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Regulation and the speed of change: the P2P experience

· Article,P2P lending,Regulation

This article was published in Compliance Monitor on 7 February 2017 (please note, the full article is behind a paywall)

36 months after the creation of a bespoke regulatory regime for the peer-to-peer lending sector, only a small proportion of platforms have been successfully authorised and the Financial Conduct Authority now wants to create new rules. Gillian Roche-Saunders discusses whether lessons can be learnt.

Once seen as the vanguard of the UK’s initiative to establish itself as the global centre for FinTech, peer-to-peer lending, or P2P lending, has been having a tough time lately.

Only a small proportion of P2P lenders have made it through the authorisation process, despite months of cooperation and information provision. But back in 2014, the future looked rosy.  The FCA, taking the rare opportunity of being largely unencumbered by European directives and regulations, decided to demonstrate how well it could foster competition and proportionate regulation by designing a set of rules bespoke to the industry. 

In December, after a summer of visiting and questioning P2P lenders, the FCA finally confirmed that it would be proposing new rules for the sector.  Both the tone and content of the feedback statement released suggests a U-turn on the embrace of innovation and the disappearance of the ‘proportionality agenda’.  And this is entirely in keeping with the practical experience of platforms over the last year, during which the regulatory journey of platforms became one of the most involved and iterative of authorisation processes any firm could experience.  

So, what went wrong and are there any lessons that can be learnt?

The rise of a sector

Nine years after Zopa – the first UK peer-to-peer lender – was established, P2P lending became regulated by the FCA.  In April 2014, when the FCA took on responsibility for 50,000 consumer credit firms previously regulated by the Office of Fair Trading, it agreed to regulate any form of P2P lending, whether it would have previously been consumer credit or not.

While some platforms facilitating small, personal loans may have needed a credit broking licence, many of the platforms facilitating loans to small businesses and landlords were unregulated until this point.  From April 2014, if any of these platforms allowed loans to be made by individuals and certain small partnerships and associations, they now became caught within the consumer credit regime as P2P activity. 

After completing a form and paying a few hundred pounds, these firms were provided with an interim FCA licence and a window in which they would need to submit an application for full authorisation.  During this time they would be subject to many of the FCA rules.  In terms of size, by the end of 2016 the P2P lending market had grown substantially, seeing an 81% increase in size from 2014 to 2015:  the peer-to-business lending sector grew to £881 million, peer-to-property lending grew to £609 million, and peer-to consumer lending grew to £909 million.[1]

Designing a new regime

Unrestricted by European directives, the FCA had free reign to create a regime specific to the peer-to-peer lending market.  It is a rare occasion on which the FCA has such a blank canvas to create policy. It sought to balance consumer protection with competition and to ensure that “firms and individuals continue to have access to this innovative source of funding”.[2]

How was such a balance to be achieved? In the lead up to April 2014, HM Treasury drafted the new regulated activity of operating an electronic platform in relation to lending, or article 36H, as the industry refers to it, to capture the business undertaken by the burgeoning sector.

The FCA decided to be prescriptive where it counted, and flexible where it could.  Detailed rules needed to be followed in areas where real detriment could occur in relation to client money and capital requirements, as you would expect.  Rules outlining the requirement for a living will, or run-off plan, were drafted specifically for the P2P industry.  A pattern emerged that showed the FCA was most focussed on protecting consumers from detriment should one of the platforms fail.

Elsewhere, flexibility was introduced.  The FCA created a primarily disclosure-based regime where platforms were to ensure that lenders and borrowers had the information needed to make informed decisions: an extension of the fair, clear and not misleading principle.  

At this point it seemed as if a great balance had been struck – many commentators said the rules were too light, others said they were too restrictive.  At the same time, the industry grew, attracting more institutional and retail lenders, and becoming the go-to place for banks referring borrowers they could not service.  Government initiatives such as bad debt relief and the introduction of the Innovative Finance ISA, an ISA wrapper for loans made through P2P and debt-based crowdfunding, were also announced. 

A tortuous process for everyone

The length of time platforms have been in the authorisation process pending full permission is growing, with some now having waited over 24 months: a long time to be dealing with uncertainty, and costly.  Even for us regulatory consultants, who see the FCA process day-in and day-out, the level of scrutiny and the twists and turns by the regulator throughout the process have been astounding. 

