P2P regulation: Uncertain times
Emily Reid, partner and Aine McEleney, associate at Hogan Lovells International LLP, analyse the regulatory landscape for peer-to-peer lending
The P2P lending market has seen dramatic growth in recent years, with the Financial Conduct Authority (FCA) estimating that the £500m invested on crowdfunding platforms in 2013 had risen to an estimated £2.7bn over the course of 2015.
The sector continues to grow and evolve at a rapid pace, but with competition in the marketplace at an all-time high and the increased likelihood of greater regulation, what do the next 12 months hold for the P2P lending industry?
P2P lending has only been subject to FCA regulation since 2014. As investment continues to rise and the scale of potential customer harm rises with it, the FCA has inevitably started to turn its attention to the adequacy of the current regulatory framework.
In December 2016, the FCA published its response to a call for input on whether its rules on crowdfunding need to change. Some of the FCA’s key focusses include:
-whether borrower protections and disclosures are sufficient, as the FCA is concerned that platforms will face commercial pressures to consider higher-risk borrowers and may relax their creditworthiness assessments as a result;
-the adequacy of systems and controls as markets continue to grow;
-the contagion risk of a platform failure and adequacy of wind-down arrangements;
-and regulatory arbitrage where more complex products are wrapped up as P2P lending to benefit from lighter regulation.
The FCA is clearly concerned about the long-term sustainability of a model that may, by its nature, encourage higher-risk investments by lenders who don’t fully understand the risks. One particular risk to both lenders and platforms identified by the FCA is that of loan ‘mis-match’, where short-term lenders are matched by platforms to longer-term borrowers, creating a reliance on future market liquidity.
Whilst we know that FCA action is almost certain and we know the broad areas of concern, at this stage we cannot say with certainty what form this action will take. The FCA plans to consult in the New Year on initial rule changes, and is also considering consulting on a further round of changes later in 2017.
One change it might consider to redress the balance between platforms and lenders is to mandate participation in investments by platforms, to ensure that when making assessments of risk, platforms do so objectively because they have “skin in the game”.
That would, however, take those agreements outside the regulated activity in article 36H of the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001, which stipulates that an agreement under which the platform itself provides credit, or assumes the rights of the lender, is not an “article 36H agreement”.
It would also generally require platforms to apply for permission to enter into regulated agreements since such loans would be regulated if made to individuals. This is likely to meet with strong opposition from the industry.
Rule changes that are more likely to be introduced next year include the introduction of additional rules for ‘more complex’ business models (although it remains to be seen how the FCA will define that), limits on the amount that individuals can invest in P2P lending and possible FSCS protection. Additionally, the FCA is likely to consult on changes that would eliminate the differences between CCA-regulated loans and non-commercial loans and which would introduce or extend regulated mortgage contract type protections to secured P2P loans.
As relative newcomers to the lending market, P2P lenders have largely operated in a low interest environment. If interest rates did go up, an obvious concern for platforms would be the return of the increased competition from high street banks, as borrowers start to access lower risk investments (protected by statutory guarantees) for increased returns.
However, the risk of rising defaults is likely to be of more immediate concern. Where borrowers hold P2P loans as well as other forms of credit, the likelihood is that as loan repayments increase across all their borrowing, borrowers will prioritise secured loan repayments where their homes are potentially at risk. This could see a steady increase in default risk on P2P loans, although platforms will generally have confidence in their sophisticated credit assessments and underwriting criteria.
In its call for input, the FCA noted that there are now over 100 platforms in the market seeking authorisation. There has been some talk of the market ‘overheating’ but it remains to be seen whether that is the case or whether, based on the rapid growth of investment, there is plenty of room for everyone. That may depend on the wider economic situation and any movements in base rate.
The industry continues to evolve and expand; whereas the lender ‘peers’ used to be individuals, we have seen a steady increase in institutional lending, with ‘P2P’ now sometimes referred to as ‘I2P’. This raises concerns that institutional lenders with large reserves to invest will have first pick of borrowers, forcing individual lenders to lender to higher risk borrowers.
Given the continued uncertainty of how and when Brexit will take place, it’s unlikely there will be an upward movement in interest rates in the near future. Against this backdrop, savers will look for alternative investment models to secure higher returns and the P2P industry will no doubt look to lead the charge.
On the regulatory front, P2P lenders should remain vigilant and continue to monitor FCA developments.
Whatever happens, the next year is likely to be an important and potentially challenging one for the P2P sector as it adapts to potentially greater regulation, increased compliance costs and deals with the influx of competition.
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