Out-Law Analysis | 30 Jan 2013 | 8:00 am | 5 min. read
The financial services sector is being hit with the age old problem of applying old laws to new technologies, and to the ways of doing business enabled by them. The new entrants, the 'fintech companies' (the peer-to-peer lenders, the crowdfunders and the international transfer platforms) are 'crying out' for more regulation, as has been reported on more than one occasion.
For some it may seem counter-intuitive for any business to demand that their activities be regulated. Greater regulation inevitably means greater compliance and operational costs and often personnel and cultural change. However, as financial markets live or die by the level of trust they engender, it seems that the fintech sector view mandatory compliance obligations as a way of snatching greater market share.
The US has been among the first to respond, with Barack Obama having signed the JOBS Act (short for jumpstart our business start-ups), which provides rules on online platforms that enable the public to receive equity in companies in exchange for funding. The US law is still subject to further action by the SEC before it comes into force.
In the UK, the process has been a little slower, as until recently it seemed that the Financial Services Authroity (FSA) did not view the market as significant enough to regulate.
The Financial Services Bill which recently came into force is likely to be used as a trigger to enable regulation of the industry, or at least in part in respect of peer-to-peer lending. Lord Newby, the Liberal Democrat peer and deputy chief whip, has stated that the intention behind the final amendments made to the Financial Service Bill were made so that "innovative sectors" would benefit from them, "such as peer-to-peer lending."
The Treasury has now announced that it will begin regulating the peer-to-peer lending industry from 2014.
And it is the peer-to-peer lending platforms that are leading the charge toward supervision. They have recognised that in order to increase their share of access to prudent investors, they need a trusted third party to 'authorise' their activities, their businesses and the individuals who run them. Better still they need regulators to do this.
What is peer-to-peer lending?
Peer-to-peer lending occurs via websites that offer an exchange service, matching borrowers seeking finance with investors looking for opportunities. Critically, the website operator does not provide loans itself, but provides a facility for its customers to enter into transactions with each other. The website operator takes a fee or commission for its services from either the borrower or lender, or both.
A business or an individual may be incentivised to borrow money via a peer-to-peer lending platform after it has failed to attract venture capitalists or obtain finance through traditional banks. Alternatively, a business or an individual may be incentivised to take this route in order to obtain lower rates or other benefits.
The incentive for investors may be the corollary, higher rates or investment opportunities to which they would not otherwise be exposed, or to which they would only be exposed at a higher cost.
Senior management systems and controls
One area that has to be addressed by the regulatory plans announced by the Treasury is that of the trustworthiness of the individuals behind the platforms.
The Financial Services and Markets Act deems a number of activities carried on by businesses involved in providing or facilitating funding as 'regulated activities.' These activities include managing and arranging deals in investments, dealing in investments an agents, operating multilateral trading facilities, establishing collective investment schemes and effecting and assisting in the administration of contracts of insurance, to name just a few.
Peer-to-peer lending is not similarly listed as a regulated activity (although the existing platforms do comply with some regulatory obligations including the need to obtain a consumer credit licence). This means that the Financial Services Authority will not treat the activities of peer-to-peer lending platforms in the same way as it treats other investment activities such as those undertaken by banks and credit unions.
For regulated activities, it is often required that the firm providing the financial products or services be 'authorised' by the FSA. It is also often required that certain individuals within the organisation also receive a personal authorisation from the FSA. While technical glitches are a cause for concern, it is the activities of management personnel that ultimately determine the trustworthiness of a financial organisation. It is individuals who have the responsibility of quantifying, monitoring and reporting market, credit and liquidity risks and assessing their impact on an organisations performance and the overall economy.
For activities that are regulated, the FSA will require key individuals to be authorised to perform particular functions, such as reporting back to the business on the extent to which internal systems, controls, procedures and policies are being followed.
Before the FSA will authorise an individual it will investigate whether that individual is a 'fit and proper' person. The FSA does this by looking into their past experiences and asking questions such as whether the individual has been convicted for fraud, theft or false accounting offences, at one end of the spectrum, to whether the individual has faced any allegations of misconduct or mismanagement in connection with any business activity at the other.
Persons acting in responsible positions at peer-to-peer lending platforms are not subject to similar background checks. This is clearly one reason why regulation is desperately needed.
The peer-to-peer lenders' response
In the meantime, in order to give investors some comfort the leading peer-to-peer lending platforms, Zopa, Ratesetter and Funding Circle have formed an industry body, the P2P Finance Association to play the part of the regulator as a trusted third party source vouching for the trustworthiness of its member businesses.
Under its 'operating principles', the P2P Association recommends that each of its member businesses "should have at least one director that the Member would be prepared to nominate to the Financial Services Authority as the Member's 'Approved Person' if that regulatory requirement applied to the Member."
Industry regulation by a newly established body however is a far cry from the detailed background checks required by the FSA. Market confidence in peer-to-peer lending would no doubt increase if this new industry body began undertaking similar investigations to that currently undertaken by the FSA. Of course, the cost implications of doing so though would be considerable. Good reason therefore for the peer-to-peer industry to push the Financial Conduct Authority to bring forward its regulatory plans.
The trustworthiness of the P2P Association itself has recently received a boost. Up until 17 December 2012, Giles Andrews, the founder of Zopa, was the industry body's Chairperson. With a key founder of a founding member organisation as its head, the industry body could not wear the independent badge. Now however, Christine Farnish, a former FSA consumer director with further broad experience in financial services, has now been appointed as chairperson giving the organisation some claim to being a trusted third party.