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Tuesday, 28 October 2014

Adding Peer-to-Peer Loans To #ISAs

The Treasury is consulting on how to implement the government's decision to allow us all to hold peer-to-peer loans within our Individual Savings Accounts (ISAs). This is revolutionary because it increases the range of assets that can be held in ISAs - increasing diversification and therefore the value of the ISA portfolio - and significantly improves the visibility of where your investment money ends up (as I've argued for some time). Adding P2P loans will also change the way ISAs and ISA managers operate, which raises the various questions that the Treasury is consulting on (set out below). This post explains the difference between P2P lending and investing in funds typically held in stocks and shares ISAs, and addresses the main issues outlined by the Treasury.

What are peer-to-peer loans?

Peer-to-peer (or 'P2P') loans are just simple loans agreed directly between lender and borrower. There is no bank or fund manager in the middle, and the operator of the platform on which the loans are agreed is not a party to the loans.

How is P2P lending different to investing in funds?

Perhaps the best way to understand the difference is by starting with the role of the fund manager as opposed to the P2P platform operator. In simple terms, a fund manager collects money paid by investors in return for 'units' in the fund, and then controls the investment of that money in its own name (or that of the fund entity) - so the manager controls the management of the money or other assets in the fund, not the investors,.

However, the operator of a P2P lending platform enables many lenders to lend small amounts of money directly to many different borrowers, and then simply administers the individual loan contracts in accordance with their terms.  So the lenders on a P2P platform, rather than the platform operator, keep control over the management of their money and loan contracts. This is a key reason why P2P loans are a fundamentally different asset class to units in investment funds.

What does this mean for ISA managers?

These differences present a challenge for today's ISA managers - whose job it is to enable you to invest using your annual ISA limits, and keep track of those for HMRC.

Currently, when you buy units in an investment fund through an ISA manager, the manager adds your order to many other orders that it receives and then buys the total number of units in the investment fund in its own name. Each unit is standardised with the same price/value and issued by the same entity. The manager then records how many units it bought on your behalf in its own systems. You have no direct contract or any other link with the investment fund at all.

But on a P2P platform, you agree many small loans directly with lots of other people for the purposes specified, and different platforms tend to specialise in different types of loans (personal loans, working capital for small businesses, commercial property etc). Everyone's holding is different, even though some lenders end up lending to the same borrower. You also directly agree the platform's fee, if any, which may be waived in some cases (sometimes the borrower pays the fees, for tax reasons, leaving the lender with just the net income).

So existing ISA managers will probably need to make systems changes to enable it to track your own unique holdings of P2P loans in your ISA, and it seems likely they'll want to see a lot of demand before they do so. Accordingly, to meet demand for P2P loans in ISAs it's likely that the operators of P2P lending platforms will become ISA managers in their own right.

What does this mean for ISA rules?

You will probably be able to withdraw P2P loans from ISAs without having to sell them and take the cash.

ISA assets can typically be transferred between ISA managers, but that isn't practicable between different P2P platforms, so it's likely that any transfer would only work by selling the loans and transferring the cash directly to the other ISA manager. However, the Treasury is not sure whether to require this, as it could discriminate against platforms that do not have ready secondary markets for the loans agreed on their platforms. Another reason not to insist on transferability is that even if there were a secondary market, there could be a delay in finding a buyer for the loans, as opposed to just waiting for them to be repaid; and a 'forced' sale could mean a low market price, even from a market-maker or underwriter.

The Treasury is also interested in arrangements for continuing to manage P2P loans in ISAs in the event that the P2P platform operator ceases to qualify as an ISA manager, similar to the FCA requirements for administration of loans in the event that the operator ceases to trade.

The Treasury is still not sure whether to allow P2P loans to be kept in their own ISA or in a stocks and shares ISA. However, assuming P2P platforms are likely to need to become ISA managers in their own right, it would seem unduly onerous to make them apply for the extra FCA permissions required to offer other investments available through stocks/shares ISAs. So I'd suggest that there will need to be a third 'P2P loans ISA', or at least the ability for platform operators to offer a stocks/shares ISA that is limited only to holding P2P loans.

The Treasury expresses some concern that P2P lending on behalf of children through Child Trusts Funds (CTFs) or Junior ISAs could mean that the parent or guardian and not the child will be the one who understands the business activity or loan purpose of the business/personal borrower. But this is no worse than investing in a managed fund where you don't know the precise mix of the constituent stocks/shares or even the actual issuers and therefore their businesses or use of proceeds.

