Written evidence from the Financial Conduct Authority (ATF 62)

Summary

This submission outlines the FCA’s current responsibilities for the regulation of SME

lending and alternative sources of finance for business. This is in order to assist the Committee in considering whether alternative methods of raising finance are sufficiently well-regulated and monitored for companies to be confident in utilising them, as per the Inquiry’s terms of reference.

Our main observations are that: 

• Lending to SMEs through alternative forms of finance like loan-based crowdfunding, often referred to as peer-to-peer lending, has grown rapidly in past years but still makes up a relatively small proportion of SME lending;

• The regulatory landscape around alternative finance is complex.  Whether and how a particular form of alternative finance is regulated by the FCA is dependent on the characteristics of the products and activities involved;
   
• In broad terms, traditional commercial lending is not currently a regulated activity, whether from established banks or newer entities (though the position is again complex);

• The FCA regulates two types of crowdfunding – investment-based crowdfunding, involving the purchase of unlisted equities and debt securities in start-up and young businesses; and loan-based crowdfunding (known as ‘peer-to-peer’ or ‘P2P’), which involves lending to individuals, businesses and projects;
   
• On assuming responsibility for regulation of the crowdfunding market, we committed to carry out a post-implementation review of its regulatory framework in 2016.  We will shortly publish a Call for Input, inviting feedback about the areas we should consider in our review. In it we will summarise some of the market developments we have seen recently and seek views on a range of potential issues related to loan and investment based crowdfunding;

• The FCA takes a proportionate, risk based approach to the areas we regulate with a particular focus on ensuring that investors are aware of the risks associated with these products.  We want to ensure that investors, including SMEs where they fall within regulation, are appropriately protected without imposing unnecessary restrictions on innovation and growth in this dynamic market.

FCA role and regulatory approach

1. The FCA was set up by Government in April 2013 to act as the conduct regulator and prudential regulator for those financial firms in the UK not regulated by the Prudential Regulation Authority (PRA)[1]. In April 2014 the FCA’s regulatory remit was extended to cover firms previously regulated for consumer credit activities by the Office of Fair Trading (OFT).

2. The FCA’s strategic objective is to ensure that the relevant markets function well. Its three operational objectives are to secure an appropriate degree of protection for consumers; to protect and enhance the integrity of the UK financial system; and to promote effective competition in the interests of consumers.

3. We take a judgement-based, forward-looking approach to assessing potential and emerging risks to our objectives. Our aim is to identify and respond promptly and effectively to emerging issues, before they cause significant harm or grow in scale. Where risks have crystallised, we focus on ensuring that effective remedial action is taken which tackles root causes, as well as ensuring redress is paid and enforcement action taken if appropriate. We seek to ensure that our regulation is proportionate, and strikes the right balance between permitting innovation that delivers consumer benefits and ensuring adequate consumer protection.

Scope of regulation

4. As noted above, the FCA’s regulatory scope and perimeter is established in legislation, particularly the Financial Services and Markets Act 2000 (FSMA) and the Regulated Activities Order (RAO), along with specific regimes under which the FCA has responsibility, such as the Payment Services Regulations. In general, unless a product type or activity is specified in legislation it will fall outside the FCA’s remit and regulatory oversight. Changing the scope of the regulatory perimeter is a matter reserved for Government and Parliament and requires legislative change.

5. As explored in the FCA’s Discussion Paper 15/7 (‘Our approach to SMEs as users of financial services’), most credit facilities provided to SMEs are unregulated. Consumer credit regulation, under the Consumer Credit Act (CCA), applies only to agreements where credit is provided to individuals (and some partnerships). For example, credit facilities for companies are unregulated; as is invoice discounting for the purposes of companies and credit broking to corporates. Additionally, business loans over £25,000 are specifically exempted from regulation under the CCA.
    
6. Other examples of unregulated business financing include invoice financing and the issuing of securities, including mini-bonds, below the Prospectus Directive thresholds or when the security is non-transferable.

Crowdfunding

7. The FCA regulates two types of crowdfunding – investment-based crowdfunding, involving the purchase of unlisted equities and debt securities in start-up and young businesses; and loan-based crowdfunding (known as ‘peer-to-peer’ or ‘P2P’), which involves lending to individuals, businesses and projects. The FCA has always had regulatory responsibility for crowdfunding where it involves a person carrying on the regulated activity of arranging deals in investments, or the communication of a financial promotion in relation to securities. On 1st April 2014, with the transition of responsibilities from the OFT, operating a peer-to-peer lending platform also became an FCA regulated activity.

