Key points in the first article:
Regulations can be onerous, but they have helped to boost this sector on an exponential growth trajectory;
They present a formidable barrier to entry and non-compliance is one of the biggest risks to the sustainability of an Alternative Finance business, but getting it right promises commercial advantages; and
If regulations are too scary, then there are ways to tap into this sector without being regulated.
In the second article of this four part series, we examine how regulation may influence the choice of your business model and the regulatory process you will encounter when making an application for regulatory authorisation.
Choosing to go Down a Regulated Path
Many of our clients looking to venture into this fast growing alternative finance sector often start out expressing their concerns about being a regulated financial services business. They anticipate an onerous and resource intensive regulatory regime, and a constant threat of regulatory risk.
Wanting to provide the right advice, we often ask: “… if we can explore ways in which you can start your alternative finance venture without the need for being regulated?”
The response is often a 180° pivot: “No, on further thought, we actually want to be regulated, because it’s going to be much better for business. It will give us more credibility, flexibility, and freedom and we think it will intrinsically increase the value of our business.”
The Appointed Representative route, we touched on in the previous article, is also viewed as an overly restrictive model, where the Principal will dictate how the business is run and how it grows. Make no mistake though, it is still one of the quickest ways to get into this market until you are ready and able to make an independent application for FCA authorisation.
If you’ve made your decision that you want to go down the full regulated path, what’s the best business model for you? Getting this right is going to be paramount to the successful launch and ongoing success of your business.
Which Path is Right for You?
A range of business models have emerged in the alternative finance sector. Choosing the right model is critical, as it will not only determine what regulations apply, it will also dictate the types of customers and competitors you attract, the revenues you will earn and how the business is run on a day to day basis.
As you may already know, you have an option to pursue one of the following alternative finance business models (we focus on regulated business models):
Peer to Peer Lending
– Private individuals or companies typically provide unsecured personal loans to individual borrowers;
Peer to Business Lending
– Individual lenders or companies grant secured or unsecured loans to small and medium sized businesses;
– Businesses sell their invoices to individual or institutional investors (not all invoice financing models are regulated);
Peer to Peer Lending for Real Estate
– Individual investors or companies lend to individuals or companies specifically for real estate transactions;
– Businesses sell a stake in their business to individual investors or companies, through an electronic platform;
Alternative asset management
– Providing an alternative investment management business model – e.g. Nutmeg;
Peer to Peer Insurance
– Relatively new model that allows individuals to form insurance networks to insure each other through a pooling of premiums and/or reinsurance through traditional insurers – e.g. Friendsurance and Guevara.
Alternative asset management and insurance business models are beyond the scope of this series of articles and we only focus here on peer to peer lending (P2P) and crowdfunding.
Regulatory treatment may well influence the business model you ultimately choose. If you are UK based, the good news is that the UK is one of the first nations in the world to have introduced specific regulatory provisions for the P2P and crowdfunding industry.
Regulatory Landscape for Alternative Finance
The UK operate a “Twin Peak” regulatory model where financial services firms are regulated by the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA). Broadly speaking, the FCA is interested in consumer protection, integrity in the financial system and fair competition. The PRA is mainly concerned with financial stability. Most alternative finance businesses will only face the FCA as their primary regulator.
The Financial Services & Markets Act (FSMA) is the legislation that apply to all types of financial services businesses in the UK. The FCA give effect to these regulation through their Handbook, which sets out detailed rules and guidance spanning in access of seven thousand pages (and it’s growing).
It’s up to firms to decide what specific provisions in the Handbook apply to their regulated activities and they need to ensure that they comply with those specific set of regulations on an ongoing basis.
Regulation of the financial services sector is a huge topic that could fill a few books. However, we can briefly explore the main differences between the regulatory treatment for P2P and crowdfunding:
– To fall within the regulated net, you must carry out a specified regulated activity. Broadly, P2P “operate an electronic platform in relation to lending” and crowdfunding platforms are involved in “arranging (or bring about) deals in investment”. Other regulated activities may also apply.
– P2P face little restrictions on the type of investors that can lend on the platform. , whilst “retail” or “unsophisticated” investors investing without advice can only invest a maximum of 10% of their assets designated for investment. Advertising (or financial promotions) to such clients is also tightly regulated;
– Individual borrowers, small partnerships and unincorporated firms are protected by consumer credit rules in the case of P2P, whilst there are no such requirements to protect companies selling equity through a crowdfunding platform;
– Most financial services firms need to retain minimum regulatory capital buffers for unforeseen risk and to deal with scenarios that could lead to its closure. P2Ps need to retain a minimum of £20,000 until March 2017, when the requirement escalates to £50,000. Crowdfunding firms are subject to existing rules and typically need a minimum of £5,000 in addition to a prescribed professional indemnity cover, or a minimum of £50,000. The regulator may impose additional buffers;
“Living Will” Arrangements
– Specifically, P2P platforms need to have robust plans in place to ensure orderly management and wind down of the loan book, in the event of it going out of business.
In my view, regulations are still relatively light touch because the government and FCA don’t want to restrain financial innovation and entrepreneurship. They will however become more stringent, with specific requirements for risk assessment, management and monitoring being introduced, for example.
Route to Regulated Entry into Alternative Finance
So you are now confident about being regulated and have made a firm decision on the business model that you are pursuing. The next step in the process of starting an alternative finance business is to tackle the regulatory authorisation process.
Unless you have an interim permission, you can’t carry out any regulated activities until the firm and senior individuals within the firm are approved by the FCA.
The next in this series of articles deals with the process of preparing for a successful FCA authorisation. Here I want to highlight the process, so that you are aware of what’s involved and the timelines you need to anticipate in your planning process.
From our experience, it will take you a minimum of two to three months to prepare for an FCA authorisation. This will depend on many factors and you will be forgiven for asking why it takes so long.
At the point of application, the FCA expect you to be ready to start trading. This means that you will have the necessary strategy, operations, systems, processes, documentation, team and financial resource already in place, for FCA to review.
Once you submit the application, the FCA are compelled to come back to you with their final decision within six months for a complete application. A complete application satisfies all their requirements and there are no significant gaps in the documentation that you have submitted. A well planned and complete application may get a decision quicker.
If the FCA believes your application is incomplete in any way, then the time frame extends to 12 months within which they are compelled to make their final decision on your application.
It goes without saying that careful preparation and planning is absolutely critical. In a market that more than doubles every few months, having to wait up to 12 months to begin trading, can put your business venture at a significant competitive disadvantage even before it starts.
After submitting your application, a case officer is assigned after a few weeks and they start to review your application in detail. The review process will result in a series of further questions that you will have around two weeks to answer. FCA may also call up senior management for an intensive and in-depth interview.
Once FCA have the necessary information they need, your application goes through their internal approval process and could result in further questions, dialogue and interviews. On completion of this process, they will hopefully agree to grant the authorisation and agree a start date. Congratulations!!
If the FCA believe that you don’t meet their “threshold conditions”, they will refuse your application, providing you with the right to appeal their decision.
Stay tuned for the next in this series of articles, where we examine in detail how to prepare for a successful FCA authorisation. This content will distil the thousands of hours our clients have collectively spent preparing their application.
Jay Tikam is the Managing Director of Vedanvi, a Risk and Regulatory Consultancy helping to further fuel alternative finance by helping disruptive and innovative financial services businesses overcome regulatory hurdles and make sense of risks and risk management.