applicable to 'financial promotions'. 

Finally, the FCA seems to advocate the inclusion of a 'secondary market' on loan-based platforms, in the context of a discussion on cancellation rights. The FCA does not explain its view as to whether or how certain exemptions to the right to cancel apply, for instance, where the lender is not acting in a commercial or professional capacity, the main service contract is not a 'distance contract' so the loan can't be a 'secondary contract' for cancellation purposes or the lender makes an irrevocable offer to lend within the cancellation period.

As to the nature of the 'secondary market itself', in its cost benefit analysis, the FCA also points to the fact that most of the main platforms have one and states:

"we estimate a one-off cost of 20 days of web programming to add secondary market functionality to platforms. We assume a cost per day of web programmer time of £200.29 This would mean that adding a secondary market to a platform could create a one-off cost of around £4,000. We also estimate ongoing costs of four hours per day to oversee the functioning of the secondary market. We estimate a cost per hour of £10 for administration work in small to medium firms, so the annual ongoing cost per firm of this option would be £10,000. It appears that, as platforms mature, they prefer to offer a secondary market, so in the long term most platforms are likely to aim to introduce a secondary market."

At last, a little ray of pragmatism, perhaps. But on what functional specification was this estimate based?

Left unanswered are a bunch of awkward issues, such as the distinction between loans and debt securities (now that both seem to be specified investments), how 'hybrid' loan-based and investment-based crowdfunding platforms should be treated, how a platform might facilitate loans above and below the £25k per loan cap, that some types of loan-based platform are lower risk than others and should receive more proportionate treatment (e.g. secured vs unsecured, or smaller numbers of customers) and confirmation that platforms do not qualify as certain other forms of investment activity (as well as others identified in Annex 2 of a submission on the Financial Services Bill in June 2012).

The new rules will take effect from 1 April 2014, but firms with 'interim permission' will have until 1 October 2014 to comply.

Investment-based crowdfunding

A crowd-funding platform needs to be authorised if it carries out the regulated activity of enabling a business to raise money by arranging the sale of unlisted equity or debt securities, or units in an unregulated collective investment scheme. The FCA is aware of about 10 authorised firms and 11 appointed representatives of authorised firms in this sector. However, exemptions may be available. For example if the firm operating the crowdfunding platform is an appointed representative of an authorised person or an Enterprise Scheme they will not need to be directly authorised.  

While the FCA already authorises investment-based platforms under existing investment regulation, the FCA concedes that the current rules don't really fit. The FCA has imposed restrictions on the authorised platforms on a case-by-case basis, which "restrict firms to dealing with professional clients and retail clients who are either sophisticated or high net worth." However, the FCA believes that its new proposals "should mean crowdfunding investment opportunities are available to more retail investors than currently, but with appropriate safeguards to check that investors are able to understand and bear the risks involved." The FCA also intends "to provide adequate consumer protections that do not create too many barriers to entry or significant regulatory burdens for firms." The new rules will take effect from 1 April 2014, but firms will have until 1 October 2014 to comply.

The FCA is proposing to limit the direct offer financial promotion of unlisted shares or debt securities (including websites) by firms to one or more of the following types of client:

• retail clients who are certified or self-certify as sophisticated investors, or
• retail clients who are certified as high net worth investors, or
• retail clients who confirm that, in relation to the investment promoted, they will receive regulated investment advice or investment management services from an authorised person, or
• retail clients who certify that they will not invest more than 10% of their net investible portfolio in unlisted shares or unlisted debt securities (i.e. excluding their primary residence, pensions and life cover).

Where advice is not provided, firms will need to apply an appropriateness test before selling them promotions for unlisted equity or debt securities.

Where crowdfunding platforms allow investment in units in unregulated collective investment schemes, the existing marketing restrictions will apply. These can only be promoted to certain types of customer, and changes to those restrictions were also recently consulted on and were made here.

Left unanswered are a bunch of awkward issues, such as the distinction between loans and debt securities (now that both seem to be specified investments), how the financial promotion rules actually apply, how 'hybrid' loan-based and investment-based platforms should be treated, and confirmation that platforms do not qualify as certain other forms of investment activity (as well as those identified in Annex 2 of a submission on the Financial Services Bill in June 2012).

The FCA considers investment-based crowdfunding to be high risk, owing to the the high rate of start-up business failures, the possibility of unauthorised advice, professionals picking the best offers, lack of dividends, equity dilution and the lack of a secondary market.

It seems bold to assume that professionals are any better than others at 'picking the best offers'. Research reveals that no one can predict which businesses will be successful. However, these risks can all be explained. What the FCA proposals views don't account for is the ability for people to lose unlimited amounts by betting on the ponies without going through any hoops at all. The FCA states that it has "no evidence to show that the wrong type of investor is investing in unlisted shares or debt securities" but concedes that "it is possible our current regulatory approach is effectively preventing this." Why is someone who bets on the ponies, for example, the 'wrong type' to be investing in a start-up?

