Why the FCA is concerned about P2P finance

This means they have to have systems in place for the treatment of client money, and processes that check for money laundering, and other procedures for ensuring the correct running of a financial business.

Many platforms have initially operated on interim permissions, before getting their final permissions, but they all now have to be on full permissions.

A recent Freedom of Information request revealed that, so far, up to 13 June, as many as 373 applications for authorisation to run a platform were made to the FCA, of which 80 per cent were withdrawn, according to RSM, the accountancy firm, rather than get to the stage where they were rejected.

The areas where they have fallen down on has generally related to the treatment of client assets, and how they reconcile client money that is held in trust, before it is deployed.

The FCA is essentially trying to regulate the sector. They're effectively trying to make everybody follow the same standards.Damian Webb

Damian Webb, restructuring partner and alternative finance specialist at RSM says: "When money comes in before it is deployed, that money must be held in trust for the clients. They weren't reconciled properly."

There have also been failures in the area of client on-boarding, especially in terms of 'Know Your Client' and prevention of money laundering.

Regulation, regulation, regulation

The FCA recently published a consultation paper where it wants to instil some further rules on the way these platforms operate.

Mr Webb says: "The FCA is essentially trying to regulate the sector. They're effectively trying to make everybody follow the same standards.

"The most significant aspect is they're trying to stop retail investors who aren't sophisticated investing in the sector because the FCA perceives it as high risk."

In CP18/20 published at the end of July, the FCA says that it intended to allow P2P platforms to market only to certain investors.

The problem, it said, was that many investors were taking on considerable risks without being remunerated correctly for that risk, or even being aware they were taking that risk in the first place.

The paper says: "We are not comfortable that risk and reward are always balanced appropriately on all P2P platforms, and we are concerned that investors cannot assess their risk exposure due to the way platforms operate."

The fear held by the FCA is that, while defaults have been minimal, the sector is new and has not been through a complete economic cycle as such, so that the default rate may increase. In addition, some platforms may diversify into riskier areas, while they are still in growth mode.

As a result, the FCA is proposing that the P2P platforms actively promote their services to just a select group of investors (one of the following):

• those who are certified or self certify as a sophisticated investor;
• those who are certified as high net worth investors;
• those who confirm they will receive regulated investment advice;
• those who certify that they will not invest more than 10 per cent of their net investible portfolio in P2P agreements.

The FCA has said its concerns are real because according to a survey of 4,500 P2P investors, conducted by the Cambridge Centre for Alternative Finance, 40 per cent said they had invested more than their total annual income, and of those, half had said they had invested more than double their annual income.

Adviser concerns

If a platform fails, this does not necessarily mean that an investor will lose his or her money. Mr Webb says: "The FCA is concerned that there's a standby arrangement in place to ensure that there's a contingency plan, [so] that in the event that a platform fails something can be sorted.

"For instance, most have a back-up servicer in place."

He added that the assets that the investor has placed on the platform are still treated as the investor's assets, so these would be released back to the investor, although not necessarily in their entirety.

The adviser community is mindful of some of the risks associated with peer-to-peer lending, and to a lesser extent investment crowdfunding.

You're effectively lending money to someone who has a great idea but possibly not a great track record.Kay Ingram

Many advisers are perhaps rightly concerned, given the promotions on the platforms' websites. One platform appeals to investors with the following: "Earn 6.5 per cent per annum interest on your capital while helping fund local businesses".

Kay Ingram, head of policy at LEBC, says: "If you had a friend or relative who came to you and said: 'I've got a business idea and I've got no money', and they couldn't get lending from the bank, and they didn't show a business plan, would you give them money? Why would you do that to a stranger?

"You're effectively lending money to someone who has a great idea but possibly not a great track record. If they had a track record and some experience behind them, then the conventional banks would help them."

The platforms would argue that they do undertake credit checks of their borrowers, and they spread the risk of lending across many different individuals and businesses, so that the risk is mitigated.

The problem is that those setting up the platforms have markedly varied backgrounds. Some come to the sector with a tech background, seeing it as a way to make money, while others have come to the alternative finance sector with their own financial backgrounds.

For example, the founders of Ratesetter, one of the more reputable firms, have backgrounds with RBS and Lazard, while the founders of Funding Circle, which has announced its own IPO, have backgrounds in management consultancy and at Barclaycard.

Checking the background of a platform's management is clearly one part of doing due diligence before taking the plunge, more of which is covered in the next article.

melanie.tringham@ft.com