An open letter to Andrew Bailey, CEO of the FCA

By Christine Farnish on Tuesday 26 July 2016

Alternative Lending

Dear Mr Bailey,

I write, further to your oral evidence to the House of Commons’ Treasury Select Committee last week, with particular reference to your answers to questions asked by Chris Philp MP, raising concerns about the risks associated with peer-to-peer lending; a potential incentive mismatch related to fee structures within the sector; and the issue of reserve funds.

Peer-to-peer platforms exist solely because they create value to consumers on both sides of the platform: investors are able to earn fair predictable risk adjusted net returns that can outperform other investment products, whilst borrowers can access fast and flexible finance. Platforms offer borrowers a form of investment, and explicitly are not an alternative form of savings account: peer-to-peer products are not positioned as a deposit and nor is there an implicit guarantee.

In responding to one of Mr Philp’s questions, you cited the differential risk profile between a deposit contract and that for asset management; it is important that potential investors understand where peer-to-peer platforms exist on that spectrum. Parliament has recognised that peer-to-peer lending is distinctive and constitutes a new form of financial services activity – designated in the Regulated Activities Order and recognised as different from both bank deposits and conventional equity investment products. In considering its approach to peer-to-peer finance, I would hope that the Financial Conduct Authority would start from first principles, based on risks and benefits to consumers, recognising that it is neither about banks nor about asset management. Such an approach would be consistent with policies, publications and pronouncements made by the Authority.

Whilst it is the case that, within the peer-to-peer lending sector, there are different asset classes each with their own risk-return profile, overall, peer-to-peer platforms offer a lower risk profile than stocks and shares with less volatility. Individual platforms, as well as the sector in general, acknowledge responsibility in ensuring that potential investors are aware of the particular risks of this form of investment, and are committed to the principles of fairness and clarity.

The Peer-to-Peer Finance Association has been consistent from its outset in arguing for, and embracing, an appropriate level of regulation to facilitate innovation and the development of this form of alternative finance, whilst providing protection for consumers. Platforms continue to work closely with the Financial Conduct Authority on the full authorisation process, and current regulatory requirements are supplemented by the Association’s own Operating Principles, requiring all members to commit to high standards of business practice as well as exemplary levels of transparency: details of every single loan originated in the marketplace must be published. The value of this openness enables individual platforms to be judged on the basis of the credit risk performance of the entirety of their loan books.

As the growth of the peer-to-peer lending sector and the base of investors and borrowers has expanded so rapidly, the challenge of ensuring that all participants are fully cognisant of the nature of the opportunities and risks have intensified, and a process of familiarisation for consumers is recognised as critical. The sector accepts its responsibility for ensuring that those investing in peer-to-peer products understand the nature of their investment, and appreciate the degree of risk incurred. The Association audits the websites of individual platforms frequently, and feedback is provided. All members are required to publish in full the details of their loan books to ensure that investors are able to hold platforms to account on credit assessment.

I believe that a degree of mis-understanding has arisen in respect of the structure of fees within the sector. It is Mr Philp’s contention that there is a mis-alignment of incentives where those operating peer-to-peer lending platforms receive fees upfront based on the volume of loans originated. In your response to Mr Philp’s question (Question 61 of the session), you suggest that structuring lending through taking fees upfront creates uncertainties. A significant part of the fees charged for peer-to-peer lending are earned over the course of the life of the loan, and are not paid at the outset. Peer-to-peer lending platforms recognise the importance of ensuring that incentives are not skewed merely in favour of writing loans, irrespective of their long-term performance: an increasingly significant amount of income comes to the platforms during the later period of the life of the loans. Platforms do not engage in maturity transformation.

The existence and use of reserve funds in peer-to-peer lending is not universal, and specific to those platforms who have designed them into their business model. Where a peer-to-peer lending platform decides to create a reserve fund, it is important that investors understand that this does not infer a guarantee for their investment.

Mr Philp’s final proposition (Question 62) advocated co-investment of a proportion of a peer-to-peer lending platform’s loans to concentrate attention on making good credit decisions. As indicated above, the peer-to-peer lending sector has embraced a level of transparency which is unrivalled in financial services, and it is possible to make judgements about the calibre of credit decisions made by each individual platform in respect of their entire loan book through material which is already published. I would argue that ensuring that investors are empowered to appraise a peer-to-peer lending platform’s credit decisions and performance obviates any requirement to mandate co-investment. I would observe that it is not a requirement for asset managers to co-invest, despite incurring greater levels of risk within their investment portfolios.

The Peer-to-Peer Finance Association welcomes the Financial Conduct Authority’s recently-announced post-implementation review of crowdfunding rules as an opportunity to ensure an appropriate balance of regulation between protecting investors and borrowers, without stifling innovation and competition. It is important that consumers are able more easily to differentiate between the various levels of risk in the multitude of alternative finance investments and make informed decisions which reflect their own preferred exposure: for example, an equity-based crowdfunding product for a start-up enterprise carries a very significantly-greater level of risk compared with most peer-to-peer lending products. The regulatory regime should reflect these divergent risk profiles.

I look forward to continuing to contribute to the on-going debate about where the appropriate balance of regulation should lie. Consumers should receive appropriate levels of protection, but they also value the improvements which innovation in customer service, credit risk management, good value products as well as cost and product transparency which have accrued through the evolution of peer-to-peer lending: opening up this form of loans to retail investors, previously the exclusive domain of financial institutions.

I hope this is helpful, and am copying this letter to Chris Philp MP, and to Rt. Hon. Andrew Tyrie MP, as Chairman of the House of Commons’ Treasury Select Committee.

Yours sincerely,

Christine Farnish

Independent Chair: Peer-to-peer Finance Association

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