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.

Keeping Humans At The Heart Of Technology: Conference Wrap

This is a long overdue summary of my closing remarks at the SCL Technology Law Futures Conference on whether humans can survive the advent of super-intelligent machines. The podcasts for each session are available on the SCL site.

I am confident that we can keep humans at the heart of technology during the current era of artificial narrow intelligence.  It seems we are a long way into the process of coping with computers being better than us at certain things in some contexts. The sense was that the dawn of artificial general intelligence, where computers can do anything a human can, is 20-40 years away. It's also possible, of course, that the machines may never completely exceed human capabilities - more a matter of faith, in any event, as it would only be us who judged that to be the case. 

There are clear signs that humans are using computers to enhance the human experience, rather than replace it. E-commerce marketplaces for everything from secondhand goods, to lending and borrowing, to outsourcing household tasks and spare rooms show that humans are working together directly to remove intermediaries by relying on faciltators who add significant value to that human-to-human experience. 

This underscores the fact that computers' lack of 'common sense' will severely limit their ability to replace us – not just rationally speaking but also in terms of a shared understanding of our own five senses, and how we co-operate and use that shared understanding with each other in subtle yet important and uniquely human ways, for example, simply to summon the smell of freshly cut grass. 

Misuse of machines by humans - to constrain choice, for example - will also hold back development or lead humans to develop alternatives. We have worked around technology-based monopolies in various industries, such as music, but we also heard how the few major mobile 'app stores' are not only becoming the preferred distribution platforms for software, but also choke points to throttle competition. Such attempts at control will prove futile if those platforms do not give us what we want or are not aligned with how we behave or fail to reinforce the shared sense of community that is a feature of, say, peer-to-peer marketplaces and the new distributed ledgers.

The point was also made that we should recognise the value in our freedom to make mistakes or to simply forget or fail to do something – indeed the fact that someone else has forgotten or failed presents an opportunity for someone else. Perhaps this is the key driver of competition and innovation in the first place. [So, would machines evolve to be so efficient that change would no longer be necessary? Superintelligence could be a dull experience!]

Yet it is human fallibility, not that of machines, which is behind most online fraud. Turns out that it's simpler and cheaper to hack the human operating system with confidence tricks than it is to cut through the security systems themselves. Ironically, in this context, it seems there’s more a role for machines to help us avoid being fooled by other humans into giving out sensitive information, rather than to evolve ever more sophisticated encryption, for example.

A key issue is that the evolution of machine ability and interoperability is adding vast complexity to the rules and contracts that govern their use. Layers and layers of rules, terms and conditions must knit together to ensure effective governance of even the humble home entertainment network. Of course, the earlier the lawyers, legislators and regulators are involved in this, the easier it is for governance infrastructure to keep up.  That point is often made by lawyers, but it was also very heartening to hear the direct invitation for more lawyers to be involved directly with engineers in the step-by-step development of driverless cars, so they are aligned with how we humans want them to work on our roads. 

Yet the speed of technological development versus the speed at which the law moves make it unlikely that the law and rules alone will be effective in directly controlling the development of machines, whereas incentives such as commission, fees and fines will likely prove more useful in nudging behaviour in the right direction and keeping interests aligned. How the economic models evolve is therefore critical - and a good area for less direct legal control of machines, particularly through the apportionment of liability and theregulation of markets and competition.

Economically speaking, however, it was pointed out that we are prone to overstating the impact of technology has had in the past, and overestimating its effect in the future. In terms of GDP growth, for example, it turns out there was no industrial 'revolution' but merely a steady increase in output in parallel with various technological improvements. Tech booms and busts are also evidence of this.

We also tend to get hung up on globalisation and the need for harmonious rules across regions, yet much of the benefit of the internet, for example, has actually occurred at local level, and most of us use our phones and email to stay in touch with local people. 

Against this background, the conference keynote speech provided an entertaining overview of artificial intelligence and the community behind it, finishing nicely with a list of the top priorities for urgent human attention. The 'Internet of things' - 50 billion connected devices by 2020 - clearly covers a vast area, so it's important to bring it down to specific scenarios, such as the home, the car, the streets and how sensors, software and machines in each context inter-operate. Other critical developments and scenarios deserving our attention are driverless cars; the use of drones in the context of both civil surveillance and warfare; and applications that control or monitor our health.

