Contrarian: Regulating alternative finance

You always know when a sector like alternative finance has hit the big time – the regulators start to take a close interest.  

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As a growing number of sophisticated private investors and wealth advisers start to dip their toes into the waters of peer-to-peer lending and crowdfunding, the regulators have at long last stirred.

According to the Sunday Times, the FCA now says crowdfunding sites in particular should only be “targeted at investors who know how to value a start-up business, and who appreciate the risks involved and that they could lose all of their money…We want it to be clear that investors in the majority of crowdfunds have little or no protection if the business or project fails”.

The paradox, of course, is this is yet another example of the horse bolting stable syndrome prevalent among financial regulators.

Alternative finance outfits have, in fact, been fairly loudly asking for FCA supervision for at least the past year. Any investor visiting sites as varied as MarketInvoice, ThinCats,Seedrs and Crowdcube (the last two are already regulated) cannot help but notice the obvious evidence of risk.

As you scan down the list of projects to fund, you cannot help but wonder how many will actually survive and prosper.

But this little ripple of regulatory interest does serve a positive purpose in shining a light on these varied and disparate alternative finance models.

In the heartland of alternative finance, outfits as varied as Zopa and RateSetter in personal loans, Funding Circle and FundingKnight in business loans, and MarketInvoice and Platform Black in invoice funding, are revolutionising finance with online platforms that bring together savers and borrowers to set market prices.

By my calculations, this group of just six platforms have already hosted transactions worth £650m in just a few short years.

No wonder that, earlier in the year, researchers at French investment bank SocGen estimated the total alternative finance space – which includes more established outfits funding infrastructure projects as well as trade finance – could be marshalling assets of €150bn in just a few years.

Given this potential for growth, it is not surprising the big alternative finance players are now attracting serious amounts of investor money.

Zopa, for instance, has also gone from strength to strength in the peer-to-peer consumer lending space, along the way acquiring prestigious investors including Jacob Rothschild.

Over in the business loans segment, Funding Circle is rumoured to be close to signing a big deal that would bring in Santander as a player on its lending platform, while smaller rival FundingKnight has just announced London-listed finance company GLI has bought a big stake in its SME platform.

Alternative finance now finds itself at an interesting crossroads. Outfits like Zopa and Funding Circle have gone out of their way to ‘mainstream’ their products, forming trade associations and beckoning regulatory intervention.

If all goes to plan, by the summer of 2014, the peer-to-peer savings and lending institutions will indeed be under the FCA’s overview. Once regulated, I have no doubt more and more wealth advisers and IFAs will start investigating investment opportunities in this sector.

Yet cynics might question whether that regulatory approval is really such a desirable outcome. Talk to most advisers and fund management companies and they would tell you they do not welcome the increasing micromanagement of the regulatory authorities.

In particular, I would be extremely worried by how the various online investment and savings platforms will react to a severe liquidity test similar to the global financial crisis of 2008.  That worry points to a more systemic risk for investors in the sector – a lack of long-term data on returns and risks, especially for default rates beyond just a few years.

As these platforms suck in more money, won’t they also suck in less desirable borrowers, keen to seek out alternative funding sources while the mainstream banks shrink their balance sheets? Most online platforms respond by arguing the market is still big enough to accommodate a massive expansion with no discernible loss of credit quality. That is a fair argument, but it will surely be tested in any future economic downturn.

On the investor side of the equation, the biggest challenge might be the sheer scale of ‘dumb’ money looking to lock money in at high rates.

Won’t the net effect be to push down effective returns to investors to such low levels they will not compensate investors for any future losses from defaults? And at the moment those defaults are not tax deductible for UK investors. Many investors I talk to privately suggest rates on the more popular platforms have dipped sharply, forcing them to investigate newer platforms for higher rates of return – and commensurate levels of risk.

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