Peer-to-peer finance, P2P, is the practice of transferring money between unrelated individuals, or peers, without going through a traditional financial intermediary such as a bank or other traditional financial institution.
Most often applied to loans or foreign exchange, it is a “disruptive technology” business model using web technologies as a foundation.
Disruptive technology business models in this context can be defined as newer firms offering new facilities to customers via the use of internet based transaction services, payments and loans.
Internet-based transaction websites (and related background technologies) are known as platforms.
Peer-to-Peer Lending Platforms
The first company to offer peer-to-peer loans in the world was UK-based Zopa, founded in February 2005; the sector has exploded with current year-on-year growth upwards of 80%, outpacing more entrenched and slower to react banks and building societies (traditional lenders).
In April 2014, P2P lending fell within the scope of the Financial Conduct Authority (FCA), after push from government which continues to encourage the industry through a range of initiatives designed to encourage early adopters, innovation and consumer buy in:
- FCA Regulation and focus
- Support through the Business Finance Partnership and the British Business Bank’s Investment Programme
- Stocks and shares ISAs to include loans made through P2P platforms (i.e. holding P2P loans within an ISA will mean that interest received on the loans will not be subject to tax)
- Consulting with industry on the implementation of new withholding tax obligations, to apply across all P2P lending platforms from April 2017
What are peer-to-peer loans?
Peer-to-peer loans are direct transactions between investor(s) willing to lend money and borrower(s) seeking loans.
These parties are brought together by an electronic platform which introduces and arranges the loan documentation between the lender and the borrower, and then manages the payment of interest and repayment of the principal according to the terms agreed between the parties.
This is the activity of operating an electronic system in relation to lending as defined by HM Treasury and explained in the FCA’s Perimeter Guidance (PERG) Handbook.
As of 1 April 2014 peer-to-peer platforms arranging loans meeting the definition of ‘relevant agreements’ in article 36H of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 are considered to be carrying on the activity of ‘operating an electronic system in relation to lending’ rather than ‘credit broking’ and have been required to be authorised by the Financial Conduct Authority (FCA).
Interestingly HM Treasury also allows P2P lenders to operate as an ‘appointed representative’ (AR) so a P2P operator could also be exempt under the Financial Services and Markets Act (FSMA) rather than being directly authorised…however other than firms in the same group, or those looking to charge extortionate fees to ‘borrow’ their licence, it is difficult to picture a situation in which an authorised firm would appoint a direct competitor as an AR simply in order that the AR need not apply for direct authorisation.
Regulation of peer-to-peer loans
Firms operating peer-to-peer platforms authorised by the FCA are required to comply with various provisions in FSMA and within the FCA Handbook.
They are also required to comply with FCA rules designed specifically to protect individuals investing and borrowing via peer-to-peer platforms (found within the Consumer Credit Sourcebook (CONC) and Senior Management Arrangements, Systems and Controls (SYSC) Handbooks).
Broadly speaking, the FCA’s rules require firms operating peer-to-peer platforms to act fairly, professionally and honestly in the best interests of their customers, and to ensure that the content of their websites are fair, clear and not misleading.
It is important to note that investors in peer-to-peer loans are not currently protected by the Financial Services Compensation Scheme (FSCS), and the FCA has clearly stated it has a ‘watching brief’ over this embryonic industry and newly printed regulation (see acting CEO of the FCA Tracey McDermott speech before the Treasury Select Committee in October).
The authorisation process is vastly different from previous processes employed by the OFT for consumer credit firms, and the work entailed should not be underestimated.
The FCA has clearly signposted its approach to dealing with consumer credit firms, and how it will regulate this sector, and consumer credit firms who thought they could carry on as before have received a rude awakening (not least Wonga, which received a hefty fine from the FCA).
The FCA has published detailed guidance to try and educate applicants in the work they need to undertake before applying to the FCA for regulation.
The FCA have been critical of the quality and standard of applications they have seen (see some of the refusal letters published by the FCA) and have enhanced their website to set out step by step the level of detail needed in an application, and the minimum conditions a firm must meet for authorisation.
Briefly, the threshold conditions cover:
- legal status of the firm
- location of the firm’s offices
- effective supervision (including the firm’s close links)
- the firm’s resources
- suitability of the firm and its personnel
- the firm’s business model
Detailed guidance can be found in the Threshold Conditions Handbook (COND) Handbook.
Risks to address
While some of the conditions above are fairly self-explanatory, detailed focus must be given to the construction of the business plan and explanation of the firm’s structure, governance arrangements and how it will go about its business.
As a new area of regulation, we have found that firms neglect to cover the risks posed in this sector within their regulatory business plans (or separate risk management documents).
Given this is a new area of regulation, and the FCA has a ‘watching brief’ it is important to demonstrate to the regulator in your application that you understand the risks posed by the business (risks to the firm, consumers, and wider market) and have created a control framework to mitigate these risks.
Risks for P2P lending will include (but are not limited) to the following, however some will be more relevant than others dependent on how you attract customers, bring together borrowers and lenders and the type of loans you deal in (for example):
Consumer understanding and transparency of information
Will you be dealing with experienced investors or the person on the street?
How will you carry out background checks and creditworthiness assessments and what information will you publish for lenders to assess the opportunities offered by your platform (and is it potentially misleading clients)?
Conflicts of interest
Firms running crowdfunding platforms are subject to a number of conflicts of interest that could lead to consumer detriment.
For example, if platform remuneration is linked to transactions or if inside information can be used to ‘cherry pick’ the best deals (how will your platform link borrowers and lenders?)
You must be able to identify conflicts of interests between shareholders, managers and key employees, and clients (big and small).
Operational risks cover a multitude of areas.
This will include:
- platform failure and poor administration of loans
- losing (or taking) client money
- failure to deal with fraud money laundering
- other aspects of financial crime
- dealing with individuals data (i.e. DPA issues)
Cyber-security is a growing issue, and can lead to platform failure or loss of data for example, and a firm should have robust business continuity plans in place (and there are specific rules in SYSC a firm should be aware of and cater for in its business plan).
Counterparty and Liquidity risk
Clearly one of the key risks with loans is that a lender will not get their money back (default rates are a key issue and much will depend on a firm’s and its clients risk appetite and the quality of its creditworthiness assessment).
Also (depending on the administrative set up or type of loan) the P2P firm and lender/borrower may not receive money when it falls due for a variety of reasons.
A lender or borrower may be uncertain about his rights and obligations vis-à-vis the parties involved, rights to withdraw for agreements, and/or legal documents may not be correctly drafted.
The FCA rules are manifold and detailed; they do not simply cover how a firm provides credit but cover every area of a firms operations.
Falling foul of the regulator could mean your application is declined, or once authorised could lead to fines, reputational risk and bans from the industry.
Of course consumers will be put at risk if the firm is not compliant with the rules, from poor communications through to failure to deal with complaints.
How Complyport can help?
Clearly the P2P market offers an opportunity for the smart well-prepared operator.
As compliance experts with a pool of experienced staff in dealing with FCA authorisations, consumer credit firms (in particular crowdfunding and other fintech alternatives) we can find solutions to compliance issues, including:
- assisting in the production of your regulatory application pack
- supplying compliance manuals and monitoring programmes
- providing detailed training on the rules you need to comply with
- ongoing support with FCA visits or contacts
We can help you every step of the way.
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