How risky is using peer-to-peer lending as an investment?

The FCA’s interim feedback paper on crowdfunding, FS16-13, highlights a number of concerns which reflects the broad concerns I’ve written about before. It gives a good indication of the risks involved in using peer-to-peer lending as an investment.

Their high level concerns are:

  • it is difficult for investors to compare platforms with each other or to compare crowdfunding with other asset classes due to complex and often unclear product offerings
  • it is difficult for investors to assess the risks and returns of investing via a platform
  • financial promotions do not always meet our requirement to be ‘clear, fair and not misleading’, and
  • the complex structures of some firms introduce operational risks and/or conflicts of interest that are not being sufficiently managed

The review specifically picked out loan-based (peer-to-peer lending) rather than investment-based crowdfunding as higher risk and picked out three key failings:

  • Certain features introduce risks to investors that are not adequately disclosed and may not be sufficiently understood by investors. For example, the use of provision funds may obscure the underlying risk to investors, which may result in investors believing that platforms are providing an implicit guarantee of the loans they facilitate.
  • The plans some firms have for wind-down in the event of their failure are inadequate to successfully run-off loan books to maturity.
  • We have challenged some firms to improve their client money handling standards.

Anyone considering peer-to-peer should read this paper. Of immediate concern is the finding that a number of lending platforms operating under interim FCA permissions are failing to hit the relevant regulatory standards. This is especially worrying given the view from the majority of respondents to the paper that a high profile failure amongst one large platform would put others at risk. Some platforms allow investment in loans formed on other platforms, which can make it harder for investors to conduct due diligence or to understand the level of risk they are taking.

Respondents added additional risks:

  • concerns about the long-term viability of firms
  • there may be too many firms in the market, leading to a potential for consolidation in the
  • future and a need for firm wind-down plans to be fit for purpose, particularly where money is held within an ISA wrapper
  • commercial pressure and conflicts of interest may lead firms to relax creditworthiness and
  • underwriting standards, leading to increasing credit risk
  • inadequate controls in some firms may lead to inadequate due diligence or poor quality financial promotions
  • debt recovery systems may not be adequate in all firms
  • the firms operating platforms are generally themselves young operations and inexperienced in matters such as risk management
  • cyber-attacks on platforms are possible
  • property loans arranged on platforms can carry significant risks to investors
  • insider trading or market abuse is possible, particularly where firms operate secondary markets
  • lack of access to banking services may create over-reliance by firms on a few payment services companies

It is acknowledged that there is a risk that the Innovative ISA could bring less sophisticated investors to something which is designed for experienced and sophisticated investors who are more likely to understand ‘the liquidity risk, under-diversification and operational risks of platforms’.

There is a chilling analogy with UCIS. ‘Increasingly, the market is using features such as maturity mismatch, automatic allocation and re-allocation of investments, and provision funds. Respondents said this is leading the market to share the features, and possibly the risks, of unregulated collective investment schemes.’

If you do look at a peer-to-peer loan as an investment, it is important to bear these risks in mind and as a minimum you should regard this as a high risk investment only suitable for sophisticated investors and for small amounts. As I’ve said before, I don’t think is suitable for the vast majority of investors right now, although I’m sure some products and platforms will do well and the paper looks at the market as a whole without naming specific platforms. The availability of the Innovative Finance ISA wrapper may drive more interest than usual from clients, but this is not an ‘extra’ allowance, it comes out of the total £20, 000 ISA allowance in April.

The FCA has also committed to:

  • review and possibly harmonise borrower protections
  • consult on application of residential mortgage standards to platforms
  • consider further controls for more complex models
  • consider a contribution limit to cap potential investor harm
  • review whether some more complex, pooled models cross over into asset management and the relevant rules applicable to this
  • consider if a separate FSCS fund is appropriate

It is worth considering these points if investing.

This just days after Zopa, the UK’s largest peer-to-peer lender announced it was capping investment levels due to a lack of creditworthy borrowers. The best days of peer-to-peer for investors may be over.

The paper also covers investment-based crowdfunding including mini-bonds.

Next steps are a Consultation Paper in Q1 2017 and final rules by the summer. I suspect they will be keeping a very close eye on this sector.

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