Alternative Lending:

A regulatory approach to Peer-to-Peer lending

Alternative Lending
A regulatory approach to Peer-to-Peer Lending

The
industry

DOUBLES
in size
every year

THE PEER-TO-PEER
INDUSTRY GREW

BETWEEN
2012-2013

THE UKS LARGEST

Peer-to-Peer
operators match

80 million
in loans per month

80

million

177%

91%

of the SME lending market

is dominated by the

big 5 banks

SME funding gap over

the next five years:

More than

5,000 SMEs

HAVE RAISED FUNDS THROUGH ALTERNATIVE

FINANCE INTERMEDIARIES BETWEEN

2011-2013

191

84

BILLION

BILLION

P2P lending
platforms
are the

LARGEST
FORMS OF MODERN
FINANCE IN THE UK

The US, the UK and China

MAKE UP

96%
of the overall financial return
Crowdfunding market:

US

51%

CHINA

28%

UK

17%

OTHERS

4%

We strongly believe
that the FCA regulation
is fantastic for the industry
as a whole, not only will it
encourage best practice, more
importantly, it will promote
trust and consumer security
amongst investors and
borrowers.

Introduction

Nicholas Harding
Lending Works

Before taking over the regulation of the consumer credit market from
the Office of Fair Trading on the 1 April 2014, the Financial Conduct
Authority published a policy statement on its regulatory approach
to firms operating online Crowdfunding platforms. As part of the
governments plan to promote alternative forms of finance, the FCA
has adopted a balanced solution that seeks to protect both investors
and an industry that is seen to be key to the growth of small and
medium sized enterprises.

1 October 2014:
FCA will start
considering
applications for full
authorisation from
firms with interim
permission

1 April 2014:
FCA takes over
regulation of
Consumer Credit
from the OFT

April 2014:
FCA to publish
paper on key risks
in the market in
order to establish
intervention
priorities

2019:
Department for
Business, Innovation
and Skills and HM
Treasury to carry out
post-implementation
review reform

1 April 2016:
Full FCA consumer
credit regime will
come into effect
replacing the
interim permission
regime

2019:
FCA to complete a
review of retained
CCA conduct
requirements and
develop rule-based
alternatives

ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING 3

The importance of alternative

lending channels
Traditionally, UK businesses have heavily relied upon banks to meet
their funding needs. It is estimated that 91% of small and medium
sized enterprises (SME) seek funding from the UKs largest five banks.
Historically, the lack of alternative funding options has proven a
hindrance to such businesses.
Nevertheless, since the financial crisis, and despite
political efforts, SMEs struggle to access the
finance they need. The Breedon Report, which
examined the financing of UK SMEs, concluded
that in the next five years there will be a finance
gap of between 84 billion and 191 billion1.
Although the report did not identify a single
solution to this problem, it established that raising
awareness about alternative finance methods
would be key.
The term alternative finance commonly
comprises any form of finance provided by nonbanking entities. It is thought that these innovative
funding methods will have a crucial role in the
creation and survival of SMEs. The government
acknowledges the importance of the funding gap
and has adopted various measures to promote
lending. Currently, it is consulting on whether to
take legislative action to help match SMEs that
have been rejected for loans with challenger banks
and alternative finance providers who are looking
to offer credit.
Amongst the alternative lending possibilities,
the Crowdfunding sector has drawn particular
attention due to its exponential growth and its
crucial role providing SMEs with access to finance.
Crowdfunding platforms provide a medium by
which businesses and individuals are able to seek
flexible financing options from an array of sources,
predominantly via online platforms. There are
numerous forms of Crowdfunding:

some are charitable donations that provide

intangible benefits; others, such as equity
Crowdfunding and Peer-to-Peer lending, do offer
financial returns.
The importance of these funding methods was
acknowledged by the Parliamentary Commission
on Banking Standards which stated that:
Peer-to-Peer and Crowdfunding platforms have
the potential to improve the UK retail banking
market as both a source of competition to
mainstream banks as well as an alternative to them
() The emergence of such firms could increase
competition and choice for lenders, borrowers,
consumers and investors2.
Lending platforms were originally regulated
by the Office of Fair Trading (OFT); however,
since 1 April 2014 they are regulated by the FCA.
The Regulator shares the governments desire
to make these alternative forms of finance more
secure and accessible. Christopher Woolard, the
FCAs Director of Policy, Risk and Research
recently stated: Consumers need to be clear on
what they are getting into and what the risks of
Crowdfunding are. Our rules provide this clarity
and extra protection for consumers, balanced by a
desire to ensure firms and individuals continue to
have access to this innovative source of funding 3.