A lucky few, or should I say lucky seven, firms, broadly missed the initial delays and were granted permission to undertake article 36H activity during the first few months of 2015, before much of what I will describe here.  A couple more passed muster a year later, and finally in November and December 2016 the first real batch of P2P lenders who have made in through the detailed process were fully authorised. 

Initial delays came down to resource and that can be no surprise.  The FCA had taken on 50,000 new firms from the OFT, adding to the 27,000 firms already within its jurisdiction.  Even the careful scheduling of application windows couldn’t eliminate the pressure of such an increase, particularly on the teams processing applications who were only just recovering from the pressure of applications from fund managers triggered by AIFMD. 

As with many sectors at the time, P2P lenders found that there were delays in their case being allocated and in the time between interactions with their case officers. All of this could be explained by the inevitable resource issues resulting from such an increase in the number of firms regulated by the FCA.  However, as the process evolved a number of new causes emerged, all of which may prove useful lessons should you ever be involved in a new regulatory regime in future. 

Interpretations and reinterpretations

Over time, different interpretations of article 36H emerged. In the purest form of P2P lending, platforms facilitate a loan between a lender and borrower, where at least one party to the transaction is an individual.  Very few business models were this vanilla. 

While the general understanding was that article 36H was drafted to capture the activity of the P2P industry, on some analysis, platform activities might go wider than this.  Without perimeter guidance or precedents, it was possible for quite different views of article 36H to be held by platforms, lawyers, consultants, HM Treasury and the FCA.  Legislation in isolation proved to be insufficient. 

FCA policy and platform practice had to adapt as more about the industry and business models were becoming evident.  As such issues emerged over time, the changes occurred as a slow evolution rather than a big bang. 

Uncertainty and the resource needed to remain in such a process take their toll. For example, when it emerged that far fewer loans would be deemed to be P2P loans under the FCA’s interpretation of article 36H, firms had to reinvent their client money processes and reconsider consumer protections.  Further down the line, an unintended consequence of this interpretation revealed itself: loans could only be included in the Innovative Finance ISA wrapper if they were P2P loans, facilitated on a fully authorised platform. This was a major blow to the industry, as the Innovative Finance ISA was viewed as one of its most significant opportunities.

Sadly the evolution occurred in pockets, with case officers applying different standards.  This meant that some of our clients would succeed in an area where others wouldn’t despite comparable circumstances, and issues previously closed would be re-opened when cases were reallocated.  Clearer policies develop over time, but as authorisation and supervision teams grapple with emerging issues, the level of challenge within the authorisation process is greatly exacerbated.

Some well-meaning interventions arrived during the authorisation process, but these created their own difficulty.  For example in January 2016, HM Treasury created an exemption so that P2P platforms would not be viewed as collective investment schemes.  However, this made the FCA concerned it could be taken to mean that any non-P2P loan activity on the platform must therefore automatically amount to a collective investment scheme. It has been asking firms to explain why their operations do not amount to CIS but has not yet made any formal pronouncement or blanket statement. On reflection, consultation on the change or some further stakeholder engagement may have prevented this reaction, which cannot have been what HM Treasury intended. 

So, some exemptions and requirements were clear from the outset yet a number of others emerged over time.  While platforms that were able to make concessions readily or were always at the more straightforward end of the spectrum are now being authorised, firms remaining stuck in the authorisation process are feeling the full consequences of emerging policy concerns. 

The problem with proportionality

To my mind, the proportionate approach taken to the initial rulebook scuppered the overall process, and future sectors may want to request such treatment with caution.  Initially P2P seemed to have received the better end of the bargain, when compared to investment-based crowdfunding platforms that were subject to MiFID or other existing and prescriptive rules.  However, over time it became clear that well-trodden paths provide comfort to case officers who have the all-important task of deeming whether models and practices are safe to allow into the market. 

Every ounce of business plans had to be proven and re-proven as case officers and their superiors needed more clarity than the rules required.  Even where specific requirements had been created for the industry (e.g. the living will obligations), we saw the FCA’s specifications increase far beyond the original detail of its own rules as it sought to get comfortable with new terrain. 

Getting to know you

In addition to predicting and adapting to evolving regulatory requirements, the need to educate the regulator about any new sector should not be underestimated.  Many platforms focussed on becoming au fait with the regulator’s expectations, hiring experienced staff and advisers, but the extent to which education of the FCA was needed was greatly underestimated. 

