The FCA published a consultation paper with proposed changes to the rules relating to P2P firms. I have put together a summary below:
The FCA issued Consultation Paper 18/20 on Friday 27th July 2018 setting out proposed regulatory changes for P2P firms. The FCA expect firms to view regulation through the lens of consumer protection to fully appreciate the harms that the FCA seek to prevent and the rationale behind their rules and proposals. The FCA expect firms to identify and control consumer risks that arise from their business models. In the P2P context, the FCA have identified two groups of consumers that are particularly susceptible to harm from P2P:
1. Pensioners who may have significant sums in savings and are concerned about low interest rates may be tempted to invest significant amounts on P2P platforms in pursuit of higher yields.
2. Young, inexperienced investors who may be attracted to the concept of P2P due to its web-based and social networking nature without fully understanding the risks.
The FCA are of the view that P2P platforms may overexpose retail investors to risky asset classes. P2P platforms engage with a wide range of borrowers and types of loans, from companies raising funds for property development, to consumers borrowing to pay for consumables. The FCA are of the view that exposure to these risky asset classes should be limited to retail investors who are capable of understanding the risks and bearing the consequences of these investment risks.
Financial promotions and communications
The FCA observed the following breaches of the clear, fair and not misleading principle in the P2P sector:
1. Consumers not given clear or accurate information, leading to the purchase of unsuitable financial products.
2. Advertisements emphasising the positive nature of investments while failing to balance this with appropriate explanation of risks.
3. Platforms creating a sense of scarcity that might encourage investors to act impulsively due to the impression that they might otherwise miss the opportunity.
4. Past performance is included in advertisements, but without a clear warning that this does not indicate likely future performance.
5. In relation to platforms that offer a target rate of return, maximum target rates of return being advertised in a way that investors might easily mistake for fixed returns.
6. Failure to provide investors with ongoing information, for example, where something material about an underlying investment has changed.
7. Failure to include a prominent investment risk warning meaning risks of investing can be easily over looked by investors.
8. Failure to clearly state that investments are not covered by the Financial Services Compensation Scheme (FSCS).
9. Failure to clearly communicate to investors what may happen if the platform administering their loan fails.
10. Not communicating the right information about the costs and charges associated with the service the platform is providing.
11. Information about contingency funds is communicated is a way that misleads investors to think that the platform is providing a guaranteed rate of return (similar to a fixed rate savings account).
To ensure investors do not overexpose themselves to asset classes in which they may incur notable losses, without understanding that this may happen, the FCA propose that P2P platforms should only be able to communicate direct offer financial promotions for P2P agreements to retail investors who:
• are certified or self-certify as sophisticated investors;
• are certified as high net worth investors;
• confirm before a promotion is made that, in relation to the investment promoted, they will receive regulated investment advice or investment management services from an authorised person, or
• certify that they will not invest more than 10% of their net investible portfolio in P2P agreements.
Where the platform facilitates the investment into the P2P agreement on a non-advised basis (as is commonly the case) the FCA propose that P2P platforms comply with the rules on appropriateness (COBS 10) similar to investment-based crowdfunding platforms.
In addition to the financial promotions restrictions, the FCA propose prescriptive rules for make it easier for consumers to compare investment opportunities across platforms as easy as possible (effective competition) and understand, not only the nature of the investment and the risks involved, but also the service being provided by the platform (consumer protection). The proposed disclosure requirements include the nature and extent of the due diligence a platform undertakes in respect of borrowers and a description of how loan risk is assessed, including a description of the criteria that must be met by the borrower before the platform considers the borrower eligible for a P2P agreement, the risks of the possibility that, in the event of the platform’s failure P2P agreements may cease to be managed and administered (essentially leaving investors to recover repayments directly from borrower(s)) and that any third party involved in the continued management and administration of the P2P agreements after the platform fails may not be subject to the same regulatory regime and requirements as the platform, and the resulting possibility that regulatory protections may be reduced or no longer available (e.g. a debt collection and debt-administration firm that provide a back-up platform service is not subject to the client money rules).
The FCA propose that platforms must provide investors with updated information such as where its wind-down arrangements change and publish its expected and actual default rates and a summary to the assumptions used to determine these on an annual basis within 4 months of each financial year.
The FCA propose that platforms must publish a public contingency fund policy on its website setting out, amongst other things, how the contingency fund is funded, governed and the process for considering pay outs from the fund. On a quarterly basis, platforms must publish the size of the fund compared to total amounts outstanding on P2P agreements relevant to the contingency fund and what proportion of outstanding borrowing under P2P agreements in default has been paid using the contingency fund
Pricing and costs
1. Investors are not remunerated fairly for the risks they are taking. It is not always clear that the interest paid by the borrower is linked to the credit risk they pose, or that the return received by the investor reflects the investment risk they are prepared to take.
