The FCA released CP13/13 last week – it’s long awaited Consultation Paper on crowdfunding.
There’s been some coverage in the mainstream press and some in the adviser trade press. Our succinct overview and analysis of the main thrust of the proposals contained within CP13/13 is available on our research hub here.
We’re also close to finalising our in depth white paper outlining exactly what the proposals mean, what the potential impact to investors, providers and advisers is and what the likely responses of stakeholders in the crowding sector are going to be. ‘An in depth review of CP13/13: The FCA’s regulatory approach to crowd funding’ will be available on the research hub shortly.
However, in this post I wanted to provide a bit more commentary on the topic. Unlike the other material, this is not solely neutral, objective overviews designed to help advisers and intermediaries with their research and understanding. Instead I’m gathering together the thoughts I have had about the good and bad bits of these proposals while reviewing CP13/13.
I’d be interested to get your feedback as well – you can reach me on daniel@intelligent-partnership.com or on @DanKiernan77 on twitter.
I’ve also blogged before on the difficulties I’ve had trying to persuade advisers to try something new (link) and I think the same barriers will crop up for advisers here – the regulatory downside risk for advisers and how to cover WOM and pick the right options out for their clients. (However, the FCA seems has indicated that it does value advice in CP13/13).
Its worth noting that this isn’t the only pertinent consultation process taking place at the moment. As well as CP13/13 the FCA have issued CP13/10 which outlines their proposed consumer credit regime and touches upon crowdfunding from the borrower’s perspective. In addition, CP13/5 proposes changes to the CASS client money rules that will now be relevant for some platforms if these new regulations come into force. The EU and the US are also currently preparing their regulatory response to the growth of crowdfunding.
CP13/13 What’s right with it?
Well, firstly it is right that the crowdfunding sector should be regulated. It’s small, but growing in popularity and gets a lot of media coverage. It’s also incredibly easy to access and invest – there are far fewer barriers than there would be for traditional investments. And many of the investments are high risk. So it couldn’t be ignored any longer and the FCA is right to step in. Hopefully one benefit on regulation will also be increased consumer confidence.
I also think that the FCA has got the broad thrust of its proposals right. Minimum prudential standards, rules on holding client money, rules on the resolution of disputes, reporting pertinent information to the FCA, rules around disclosure of information and a stipulation that a process must be in place to ensure that client’s investments will continue to be managed in the event of a platform failure all make sense. These proposals will ensure best practice is followed across the crowdfunding sector and bring it into line with the rest of the saving and investment industry.
Finally, it was great to see the FCA recognise the value of advice in CP13/13 as one of it’s key proposals: retail clients who confirm they are taking advice in relation to the investment are free to invest. I’m a big supporter of the value of good and its good to see the FCA recognise the importance of advice.
CP13/13 What’s wrong with it?
CP13/13: An inconsistent approach to crowdfunding
All of that said, I do think there is something of an inconsistent approach from the FCA here. It seems that there is an inbuilt bias that favours mainstream, listed investments in the public markets – despite evidence that these can sometimes be poor value and poor performers.
For example, in Annex 1 paragraph 32 of CP13/13, the FCA is implying that irrational investor behaviour might lead to sub optimal investment decisions – surely something that applies to any investment market! The three irrational biases they highlight (overconfidence, anchoring and herding) occur all the time in many, many decisions we make (not just investment based decisions). Consider their description of herding:
“the more investors show interest in a particular investment, the more other investors will assume that it is a good investment. Such behavioural biases might be particularly relevant to the auction model where investors effectively bid against each other to invest.”
Isn’t that an apt description of the stock market? It seems strange to pick these issues out only in relation to crowdfunding.
CP13/13 also suggests that approximately 5% of funds are ‘mis-invested’ on crowdfunding platforms. I would be very interested to know what the equivalent figure would be for stock market or fund based investments – I’m sure a much higher percentage of funds are mis-invested by people following the latest flavour of the month or suffering from one of the behavioural biases highlighted above… Again, this 5% figure may well be true (although it’s not clear how the figure was calculated) but why single out crowdfunding?
Cp13/13 also picks out platforms for improved disclosure of information to clients on their websites. Of course this right and a positive step. But taking platforms to task for quoting levels of return without including the impact of charges or taxes again seems a little inconsistent – many fund based investments will quote performance gross of fees and tax. So its a good step – but lets apply it to the whole investment and saving industry.
(to be fair on the issue of charges, it looks like the FCA will be taking a good hard look at fund charges (fund-charges-face-major-reform) and the DWP is reviewing pension charges with a view to capping them (auto-enrolment-charge-cap-options). So perhaps there is no hiding place for charges on any products in any asset class any more).
Finally, CP13/13 also states that crowdfunding carries particular risks for some people with protected characteristics (such as learning difficulties, those without disposable income and young and inexperienced investors). I agree that there is a risk here – but is crowdfunding in particular really more risky for these classes of investor than the mainstream markets or with spread-betting? Again, why single it out in CP13/13?
I’m not sure why CP13/13 picks out crowdfunding as an asset class these risk are unique to. All of these risks apply just as much in the public markets. There are many different ways to invest money, and policy should give people the flexibility to invest where they want, rather than sanction particular asset classes.
CP13/13: When is advice needed?