Breedon Report: Boosting Finance Options for Businesses

Parliamentary Commission on Banking Standards: Changing Banking for Good (57)
The FCA outlines how it will regulate crowdfunding: http://www.fca.org.uk/news/the-financialconduct-authority-outlines-how-it-will-regulate-crowdfunding
1
2
3

4 ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING

FCAs regulatory approach

to Crowdfunding
The FCAs policy statement, published in March 2014, does not
propose fundamental changes from its original Consultation Paper
(CP 13/13). Firms holding an OFT licence should have applied for
interim permission before 1 April 2014.
Those organisations that did not complete the
application by the 1 April, will need to apply for
full authorisation and will be unable to conduct
Crowdfunding activities until they are authorised.
The Regulator has decided to maintain the
polemic distinction between investment-based
Crowdfunding and loan-based Crowdfunding (or
Peer-to-Peer lending).
Investment-based Crowdfunding consists
of investing in businesses by buying unlisted
securities that are hard to value independently or
sell on a secondary market. The FCA considers
that, given the high risks that investors face by
investing in non-readily realisable securities,
they should only be promoted to individuals that
understand their inherent dangers or to those
than can cope with the potential financial losses,
that is: professional clients, retail clients who are
advised, retail clients classified as corporate finance
or venture capital contacts and sophisticated or
high net worth investors. Those retail clients that
are not provided with investment advice will need
to pass an appropriateness test and certify that
they will not invest more than 10% of their net
investible assets in these products.

Investment-based Crowdfunding firms were

given a transition period to comply with the new
rules. While many are choosing to implement the
changes to ensure compliance immediately, they
will become mandatory from 1 October 2014.
Nevertheless, by imposing investment restrictions,
the Regulator has been accused by entrepreneurs
of taking the crowd out of Crowdfunding.
Conversely, Peer-to-Peer lending, which
consists of financing businesses and loans with
contributions from a large number of sources, has
been subject to lighter regulation.

Small and medium-sized

businesses need access to a
diverse range of finance options,
including non-bank lending. These
new forms of finance are still small
in scale today but they should, over
time, bring additional choice and
greater competition to the
lending market.

Vince Cable
Secretary of State for
Business, Innovation and Skills

ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING 5

New rules and capital

requirements
The FCAs approach to Peer-to-Peer lending platforms is much lighter
as they are considered to be lower risk. The Regulators rules can be
summarised as follows:
Prudential
requirements:

The FCA has decided to recalibrate its volume-based financial resources requirements to reflect
economies of scale in extremely large organisations. The Regulator has proposed a transition period:
Until 31 March 2017, the fixed minimum prudential requirement will be 20,000. From that date,
the minimum requirement will increase to 50,000. Transitional arrangements will not apply to OFTregulated organisations until they become fully authorised.

Protections in
case of firm
failure:

Platform operators will have to create programmes that ensure loans can be managed to maturity
in case of platform failure. The Regulator has decided not to impose stringent requirements for the
arrangements that firms must have in place. Nevertheless, firms are expected to have appropriate
systems and controls depending on their customer needs and their business model particularities.

Client money
rules:

Lenders holding client money will need to apply the existing client money rules contained in the Client
Assets Sourcebook (CASS). The application of the regime will entail additional reporting requirements
for CASS medium and CASS large firms. However, Peer-to-Peer lenders will not be subject to these
measures until October 2014.

Disclosure
rules:

The Regulated Activities Order and the Financial Promotion Order have been amended; therefore,
lending websites and details of loans will be considered as financial promotions. The rules require
firms to ensure investors have enough information to make informed investment decisions and that all
communications are fair, clear and not misleading. The Regulator didnt mandate specific disclosures
placing the onus on firms. These rules, considered to be essential for consumer protection, have
been applicable since 1 April 2014.

