Low interest rates and a squeeze on small business credit have driven a surge in peer-to-peer lenders, operating almost exclusively online. In response, the Financial Conduct Authority has moved swiftly to establish appropriate protection for investors and borrowers, writes Stuart Holman
From 1 April 2014 peer-to-peer (P2P) lenders have been regulated by the Financial Conduct Authority (FCA), and while firms with a consumer credit licence were able to apply for interim permission, new starts ups – or those who did not apply for interim permission – will need to seek authorisation from the regulator before they are able to conduct business.
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So what must existing and start-up firms do in order to ensure that they comply with the FCA’s regime?
An explosive force
P2P lending has been an explosive force in an economy with flatlining interest rates and a universally recognised gap in the provision of small business finance.
The industry has been eagerly seized upon by governments in many countries as a solution to this problem, but there’s a danger in assuming that government support for the sector means light-touch regulation.
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By GlobalDataIn the UK, the enthusiasm of the coalition for facilitating the growth of the peer-to-peer lending market is not necessarily shared by the FCA, which is tasked with the operational objective (among others) of securing an appropriate degree of protection for consumers.
According to industry body the Peer-to- Peer Finance Association, the sector more than doubled in size in 2013 and the leadingmarket participants are growing rapidly. Indeed, P2P consumer and business lending platforms (P2PLPs) now constitute the largest source of alternative finance in the UK and the market was worth £480m in 2013.
When the FCA became responsible for the regulation of consumer credit activities, including P2PLPs, firms which had an OFT
licence and which were relying on interim FCA permission were subject to the FCA’s 11 Principles for Businesses and its financial promotion rules from 1 April, with transitional arrangements applying to the remainder of the detailed requirements (including the client money rules), until 1 October.
New P2PLPs obtaining FCA authorisation will be subject to the full FCA requirements immediately, although in both cases the capital requirements are phased in over a longer time period.
Below I outline the five areas of business where new and established P2PLPs should pay the most attention.
Financial promotions – be wary of comparisons
In terms of the promotional material P2P lenders issue, there are some key considerations. When the regulator says "fair, clear
and not misleading", there’s a back-story implicit in this requirement that P2P lenders would do well to become familiar with.
The area that the regulator is perhaps most concerned about is the issue of comparisons with other investment products. Forexample, a P2P lender may claim that it can achieve an 8% return on a particular loan, compared to, say, a 3% return on a deposit account.
The FCA would argue that this is not a viable comparison because a deposit account is a different product and is subject
to guarantees such as the Financial Services Compensation Scheme (FSCS). Money lent through P2PLPs is not covered by the protections of the FSCS and the retail investor risks losing the entire sum advanced.
The regulator also expects promotions to be "balanced". In other words, the message that the consumer receives is evenly spread between the ‘good news’ and the ‘bad news’. This means not having, for example, headline banners of high returns while having the risks in very small print at the end of a promotion.
The Financial Services Authority (FSA), the FCA’s processor, issued a considerable body of material explaining its concerns
about the financial promotions it monitored as part of its supervision. The FSA also provided clarification of the standards it expected. P2PLPs would be advised to look at this guidance in order to gain a good understanding of the approach of the FCA; in many cases it hasn’t changed, and the FCA is as concerned about balance as the FSA was before it.
Financial warnings must not be overshadowed and there must be no misleading headline claims, no small print and sufficientprominence must be accorded to the key risks.
Any benefits highlighted must be accompanied by a clear presentation of the key drawbacks so that the promotion as a whole is balanced. There must be a clear warning of the risks of loss, prominently highlighted to ensure these are not disguised, diminished or obscured by the benefits being promoted.
Promotions must include prominent reference to the tax treatment and the fact that taxation depends upon the individualcircumstances of a particular investor and may be subject to change. Firms should consider the target audience, the nature of the product and the likely information needs of the average recipient in the target group, and to this end firms should use targeted consumer testing.