Finally, the Treasury believes that title to P2P loans made via CTFs and Junior ISAs would need to be held by the ISA manager or some third party, as loans made by minors are not enforceable (as a matter of contract law).

Those Treasury questions in full:
  1. In relation to the proposals generally, what necessary set-up costs (one-off costs) would be necessary for your business to arrange peer-to-peer loans meeting the proposed eligibility requirements for ISAs? What would be the estimated ongoing annual costs of doing so?
  2. Do respondents agree that the government’s proposed approach provides sufficient clarity as to which peer-to-peer loans will be eligible for ISA inclusion?
  3. Do respondents agree that the proposed regulatory requirements strike the correct balance between investor protection and a proportionate regulatory regime?
  4. Are existing ISA managers considering offering peer-to-peer loans alongside other ISA eligible investments? What factors may affect this decision?
  5. Are firms operating peer-to-peer platforms considering seeking authorisation to act as ISA managers if the government permits this? What factors may affect this decision?
  6. Do respondents have any concerns regarding FCA-authorised firms operating peer-to-peer platforms being allowed to act as ISA managers? If so, what are they?
  7. Do respondents see any risks arising from firms operating peer-to-peer platforms approved as ISA managers not being required to have legal ownership of peer-to-peer loans held within ISAs?
  8. Are there any drawbacks to the proposed withdrawal procedure for peer-to-peer loans? If so, what are they?
  9. If the transfer requirement is applied to peer-to-peer loans – do respondents foresee any risks or detriment for consumers resulting from the proposed modification of the current ISA requirements? If so, what are these?
  10. Following the sale of the peer-to-peer loan and transfer instructions from the investor, what would be the most appropriate time period within which the cash realised should be transferred?
  11. Is the proposed modification to transfer requirements t likely to present any difficulties or administrative obstacles for ISA managers (including those receiving transfers)? If so, what are these?
  12. What are respondents’ views on requiring the existence of a secondary market in order for a peer-to-peer loan to qualify for ISA eligibility? Would such a requirement provide a useful degree of reassurance to investors?
  13. Would a requirement to offer a secondary market pose any problems or difficulties for peer-to-peer platforms and if so, what are these? Could secondary market arrangements of this type be easily defined?
  14. Do respondents think that a guarantee of a sale at market value within a given period would be desirable in addition to the proposed requirement of a secondary market?
  15. Is there merit for investors in requiring that there must be a mechanism by which loans can be sold at market value within a given period? What period should this be, taking account of the times taken at present to achieve sales on existing secondary markets?
  16. Are there other ways in which to facilitate transferability, besides those described above? If so, how might these work?
  17. Overall, do respondents feel that the benefits to investors from applying transfer requirements to peer-to-peer loans held in ISAs outweigh the possible risks of doing so?
  18. Do respondents have suggestions as to how loans held within ISAs could continue to be managed by an ISA manager in cases where either a firm operating a peer-to-peer platform collapses and they were acting as ISA manager, or where such a firm becomes ineligible to act as an ISA manager following removal of its FCA permissions?
  19. How important is it that investors should be able to mix peer-to-peer loans with other eligible investments within their ISA in a single tax year? Do respondents believe most investors wishing to place peer-to-peer loans into an ISA account will additionally want to invest in other types of non-cash ISA investments within the same tax year?
  20. Would a third ISA type be helpful in alerting investors to the different rules which will apply to peer-to-peer loans within ISAs? Overall, would a third ISA type aimed specifically at alternative finance products such as peer-to-peer loans be a good thing – and if so, why?
  21. What potential difficulties or challenges might the creation of a third ISA type present for savers, investors, ISA managers or others?
  22. If the government decides not to introduce a third ISA type, how can we best ensure that customers are clear about the special characteristics associated with peer-to-peer loans, for example that they are not covered by the FSCS, and that they may be difficult to liquidate?
  23. Do respondents have any concerns about offering a tax advantage where loans made by or on behalf of children might be made without knowledge of the intended recipient(s) or usage of the loaned funds? If so, what are they?
  24. Do respondents agree that if peer-to-peer loans are made eligible for CTFs and Junior ISAs, these loans should be in the legal ownership of the ISA manager? If not – what alternative approach might be considered?


