At PrimaDollar, like many non-bank financial institutions, we are not subject to the capital or conduct controls which apply to a bank or a mortgage lender.
Even so, regulators effectively do reach us – as they now control how any lender (peer-to-peer or conventional) may finance itself in today’s capital markets.
This regulatory control may well mean that fintech lenders will struggle to grow beyond niche models. Moreover, the issue is likely bigger in the UK than in other countries due to the potential contradiction between EIS / VCT rules and the EU capital market regulations.
The 2008 financial crisis has been blamed on many things – but the “originate to distribute” business model has been singled out. Politicians and regulators have determined that this model is no longer desirable.
Typical pre-2008 examples of this business model were in the mortgage market. Such a business used securitisation technology to finance, often, 100 per cent of what was originated. For the business owner, this was great. If things went well, the owner took the profit; if things went badly, the debt-providers took the loss.
Asset originators tended to care more about volumes than quality. This also led to excessive leverage in the system. The absence of any “skin-in-the-game” is now cited as one of the reasons for the collective loss of market sanity.
Yes, kind of. Today, peer-to-peer platforms do originate-to-distribute. The platform originates loans, and all the risk is entirely taken by the participants who buy all the loans.
Peer-to-peer platforms are different because there is no pooling of the loans and the platform does not own equity in the loans.
Pooling (or mutualisation) means aggregating the loans into a single asset rather than selling fractional shares in individual loans. Investors become subject to the collective risk of the pool rather than the risk of specific loans that they might have chosen themselves. If you can mutualise, you can then tranche. Tranching refers to creating senior and junior (and often intermediate) financial obligations secured on the single pool of assets that are ranked in terms of payout. This is also sometimes called “slicing-and-dicing”.
If you can mutualise to create a pool of loans, you can tranche the risks and returns that investors receive. This means that you can create interesting instruments that offer low risk / low return (senior, paid first – ideal for conservative investors) and high risk / high return (junior, paid later, ideal for yield-hungry investors).
Tranching widens the population of potential investors substantially
and means that lower yielding assets can be funded profitably.
Without tranching, investors can only obtain the direct unleveraged return (net of fees) on individual loans, and therefore only certain niche asset classes are likely attractive.
Well we can.
But the regulators are worried that pooling and tranching can lead to excessive leverage and hard-to-see risks. They want to control how this technique is used in any situation where “regulated money” gets involved.
As soon as we start to mutualise and then tranche our funding to any material degree we run into EU regulations: UCITS V / AIFMD (asset management), CRD IV (banks) and Solvency II (insurers). The US has its own equivalents. The implications are significant:
Large volumes of capital markets debt financing are not available without access to regulated pools of liquidity (banks and insurance funds). So, via this indirect method, these regulations effectively apply to us.
The details of the regulations are beyond the scope of this article, but the killer punch is article 405 of EU regulation 575/2013 setting out the CRR (the “capital requirements regulation”):
To an outsider, these look like deals done by platform participants and not by the platform itself.
The principal beneficiary of the securitization looks to be the institutional participant in the platform.
Effectively, these securitisations are likely another form of institutional liquidity.
The implications of the capital requirements regulations are far-reaching.
It seems to be widely accepted that smart fintech lenders should expand their business models, broadening the product mix, and getting into the mainstream - see altfi article “addressable market space" on why this may be important.
But here are the contradictions:
Many platforms in the UK have raised equity using EIS or VCT schemes in the UK (tax-advantaged investment structures). These schemes have eligibility rules which explicitly exclude the provision of financial services. Changing the business model of a platform so that it can take funding risk as a principal to comply with the CRR may well breach these tax rules, potentially losing equity investors their tax breaks.
There is a fundamental contradiction between the philosophy of a peer-to-peer platform and the views of the regulators. For PrimaDollar, these issues (and contradictions) have exercised us extensively.