From a policy standpoint, if it's ok for somebody to stick a tenner on the next race, when the betting shop is the real winner, then surely, so as long as the risks are clearly explained, the same person should be able to back a small business, where the economy is the winner. 

But who in government will take responsibility for this inconsistency?

Crowdfunding: Brussels Sprouts!

At last, the European Commission has realised that peer-to-peer finance might really be more efficient than banks at getting funding to those who need it. In Brussels, that translates roughly into "let's regulate". So, today the Commission launched a consultation aimed at understanding "crowdfunding: its potential benefits, risks, and the design of an optimal policy framework to untap the potential of this new form of financing."

The consultation paper is here, and responses are due by 31 December. The relevant Commission officials can be reached here. 

If my experience of the Commission's approach to regulating other aspects of e-commerce is anything to go by, it will be a huge challenge to educate officials - particularly for fast-moving entrepreneurs who have little time or resources to spare. 

Yet the risk of awkward, confusing and disproportionate regulation is high, so no one resident in the EEA can afford to be complacent.

So, at the very least, I'd recommend that any UK platforms and/or trade bodies capitalise on the evidence they've submitted to UK officials and Parliamentary committees over the past year or so, including whatever submissions are made in the current round of FCA consultations on peer-to-peer lending and crowd-investment. 

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

P2P Finance Policy Summit

Everyone seemed to enjoy the Peer-to-Peer Finance Policy Summit on Friday. Huge thanks to our hosts, panellists and all in attendance for putting so much effort into a great discussion. There will be de-brief at The Finance Innovation Lab tomorrow and a summary of the output from the summit should be available shortly [now here]. In the meantime, I've embedded my presentation below.

A pan-EU version of the Open Letter will be available this week to support a series of other events that are occurring in Europe.

As I mentioned on the day, this event grew out of a session at the Finance Innovation Lab in March on whether disruptive policies can help deliver a sustainable financial system. We thought that financial innovation could be fostered through a series of such forums involving representatives of IT, marketing, finance, operations, legal and so on, as well as platform participants, regulators and policy-makers. Proportionate self-regulation and formal regulation could evolve through this process, as considered necessary. Such 'co-regulation' already has successful parallels in contexts such as broadcasting and advertising, to name but a few, and it will be interesting to see the extent to which such a process develops here.

We may even see some counter-regulation, where offline businesses are required to implement the benefits of successful online business models, as in the case of midata.

How P2P Finance Models Work: Risks, Controls and Regulatory Barriers 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.

Government to Challenge Financial Red Tape

The UK government has announced proposals to clear the path for the growth of peer-to-peer finance platforms (also known as 'crowdfunding'). 

The latest government response to the Red Tape Challenge shows a determination to make it easier to innovate in ways that deliver lower cost, transparent financial services to consumers and small businesses. 

The government is sensitive to concerns that any regulation in this area should be proportionate and not raise barriers to entry or further innovation. As a result, the government wishes to encourage continued self-regulatory efforts by the Peer-to-Peer Finance Association to address common operational risks, and to engage with policy-makers and regulators. 

Critically, the government will also create a cross-departmental working group comprising representatives of all the relevant bodies it considers ought to be engaged in the development of peer-to-peer finance. Specifically, that working group will "monitor the appropriateness of the current regulatory regime for peer-to-peer platforms" and take the lead in engaging with the peer-to-peer finance industry. 

The composition of this working group is testimony to the broad policy implications and opportunities posed by this new form of financial model. The list of members includes the Office of Fair Trading, the Department of Business Innovation and Skills, HM Treasury, the Financial Services Authority and the Cabinet Office. However, it is known that the Department for Culture Media and Sport is also very interested in the potential for peer-to-peer finance to fund the development of the arts and entertainment industry. 

Peer-to-peer industry concerns were also backed by Mark Littlewood, Director-General of the Institute of Economic Affairs, in his response as Sector Champion for this aspect of the Red Tape Challenge. His report offers various additional solutions as an alternative to regulation. However, he does recommend certain exemptions be introduced to the financial regulatory framework to enable 'crowd-investing' for shares in start-up companies. 

Interestingly, Mark Littlewood has also suggested a means of 'future-proofing' regulation. He suggests regulators should be open to engage with new entrants at an early stage of their development to provide them with enough certainty to get started quickly. Officials should support appropriate self-regulation in the early phases, for example, through accreditation with the UK Accreditation Service (who presumably would also need to be similarly approachable and flexible).

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.