2. Investors may pay excessive costs for a platform’s services.
3. The FCA observed a number of instances among P2P platforms where loans are being transferred to investors in a way that transfers value inappropriately. For example, transfers take place without taking into account the value of the loans at the point of transfer (i.e. the interest rate at transfer may be based on the initial credit risk assessment as opposed to taking into account changes in a borrower’s risk profile).
4. Platforms that price loans or choose loans on behalf of investors do not always demonstrate a good understanding of the credit risk associated with the loans.
5. Platforms that manage loan portfolios on behalf of investors (Discretionary platforms) do not have adequate risk management frameworks to assess the risk and return profile of loans, likelihood of default and loss and, in some cases, to manage this effectively over time.
6. Discretionary platforms’ risk management framework do not include credit analysis and valuation methodologies that are tailored to the risks associated with the particular type of loans (i.e. property development, SME loans or unsecured consumer credit).
The FCA propose a prescriptive set of rules for the risk management framework required by platforms to set the price of agreements. The FCA propose that a platform will be required to:
a. gather sufficient information about the borrower to be able to competently assess the borrower’s credit risk;
b. categorise borrowers by their credit risk in a systematic and structured way (taking into account the probability of default and the loss given default);
c. set the price of the agreement so it is fair and appropriate, and reflects the risk profile of the borrower.
The prices set should consider, as a minimum, the time value of money and the credit spread for the specific loan.
Platforms risk management frameworks should adequately assess price and value over time. This is particularly relevant when a platform exposes investors not just to newly originated loans (for which the interest is being set at that point), but to existing loans (for which an interest rate is already set contractually), for example with pre-funded loans or platforms that reallocate loans on a secondary market. As the interest rate will already be contractually set for loans that exist, the only adjustment that can be made is to the amount at which the loan is transferred compared to outstanding payment (i.e. any discount to its face value). As a minimum, platforms must re-value loans that have defaulted.
The FCA’s rationale is that a good risk management framework must be underpinned by the right governance structure. The FCA propose to bring P2P platforms more into line with the systems and controls requirements that apply to certain investment businesses such as investment management.
The FCA propose that P2P firms:
a. maintain adequate risk management policies and procedures;
b. have an independent risk management function who should implement and monitor the effectiveness of the platform’s risk management policies and procedures and report to and advise senior management on matters of risk; and
c. have a permanent and independent compliance function who should monitor the effectiveness of the platform’s compliance policies and procedures and advise senior management on compliance matters.
The FCA propose that to maintain the independence of these functions the individuals involved in those functions must not also be involved in the services or activities which they monitor and should not be remunerated in a way that compromises their objectivity.
In addition to the compliance and risk management functions, the FCA propose that Discretionary platforms and Pricing platforms (i.e. platforms who set the price of loans) have an independent internal audit function which is responsible for assessing the adequacy of the platform’s systems and internal controls, issue recommendations and follow up implementation of those recommendations and report to senior management on internal audit matters.
The FCA propose that platforms’ risk management frameworks must be headed by an individual who is an approved person for a significant influence controlled function such as a director. Such an individual must demonstrate that they are suitably qualified and competent to have this responsibility.
The FCA’s supervision and post-implementation review (PIR) work have identified inadequacies with the comprehensiveness and effectiveness of some P2P platforms’ wind-down arrangements should the platform fail.
The FCA propose that platforms produce and maintain an up to date P2P resolution manual, similar to a CASS resolution pack, which would assist in resolving the platform in the event of its insolvency. A platform’s P2P resolution manual must include, as a minimum, a written explanation of how the platform conducts the business of management and administration of P2P agreements that it has facilitated, what the day-to-day operations of that business entails, and what resources would be needed to continue that business if the platform ceased to carry it on, including a specification of:
• critical staff and their respective roles;
• critical premises;
• IT systems;
• record keeping systems, including how records are organised;
• all relevant bank accounts and payment facilities;
• all relevant persons outside the platform and their respective roles, including any outsourced service providers;
• all relevant legal documentation, including customer, service and supplier contracts;
• a group structure chart;
• the steps that would need to be implemented under the wind-down arrangements;
• any terms in contracts that may need to be relied upon; and
• how the platform’s systems can produce the detail specified in respect of ongoing disclosures.
Points of consideration
At present P2P firms can operate in an AR capacity. The FCA’s proposals only directly apply to principal authorised platforms. Principals will be responsible for ensuring the compliance with the proposed rules by all of their appointed representatives
Firms have until 27th October 2018 to respond to the FCA’s proposed changes and influence what the final rules will look like. Judging from previous experience it is unlikely that the final rules will significantly vary from the proposed.
It is prudent for platforms to review their businesses to assess whether any of the drivers of misconduct set out above are present and take action to ameliorate standards.