8. With regard to alternative finance providers such as loan or equity crowdfunding platforms, it is often the case that the platforms’ dealings with businesses seeking funding on the platform are unregulated, while their dealings with the individuals who provide finance to businesses through the platform are regulated.We conduct detailed analysis of each application for authorisation to operate a loan- or investment-based crowdfunding platform against our Threshold Conditions to ensure that firms meet rigorous standards.  This benefits both investors and businesses seeking finance on the platform as well as contributing to the overall stability of this market.  More information on the authorisation process and progress in assessing applications is set out below.

9. Certain competition enforcement powers (which we share concurrently with the Competition and Markets Authority in relation to financial services) are wider in scope and can also apply to otherwise unregulated financial services. Those powers include enforcing against breaches of the prohibitions on anti-competitive behaviour set out in the Competition Act 1998.  We also have powers to conduct a market study (or refer the matter to the CMA for in-depth investigation) where a feature or features of a market may be distorting competition.
    
10. On assuming wider responsibilities for regulation of the crowdfunding market in 2014, we introduced rules to ensure that consumers were protected, without preventing the market from boosting competition through expansion and innovation. At the same time we committed to carry out a post-implementation review of its regulatory framework in 2016. We are shortly due to publish a Call for Input, inviting feedback about the areas we should consider in our review. In it we will summarise some of the market developments we have seen recently and seek input on a range of potential risks to investors. In addition, over the coming months we will use our supervisory powers[2] to investigate practice across a range of firms operating in the market, alongside additional research into the market to inform the review.

11. The crowdfunding market is an innovative and rapidly growing sector. Our post-implementation review will consider whether our requirements remain appropriate and ensure that the balance is right between supporting this dynamic market and ensuring consumers are adequately protected.
     
12. The review will seek views on a range of issues relating to loan and investment based crowdfunding including:

• whether detailed requirements such as the content and timing of disclosures to consumers, checks on the knowledge and understanding of those lending money and the financial promotions rules remain appropriate;

• whether there is sufficient protection for investors if platforms fail, for example the coverage of the Financial Services Compensation Scheme;

• how to respond to recent innovation in firms’ business models, for example firms offering mortgage and mortgage-like products and whether these should be subject to normal FCA mortgage lending standards; and

• anything else that is concerning users of crowdfunding platforms, the industry or other stakeholders.

SME lending

13. The proportion of SMEs that currently uses either loan or equity based crowdfunding is still comparatively low – the SME Finance Monitor, prepared by independent research consultancy BDRC Continental, estimated this at ca. 1% as of Q4 2015. However, as of Q4 2015 one in nine SMEs were both aware of this source of finance and would consider using it in future – and the share of both users and would-be users is rising slowly but steadily.

14. In 2015, according to research by the University of Cambridge and innovation charity NESTA, the UK online alternative finance sector grew by 84%, facilitating £3.2bn in investments, loans and donations, of which £2.2bn was to businesses. Business lending alone made up £881m of this total. It is estimated that peer-to-business lending was the equivalent of 3.9% of new loans lent to SMEs based on the BBA’s 2014 baseline figure.[3] The annual rate of growth in both alternative financing for both consumers and businesses fell for the first time between 2014 and 2015. 

Regulation of specific product types

15. There are a number of similar but distinct products and sectors to consider in looking at regulation of alternative sources of finance.  The extent to which any individual activity that could be described as ‘peer-to-peer’, ‘crowdfunding’ or similar is regulated will depend on its specific nature – some such activities are not regulated, and the regulatory perimeter in this area is complex.

16. The table below summarises a number of types of product (including different types of crowdfunding) that can be used as alternative sources of finance, and that are regulated and unregulated.

17. There are a number of other alternative ways for firms to raise funding outside wholesale markets, which again can be regulated or unregulated depending on their nature, but these are not widely used by SMEs. These include Alternate Investment Funds, Collective Investment Schemes (CIS) and Unregulated Collective Investment Schemes (UCIS). There are restrictions on the marketing of these investment vehicles to retail investors.

Regulation of crowdfunding platforms

18. In 2014, new rules came into force for the regulation of crowdfunding platforms operated by firms authorised by the Financial Conduct Authority (FCA). We committed at the time to carry out a post-implementation review of the crowdfunding market and regulatory framework in 2016 to identify whether further changes are required. We intend to publish a call for input shortly as part of this review, seeking views on how this industry has evolved since 2014 and whether our current regime needs to be adjusted in light of the growing reach and sophistication of the industry and the emergence of new business models.