More on those fronts in due course, no doubt.

Thanks again to all the speakers for such a thought provoking series of presentations.

Artificial Intelligence, Computer Misuse and Human Welfare

The big question of 2015 is how humans can reap the benefit of artificial intelligence without being wiped out. Believers in 'The Singularity' reckon machines will develop their own superintelligence and eventually out-compete humans to the point of extinction. Needless to say, we humans aren't taking this lying down, and the Society for Computers and Law is doing its bit by hosting a conference in June on the challenges and opportunities that artificial intelligence presents. However, it's also timely that the Serious Crime Act 2015 has just introduced an offence under the UK's Computer Misuse Act for unauthorised acts causing or creating the risk of serious damage to "human welfare", not to mention the environment and the economy. Specifically, section 3ZA now provides that: 

(1) A person is guilty of an offence if—
(a) the person does any unauthorised act in relation to a computer;
(b) at the time of doing the act the person knows that it is unauthorised;
(c) the act causes, or creates a sign ificant risk of, serious damage of a material kind; and
(d) the person intends by doing the act to cause serious damage of a material kind or is reckless as to whether such damage is caused.

(2) Damage is of a “material kind” for th e purposes of this section if it is—
(a) damage to human welfare in any country;
(b) damage to the environment in any country;
(c) damage to the economy of any country; or
(d) damage to the national security of any country.

(3) For the purposes of subsection (2)(a) an act causes damage to human welfare only if it causes—
(a) loss to human life;
(b) human illness or injury;
(c) disruption of a supply of money, food, water, energy or fuel;
(d) disruption of a system of communication;
(e) disruption of facilities for transport; or
(f) disruption of services relating to health.

I wonder how this has gone down in Silicon Valley...

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.

A Short History Of The P2P Marketplace Model in UK Finance

During a recent panel discussion at the annual conference of the Society for Computers and Law, I explained briefly how the online peer-to-peer marketplace, pioneered by eBay in the US, came to be applied in financial services in the UK. The slides are here, and below is a slightly longer written explanation. Note that the focus is on the history, rather than explaining the differences between various types of 'crowdfunding'.

eBay pioneered person-to-person sales of second-hand items in the US from 1995, proving the concept to be hugely attractive. The particular "'Aha!' moment" came when people actually paid for the item they'd agreed to buy, not to mention the delivery of the item.

In 1999, the team at X.com (later PayPal) expanded the eBay model into payments by enabling consumers to pay each other using a credit card. This was rapidly adopted by eBay users (to the point where eBay eventually had to buy PayPal as a defensive measure). Coincidentally, in the same year it became clear to the entrepreneurs who had created PlusLotto, an online lottery in aid of the Red Cross, that the payment part of their system, which enabled people to prepay funds in many different currencies to centralised bank accounts then log-in to their data accounts or 'wallets' to purchase lottery tickets with the balance, should be made available to other merchants. They started Earthport as a separate payments provider the same year, and I was among those asked to join the board of the new entity. The initial strategy was to roll-out the wallet offering directly to consumers and merchants. But in 2000 we raised £25m through a private placement - literally weeks before the DotCom bubble burst - to fund a switch in strategy. The plan was to leverage the marketing budgets of banks, telcos and major Internet portals to offer own-branded wallets to their customers. Of course, those plans ran into the headwind created by the tech slump. But I'm happy to report that Earthport remains alive and well.

Meanwhile, in 2003, a team at artistShare in the US adapted the P2P payments model to enable music fans to donate money to fund musicians and music projects. The reason for this donation-based model of 'crowdfunding' was the need to avoid US securities regulation, which is notoriously rigid and complex, and applies expensive registration requirements even to very simple loans. The battle to liberate that regime continues to this day (see below).

At any rate, late in 2003, a small group of executives left Egg, the internet bank (which also happened to be one of Earthport's early customers), to try to reinvent financial services. During their brainstorming process, Dave Nicholson, suggested 'eBay for money' and the idea took hold. Coincidentally, they approached me in the summer of 2004 to see if I could help avoid any US-style regulatory problems. By the time we launched Zopa, the P2P lending platform, in March 2005 we had moved away from the idea of eBay-style 'auctions' to a more automated marketplace for personal loans. Borrowers and lenders had told us they did not want to reveal too much about themselves to each other, but were happy to give Zopa enough information to guard against fraud, assess creditworthiness and match their bids and offers to produce loan contracts directly between them.