Should any industry have to force feed their regulator?  It is certainly not the case that there was a lack of transparency or openness to cooperate from what I have seen of the platforms and trade bodies efforts.  However, with the benefit of hindsight, I suspect a more proactive approach to education would have been taken. 

The difficulty here is that, as outlined by the threshold conditions, the FCA must be able to supervise your firm adequately.  Understanding of how your business or market operates is key to this. 

Once the FCA truly grasped the extent and complexity of the industry, the level of probing developed. Two years after taking on the consumer credit industry and 18 months after many applications were in, the FCA conducted on-site visits for firms waiting to be authorised. Thematic review style visits and CASS reviews took up the Summer, alongside increasingly penetrative and focussed questioning from case officers.  In Spring and Summer of 2016 it became clear that the FCA knew enough to identify where it should delve, and delve it did.

With higher standards than the original rules now being required by the authorisation teams, it is entirely appropriate that these standards should be codified and standardised – the proposed new rules are expected imminently.  However if these standards are required, much of the delay and expense involved in many of the iterations and evolutions we have witnessed could have been avoided.  The level of innovation may be blamed for the changes in policy, but from the ground it looks very much as if there was a healthy dose of the initial drafting being insufficient at the time, or insufficient for the current regulatory appetite. 

The pace of change

FinTech companies can develop at a pace.  The P2P industry moved forward while the drafting of article 36H (and the FCA queue) stood still. All innovative companies, needing to secure market share in a competitive, emerging sector will do the same.

As institutional money began to be attracted, new retail lender bases opened up and new competitors emerged, platforms honed their offerings.  Some developed consumer protection mechanisms such as provision funds, others created auto-diversification features to appeal to more passive investors, and many used institutional underwriting or pre-funding to help them secure the best deals for consumers.  

Such “bells and whistles” hampered the FCA’s analysis, and changing goalposts did nothing for the regulator’s confidence to be able to authorise firms.  However, can a modern regulator expect a business model to stand still if authorisation takes 18 or 24 months?  Even firms experiencing a six-month process find that they need to adapt aspects of their plans, and this is the nature of business for early-stage and growth companies. 

While it is unrealistic to expect business models to stand still, it would be interesting to know if, with the benefit of hindsight, some platforms would have chosen to hold back development artificially.  If the price of new products, services or structures, is a slower authorisation process, firms in a competitive and evolving environment will have a real dilemma on their hands. 

There may be no right or wrong answer, but future industries may want to weigh up the options consciously, and if they choose to change, consider collaborating with the regulator from the outset to reduce the risk of further delay. 

Going forward

A comment in the FCA’s December feedback statement suggested the process has taken its toll: “While the FCA has placed great weight on promoting innovation in financial services in general, we are growing increasingly concerned about the speed of change”.  Having positioned itself globally as a leading regulator because of its approach to innovation - through Project Innovate and the Regulatory Sandbox - one can only hope that this comment does not signal the demise of the FCA’s openness and positive approach to FinTech.  A regulator that is able to tackle and adapt to complex new businesses, enables the financial services industry to flourish.   

In terms of P2P, neither the platforms nor the FCA expected the delays we’ve seen.  While the resource issues and changing business models were probably inevitable, both sides may have adjusted their approaches with hindsight.  The inconsistent application of evolving policy has been incredibly difficult to deal with and much of this is due to conflict between a predominantly disclosure based regime, with limited guidance or precedent available for authorisations staff or firms to use, and the natural tendency and need for any regulator to get comfortable that it knows the market it regulates. 
 

While the process may have been painful, the outcome is a regulator who has forensically looked under the bonnet of this new sector and, once the FCA provides the final green light, platforms have truly been through the most thorough of regulatory MOTs. 

  1. 'Pushing Boundaries: the 2015 UK Alternative Finance Industry Report' by Nesta and the Cambridge Centre for Alternative Finance (www.nesta.org.ukjsites/default/files/pushing_boundaries_o.pd/).

[2] Christopher Woolard,'The Financial Conduct Authority outlines how it will regulate crowdfunding,' 24 October 2013 (wwwfca.org.uk/news/press-relaeses/financialconduct-authority-outlines-how-it­will-regulate-crowdfunding)

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