As discussed in the previous articles in this series, in order to offer regulated lending through a peer to peer program in Australia, the program needs to operate under:
- an Australian Financial Services Licence (AFSL) to operate a Managed Investment Scheme (MIS) to generate the investment unless exempt, and
- an Australian Credit Licence (ACL) to lend regulated credit.
Basics of an MIS
A managed investment scheme is essentially a pool of funds that is used for a common purpose when the original owners of the funds do not have day to day control over the funds and the investment activity. The investors buy ‘units’ in the MIS trust. The fund manager invests the funds to achieve a return for the unit holders.
The MIS can either be a ‘wholesale’ or ‘retail scheme'. Investors in a wholesale scheme need to be ‘wholesale’ investors, meeting one of the tests in the Corporations Act. The Act provides various tests, such as the individual earns $250,000 a year for two years, or controls $10 million or more. Retail investors are seen as less sophisticated, and more affected by loss. As a result, all retail financial services must be provided with more disclosure, and greater protection under law. The constitution of retail schemes must be registered with ASIC. ASIC may require considerable evidences prior to permitting a scheme to be registered.
Because of the difference in compliance requirements between retail and wholesale schemes, it is easier and cheaper to obtain a wholesale AFSL, and run a wholesale MIS. However, this limits your investors. If you’ve not got a track record of running an MIS, a wholesale MIS is a good place to start. Society One is an example of an Australian P2P MIS that currently only offers investment opportunities to wholesale investors, with a view to offer retail investment in the future.
Is there an alternative to a MIS?
A MIS is not required if investors have day to day control over their investment. If a single investor controls the whole one or more loan, that investor could have day to day control of that loan. However, there are significant practical difficulties in structuring straight through loans in this fashion in Australia.
Do retail investors really need additional protection?
Australian regulators are always cautious when it comes to retail investor protection. They don’t necessarily intend to stifle innovation, however, MIS and P2P models have a history of attracting scrutiny from the regulators. If retail investors are not given adequate protection, and the fund in which they invest collapses, they can suffer substantial life-changing financial ruin. We all remember Storm Financial, the various failed forestry plantation MIS schemes, and Timberland.
Under a P2P model, the financial risk is pushed to the investor – if a loan goes bad, the investor could lose their investment. Depending on the structure, investors don’t have control over how their money is invested, and so the lender needs to have highly robust lending and collection practices.
Can MIS promoters afford to be lax?
MIS promoters do have a good motivator to run a tight lending business because bad debts will reduce investors’ return and could eventually become unviable.
Promoter diligence is only one aspect of success. In the US, P2P lending has been popular for a while, but even the large companies such as Prospa ran into trouble in the GFC when borrowers couldn’t afford to repay their loans. A few negative investor experiences can have significant impact for that class of investment.
Do investors fully understand the risks?
Australian law requires a substantial amount of disclosure when AFSL holders want to sell financial products, particularly when selling to a retail investor. Regulatory Guidance RG234 requires a licensee to give as much prominence to the product risks as to the product benefits.
In the UK, the British Business Bank Program through the Department for Business, Innovation & Skill made a £40million investment through Lending Circle’s P2P platform to lend to small business. This is a wonderful demonstration of support for innovation and new business, but has been criticised as conveying the message to the public that P2P is ‘safe’ or has a stamp of approval, when in fact, it does carry risk.
What types of protection mechanisms are available?
P2Ps can use mechanisms such as a provision trust to protect investors. RateSetter charges borrwers a ‘risk assurance’ charge, and allocates the additional funds to a provision trust. The trust is a form of insurance to repay investors who suffer loss as a result of borrower default. This is likely to be seen by the Australian regulators as a good step to assist investor risk.
Pooling investment funds or limiting the amount that can be matched to individual loans can also reduce risk.
Overall, P2P lending has resulted in a wider selection of financial products for investors, and an innovative source of borrowing and investment. It’s wonderful to see that Australia is catching up with the rest of the word with regards to financial and credit products.