The regulators have finally delivered their verdict on the future of P2P and alternative finance, and judging from the reaction of most key industry players, it sounds like there’s been a collective sigh of relief. Christian Faes, for instance, co-founder and CEO of LendInvest, welcomed “the crackdown on the peer-to-peer industry.” Perhaps reflecting the recognition that P2P is now mainstream enough to warrant such close regulatory change. Rhydian Lewis, co-founder and CEO of RateSetter, also welcomed the changes arguing that peer-to-peer lending “will become a part of every investor’s diversified portfolio and the proposals from the FCA do not change that belief. I welcome this consultation paper because the clearer the regulation, the better chance peer-to-peer lending has of becoming meaningful competition to the banks.”
A slightly more cautious tone eminates from P2PFA Chair, Paul Smee, who admitted that there “is a lot of detail in this document, and we will be working through its implications, to ensure that the eventual regime is practical, proportionate and allows for the development of a healthy and competitive market in peer-to-peer lending”. Bear in mind that the P2PFA’s original priorities for the review headlined with the aim of “reducing the risk of consumer confusion through the conflation of equity- and loan-based crowdfunding with the use of the overarching descriptor ‘crowdfunding’.
I would argue that the P2PFA’s reaction points to a rather different, arguably negative narrative on these proposals. I think the FCA has made a major category error by dumping lending into the same bucket of risk as crowdfunding. Even worse I think the idea that only letting the right kind of investors tap these lending markets is a big mistake, and one which will serve to chill growth in the market. Perhaps more to the point I’m not even sure these suggested ‘protections’ will actually work to help investors – they’ll be gamed and undermined as they have been in both the UK and the US with previous regulatory interventions.
So, what’s about to change? I don’t propose to repeat what my colleague Ryan Weeks has already summarised here about these proposals. But I think it is necessary to look at the key change. This, Ryan reckons, is the suggestion that: "The FCA is proposing that P2P promotions target exclusively the following groups: those certified or who self-certify as sophisticated investors, those certified as high net worth investors, those under advisement from an authorised person, or those who certify that they will not invest more than 10 per cent of their net investible portfolio in P2P agreements. In other words, the regulator is looking to apply the same marketing rules to debt-based platforms (P2P) as apply to investment based platforms (equity crowdfunding). This must surely be seen as a blow to the industry."
To be precise the FCA proposes 'to extend marketing restrictions that already apply to investment-based crowdfunding to P2P platforms'. In effect the FCA proposes to “limit P2P platforms’ ability to market to certain investors". This means that P2P investments can only be marketed to those certified or who self-certify as sophisticated investors, those certified as high net worth investors, those under advisement from an authorised person, or those who certify that they will not invest more than 10 per cent of their net investible portfolio in P2P agreements.
Why this regulatory push to manage risk – partly it’s because the regulator says it has observed poor practices in the sector, ‘particularly among loan-based platforms’. It’s also worth noting that the regulator sees pensioners investing in P2P as a risk. It feels that low interest rates may drive them into alternative investments, taking 'inappropriate' levels of risk with their money. At the same time, the young are at risk due to the web-based, 'social networking nature' of crowdfunding, which might lure them into investments they do not fully understand.
The backdrop to this is a wider UK regulatory drive which I nickname behavioural channelling. In the FCA's mind, retail investors are simple folk who need protecting against – against unscrupulous professionals and their own worst nature and greed. This mainstream, core audience needs proactive protection and thus needs to be channelled down pathways which deliver them to simple to understand products brought to them big, scale players such as asset managers. This featherbedding of oligopoly favours the established investment players against the rivals. So the likes of Neil Woodford with their easy to understand mainstream UCITs funds are OK – as are high street savings accounts that pay derisory interest rates – whereas much most anything alternative is regarded as too risky.
Anyone who falls outside of this retail channelling definition – high net worths, sophisticated investors and professionals – can be left to their own devices. As long as they can prove they know what they are up to, they can invest in much most anything they want. They are adults and thus fair game.
This distinction has been echoed in the US where the JOBS Act amongst other things allowed a new designation of accredited smart investors who could be marketed to by leading hedge funds. This unleashed a wave of new products that could be advertised to investors who didn’t fall into the mainstream retail designation.
On paper this all sounds sensible guided by a lorry load of insights from behaviourial finance. But I would proffer three criticisms. The first is that by dumping P2P into the same bucket as crowdfunding, it makes lending look as risky as crowdfunding. Which we all know is a complete nonsense. Crowdfunding is great fun and can every once in a while produce a massive tenbagger hit but by and large failure is common place and no one should be remotely surprised that a great many early stage businesses go bust. It's risky. It always has been and always will be.
Lending by contrast produces nowhere the same level of losses – so far – and the nature of the investment proposition is entirely different. You are receiving a relatively low return – there are no ten baggers in the lending neighbourhood – precisely because you have recourse to strict lending criteria and security (in some cases). My sense is that most mainstream investors will know look at P2P and say “hell, the regulators think this is really risky, so it must be”.
My next observation is that as soon as an investment gets moved into the non retail channel I describe above, many investors and especially their advisers just stop looking. I’ve covered structured products for many years and they’ve also become subject to stringent marketing rules after some well publicised scandals. The vast majority of plans are now sold direct via IFAs, most of whom run a mile from structured products because the FCA has given the impression that they are all potentially risky and dangerous.
My last observation is that the rules can also be gamed by those with a real interest in gaming them. I’ve long invested for instance in securitised derivatives and traded options. These are also subject to stockbroker managed accreditation processes designed to weed out the naïve retail investor from the smart investor. These forms ask all the right questions and in my experience most broker platforms know damned well that a good one third to a half of their clients lie through their teeth. “Have you invested more than five times in the last year in options and derivatives?” “Yes sir, and three bags full”. The firey, burning pants can’t be seen on line!
That last point matters because unscrupulous platforms – and equally greedy investors – will game these accreditation requirements. As long as both parties conspire to proclaim the sophistication of their clients, bad practise will thrive. More to the point, it’ll then drag down the mostly honest operators who scrupulously keep to the rules.
So, in sum these proposals I think will have a chilling effect on the growth of the industry. They also won’t stamp out the bad practises and they’ll be gamed like crazy. Most importantly they make the industry look much more risky than it really is. Many established players will of course shrug off these concerns, craving as they do regulatory respectability and a narrowing of competition but I think the impact on innovation and the supply of fresh risk capital to the UK economy will be significant and negative. Its not too late for a rethink?