 

In 2010, the team at FundingCircle applied the P2P lending model to the small business lending market. They also enabled direct loans between each lender and business entity. But to provide security for the additional risk of lending larger amounts to businesses, they introduced a separate entity that would hold security over the assets of the borrower in trust for the lenders. That trustee entity could then enforce the security on the lenders' behalf if the borrower defaulted under the P2P loans. Since then, this model has also been introduced to the commercial property sector.

It was only a matter of  time before the P2P marketplace model penetrated the investment world. In 2011, Crowdcube launched the concept of enabling many individual investors to finance unlisted start-up companies in return for shares. And a team that included Bruce Davis, an ethnographer who had helped develop both Egg's and Zopa's marketing propositions, launched Abundance Generation to fund alternative energy projects by selling long term debentures to retail investors who could use the returns to pay their own energy bills.

 

The same year, the Peer-to-Peer Finance Association was launched to call for proportionate regulation of the peer-to-peer lending sector.

 

Since 2011 many different types of P2P lending, crowdfunding and crowd-investment platforms have launched. Approximately 30 platforms signed a letter to EU and UK policy makers at a P2P finance policy summit held in London in December 2012, and many others have launched since.

 

In March 2014, the first FCA rules took effect which specifically regulate both peer-to-peer lending and crowd-investment. The EU has since convened a "European Crowdfunding Stakeholders Forum" to help determine whether there is scope for EU regulation to help develop the sector.

 

Clearly we are still witnessing the dawn of this trend. 

 

PS on the US:

 

While this post has focused on the UK, it is worth mentioning that we attempted to launch Zopa's P2P model in the US during 2006-07. However, it was clear from our own regulatory discussions, and the subsequent experience of Prosper.com, that the Securities Exchange Commission was determined to view simple loans as securities that require registration and intermediation using the same model that applies to more complex instruments. Zopa declined to launch that type of model, but it had to be deployed subsequently by Lending Club and Prosper (a similar version was also deployed by Prodigy Finance in the UK, due to the need to support international cross-border lending activity). Essentially, rather than agreeing loans directly with individual borrowers, investors buy bonds that are backed by loans made to those borrowers by a licensed lending entity. The lending entity sells the loans to the bond issuer, which distributes the loan repayments to the bondholders. While the JOBS Act was supposed to liberate crowdfunding in the US, the SEC has been less than enthusiastic in implementing it. Fortunately, UK regulators have been positively supportive and it's important to note that the SEC does not have any responsibility to promote innovation and competition, while the FCA clearly does. 

SEC Crowd Investment Rules

Today, the US Securities Exchange Commission (SEC) finally published its rules to enable securities-based crowdfunding (or 'crowd investing') under certain exemptions from Federal securities registration requirements (Title III of the JOBS Act). 

The proposal document is some 585 pages long, so it may take some time to fully digest the proposals. Comments are open for 90 days. That review is complicated by various State laws that are being rushed through to permit intra-state crowd investing out of frustration at what is perceived as SEC foot-dragging. And, on this side of the Pond, the FCA's own consultation on crowdfunding, due out this week. A lawyer's work is never done [sighs].

As a reminder, the JOBS Act exemptions apply to transactions by an issuer that meet requirements which include:

• the amount raised must not exceed $1 million in a 12 month period (adjusted for inflation at least every five years); 
• individual investments in a 12 month period are limited to the greater of: 

• $2,000 or 5 percent of annual income or net worth, if annual income or net worth of the investor is less than $100,000; and 

• 10 percent of annual income or net worth (not to exceed an amount sold of $100,000), if annual income or net worth of the investor is $100,000 or more (adjusted for inflation at least every five years); and 

• transactions must be conducted through an intermediary that is either registered as a broker, or is registered as a new type of entity called a “funding portal” that is exempt from broker/dealer registration;
• issuers and the intermediaries must provide certain information to investors and potential investors, take certain other actions and provide notices and other information to the Commission;
• the securities acquired through this exemption are also to be exempt from registration requirements.

