Taming the beast – the need for regulation in peer-to-peer lending
December 2017 | EXPERT BRIEFING | BANKING & FINANCE
Under existing Financial Conduct Authority (FCA) guidelines, peer-to-peer (P2P) lenders operate within a virtually unregulated space. While this is not damaging in itself, it does create a number of risks, as the FCA has acknowledged. The most significant of these risks are that as companies become more sophisticated, their resemblance to traditional financial institutions increases, but their regulatory obligations do not. This misleads people into forgetting that P2P is still a risky investment, where the likelihood of regulatory arbitrage is higher than within other financial services firms. When a risk is realised under these circumstances it jeopardises the industry’s reputation.
True, there are some regulations in place. Namely, P2P lenders must conduct themselves with diligence, integrity and skill, as per the FCA’s Principles for Business. They must also have a contingency plan should their company fail, including a small amount of reserve capital to act as a level of protection for investors. However, these regulations are more fitting for what P2P lending once was: a means of matchmaking between borrowers and lenders, rather than the sophisticated financial operations they are today. In their evolved form there is a need for greater regulation, particularly around how P2P lenders attract and manage the money that is invested, as well as their obligation to report to the FCA.
Over the past year, there has been a noticeable rise in the number of P2P lenders using low rates as an advertising measure. Unlike credit card providers that must give 50 percent of all applicants the headline rate they advertise, P2P providers can simply pick a rate and then advertise it, as, unlike their counterparts, it is very difficult for the legitimacy of their offer to be checked. This means that investors can be drawn in by the prospect of a good value option, only to be told that they do not meet the criteria necessary to access the lower rate, which ultimately damages their perception of the P2P industry.
The reason for the race to the lowest rate is simple: there is a huge amount of money to be won in the market, and every company wants to secure as many deals as possible to get its slice of the pie. There are no regulations on how low rates can be, so setting up an enticingly good offer is a simple way to achieve this. A high proportion of the time they will not be available, but when they are, the situation is little better as the costs must be offset elsewhere, meaning a good value deal is secured at the expense of the quality of the service the lender provides. This turns the value proposition of P2P lending, as a service-led business, on its head, further damaging the industry’s reputation.
The regulation for managing assets once invested is no better. Lenders build their reputation on successfully using the funds investors have supplied. This means there is a strong incentive for them to secure a borrower as soon as possible so they can begin to generate a profit for their investor. If they are having difficulty doing so they will become increasingly likely to make a high-risk deal. In these circumstances, the interests of the owners and investors do not always align. Yet, the latter has no say over how their money is used – an issue which causes significant disputes if the loan subsequently defaults or does not perform.
When this happens, the P2P company is not required to report this to the FCA or to even hold the capital on its balance sheet. This means two things. Firstly, an investment can remain stagnant for multiple years without action, as the loan has not yet been defaulted or recovered. In this event, investors who did not seek advice prior to investing will lack recourse to the Financial Services Compensation Scheme (FSCS), as their decision to work with a P2P lender is seen as a risk. Secondly, future investors will be lulled into working with the company under false pretences, as they are not privy to the amount of ineffective deals made. Regulation makes it impossible for other financial services firms to do the same.
It is clear that there is a requirement for greater industry guidelines, so it can sometimes seem mystifying that bespoke regulations have not already been put in place. Simply put, this is because the P2P industry is developing at a much faster rate than the regulatory bodies are acting. The FCA needs to become more agile, rather than waiting to take retrospective action once one of the big lenders has gone bust.
When doing so, the FCA must focus on creating regulation specifically for the P2P industry, rather than trying to enforce ill-fitting guidelines created with other financial services’ needs and challenges in mind. In particular, more attention must be given to how funds are managed within the system, reporting to the FCA and the disclosure of risk to potential investors prior to involvement. While this regulation takes shape, there should be an effort to enforce a rating system for providers, so lenders and customers alike can more easily identify which platforms are reputable.
It is undeniable that there will be some resistance to the enforcement of more stringent P2P regulations. However, regulations would resolve many operational issues for lenders. For instance, empowering the agencies to report defaulters to credit information bureaus would ultimately generate greater interest in the industry among borrowers and investors by underlining the fact that P2P is a trustworthy alternative to traditional finance options.
Rajiv Nathwani is the founder and director of Quivira Capital. He can be contacted on +44 (0)20 3051 5298 or by email: firstname.lastname@example.org.
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