By Ryan Weeks on Thursday 2 June 2016
Andrew Tyrie MP – Chairman of the Treasury Select Committee – has written a pair of probing letters to the FCA and PRA on the subject of crowdfunding.
To Andrew Bailey, Deputy Governor for Prudential Regulation, Tyrie asked:
N.B. Tyrie appears to be referring to both equity and debt based “crowdfunding” platforms.
In answer to the first of these questions, McDermott will surely point to the fact that the major peer-to-peer lending platforms have taken it upon themselves to publish their full loan books online. She will likely point to the fact that the P2PFA requires its eight member platforms to adhere to certain standards of loan book disclosure. She may even cite the fact that independent data analytics companies, such as AltFi Data, are now applying further scrutiny to these loan books and are building tools around them, like AltFi Data Analytics, in order to allow the information to be more easily appraised. However, Tyrie’s question remains a good one. There is at present no regulatory requirement for the platforms to publish their loan book data, nor is there any regulatory oversight as to the veracity of that data.
In the equity crowdfunding sector, McDermott may have to concede defeat. Reporting standards within the more nascent equity crowdfunding sector are far from adequate. We remain a long way away from any kind of standardised format even for reporting volumes and self-reported performance data is but a distant dream. The industry’s mixed reception of our own, painstakingly crafted “Where are they now?” report – which sought to ascertain the health of every equity crowdfunded company in the history of the sector – is indicative of the state of things.
Tyrie’s second question relates to due diligence, and specifically to incentivisation. Track record, within peer-to-peer lending at least, is worth mentioning. The Liberum AltFi Returns Index (LARI) demonstrates that the major peer-to-peer lending platforms have to date managed to assess creditworthiness with a high degree of accuracy. The LARI is a 12 month back-dated, loss-adjusted representation of performance in the peer-to-peer sector, powered by loan-by-loan level, cash flow data from Funding Circle, MarketInvoice, RateSetter and Zopa. The blended line of return fluctuates between around 5% and 7% since the inception of the industry. This developing track record of investor returns would suggest that the platforms are well aligned with the needs of investors.
On the broader subject of incentivisation, neither peer-to-peer nor equity crowdfunding platforms – for the most part – hold actual skin in the game. In peer-to-peer, the level of transparency provided by the platforms is often pointed to as the panacea to that lack of skin-in-the-game. The rationale is that instances of poor underwriting would be quickly picked up on by investors – thus effecting falls in investor demand.
In equity crowdfunding, there are certain structural answers to the agent/principal conflict. One is the “platform carry”, whereby the platform effectively back-loads a part of its facilitation fee, to be deducted from investor profits in the instance of an exit. However not all of the platforms subscribe to this method of fee charging.
Here Tyrie does his best impression of the Yorkshire Building Society. It’s frankly very difficult to gauge how cognisant the average consumer is of the risks associated with any investment. McDermott will probably point to the FCA’s stipulations around investment risk warnings and the restrictions that apply to the marketing of crowdfunding investments. These rules span from advertisements on the tube right through to tweets and Facebook posts.
When the FCA was subjected to the scrutiny of the Treasury Select Committee in October of last year, Chris Philp MP spearheaded a similar line of questioning. “Do consumers properly understand that they are taking one-to-one, bilateral, counterparty risk?” He asked. McDermott admitted then that it was too early to accurately gauge the quality of consumer understanding in relation to peer-to-peer investments. She also noted, as a potential concern, that the onus to diversify funds occasionally sits with the investor in peer-to-peer.
It’s difficult to predict where McDermott may go with this one. The impact of the “crowdfunding” industry on the broader financial services sector is still negligible, as the platform bosses themselves will be the first to admit. But the growth rates are gaudy and the ambition is bottomless. Funding Circle’s stated intention is to hit £100bn in annual lending to small business by 2025. McDermott will likely make mention of the Innovative Finance ISA as a key cog in fast-tracking the peer-to-peer sector into the mainstream.
