Today the FCA (Financial Conduct Authority) have published the policy statement "The FCA’s regulatory approach to crowdfunding over the internet, and the promotion of non-readily realisable securities by other media". The response was what we expected, but we had argued that peer-to-peer lending should fall within the remit of the Financial Services Compensation Scheme where the platform itself failed.
The FCA stated:
We received 41 responses to the question we asked about this proposal. Of these, 28 agreed that loan-based crowdfunding platforms should not fall within the remit of the FSCS and 13 disagreed.
Some of the respondents who agreed with our proposal made additional observations:
- Some felt that this situation should be kept under review as, while it is appropriate at present, since the market is embryonic, this may change in the future if loan-based crowdfunding becomes a significant investment for a large proportion of investors
- The fact that a platform is not within the remit of the FSCS must be made clear to investors.
- Platforms should also make clear that un-lent funds are held in a bank account which would be within the remit of the FSCS.
Respondents who said that loan-based crowdfunding platforms should fall within the FSCS remit made the following points:
- Most of these respondents felt that loan-based crowdfunding should be treated in the same way as other investments as this would give additional protection to investors where a platform fails, or if the firm running the platform used client funds for its own purposes, was negligent or committed fraud.
- Others made the point that lack of recourse to the FSCS could reduce new investment.
- One respondent suggested that platforms should be within the FSCS remit if this only leads to a small charge for firms.
- One respondent thought that requiring the firms running platforms to meet minimum prudential requirements seems contradictory to a lack of recourse to the FSCS.
We agree with the respondents who noted that it is important for the regulatory framework to be proportionate, especially while the market is young and growing. Bringing these firms within the FSCS remit would impose additional regulatory costs, which may be quite significant.
We do not consider that it would currently be proportionate to include loan-based crowdfunding platforms within the FSCS remit. As loan-based crowdfunding is not currently within the FSCS remit, we do not expect this to lead to a reduction in new investment. Firms should ensure that investors understand the risks involved.
Other protections that we are introducing – such as the minimum capital standards and the requirement for firms to have arrangements in place to continue to administer loans in the event that the platform fails – should provide adequate protection at this time. We do not consider that it is contradictory for these firms to be subject to some regulatory requirements but not others.
Overall, we believe that the approach we are adopting is proportionate and appropriate for the market and the risks it carries at present.
We have committed to review the crowdfunding market and our regulatory framework for it in 2016 and, at that stage, will consider again whether loanbased crowdfunding should be within the remit of the FSCS.
We hope that the FCA will change its mind, as lenders have lost money when platforms have failed because they were unable to recover payments from borrowers. Retail lenders would be unable to perform sufficient due dilligence on the platform itself and if there is a failure this would seriously damage the peer-to-peer lending sector.
I was really looking forward to speaking at the P2P Finance Association conferance on Tuesday, but unfortunately the flu had other plans for me!
My peer-to-peer story began in 2005 when I read an article about a new website where you could lend direct to individuals who need a loan. You were the bank manager and you could set your own interest rate, per risk band.
Your money was spread to at least 20 borrowers, so if a single borrower defaults you won't have lost all of your capital.
Having invested in shares previously with various degrees of success, I thought this was a lower risk venture. At the time the minimum deposit was £500 which I though was a lot, but decided to give it a go.
My first loan went out in July 2005 and was repaid successfully without incident - which is what you would want it to be. Over time I lent more money through Zopa.
For a while Zopa was the only peer-to-peer company in the world, but in 2006 Prosper, a US based company, launched a different concept in peer-to-peer lending. Unlike Zopa which operated a market model, Prosper had a listing based system, where individuals could choose whether to lend to any individual and at what rate. These two competing models cover by far the majority of peer-to-peer systems today.
Zopa did launch their own listings model which was significantly different to the market model, and less checking was performed on the individuals, and ultimately this difference was the cause of its downfall as the bad debt rates for listings - where Zopa did not provide any estimates - were excessively large. A larger than expected proportion of my bad debts from Zopa were from listings.
My lending on Zopa was performing better than estimates until 2008 when bad debt spiked and then in 2010 when it became aparent that taxation should be paid before bad debt, despite Zopa's website showing returns after bad debt.
