It probably won’t have escaped the attention of those in the crowdfunding and P2P sectors that on Friday the FCA formally launched its much anticipated review of rules for the sectors, by way of a call for input.
The last major change of rules occurred in 2014 together with the switch of regulation of P2P firms from the OFT to the FCA, and the FCA’s rules on non-readily realisable investments. Much has changed in both sectors since then, and a quick read of the FCA’s document gives a clear insight as to where regulation may head next as the regulator seeks to ensure regulation keeps up with the pace of change.
The FCA’s document also identifies some of the regulator’s key concerns with the industries and firm’s should take action now, in advance of likely supervision activities as part of the review, to ensure that they remain compliant.
- The number and variety of products in the P2P sector is ever increasing including P2P mortgages, pawn broking, and increasing levels of institutional lending. The latter has created a duplication of regulation with both lenders and platforms required to comply with similar provisions of the Consumer Credit Sourcebook (CONC).
The FCA intends to require platforms to comply with the relevant MCOB provisions where the loan is one ordinarily caught by the Mortgage Credit Directive. It also intends to review the consumer credit provisions applicable to P2P platforms as part of its wider review and reform of the remaining provisions of The Consumer Credit Act 1974.
- The increasing institutional engagement in P2P platforms is creating:
- an emerging trend of securitisation of P2P agreements
- the potential risk that institutional lenders will be given preferential treatment by platform operators
The requirement upon firms to ensure they appropriately manage conflicts of interest may be tightened and become more prescribed.
- Some platform operators are ‘pooling credit risk’ by maintaining a shared provision fund, or similar, which is designed to protect lenders in the event of defaults. Whilst this does not amount to a Collective Investment Scheme it may amount to an Alternative Investment Fund (subject to the structure) and therefore be caught by AIFMD.
The FCA raises concern that business models of this nature are similar in nature to asset management yet sit under a regulatory framework that was not designed for such thus creating what it cites as ‘regulatory arbitrage’.
Asset management type rules may be introduced for those firms seeking to pool investment risk.
- The regulator has identified a mis-match between the liquidity sought by borrowers and that offered to lenders. In other words, borrowers are being offered terms longer than lenders are required to commit to therefore creating a liquidity risk. In the regulation of banking this is dealt with, inter alia, by way of capital adequacy requirements.
Greater capital adequacy may be required for those firms who offer products where there is a mis-match on term between borrower and lender. Alternatively, greater transparency may be required, by way of disclosure requirements, to ensure the liquidity risks are adequately explained to investors.
- The FCA suggests that ISA and SIPP wrappers for P2P loans may give greater confidence to retail investors than they might otherwise have. This may leave such investors in a position whereby there are investing without truly appreciating the risks involved.
At this stage there is no indication as to rule changes with the FCA merely requesting input, however there is the potential for additional appropriateness tests to be introduced particularly where there is an inward transfer from an existing investment wrapper.
- The FCA raises concerns about the adequacy of the systems and controls being operated by some firms. This is not unsurprising given that many firms in the sector are continuing to operate on interim permission following transition from the OFT regime under which such requirements were almost non-existent. Wind down plans continue to be reviewed by the FCA.
Malpractice and cyber-security are cited as the two main concerns although it is clear from the general theme of the paper that the FCA has concerns about corporate governance within firms. Given the impending implementation of the Senior Management Regime to financial services firms generally, it is possible that specific rules for P2P firms may be introduced to improve risk accountability in the sector.
- The level of due diligence and creditworthiness undertaken on peer to business loans is brought into scrutiny.
The regulator will be reviewing the approach taken by firms however it is likely that there will be strengthened creditworthiness rules, as part of the FCA’s general review of creditworthiness requirements in CONC, which is already under way.
- Prudential requirements and client money arrangements are referenced but only in so far as reiterating the current requirements.
Whilst there is no discussion as to rule changes the FCA’s concerns over systems and controls and liquidity may mean that additional changes are considered, including further increasing capital adequacy, and strengthening client asset rules.
- Concern is raised regarding the level of disclosure made by platform operators to investors, on default rates in particular, and the approach which firms take to ensuring investors understand the products in which they are investing. Investor understanding of risk features heavily throughout the document.
The rules currently applied to crowdfunding with regard to assessing investor understanding could be applied to P2P firms, with specific rules also being implemented on disclosure requirements
- FSCS coverage for P2P investments is to be subject to review as part of the FCA’s general review of the funding of the FSCS, but it cites difficulties in providing protection for P2P investments through the scheme.
It is difficult to see how the FSCS could be funded to cover potential P2P losses without putting significant costs upon market participants, although advised transactions may be covered not least to encourage investors to seek advice prior to making an investment.
- Similar to P2P, crowdfunding is cited as attracting increasing levels of institutional investment. Unsurprisingly the FCA raises the same concern with regard to such investors being given preferential treatment over retail investors. There is also an increasing variety of investments being offered via platforms including REITs and convertible loan notes.
Concern is also raised regarding the conflict which exists between the need to raise funds for investment issuers, and acting in the best interests of investors.
One of the biggest risks for investors in the sector is capital loss and therefore it is unsurprising that the level of due diligence carried out on investments by platform operators, prior to listing on platforms, is cited as a key area of risk by the FCA.
As well as potentially strengthening requirements on conflicts of interest, there is a suggestion that rules may be introduced requiring third party due diligence to be undertaken on proposed investments prior to listing on platforms.
- There are currently no rules mandating the form of the appropriateness test to be carried out by platforms prior to enabling an investor to make an investment, but the FCA intends to review the arrangements adopted by firms.
The regulator also raises concern regarding the certification of investors by platforms, and in particular the classification of investors as sophisticated when they are not.
This is one of the few areas in the paper where the FCA makes it clear that it will consider sanctioning firms, and requiring redress, if it identifies non-compliance as part of its review. Further rules should be expected in this area.
- As with P2P, the FCA intends to closely review the disclosure arrangements adopted by firms. In particular, the level of failure rates of investments listed by platforms is likely to be brought under scrutiny, together with the disclosure made by platforms where parties connected to the investment issuer are making investment via the platform.
Disclosure rules are likely to be introduced on both failure rates and the contribution of investment by connected parties.
- Again, as with P2P, The FCA suggests that ISA and SIPP wrappers for P2P loans may give greater confidence to retail investors than they might otherwise have. This may leave such investors in a position whereby there are investing without appreciating the risks involved.
At this stage there is no indication as to rule changes with the FCA merely requesting input, however there is the potential for additional appropriateness tests to be introduced particularly where there is an inward transfer from an existing investment.
Responses to the call for input must be made by the 8th September.
Firms who are currently active in the sector should ensure they conduct a focussed review in advance of likely engagement with the FCA’s supervision teams in the coming months. For those who are in the process of authorisation they should consider reviewing their regulatory business plans to ensure the FCA’s concerns are appropriately addressed.