As to competition, user experience, speed and flexibility are the fields in which “crowdfunding” platforms excel. Price is generally less of a competitive advantage. We’ve arguably already seen the beginnings of how the innovations of online lending platforms might sharpen the processes of the banks. Globally, ING, Santander, DBS and JPMorgan Chase have effectively licensed the technology of alternative lenders in order to more effectively service their existing customer bases. We’ve also seen referral partnerships formed between the likes of RBS and a range of alternative lenders, including Funding Circle and Assetz Capital. These are positive developments in the field of competition.
We’ll be fascinated to see what Bailey comes back with. The sector’s resilience to economic shock is a frequent talking point at industry conferences. The simple answer is that nobody knows. There has been some independent stress testing within the UK’s peer-to-peer lending sector. Both Funding Circle and Landbay have had such tests carried out on their loan books, and both exhibited a reassuring level of durability. The scenario trialed by Funding Circle mirrored the most stringent scenario laid out by the Prudential Regulation Authority (PRA) for the 2014 banking stress test. The bottom line, results wise, was that even in the most extreme economic conditions, the average annualised returns for Funding Circle investors remained upward of 5.5%. Experian’s Gareth Rumsey effectively second guessed these results at the AltFi Europe Summit 2015, finding them to be consistent with those produced by Experian’s own modelling.
In the past few months, we’ve seen several hikes in the average rates charged to borrowers by the major marketplace lending platforms in the US. These rate rises are designed to pre-empt moves in the base rate and shifts in the economy. While we haven’t yet seen similar moves in the UK, it’s reassuring to know that such levers exist as a means in guarding against economic shock.
It’s much more difficult to conceive of how an economic shock might affect the equity crowdfunding sector.
Here Tyrie wonders what might be the risks of the financial sector’s increased exposure to unsecured lending, should the major peer-to-peer platforms continue along their current growth trajectory. What we’d say is that unsecured loans are not in themselves a risk; the risk is that they are mispriced. We’ve already touched upon underwriting quality in our answer to question 2, but it may also be worth noting the fundamentally conservative fashion in which the peer-to-peer lending sector in the UK has been shaped to date. This conservatism is perhaps most evident in the divergences between the UK and US industries, which we expand upon here.
“Growth in un-secured lending is not a bad thing per se. What matters is that the loans are extended to creditworthy borrowers and that the risk is appropriately priced. Secured loans can prove just as risky, or even more risky, than unsecured loans if asset prices take a hit. On the other hand u-secured lending is more sensitive to levels of personal income. The prevailing climate of booming asset prices and stagnant incomes shapes our perception of the relative risk today but that could easily change in the future."
"The more interesting, and potentially beneficial, issue is that credit risk is being moved away from the banks and fragmented across the financial system. Given the too big to fail issue, that ultimately creates a liability for tax payers, there are prudential benefits to be gained from reducing concentration risk around the big banks.“
Commenting on the correspondence, Andrew Tyrie MP offered comment:
“The Committee is concerned to ensure that the FCA is paying due attention to the risks – and the opportunities – afforded by the growth of peer-to-peer lending and related markets. With this is mind, I have written today to Tracey McDermott to ask for an explanation of FCA policy.”
“Government policy – letting peer-to-peer investments form part of an ISA allowance, for instance – represents a form of official support for investments that may be inherently higher risk. Peer-to-peer loans are estimated to have totalled £4.4 billion in the final quarter of 2015 – up from close to zero five years ago.”
“Whether and, if so, to what extent investors would benefit from stronger consumer protection now needs careful thought. Poorly informed investors may be left with a false sense of security about the balance of risks versus returns. But greater regulation is not necessarily the answer. If this market can substantially increase competition it may offer benefits to the consumer. It is crucial that the regulator is doing what it can to find the right balance between these risks and opportunities.”
“The prudential impact of the financial sector’s increasing exposure to unsecured loans through crowdfunding platforms also warrants closer scrutiny. The sector’s ability to see through an orderly decline should be considered sooner rather than later.”