Happy reading!

Regulating Convergence

This week I get the chance to chat about my three of my favourite topics from a legal standpoint: payments, peer-to-peer finance and data. 

All three are in a state of regulatory flux (which is also making for some late nights). But that tells you a lot about where commerce, and society itself are headed. The much vaunted 'convergence' of Web 1.0 has definitely arrived.

As ever, the challenge for independent regulation of these areas is to approach electronic commerce in a holistic way that promotes competition and innovation, rather than in a blinkered fashion that results that strangles innovative services at birth...

It should be a lively week.

More in a wrap-up post at the end.

Crowdfunding Guest Post On Nesta...

My guest post on the impact of regulation on crowdfunding in the UK is now up on Nesta's "Economic Growth" blog. The overview appears as one of a series of posts that accompany Nesta's crowdfunding directory at Crowdingin.com, which lists information on platforms open to fundraising from individuals and businesses in the UK.

Why Doesn't The ECB Try P2P?

horizontal vs vertical credit intermediation

In April, European officials finally realised that Europe's banks will be unable to lend enough to small businesses to finance economic recovery. The failure of the UK's Funding for Lending scheme has not gone unnoticed. So rather than establish an EU version of that scheme, the European Central Bank has been considering whether to kick-start a small business securitisation market. Last week, however, the ECB played down that idea. After all, the banks don't have the capability to make enough loans in the first place, and the 'shadow banking' sector has demonstrated that it can't reliably price endless tiers of bonds, CDOs, CDOs of CDOs.

So now what?

Peer-to-peer lending has grown rapidly in the UK, despite an awkward (though permissive) regulatory framework and perverse tax incentives. That headwind is changing, as even the UK government has begun lending on some platforms, and officials are getting on with the job of bringing P2P lending firmly within the regulatory sphere.

Oddly, perhaps, those regulatory changes are being made in the context of moving the supervision of consumer credit from the Office of Fair Trading to the Financial Conduct Authority in April 2014. However, that merely reflects the fact that P2P lending originated in the personal loan market, whereas there are now platforms that facilitate business loans, asset finance and commercial real estate funding. In other words, P2P lending has expanded into institutional investor territory, which should be of real interest to the ECB as it looks beyond the banking sphere.

As I've pointed out many times since 2010, a key feature of P2P lending platforms is that each borrower's loan amount is provided via many tiny, direct loans from many different lenders at inception. This permits lenders to diversify at the outset, so that loan maturities and rates of return do not need to be 'transformed' via securitisation later on.  Enforcement and due diligence are made easy on P2P platforms because the one-to-one legal relationship between borrower and lender is maintained for the life of the loan, and the performance data also remains readily available via the lender's account. This enables P2P lenders to avoid the concentration of credit risk that securitisation tends to obscure through endless re-packaging and re-grading, and the ensuing disconnect between bonds and the underlying loans. 

It will also be of special interest to the ECB that the scope for moral hazard is contained in the P2P context - the platform operator itself has no balance sheet risk, yet is able to implement all the compliance and operational risk controls one would ordinarily expect of lenders. This brings regulatory efficiencies, too. The authorities need only supervise the P2P platform operator rather than the lenders and borrowers on either side, who are effectively just payers and payees, as in the case of a payment institution. Funnily enough, that's the reason the UK's Peer-to-Peer Finance Association borrowed the substance of its "Operating Principles" from the Payment Services Directive - a piece of legislation with which the ECB is also very familiar...

That paves the way for anyone to lend to consumers and small businesses via P2P platforms without any concern about the need for lender-licensing. Indeed, the UK's Financial Conduct Authority has said that it intends providing investor-type protection for P2P lenders. That would mean exemptions for marketing P2P lending to high net worth and sophisticated investors and professional investment firms. So it would be strange to also require such investors to be separately authorised to lend, especially when the platform operator is taking care of all the compliance obligations. It would be like requiring a firm to be authorised to deposit money in the bank or to make payments via a payment institution - just red tape.

Given access to loan capital on that industrial scale, the ECB could justifiably view P2P lending to small businesses as a significant potential driver of economic growth. 