Competition to Zopa did not appear until 2010 when a company called YES-secure appeared, boasting a significantly larger IT team behind their business. YES-secure, like Propser, operated a listing style model. Unfortunately, bad debts quickly appeared and despite several rebranding excercises, YES-secure now trading as Encash now have less than £50k of loans outstanding. As a lender I did invest some funds, but subsequently sold all loan parts and withdrew all funds.
Peer-to-business appeared in 2010 with a new company called Funding Circle, but it actually started a year earlier with a much smaller company called BigCarrots. Funding Circle was the first serious competition to Zopa.
RateSetter also appeared within 2010, with the innovative provision fund which would cover bad debts, so lenders were not subject to the chance event of a default. This has proved popular with several later peer-to-peer companies offering something similar, and even Zopa launched their Safeguard which operates in a very similar way.
Zopa, RateSetter and Funding Circle are the three main peer-to-peer providers in the UK even today, and these are the three companies I have used the most. With new companies launching on a regular basis it is becomming harder to differentiate them from their competition, and there have been a number of failures over the years.
The most notewothly failure so far was a company called Quakle, also launching in 2010. This was one of the few peer-to-peer companies that I avoided completely as I didn't believe they had a viable business model. Quakle didn't initially perform credit checks, but relied on social trust. If person A knows and borrows from person B, then they are likely to repay. This unfortunatly was doomed to failure and bad debts quickly spiralled out of control. The company shut down their website less than a year later, and most lenders were left significantly out of pocket as there was no mechanism to continue to collect payments from borrowers.
My peer-to-peer story will continue as the returns have been significantly better than what would have been achieved within a fixed rate savings account, but the difference is continuing to reduce. With the introduction of regulation this year there will be a an in-rush of new funds and the interest rates will continue to fall.
The P2P money website is pleased to announce that there are now five cashback schemes for new lenders, and four cashback schemes for new borrowers. Lenders are able to earn up to £40 with Funding Circle, and personal borrowers are able to earn up to £25 with Zopa and RateSetter. Business borrowers are able to earn up to £1000 with Funding Circle.
There has been an interesting discussion on the independent P2P forum about a loan recently made by Funding Circle. Without naming the company concerned, they already had a loan arranged though the platform and applied for a second loan. When companies apply for additional loans, some lenders are willing to lend to a company with a good track record of payments. Other lenders would be concerned about over exposure. This is where they are lending one company a larger than normal proportion of their funds. While the risk of default is largely unaffected, the effect of a default would be greater.
When the company applied for an additional loan, they made the following statement.
Please note: this company has an existing Funding Circle loan. This loan will be used, in part, to clear the outstanding balance on the first loan.
Existing lenders would therefore not be concerned about over exposure, as any existing loan would be repaid. After the loan was approved, it appears that the borrower requested not to settle their first loan, and draw down all lent funds. One lender decided to contact Funding Circle and received the following reply:
The borrower has decided not to settle their first loan and will continue with both loans; a comment has been added to loan 1141.
I understand that there has been a long delay. This is because the borrower expressed an interest in receiving the full amount of their second loan, as opposed to using a partial amount of the second loan to settle the first loan.
We therefore held back the portion of these funds that would have been used to settle the first loan while we assessed whether from a risk perspective we were happy to increase our exposure to them.
This risk band has now been reinstated and the borrower is up to date in their repayments.
The new loan was downgraded from an A+ to an A risk rating due to the increased exposure of lenders.
You are correct in saying that the two loans should be at the same risk band.
Originally, in line with the expectation that the company was going to use the second loan to settle their first loan, the Underwriting team rated the second loan as A+, based on their latest assessment and the amount of exposure on the second loan.
However, because the company are now continuing to service both loans, our exposure to the company is now higher. The Underwriting team have subsequently taken the decision to amend the risk band for Loan 4573 to an A, in line with Loan 1141.
Unfortunately there was a slight delay of a few days between the risk band being reinstated on the first loan and the amendment on the second loan. This is not a standard procedure and therefore the Underwriting team took a few days to consider their decision.
With the new loan being downgraded lenders, who were over-exposed through no fault of their own, found themselves unable to sell loan parts except at a large loss. Several lenders expressed their concern that this situation was allowed to happen and requested their money back, which would be quite difficult as the loan had already been paid out.