Dispute
resolution
and reporting
requirements:

Loan-based Crowdfunding platforms will be subject to the FCAs dispute resolution rules. Moreover,
in order to assist with market monitoring, organisations will need to submit regular reports on their
financial position, the client money held, complaints and the loans arranged each quarter.

6 ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING

It is important to note that investments via

Peer-to-Peer lenders will not be covered by the
Financial Services Compensation Scheme (FSCS).
The Regulator expects firms to disclose the lack
of coverage and its consequences to potential
investors. The FCA considers that the prudential
requirements and the arrangements in case of firm
failure should be sufficient to protect investors.
Nonetheless, the possibility of including these
alternative lenders within the FSCS remit will be
reconsidered in 2016.
Lending platforms suffer from all the risks
associated with credit provision, including
money laundering and terrorist financing. The
Joint Money Laundering Steering Group has
published draft guidance for these type of firms
relating to their compliance with anti-money
laundering regulations.

Volume-based capital requirements

(Applicable from 2017)
0 to 50 million

0.20%

> 50 million to 250 million

0.15%

> 250 million to 500 million

0.10%

> 500 million

0.05%

Appropriate
prudential requirements
are critical for our industry.
We believe that higher capital
requirements than those initially
proposed by the FCA could
be beneficial; they would
help prevent the failure of
businesses and increase our
credibility.

Nicholas Harding
Lending Works

ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING 7

International approach
to Crowdfunding
The Peer-to-Peer lending market remains a relative newcomer in terms
of global credit provision. While growth is encouraging, particularly
in the UK, USA and China, the proportionate share of credit markets
remains small.
However, due to its growth potential, policymakers are demonstrating an increasing appetite
to regulate the sector, both to mitigate risk and
encourage customers to make use of the alternative
funding options the industry provides. Striking the
perfect regulatory balance is not easy, and while
policy approaches vary from country to country,
a certain degree of harmonisation is likely to be
necessary due to the prospective cross-border
nature of the Crowdfunding industry.
In the US, the largest Peer-to-Peer lending
market, platforms must follow an arduous
regulatory process. Each lender needs to be
regulated by the Securities and Exchange
Commission (SEC) at a Federal level, and register
the loans they originate. These businesses receive
the same treatment as a public company, therefore
they have to comply with high disclosure
requirements: their finances, loan origination
and practices are public. Peer-to-Peer and
Crowdfunding activities are not permitted in
certain states, hence state approval is necessary
too. Those platforms that want to operate in more
than one state can either become a public business
or apply to each state separately.

Market share Crowdfunding market 2013

4%
17%

28%
China
US
UK
Others
Source: Iosco

51%

As in the UK, equity Crowdfunding has certain

limitations. Sophisticated investors can only
deposit 5% of their annual income. This limit
goes up to 10% when the annual income is over
$100,000. The SEC is considering extending these
rules to retail investors.

8 ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING

Conversely, China, another Peer-to-Peer giant,

has not regulated the Crowdfunding industry. The
lack of regulatory guidance and tighter monetary
conditions resulted in the failure of nearly seventy
Peer-to-Peer lending websites at the end of 2013.
Although they only represent a small fraction of
the circa 1000 Peer-to-Peer platforms currently
operating in China, the collapse sparked concern
in Europe and the US. As a result, the Chinese
Central Bank assured that it will provide closer
supervision and stressed that illegal lending
practices, such as investing clients funds in
financial products, can result in death penalties.
The European Commission (EC) recently
issued a report discussing the long term
possibilities of the Crowdfunding industry to
complement traditional sources of finance. The
Commission considers that Crowdfunding
can contribute to building a pluralistic and
resilient social market economy and sustains
that burdensome and premature regulatory
action could hinder the industrys development.
The EC will conduct a detailed study in 2014 in
order to better understand national European
regulation and explore the possibility of launching
a harmonised solution.