The design and layout of financial promotions has been the subject of practical guidance by the regulator, down to text, background, colour and font size. One area of concern for the regulator is that warnings need to be the right ones for the product, the medium, the audience and the contents of the promotion.
Firms using clustered boilerplate warnings will alert the FCA. There may be promotions in circulation that don’t meet the standards set by the FCA and firms need to be wary of simply copying competitors and assuming they must be meeting the necessary standards.
Senior management of P2PLPs are responsible for ensuring the firm has the systems and controls in place to ensure financial promotions are compliant and are required to apply proper skills in determining whether a financial promotion complies with the regulatory standards expected by the FCA. This probably means providing training and guidance to the people responsible for the preparation of marketing campaigns to enable them to design compliant marketing materials.
Firms that expect the compliance function to review and sign off a promotion at the end of the process, typically at 4pm on
a Friday afternoon before launch over the weekend, are heading for trouble.
Gone are the days where it’s the compliance function’s job to clear up the mess that marketing has created. Compliance is about achieving compliant promotions from within the marketing operation in the first place.
The P2P lender must give an accurate description of the characteristics of the investment, what the potential returns are
but equally what the potential risks are at the same time.
The regulator’s own market research has proved that consumers who are presented with an initial message of strong returns and only provided with risk warnings at the end of the promotion will generally overlook the ‘bad news’ in their decision-making.
Treating Customers Fairly
P2PLPs need to consider the imperatives behind the FSA’s Treating Customers Fairly initiative in order to understand the FCA’s
expectations of the firms it regulates.
This includes ensuring products are designed to meet the needs of identified consumer groups and are targeted accordingly;
that consumers are provided with clear information, with sufficient product information; a fair and realistic impression of the product is produced in the mind of the investor; and that investors are provided with products that perform as firms have led them to expect.
Firms must also ensure that investors are kept appropriately informed before, during and after the point of sale.
Rules for handling client money
Firms holding client money, which many P2PLPs will do, need to remember that:
- Firms holding client money have a fiduciary duty to their clients and can only pay out client money in such a way as discharges this duty;
- Firms must deposit client money at an appropriate institution and undertake relevant due diligence in relation to this third party;
- Firms must keep records and accounts so they can always distinguish client money held for one client from client money held for another. In order to meet this requirement;
- Firms must conduct internal and external reconciliations, and
- Client money must be held under a statutory trust.
In addition, there must be a set process in place when dealing with client money in the event of firm failure, or in the event of
a third-party failure where the third-party holds client money.
Systems, controls and governance
There is then the need to ensure the firm establishes proper systems and controls, governance and record-keeping. This will involve conducting assessments of who the product is aimed at and making sure the standards established by the FCA for the product life cycle are being met.
Notwithstanding P2PLPs being new to regulation, the regulator perceives that they hold the balance of power between themselves and the investor. This is because the P2PLP has a greater knowledge of the product and so it is under a positive duty to wield this power wisely and not to mislead investors.
One aspect of systems and controls that is very important is the need for firms to have a ‘resolution’ plan; that is, the platforms need to have suitably robust arrangements that enable the loans to continue to be administered in the event that the platform itself collapses. Firms therefore need to consider insolvency laws, the migration of the loans from one platform to another, and how the P2P lender would interact with the administrator. These requirements are akin to the ‘living wills’ required by banks.
Conclusion
The major players in the market will have already set up their policies, procedures and systems. It’s always more difficult to
make a business that’s already operational comply with new regulation, such as those affecting client money, than when designing systems when a business is still in start-up mode. Start-ups can usually buy an off-theshelf solution in order to comply; established businesses must adapt the systems it already has.
It will be interesting to see how the industry reacts to this new regulatory regime. I imagine that the need for authorisation will slow down the number of new market entrants, but with interest rates predicted to stay at low levels for some time yet, I imagine that this will only be a temporary lull.