There is a happy end to this story as Funding Circle decided to buy out all existing lenders, and made the following comment.
We have taken the decision to settle both this loan (ID 4573) and the other loan to this borrower (ID 1141) and take over the liability from our investors. The decision to increase the total lending to this business and change the risk band was made after loan 4573 had completed. We accept that it was not right to lower the risk band from A+ to A in retrospect. We apologise for this. The funds will appear in your account today and the loan will display as “repaid”. In future, no decision to increase total lending to a business will be made without listing a new loan request.
We believe Funding Circle have made the right decision in this case, but it did cause some concern to lenders.
Evolutis, one of the latest peer-to-peer providers, specialises in lending to "professional services". They have produced a white paper entilteled "the case for lending to professional service firms" and it is an interesting read for lenders looking at lower risk investments.
Small businesses need credit. This has been true since the beginning of time, when merchants borrowed money to buy stock to transport across seas and deserts to sell in faraway markets. Today, like then, the problem for small businessmen is securing the loans they need at prices that make commercial sense.
Before the financial crisis of 2007/2008, there was a one stop shop to borrow money. Your local high street bank would make money available to an enormous range of businesses at very attractive rates, and take practically anything as security. Banks lent freely and easily against payment due, stock in transit, shop floor display products, work in progress and a whole host of other assets – almost anything that had a value. This was because US and other banks wanted loans of pretty much any type to put into securitised asset pools that could be sold as bonds.
After the crisis, investors realised that many of these loans were extremely difficult to collect upon, and the pendulum swung the other way. Banks now are extremely reluctant to lend on anything but real estate assets. For many small businesses, this is a threat to their very existence. Good, solid businesses that have existed for decades suddenly are starved of one of their raw materials, capital.
But the problem wasn’t that the assets or the loans were fundamentally flawed, the problem was that the banks didn’t know, and in many cases didn’t care, about how to underwrite them. So long as they could sell loans to the securitisers, they kept on originating, knowing that if the loan went bad it would be somebody else’s problem.
Within the small business world, there are all sorts of niches of profitable lending that can be carved out. The trick is to pick a niche with enough opportunities to build a profitable business, without carving such a big “niche” that the characteristics within it are so diverse that you can’t truly get your head around the issues.
The need for borrowing by professional services firms
One niche that has proved extremely interesting is the area of professional services firms – Doctors and other medical professionals such as dentists, accountants, lawyers and vets. At first sight, this might not seem like a very fertile sector for a potential lender to look at. The common perception of professionals is of a wealthy chap, driving a Mercedes or a Jaguar to the golf club and living in a nice big house in the more fashionable parts of town. Surely he doesn’t need to borrow money?
He might not, but his business does. Medical practices are full of very expensive kit. A dentist’s chair costs around £10,000, for a chair, before you even start with compressors, drills, suction machines, X-rays et etc. New EU laws mean that many dentists are having to upgrade their sterilisation equipment, at costs of up to £50,000 per practice. Like most small businessmen, dentists tend to take the profits out of their businesses as income each year, so there is unlikely to be money in the company to fund this kind of capital expenditure.
What about the lawyers and accountants? Other than a few cheap laptops and leased photocopiers, surely they don’t have expensive kit that needs to be financed? Well actually they do – it’s just that their expensive kit puts on coats and walks out of the office every night. The biggest cost to most accounting and legal practice is the salary bill. They employ well qualified, expensive people who need to be paid every month. This would be easy to manage, but in the case of lawyers invoices are often only raised when a transaction or case is completed, and accountants are often only paid when the company report and accounts are finalised. Any interim invoices along the way typically only fund a small part of the costs to date.
In the “old days” pre credit crunch, these businesses would have funded these costs with an overdraft or the more sophisticate firms might have used some sort of work in progress financing facility. These are now as rare as hen’s teeth. Hence the opportunity for non-bank lenders such as Evolutis Lending to step in and lend to these businesses.
Is the market big enough to be interesting?
The table in Figure 1 shows the number of professionals in each sector, and the number of firms employing them.