International regulatory regimes

Regulatory
regime

Description

Countries

UK model

Platforms need
approval from the
FCA to operate

United Kingdom

Exempt market/
unregulated through
lack of definition

P2P is either an
exempt market
or there is a lack
of definition in
legislation

Brazil, China,
Ecuador, Egypt,
South Korea, Tunisia

Intermediary
regulation

Regulates P2P
lending platforms
as an intermediary,
which requires
registration and
other regulatory
requirements

Australia, Argentina,
Canada and
New Zealand

Banking regulation

Regulates P2P
platforms as banks

France, Germany,
Italy

US model

Requires registration
of the platform with
the SEC and state
authorisation

United States

Prohibited

Both P2P lending and

equity Crowdfunding
are banned

Japan, Israel

Source: Iosco

ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING 9

Conclusion

Initial reactions to the FCAs rules have been broadly positive, many
precepts are a close reflection of the Peer-to-Peer Finance Association
code of conduct. Nicholas Harding, founder at Lending Works,
confirmed: We strongly believe that the FCA regulation is fantastic for
the industry as a whole, not only will it encourage best practice, more
importantly, it will promote trust amongst investors and borrowers.
The Regulator acknowledges that higher consumer
protection comes at a price. So far, it has published
two cost-benefit analyses which indicate that the
rules will result in certain companies leaving the
Peer-to-Peer industry and that compliance costs
will be permanently higher for those that survive.
Increasing costs and new industry entries may result
in market consolidation.
While the estimated 840 million that will be
lent by alternative finance providers in 2014 only
represents 2% of annual UK business lending,
this amount has grown at a rate of more than
90% year-on-year. Peer-to-Peer lenders are often
described as game-changers; not only because
of the seductive rates they offer, but because both
borrowers and investors are captivated by their
speed and simplicity.
More importantly, the industry benefits from
Government support. In March, it was revealed
that Peer-to-Peer lending was to be included
within the tax-free ISA allowance. According
to one of the biggest market participants, the
announcement represents a crucial moment for the
industry. Lending platforms believe that it is a great

opportunity to lobby for increased sharing of credit

information with banks, although this would require
a considerable softening of attitudes from traditional
lenders and increased collaboration with alternative
finance providers.
The lack of competitiveness in the lending market
causes concern among policy-makers globally. Many
countries see the benefits of supporting alternative
forms of finance. Nevertheless, the inherent
risks that Peer-to-Peer lending entails cannot be
disregarded. Although default rates in the industry
are currently low, the data can be misleading: most
of these platforms were established in the last three
years; therefore the majority of their loans have not
reached maturity yet. Market participants expect
regulation to prevent the failure of alternative
lending institutions, which would have a disastrous
reputational effect; Nicholas Harding, added:
Appropriate prudential requirements are critical
for our industry. We believe that higher capital
requirements than those initially proposed by the
FCA could be beneficial, they would help prevent
the failure of businesses and increase our credibility.

10 ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING

Despite most lending platforms having robust

credit checking systems in place, some would like
the Regulator to be more prescriptive about the
quality of the technology and the competencies of
the individuals running these businesses. The long
term effects of the regulatory approach adopted by
the FCA is yet to be seen, for now the future of the
Peer-to-Peer lending world is full of possibilities
which include the development of innovative
payment methods and the smart use of big data.
The rate of growth, both in value and maturity, of
the alternative lending industry is unprecedented.
The manner in which these businesses have adapted
to initial regulation paints a positive picture for the
future prosperity of a sector with a major role to
play in the Financial Services industry of the future.

Peer-to-Peer lenders
are often described as
game-changers; not only
because of the seductive rates
they offer, but because both
borrowers and investors are
captivated by their speed
and simplicity.

We need to see
more small, innovative,
alternative banks and nonbanks. There are many new
financing models which have been
created, such as Peer-to-Peer lending,
which have taken off like wildfire.
I am now beginning to encounter
companies around the country
which would have gone under
were it not for Peer-toPeer lending.

Vince Cable
Secretary of State for
Business, Innovation and Skills

ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING 11

Contact us

Tarun Mistry
Partner, Financial Services
Corporate Finance
T (0)20 7728 2404
E tarun.mistry@uk.gt.com

Gareth Miller
Associate Director, Regulatory
T (0)20 7865 2863
E gareth.a.miller@uk.gt.com

Jake Wombwell-Povey
Financial Services
Corporate Finance
T (0)20 7865 2569
E jake.wombwell-povey@uk.gt.com

Peter Landers
Head of Consumer Finance
T (0)20 7865 2792
E peter.landers@uk.gt.com

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