The FCA is considering, given the recent rapid increase in the size of the crowdfunding market, whether now is an appropriate time to consider whether rule changes are needed to regulate crowdfunding. To facilitate this, the FCA published a call for input last July, and has recently published a paper, Feedback Statement 16/13, summarising the responses received and providing the FCA’s initial views. In this briefing, we summarise the main issues that have emerged from the feedback the FCA received.

The different types of crowdfunding

In broad terms, the FCA has focussed on two types of crowdfunding:

  • loan-based crowdfunding platforms, through which people and institutions lend money to consumers or businesses in the expectation of a financial return through interest payments and repayment of capital over time; and
  • investment-based crowdfunding platforms, through which people invest in non-readily realisable shares or debt securities issued by businesses.

The FCA sees these different types of crowdfunding platforms as two distinct markets to be subject to largely separate regulatory regimes. The FCA sees loan-based crowdfunding as posing risks to the FCA’s objectives, in particular as regards consumer protection, whereas investment-based crowdfunding sector is seen as posing less issues.

Areas of specific FCA concern

Disclosure

The FCA is concerned, in the context of loan-based crowdfunding, that standards of disclosure used by firms do not meet its expectations. To aid firms and to raise standards, the FCA plans to consult on additional provisions to provide a consistent minimum basis for investor disclosures. A particular issue is that the FCA does not agree that loan-based crowdfunding can be described as a ‘savings’ product. It takes the view that detriment is possible if investors regard loan-based crowdfunding as a type of deposit as the risks, particularly to capital, are different. The FCA also reminds firms of their need to comply with the financial promotions rules generally.

The FCA’s disclosure focus for investment-based crowdfunding is the issue of financial promotions. The FCA is considering requiring disclosure of information about funding sources and the ongoing responsibilities of the platform, including specific disclosures about the due diligence process.

Conflicts of interest

For investment-based crowdfunding, the FCA’s focus is on ensuring crowdfunding platforms treat those on both sides of the transactions they facilitate as clients. This is not seen as creating conflicts of interest, but rather clarifying that conflicts of interest are likely and must be considered appropriately. Once conflicts of interest have been identified, firms must seek to manage them to avoid consumer detriment, or alternatively disclose the conflict in a way that makes clear that the firm cannot manage the conflict and that investors are likely to suffer detriment.

For loan-based crowdfunding, the FCA has examined the interaction between institutional and retail investors using crowdfunding platforms and is concerned that some firms may not be managing their conflicts of interest obligations adequately when dealing with both groups. The FCA is considering further intervention if it finds that current business practice is creating a significant risk of consumer detriment.

Regulatory arbitrage

The FCA perceives that there is generally a risk of regulatory arbitrage, and potential for investors to misunderstand the nature of the products offered, in particular when crowdfunding is compared to:

  • asset management, in that there appears to be increased pooling of credit risk for investors; and
  • banking, if borrowers borrow on the usual terms for loan periods of, say, five years, but investors invest in products which aim to allow them to take out their money after a certain notice period or initial term. These products have similarities with banking business, where banks lend money on longer terms than savings account notice periods.

The FCA notes that this issue has grown in significance as business models are becoming more complicated and look increasingly similar in substance to other, existing regulated activities, and in particular the FCA will continue to monitor this area from a consumer protection perspective.

Protecting different classes of client

The FCA confirms that investment-based crowdfunding platforms need to analyse whether clients meet the requirements to be classified as high net worth or sophisticated before certifying them as such. The FCA is considering whether there should be greater supervision of the client assessment process, as there seems to be suggestions of misunderstandings by firms and concerns that the current market practice is insufficient. The FCA is also looking at the need for greater mandatory disclosures for investment-based crowdfunding platforms providing non-readily realisable securities to be held within Innovative Finance ISAs.

The FCA is also examining whether investors using loan-based crowdfunding platforms via an Innovative ISA are at particular risk due to being less sophisticated, yet trusting in the ISA brand inappropriately. The FCA is undertaking research into investors’ knowledge, experience, expertise, behaviour and expectations, and does not believe past experience investing in other investments means that investors necessarily appreciate the liquidity risk, under-diversification risk and operational risks when using crowdfunding platforms.

Wind-down plans

The FCA is concerned that, in practice, wind-down plans for loan-based crowdfunding platforms may not work as expected, and may be inadequate to enable a loan book to be administered to conclusion in the event of platform failure. To help guard against this, the FCA proposes to consult on strengthening the rules in this area.

Next steps

The FCA believes there is evidence of potential investor detriment and intends to publish a Consultation Paper in the first quarter of 2017 proposing new rules. While the primary focus is the loan-based market, the FCA has concerns across both loan-based and investment-based sectors and will propose new rules for both. Final rules are expected in the summer of 2017.

In addition, the FCA is continuing market research into this sector which should be completed in early 2017. Depending on the outcome, a second consultation paper with additional proposed rules may follow in mid-2017.