This is a little unclear due to the wording of CP13/13. In the summary of their proposals (para 1.18) they state that the direct offer financial promotion of unlisted shares or debt securities (investment based crowdfunding) will be restricted to 4 categories of clients including:
- retail clients who confirm that, in relation to the investment promoted, they will receive regulated investment advice or investment management services from an authorised person
However, in the detail of the proposals (para 4.16) they change this to:
- retail clients who 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
Its only a subtle difference, but it could have an impact. As CP13/13 states, crowdfunding platform websites are classed as direct offer financial promotions (para 3.69). Therefore, if the second wording of the client category applies, crowdfunding platforms may need to introduce a step on their website to qualify clients and assess their appropriateness before they start researching the information on the site.
How practical this will be is debatable and it may be one of the elements that puts up a barrier to the ‘crowd’ who want to be involved in crowdfunding.
CP13/13: Oversimplification?
The broad split of crowdfunding into either ‘loan based’ or ‘investment based’ may risk oversimplifying the sector and does not acknowledge the range of different risks and returns on offer. This creates some inconsistencies.
For example: an investment into the debt of an established renewable energy project with predictable revenue streams that are based upon inflation linked feed-in tariffs is considered comparable to an investment into the equity of a small technology startup firm at a pre-revenue stage. Yet the former carries a much lower investment risk than the latter. Both of these would be restricted to only 10% of an ordinary retail investor’s portfolio under the new proposals.
Similarly, the paper seems to suggest that privately lending money to an individual or small business is considered to be less risky and therefore subject to fewer restrictions than investing in the debt securities of an established renewable energy project issued by a regulated firm. (It’s also unclear exactly what the distinction is between a tradable loan and a debt based security).
The UK Crowdfunding Association has already indicated that it will be lobbying for a more proportionate regime that will provide a lelve of consumer protection commensurate with the real risks involved in each of the various models.
CP13/13: What is the difference between a tradable loan and a debt security?
In CP13/13 the FCA has distinguished between loan based crowdfunding, and investment based crowd funding and they are treated differently in the proposed regulations. Investment based crowd funding includes unlisted debt securities (such as corporate debentures).
What is unclear, is how a loan that is only a small part of the total amount borrowed and is tradable on a secondary market (loan based crowdfunding), differs from an unlisted debt security that also has a secondary market? (investment based crowdfunding).
Its important – because it is this distinction within CP13/13 that leads us to the point where there are fewer restrictions on lending money to a small business with a poor credit rating than there are on investing in the debt securities of an established business issued by a regulated firm.
CP13/13: The on-going liquidity fetish…
The liquidity fetish continues – the regulator continues to demonstrate a bias against illiquid investments. Of course, lack of liquidity is a risk and must be considered, but I do think we over-value liquidity. The stock market may well be liquid, but just because you can sell doesn’t mean your going to be able to get your capital back if the market has gone against you. I’m sure this is an obvious point, so why do we prioritise liquidity so much?
CP13/13: How will we judge success?
The dominance of the UK consumer credit market by the high-street banks, and the dominance of the retail savings and investment market by a small number of entrenched financial services firms has been criticised as leading to a lack of competition and subsequently a lack of innovation. The need for ‘challenger’ firms to disrupt the market and encourage innovations that benefit the consumer has often been acknowledged. Crowdfunding has the potential to be a disrupter and drive these kinds of innovations.
The FCA does have a duty to discharge its general functions in a way that promotes effective competition. However, at the same time it must secure an appropriate degree of protection for consumers. The FCA acknowledges the tension between these two statutory objectives in CP13/13 and has proposed legislation it hopes provides adequate consumer protections that do not create too many barriers to entry or significant regulatory burdens for firms.
It’s going to be interesting to see if the FCA has struck the right balance here, but evaluating success could be difficult.
On the one hand, if consumer exposure to investment failures is minimised and there are few complaints, that could be considered to be a ‘success’. But at what cost? If the sector fails to grow to its full potential and challenge the banks, would this be a missed opportunity to improve some markets in favour of the consumer?
On the other hand, if the sector was to grow spectacularly and challenge the incumbent institutions’ dominance, but this came at the cost of patchy outcomes for investors, with some big winners and some big losers; that could hardly be judged to be an outright success either.
So it is easy to see the dilemma the regulator has here. How to encourage innovation, minimise the regulatory burden, keep barriers to new market entrants low and keep the ‘crowd’ in crowdfunding, whilst protecting consumers from poor quality investments, market failures and fraud?
CP13/13: In conclusion
So in summary, CP13/13 is a step in the right direction and a significant milestone for the crowding industry. The FCA deserves praise for recognising the need to allow this sector to develop, reach its full potential and hopefully provide a healthy challenge to the incumbent intermediaries, rather than over-regulating and shutting the crowd out of crowdfunding. However, there is still work to do – these proposals could be improved
They could do more to acknowledge the many different crowdfunding models and the many different types of underlying assets
They must clarify exactly what the difference between tradable loans and unlisted debt securities are, and exactly when appropriateness tests and confirmation that advice will be taken must be applied
The overall regulatory approach could be more positive to disruptive and innovate ideas such as crowdfunding. At the moment policy seems to maintain that banks and the public markets are the only place investors should place their money – as long as this is the case, the regulator will be a barrier to innovation.
Hat Tips and Links
Hat tips to:
Bruce Davis – here’s his piece on oversimplification: fca-risks-oversimplifying-crowdfunding-badly
Simon Dean-Johns – more of his fantastic analysis here: fca-crowdfunding-consultation
Louise Wilson on the idea that policy favours public markets: do-not-tell-me-where-to-invest
@GillianR_S for her help over Twitter shaping my views on accessibility for people with Protected Characteristics
The EU consultation
The regulations the SEC has proposed
CP13/13: cp13-13