Real and present danger
What happens when a peer-to-peer lending platform becomes insolvent? Danielle Levy investigates the impact on the industry and its investors…
A PEER-TO-PEER LENDER becoming insolvent is surely the worst-case scenario for both the business and its customers.
This danger came to the forefront last year when Collateral collapsed, leaving all stakeholders in the dark. However, the silver lining is that it highlighted the importance of having a robust wind-down plan in place.
12 months since Collateral went into administration, the wind-down process is still ongoing and investors are waiting to receive their money back. It is worth noting that Collateral’s wind-down process is unusual and has been littered with problems because the lender had been operating without the requisite regulatory permissions.
Nevertheless, wind-down plans are firmly in the sights of the Financial Conduct Authority (FCA), after it “identified inadequacies with the comprehensiveness and effectiveness of some P2P platforms’ wind-down arrangements”. In a number of cases, the regulator said it was unclear whether reasonable steps had been taken to put these arrangements in place.
With this in mind, the FCA has outlined plans to strengthen rules concerning wind-down arrangements as part of its post-implementation review of the P2P sector, released last July. For example, plans will need to take account of the practical challenges that platforms could face in the event of an insolvency, such as the continued functioning of their complex IT infrastructure. They must also ensure that loans continue to be managed and administered.
If a platform is unable to wind down or transfer its business, the FCA is concerned that investors could be forced to retrieve their money directly from the borrowers. However, since most platforms spread investments across a number of loans, this could prove difficult.
In addition, the City watchdog is worried that investors may not be aware of the potential risks associated with a platform closing, so it has proposed that P2P lenders tell investors exactly what will happen to their money in the event of an insolvency.
The FCA is expected to publish its final thoughts on wind-down plans over the summer.
A smooth process
In the meantime, how can investors feel reassured that a P2P platform has the right measures in place in the event of insolvency?
A good starting point is to consider the four arrangements that the FCA currently expects platforms to have in place.
“These include arranging for another firm to take over the administration of the loans; holding funds in a segregated account to cover the cost of winding down the loanbook; arranging for another firm to act as a guarantor for the P2P agreements; or using income generated from the loanbook to cover the costs of winding down and administering the remaining contracts,” explains Dena Chadderton, senior adviser at regulatory consultancy BWB Compliance.
Frank Wessely, partner at business advisory firm Quantuma, notes that much will come down to the structure and quality of the agreements that are in place between borrowers and investors. However, the quality and nature of these can vary considerably from platform to platform.
Likewise, the quality of the data that a platform keeps on both its borrowers and investors will prove vital in the event of an insolvency. For example, some of the hold-ups in Collateral’s wind-down process stem from the poor data it held on its borrowers.
“Collateral is a great example of how a platform collapse can go badly wrong because of the mistakes that were made by the platform when it was up and running,” Wessely explains.
He adds that a robust wind-down plan will include practical steps to ensure the closure of the platform does not cause financial distress for any relevant parties.
“A platform needs to be aware of its options in a financially distressed scenario,” Wessely adds. “Its priority is to protect the interests of its creditors rather than its shareholders.”
Put to the test
One of the biggest challenges is that there has not been a practical example of a regulated P2P platform becoming insolvent and putting its wind-down plan into action.
Wessely points out that it is impossible to know the true efficacy of a platform’s wind-down plan while the company is still solvent.
“They were an essential part of a platform’s governance historically,” he explains. “A wind-down plan was needed but they were only contemplating a structured shutdown of a platform in a state of solvency not insolvency.”
He adds that in reality this could mean that some wind-down plans are “not worth the paper they are written on” because this type of event rarely happens; wind-down plans will only truly be tested when a platform becomes insolvent.
The FCA’s proposal to introduce a P2P Resolution Pack could prove integral to wind-down plans in the future, according to BWB’s Chadderton. The pack would contain all the information an administrator requires in the event of an insolvency.
“It would, amongst other things, signpost critical staff, premises, IT systems, bank accounts and legal documentation,” she says.
Combined with the procedures that should be in place as part of a wind-down plan, Chadderton believes these measures would help to ensure a platform’s lenders and borrowers are protected.
Neil Faulkner, founder of P2P analysis firm 4th Way, expects platforms to have wind-down plans in place that are fully funded, with a minimum of £50,000 set aside in cash to cover the process (in line with FCA rules). For larger platforms, the amount set aside will be higher and must be appropriate for the size and complexity of the loanbook.
“Platforms haven’t really opened up about their wind-down plans yet, so instead when you evaluate them you need to rely on what they do say about their plans, as well as their overall competence in risk planning and technology – and take a view on their trustworthiness as well,” he explains.
In Faulkner’s opinion, one of the most important aspects of the winddown plan is to have a reliable and experienced back-up service in place, as transferring the platform to a third-party is likely to be the trickiest part of the process. He would also hope to see that the platform has taken into account the potential costs associated with this transfer.
“Make sure the fee being charged by the back-up provider is reasonable to cover the cost of winding down the loanbook,” Faulkner says.
If platforms were obliged to make their wind-down plans public right now, he suspects we would see a “mixed level of preparedness”.
“Overall, the level of preparedness does not concern me,” he comments. “The least prepared are likely to be the smaller platforms – but they are much easier to wind down. Some of them only have 100 loans, so the chief executive could probably wind down those loans in his spare time.
“The larger ones tend to have more processes in place and you can see that across their businesses.” Funding Options, a business finance aggregator which works with P2P lenders, takes some comfort from the fact that platforms are regulated by the FCA.
“One assumes that the FCA has looked at the platform’s current financial situation, stability but also the wind-down plan in the event that it ceases trading,” says Conrad Ford, chief executive of Funding Options.
Given the potential risk of a platform insolvency, where possible Funding Options works with P2P lenders which have significant backing, are well-capitalised and have a solid track record.
Peer2Peer Finance News asked a number of P2P platforms what wind-down plans they had in place and whether they were making any changes to these. However, many declined to comment.
RateSetter, which was one of the few to comment, said it has planned for all contingencies. In the event that the platform failed or closed to new business, it believes it has a fully funded plan in place to ensure that investors are repaid according to the schedule.
“The funding of the plan comes from a combination of the income RateSetter receives from the loans plus any shareholder capital required,” says a spokesperson. “In the unlikely event that RateSetter goes into administration, the contracts between lender and borrower are still legally valid and will not change. Borrowers will have to make payments to lenders as usual.”
Meanwhile, Funding Circle noted that it has a back-up service provider in place which is authorised by HMRC as an ISA manager, and would be able to take over the administration of Funding Circle’s ISA accounts.
It added that investors’ funds that have not been lent to borrowers are ring-fenced in a segregated account with Barclays.
Although there have not been many P2P platform closures so far, some fear that tougher economic conditions could spark an increase in insolvencies. If this does happen, it will be incumbent on the industry to manage any contagion and make sure a run on investor funds does not take place.
However, this could prove difficult because confidence can be knocked quickly when it comes to P2P investments, particularly as they are not covered by the Financial Services Compensation Scheme.
If a wind-down of a platform proved to be orderly, this could help to stem any contagion, according to BWB’s Chadderton.
“Another high-profile insolvency could certainly affect confidence, but the circumstances around the insolvency will affect the degree, if any, to which this confidence is dented,” she states.
“If customers see signs that the management of a loanbook can continue successfully, even with the insolvency of the original P2P firm, this could improve confidence in the sector.”
This article appeared in the March issue of Peer2Peer Finance News, now available to read online.