19. As discussed the FCA regulates two types of crowdfunding:

• investment-based crowdfunding, which involves the purchase of unlisted equities and debt securities in start-up and young businesses, and

• loan-based crowdfunding, commonly known as peer-to-peer (P2P), which involves lending to individuals, businesses and projects

Investment-based crowdfunding

20. Investment-based crowdfunding firms have for many years been subject to FCA rules which are standard for many types of investment firms. These include minimum capital requirements, rules on conduct of business, rules on systems and controls and requirements for disclosures to be fair, clear and not misleading. Many of these rules are derived from the EU’s requirements (for example the Markets in Financial Instruments Directive - MiFID). Firms are also subject to the FCA’s high-level “Principles for Businesses”, which include requirements to treat customers fairly and conduct their business with integrity.
21. In 2014 we introduced new requirements.  The main change was to limit the ability of firms to market crowdfunding offers of illiquid securities to only certain types of consumer in the retail market, specifically:
• those who take regulated advice or receive regulated investment management services;

• particular types of experience or sophisticated investors; or

• those who certify that they will not invest more than 10% of their net assets.

22. Additionally, if consumers do not receive advice, firms are obliged to assess whether they have the knowledge or experience to understand the risks involved (the appropriateness test) in respect of any transaction which arose in response to the marketing of the security.
23. Investors have recourse to the Financial Services Compensation Scheme (FSCS) in the event that a firm operating an investment-based crowdfunding platform fails, in circumstances where:
• an FCA-authorised firm has failed and cannot meet claims against it; and
• the claimant is eligible to claim to the FSCS; and
• the claim relates to an activity protected by the FSCS; and
• the firm owes a civil liability to the claimant, e.g. it is liable to the claimant for breach of contract or in negligence. Proving this may be difficult.

Loan-based crowdfunding/peer-to-peer (P2P)

24. In April 2014, the FCA took over responsibility of regulating consumer credit from the OFT and a new regulated activity of ‘Operating an electronic system in relation to lending’ was introduced into the RAO. As with other consumer credit businesses, firms who had been operating P2P platforms before April 2014 were permitted to continue carrying on the activity on the basis of an ‘interim permission’, a regime that was established to facilitate a smooth transition of firms under the new regulatory regime. New entrants to the market since 1 April 2014, who did not previously hold an OFT licence, have been required to apply for full authorisation.
25. Firms operating under an interim permission had an ‘Application Period’ during which they needed to apply for full authorisation. Firms that did not apply during that period lost their interim permission, while those that have applied continue to have interim permission until their applications are determined by the FCA. 
26. As part of this new regulatory regime, new and existing rules were applied to this population of firms. At a high level, the relevant rules comprise organisational and conduct requirements to protect investors and rules to protect borrowers.
27.                         In particular, we require loan-based crowdfunding firms to:

• ensure that financial promotions are clear, fair and not misleading, both in relation to borrowing and to lending via a P2P platform;

• assess the creditworthiness and affordability of prospective borrowers who are individuals; and

• provide the borrower with a pre-agreement explanation of key features, including key risks.

28. Investors do not have recourse to the Financial Services Compensation Scheme (FSCS) in the event that a firm operating a P2P platform fails.[6] In setting out our approach to crowdfunding regulation (CP13/3 and PS14/4), we decided not to include P2P within the FSCS jurisdiction as the additional regulatory costs would be disproportionate to both the amount of loss investors were likely to suffer given the nature of the market at the time; and the limited cover that the FSCS would provide in any event.[7]

Peer to Peer authorisations

29. On 1 April 2014, 185 firms had registered for interim permission (IP) for P2P activities, and of this population we considered that 143 firms were not previously active in the market.  Firms given IP status are allowed to engage in regulated activity until the FCA determines their application for full authorisation, or they opt not to continue with their application (e.g. because they no longer require the relevant permission). 
30. The P2P sector is innovative and diverse and we have found that business models vary in both complexity and specialism. The FCA has taken time to consider applications for authorisation carefully to ensure that they are assessed properly and that the firms meet rigorous statutory standards.
31. The FCA is currently assessing 88 P2P applications for authorisation, and this is a combination of IP holders and new entrants to the market. This figure will change regularly as firms are authorised, new applications are received or firms withdraw applications. As of June 2016, the FCA has authorised 9 firms and has not yet refused authorisation to any P2P firm.

6 July 2016

FCA written submission to BIS Select Committee              7