Opinion

The regulation of crowdfunding

6 min read

12 November 2013

“Crowdfunding” involves one ‘crowd’ of individuals directly funding the activities of another ‘crowd’ of people or businesses through a single online platform by way of donation, loans or investment. It emerged in the UK in 2005 and has grown to more than £350m a year in response to both the lack of bank finance, and the desire for savers and investors to diversify and get a better return on their surplus funds.

Yet person-to-person lending only accounts for about one per cent of the total market for personal loans, and investment-based crowdfunding is smaller still. As a result, the industry has urged the government to create a regulatory regime that enables the new platforms to compete with banks and authorised investment firms more effectively. This led the Financial Conduct Authority to propose new rules for peer-to-peer lending and investment-based crowdfunding at the end of October. 

The FCA’s proposals are definitely a positive step. They enhance the credibility of the sector, and meet a key requirement for new asset classes to be included in ISAs and pensions. Unfortunately, the proposals still do not strike the right balance between protecting consumers and fostering innovation and competition. 

In particular, the decision to apply the FCA’s investment rules to peer-to-peer lending will substantially increase operational costs without improving on the platforms’ own self-regulatory principles, which are modelled on payment services regulations that are also supervised by the FCA. Indeed, the overly-prescriptive client money rules for investments could mean it is more cost effective for platforms to rely on payment institutions to handle customer funds. 

Oddly, anyone who invests in loans to consumers or sole traders ‘in the course of a business’ on an authorised peer-to-peer lending platform will also need to be authorised by the FCA, even though they are not using their own systems to create and administer the loans. Such dual regulation cannot have been the intention behind the EU consumer credit directive, as the FCA seems to believe, since it pre-dated crowdfunding. But this also means it will be much easier for a business to deposit funds in a bank account or to buy stocks and shares via an investment firm than to bother lending directly to consumers or sole traders. 

The FCA will also only allow investors to join in the crowdfunding of start-ups and other businesses if they agree not to invest more than ten per cent of their ‘net investible portfolio’ and either satisfy an ‘appropriateness test’ or act only on investment advice. This is because the FCA considers crowd-investing in start-ups to be high risk.
In reaching this view, the FCA cites the high rate of business failures, the possibility of unauthorised advice, professionals picking the best offers, lack of dividends, equity dilution and the lack of a secondary market. But the FCA does not appear to consider the benefits to individual investors choosing to support local businesses where banks have failed to do so.

The UK relies on SMEs for 60 per cent of new jobs and a third of private sector turnover (according to the Federation of Small Businesses). So it may be true that over half of businesses fail within three years, but they still employ people in the meantime. And perhaps more of those businesses would survive if people lent to them, or invested in their shares, instead of playing bingo, buying lottery tickets or betting on the races, for example. The FCA does not explain why a person who rejects those options to join in the crowdfunding of a local business would be the “wrong type of investor”. Such a paternalistic attitude not only prevents people making more responsible economic choices but poses a very real challenge to building alternative financial services for consumers and SMEs. 

In this context, it is also crucial for the FCA to differentiate between the risk profiles of the various types of lending and investment opportunities, including the presence or absence of security for the repayment of loans and the difference between ‘loans’ and ‘debt securities’. 

The FCA’s authorisation process itself operates as a brake on competition. Entrepreneurs must be nearly ready to launch before applying for authorisation, even though the FCA may take six to twelve months to approve or reject the application. That means their own investors must commit funds a long time in advance of the platform’s launch. In contrast, it only takes the FCA three months to approve an application to start a payment institution, and there is a lighter form of registration for small platforms.
Interestingly, the French propose to use payment services regulation as the basis for their peer-to-peer lending, and this could lead the European Commission to adopt the same approach when it revises the Payment Services Directive early in 2014.

Simon Deane-Johns is a consultant solicitor with Keystone Law

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