Figure 1: Number of UK Professionals and Firms
As can be seen, there are nearly 50,000 firms in the target sectors in the UK. In the pre-2007 days, almost all of these had some form of borrowing, be it an overdraft, business development loan or similar. The average size of loan application we have seen from these kinds of practices is between £20,000 and £25,000. In order to be conservative, if we assume that only 50% of these companies are potential borrowers and they might borrow £15,000 each, then the total market size is £375 million. In fact, we believe that the market is much, much larger because if these firms were able to borrow they would do so. Once they know about Evolutis, they will not just be more likely to borrow, they will borrow bigger sums to grow their businesses.
Will professional services firms pay lenders back?
There is an old saying in banking that it’s easy to lend money, getting it repaid is harder. So the question is how safe are professional services firms compared to other borrowers in the UK. The UK Insolvency Service collects data on how many people and companies don’t pay what they owe and go bankrupt. The data is shown below in figure 2:
Figure 2: Insolvency rates for UK companies and personal bankruptcies in the UK. Source: UK Insolvency Service
As can be seen, between 1985 and 2013, the insolvency rate for individuals has varied between 0.025% and 0.325% and for all UK companies between 0.6% and 2.75%. In the case of individuals, some rules were changed in the early part of the 21st century, making it easier to go bankrupt and recover, meaning we are unlikely to see the very low rates seen in the 1980s and 1990s again.
Getting data on insolvencies by just professional services firms is difficult, for example the British Dental Association say that they do not recall ever seeing a dental practice cease trading because it cannot pay its debts. One group that has very good data is the lawyers.
The Solicitors Regulation Authority tell us that in 2013, there were just over 125,000 solicitors licenced to practice in the UK, who worked for 10,734 distinct firms. These numbers have been remarkably stable over the last few years. In the last 5 years, the number of practices that have gone bankrupt has varied between 6 and 11, for a rate of between 0.0006% and 0.001%.
When these numbers are compared to firms as a whole, it can be seen that lawyers are at least 600 times less likely to go bankrupt than an average firm in the UK. From a lenders perspective, this means that on average you’re 600 times more likely to get your money back.
Evolutis Lending’s sister company Orchard Funding has been lending to accountancy practices for over 12 years. In that time, not one penny of principal has ever been lost because a practice failed to repay its loans.
For a peer to peer investor, these numbers are very relevant. Unlike in bank, if a borrower from a peer to peer investor defaults, then the borrower feels that loss directly. Therefore, the investor needs to subtract the likely loss rate from the headline rate advertised by the lender to calculate the return he is likely to get.
In the case of a peer to peer lender like Funding Circle (who lend to pretty much any type of business), the comparison is simple to make. Take the headline rate, subtract something between 0.6% and 2.75% from the headline rate and you arrive at your net return. For a loan to a professional services firm, you only need to subtract 0.001% to cover your average likely loss.
If professional firms are so safe, why are they prepared to pay attractive rates to investors?
As any business school student will tell you, the best indicator of risk on a loan is the interest rate an investor is prepared to pay for that loan. In a perfect market, this would be true but the sad reality of business today is that not only is the market for loans not perfect, it often doesn’t exist.
For many professional services firms, the issue isn’t how much the bank will charge them, it is whether they bank will lend to them at all. As mentioned above, since the financial crisis, banks have largely withdrawn from lending against anything except property. For most small businesses, this is a significant problem because most choose to rent their premises. In the case of professional services firms, in the relatively few cases where there is any connection to the ownership of the building they operate from, it’s most often because it’s an asset of the partner’s pension scheme rather than directly owned. Either way, the practice can’t mortgage the building to raise finance.
List most businesses, professional services firms see reliability and certainty as more valuable than a slightly cheaper price. It’s simply not worth taking an expensive employee off a job that generates fees to try to find a slightly cheaper loan. Evolutis Lending’s sister company has built up relationships with many of its repeat customers over many years. They understand the lending process, and appreciate the fast turn-around times. To them, the loans represent the difference between being able to do the volumes of business they want and having to scale back.
We hear from our customers that the more generalist P2P lenders don’t really understand their businesses or their needs, and often turn them down for loans. Until more lending capacity enters the market with the necessary skills to understand this niche, the investment opportunity will remain very attractive.