Crowdfunding Regulation

Last week the FCA published its policy statement outlining how it will regulate crowdfunding. If you want to take a look at it, it’s PS14/04 and you can find it on their website here: PS14/04.

The policy statement implements all of the regulations that were proposed in the consultation paper CP13/13. The only real changes were to the way prudential requirement for crowdfunding platforms are calculated, the introduction of a new term “non-readily realisable security” instead of the previous terms ‘unlisted shares’ and ‘unlisted debt securities’.

If you’ve not been following this issue, you can read our summary of the consultation paper here, or our overview for advisers here.

For a more polemical view on the regulations, read my previous blog post here.

(We will shortly be publishing our summary the policy statement as well, but as the PS is the same as the CP, our summary won’t change much either!)

As ever, the articles on the research hub are there to provide neutral, unbiased information with high level analysis. This blog post will be a more personal view.

The Policy Statement

Overall, I feel that the policy statement is a fantastic milestone for the crowdfunding industry. Getting regulated will help keep some of the cowboys out and give the sector increased credibility. More people are likely to invest in this sector now.

I also think that the FCA deserve credit for trying very hard to tread a fine line between their two statuary objectives of protecting the consumer on one hand and encouraging competition on the other. Crowdfunding could represent a real challenge to the status quo of fund based investing and that would be of benefit to consumers.

And as I stated in my blog on the CP,  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’s great to see the FCA recognise the value of advice in one of the key proposals: retail clients who confirm they are receiving regulated investment advice are free to invest without restriction. Since RDR advisers are very highly qualified professionals and there is no danger of commission bias influencing their decisions. Whenever advisers are involved in the investment process, the regulator should have confidence that the consumer is in safe hands – perhaps this policy paper is the first indication that the regulator will place faith in the advice process and let advisers advise.

What’s in a Name?

A small but important point. I think the best umbrella term for this sector is ‘Alternative Finance’. Crowdfunding really describes on-line equity fundraising, but that is only a small part of a sector that also covers peer to peer loans, asset backed debt, debt instruments and many different variations on these themes. I think continuing to call it crowdfunding will be detrimental as it implies a very risky investment activity and might dissuade some people from taking a closer look. Alternative Finance is a much more grown up sounding name.

Insider Trading

One respondent to the consultation pointed out a danger I had not considered before – the risk of somebody working for a crowding platform with a secondary market using privileged information to indulge in insider trading. It’s probably only a small risk at the moment, but its a good point that I haven’t seen picked up anywhere else.

Over-simplification?

The FCA has responded to the charge that it was over-simplifying the sector by treating all “investment-based crowdfunding” as the same – so an investment into the unlisted equity of a pre-revenue start up is the same as purchasing a corporate debenture from an established business with valuable assets and proven revenues. In the policy paper it states that

“We agree that different securities will be issued on different terms and have
different inherent risks. We also agree that it is difficult for ordinary retail
investors, who are not receiving advice, to assess the value of an investment
and likelihood of investment returns if they do not have access to reliable due
diligence information about the securities they are offered. So, even when
secured, asset-backed or issued by a more established company, we take the
view that investors face significant risks when buying a non-readily realisable
security. These include the risk of capital loss (which is exacerbated if the price
paid for a security is based on an over-valuation of the business or if the security
is a long-term debt security that will not return capital for periods such as
20-25 years), the risk of dilution of shareholder value, the risk that dividends
will not be declared, and illiquidity risk. We do not propose to draw distinctions
between the different types of non-readily realisable security.”

The FCA does not look like it will budge on this issue – as least for the time being. My view is that this is still an oversimplification that makes it harder for consumers to access some good, risk diversifying investments.

Inconsistencies

I’m not going to pick through the entire paper in detail: I did that for CP13/13 and my thoughts have not changed a great deal. However, I will highlight what I think are the two biggest inconsistencies with the thinking behind this paper:

Firstly, it is still easier for consumers to spend their money in a betting shop or on-line spread-betting account than it is to invest in alternative finance opportunities that benefit the economy (and have a better chance of providing a return). There seems to be an inconsistent approach between the what the government (this is hardly the FCA’s fault) does and does not allow people to do.

Secondly, 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?

Conclusions

Overall the paper is a welcome step forward for the alternative finance sector and I think the FCA have done a good job of protecting consumers, increasing confidence in the market and keeping the ‘crowd’ in crowdfunding. It’s not perfect and I would have liked to have seen a more liberal approach that opened up the sector to more investors than it does, but it is a good starting point.