Yesterday, the FCA was subjected to the scrutiny of members of the Treasury Select Committee at Portcullis House in Westminster. As part of a broader review of the entire operations of the FCA, Tracey McDermott (acting Chief Executive of the FCA) and John Griffith-Jones (Chairman of the FCA) were grilled by the Committee for a full 90 minutes, with some eight minutes of the session dedicated to the subject of peer-to-peer lending and equity crowdfunding. Chris Philp (MP for Croydon South) spearheaded the alternative finance-related questioning.
Mr. Philp set the tone of his inquiry by first noting the rapid growth of the peer-to-peer sector, before then stating:
“It is likely to continue growing quickly, and I’m concerned that it might be the next big regulatory or financial services scandal.”
Authorisation within the P2P Space
Philp was especially intrigued by the ongoing process of full authorisation within the peer-to-peer space. McDermott clarified for the Committee that there are currently 56 peer-to-peer lenders and 35 “investment based crowdfunders” (equity crowdfunders) that are either already authorised or that are currently going through the authorisation process. She didn’t offer exact numbers for withdrawals or refusals, but recent research from Bovill would suggest that as many as 30 peer-to-peer lending applications have been withdrawn in recent months. McDermott made the point, however, that withdrawals are not permanent – with some companies withdrawing only in order to tinker with their application before reapplying.
Mr. Philp was keen to understand exactly how the FCA is due diligencing applicants, asking specifically whether the regulator has been digging into the credit assessment abilities of the various lending platforms. McDermott replied that the FCA first assesses the business model, and how a company’s plans for making money stacks up against their plans for protecting investor money. She said that the credit processes of established platforms will be analysed, but that many applicants are startups that have little or nothing in the way of lending history to assess.
Mr. Philp had a number of broader concerns, beyond the matter of full authorisation. He requested of McDermott statistics on loss rates for those investing via P2P in the UK to date, to which she offered an answer of “around one percent”. Philp questioned whether so low a figure was “too good to be true”. “Indeed!” replied McDermott, but she did issue the caveat that the FCA is seeing some lenders moving down the credit spectrum and that she expects loss rates to increase. Our colleagues at AltFi Data inform us that representing the default performance of the industry in one number is not possible given how quickly the industry is growing. The one percent loss rate also looks a little low.
Philp then rounded onto the issue of maturity, suggesting that the vast majority of the loans originated by peer-to-peer lenders have yet to even near maturation, and that any representation of loss rates is therefore bound to be artificially low. Our answer? The UK’s “big three” P2P platforms – Zopa, RateSetter and Funding Circle – have each been around for at least five years (Zopa for more than a decade). Individual lenders may freely peruse the bad debt rates of each platform for every year that they’ve been lending. The historical returns of these platforms are calculated and published in the Liberum AltFi Returns Index, allowing investors to observe the return history of the sector for the past nine years. And these three platforms comprise 60.8% of the UK’s peer-to-peer lending space, according to the Liberum AltFi Volume Index UK. It also appeared that the committee was under the impression that peer-to-peer loans are bullet loans, paying back all principal at the end of the loan term. This is not the case, with bullet or interest-only loans in fact making up only a small portion of P2P lending in the UK.
McDermott readily admitted that there is a lack of performance data available for the equity crowdfunding sector at present. She stated that the FCA has thus required operators to be abundantly clear, through the medium of risk warnings, that the majority of startups fail.
On the mechanics of peer-to-peer lending, Mr. Philp offered the following:
“When people invest in these crowdfunding platforms, like Zopa or others, there is probably some sense that they’re in some way investing with the institution, and they may have the benefit of a portfolio effect. Of course, that is typically with peer-to-peer lending not the case. They’re effectively facilitating bilateral loans between Mrs. Smith in Brighton and whoever the end borrower is, and if that one end borrower happens to default then Mrs. Smith in Brighton will suffer a loss. There will be no pooling effect – which you would have in a bank or in a fund. Do consumers properly understand that they are taking one-to-one, bilateral, counterparty risk?”
In response, McDermott correctly pointed out that, in fact, investors will typically hold multiple exposures within peer-to-peer lending portfolios. However, it is true that the onus to diversify funds occasionally sits with the investor in peer-to-peer, depending on the platform in question. On Funding Circle, for instance, investors may choose the businesses that they wish to lend to. The platform recommends that investors spread their risk across at least 100 individual loans, but they are not forced to. McDermott admitted that it’s very important for customers to understand such subtleties, but that it is perhaps too early at this stage to gauge the quality of their understanding. She also declared that the FCA has worked hard to make crystal clear the fact that investing via peer-to-peer platforms is not the same as placing money in a deposit account with a bank.
Mr. Philp suggested a range of requirements that might (or perhaps ought to) be imposed upon peer-to-peer lenders. He called the £20k reserve capital requirement – a staple of full authorisation – a “laughably small amount of money, given the scale of their [peer-to-peer lending platforms] operations”. Mr. Philp asked whether platforms should be required to establish a “sinking fund” – into which a portion of profits should be allocated each year, to act as a form of contingency protection for a platform’s investors. McDermott pointed out that a fair number of peer-to-peer lenders already employ a “provision fund” – not dissimilar to the model described by Mr. Philp – but the Croydon South MP dismissed the comment, suggesting that these probably existed for “marketing purposes”. McDermott also noted that what was being proposed by Mr. Philp sounded a little bit like the Financial Services Compensation Scheme (FSCS), and that the FCA’s position is that the fundamental “riskiness” of peer-to-peer lending means that the sector is not suitable for inclusion within the FSCS.
John Griffith-Jones stepped in towards the end of the exchange (no doubt he had been internally debating whether or not to do so throughout the session…) to discuss the matter of intervention. He perceives a transition within the peer-to-peer lending space, with the platforms beginning to offer “packages” to investors, rather than direct loan contracts. “At that point,” said the FCA Chairman, “they become awfully like a bank, and I think it is very important for the regulator not to allow regulatory arbitrage into the system. What I can assure you is that we are not asleep at this wheel. What I can’t assure you of is when is the right moment to intervene.”
It must be remembered that peer-to-peer lenders lobbied for and welcomed regulation – something that is not often seen in a nascent financial sector. The sector has enjoyed a fairly light touch approach from the regulator to date, as LendInvest boss Christian Faes recently asserted. However, Griffith-Jones’ comments are fair warning indeed. In his keynote speech at LendIt Europe earlier this week, Funding Circle CEO Samir Desai cautioned against over-complicating the peer-to-peer business model. Desai honed in on maturity transformation – the practice of using shorter dated investor funds to satisfy longer dated loans. This maturity mismatch is an area that has traditionally been the reserve of the banks – one that has caused them significant trouble in the past (see, for example, Northern Rock). Could this be the sort of thing that Griffith-Jones had in mind when commenting on intervention?