Regulating Peer-to-Peer Lending

The Government recently outlined its proposals for regulating peer-to-peer lending, at the same time as its plans for moving the regulation of consumer credit from the Office of Fair Trading to the Financial Conduct Authority in April 2014.

Since the launch of Zopa in 2005, peer-to-peer lending platforms have provided nearly £500m in loans to consumers and small businesses. However, it has long been clear that regulation and perverse tax incentives are constraining the development of the sector. In 2011, the leading operators formed the Peer-to-Peer Finance Association to seek proportionate regulation that would encourage responsible growth. The government welcomed the creation of the P2PFA in several reports during 2012, and the Treasury foreshadowed its latest consultation at the P2P Finance Policy Summit in December, following some fairly intense debates on the Financial Services Bill in the House of Lords. At that time, the Department of Business Innovation and Skills also announced that the Business Finance Partnership would lend about £30m to small business borrowers through peer-to-peer platforms.

The latest Treasury consultation maintains this momentum, stating (at paragraph 4.12) that:

“The Government is keen to see this sector continue to grow and evolve, and therefore it will be important to develop a proportionate regime that recognises the needs of this innovative sector.”

Under the Treasury's proposals the activity of “operating an electronic system in relation to lending” will become a 'Tier 1' regulated consumer credit activity (along with consumer lending, for example), and certain 'ancillary' consumer credit activities will become more lightly regulated 'Tier 2' activities. There are various issues relating to the finer points of the definition which will hopefully be ironed out in the response to the consultation.

While corporations will not get the benefit of regulatory protection, the Financial Conduct Authority "envisages the lending aspect of a peer-to-peer platform’s activities being treated as an investment activity and that lenders providing the finance should be appropriately protected regardless of the status of the borrower." However, we won't know exactly what sort of protection this involves until the FCA consults on the detail of its proposed rules during the autumn of this year. It is to be hoped that the reasonably straightforward customer experience of today will be maintained...

What we do know is that firms wishing to undertake consumer credit activity (including peer-to-peer lending) after 1 April 2014 will need to obtain a Consumer Credit licence from the OFT (if they don't already hold one) and apply to the FCA for "interim permission" prior to 1 April 2014. OFT-licensed firms who are already FCA-authorised, or who are appointed representatives of FCA-authorised firms, must apply to the FCA for an “interim variation of permission”.

The FCA will then invite the various types of firms who hold interim permissions to apply for full authorisation in waves (since there are over 40,000 consumer credit licence holders in total). A firm's interim permission will last for as long as the FCA takes to consider the firm's application for authorisation or 1 April 2016, whichever comes first. 

However, it's worth noting that firms with interim permission “may not act as principal for appointed representatives in relation to the activity for which they hold an interim permission”. The effect of this could be that service providers who hope to avoid the cost of full authorisation may need to apply for interim permission in their own right until such time as the firm with interim permission obtains full authorisation and is entitled to appoint them as representatives. Perhaps this issue will be ironed out during the autumn, along with certain others. 

If you would like to know more, by all means get in touch via @sdjohns on Twitter.

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

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).

Innovation Meets The Financial Services Bill

Embedded below is a set of amendments to the Financial Services Bill which I've prepared with the help of a colleague, Tony Watts, at the invitation of several Peers to aid in their review of the Bill. The paper builds on a submission to the UK government in January.

The aim is to require the authorities to encourage responsible innovation in retail financial services generally and, as a case in point, to clear the way for the growth of peer-to-peer platforms - transparent, low cost services that are open to all but which don't tie up vast amounts of capital or require a public guarantee.

Specifically, these amendments will:

1. Generally oblige the financial authorities to look outside the regulated markets when assessing whether there is adequate competition within those markets;  
2. Remove the uncertainty, cost and delay in launching new peer-to-peer platforms, by creating a clear set of rules by which they must operate, regardless of the type of instruments available (reflecting the carve-out for retail payment services from the historic ‘banking monopoly’); 
3. Enable the inclusion of peer-to-peer loans and investments within the small range of assets currently available to ordinary people via ISAs.
4. Enable the same process of evolution towards cost-efficient and transparent financial services that we have already seen in other online retail markets.

The document is still in draft, and comments are welcome.

Proposed amendments to the financial services bill sdj 21 06 12

View more documents from Simon Deane-Johns.

Image from NE Generation.