Thursday, 23 October 2014

Regulatory Creep Hits Big Loyalty Schemes - Updated

Store cards, gift cards and loyalty rewards are currently exempt from payments regulation where they are only accepted within the issuer’s premises or certain ‘limited networks’. The new European Payment Services Directive (PSD2) extends the scope of this exemption - which is helpful to some extent - but also introduces a notification requirement that will bring big schemes within the regulatory sphere from 13 January 2018, and oblige the authorities to decide whether the exemption is available. This post explains the changes, and the options open to the operators of such schemes. For other significant changes proposed under PSD2, see my longer SCL article). The Treasury's consultation on introducing PSD2 in the UK has just been published.

The limited network exemption under PSD1 applies to services based on instruments that can be used to acquire goods or services only: (a) in the premises used by the issuer; or (b) under a commercial agreement with the issuer either (i) within a limited network of service providers or (ii) for a limited range of goods or services (my numbering/emphasis).

The exemption under PSD2 is for:
"services based on specific payment instruments that can be used only in a limited way, that meet one of the following conditions:
(i) instruments allowing the holder to acquire goods or services only in the premises of the issuer or within a limited network of service providers under direct commercial agreement with a 'professional issuer' [not defined];
(ii) instruments which can be used only to acquire a very limited range of goods or services;
(iii) instruments valid only in a single Member State provided at the request of an undertaking or a public sector entity and regulated by a national or regional public authority for specific social or tax purposes to acquire specific goods or services from suppliers having a commercial agreement with the issuer." (my emphasis)
Some guidance as to what is meant by 'limited' or 'very limited' is to be found in the relevant recital to PSD2, which states:
"Instruments which can be used for purchases in stores of listed merchants should not be excluded from the scope of this Directive as such instruments are typically designed for a network of service providers which is continuously growing."

In addition, operators of large limited network schemes will be obliged to notify the regulator “if the the total value of payment transactions executed over the preceding 12 months exceeds the amount of EUR 1 million”. The regulator must then decide whether the exemption criteria actually apply, and notify the service provider if the regulator concludes that it does not. There is no provision for a transition period to explore alternative methods of supporting the scheme.

This means that loyalty scheme operators need to consider now whether their scheme will be covered by the revised limited network exemption in January 2018 and, if not, whether they should outsource the operation of the programme to an authorised firm (or the agent of one); or seek their own authorisation (or agency registration). Ultimately, they might restructure the scheme to fit the exemption, or shut it down.

The UK Treasury was due to issue its consultation paper in August 2016 on how it plans to implement PSD2, but has not done so yet. Hopefully, either the Treasury and the FCA will clarify further how they plan to handle the notification process, including whether pre-clearances will be possible during 2017, for example, given the lack of any transition period should the FCA conclude that the exemption does not apply.  Otherwise, queries arising out of any uncertainty in the application of the exemption might be directed to the FCA's Innovation Hub

This kind of regulatory 'scope creep' is not at all healthy, however. PSD2 should be clearer on what activities are in or out of scope. Instead, we have activities that are out of scope altogether; in scope but exempt; in scope with authorisation required; in scope with registration required; or in scope with only notification required (as here).

The question also remains why loyalty schemes are being targeted in this way. There is no evidence of any harm to consumers in such scenarios, as discussed in the context of earlier plans by the UK Treasury to propose self-regulation to ring-fence retail loyalty scheme funds (here and here).  It seems a case of mistaken identity with retail pre-payment schemes such as operated by Farepak and certain tour companies which don't appear to be caught anyway.  Similarly, there is no distinction made for 'limited network' schemes whose rules do not allow cash to be obtained by either redeeming the limited network value or seeking a refund for a purchase made using that value.

[First published 23.10.14, and since updated to reflect the change to the notification threshold; again to reflect the removal of 'unlimited' in a late draft of PSD2; and again to include the date when PSD2 takes effect in national law]

Monday, 20 October 2014

Developing EU Policy On #Crowdfunding

I've finally had a chance to catch up with the minutes of the initial meeting of the EC's "European Crowdfunding Stakeholders Forum" (ECSF) in late September. Clearly these are still early days and the Commission is rightly (and rather atypically!) waiting to see how the various types of crowdfunding develop at national level, rather than rushing to regulate.

Unfortunately, it seems there was no time to take account of the UK regulations on P2P lending and crowd-investment, which took effect on 1 April 2014. These are cited in either the European Banking Authority's submission to last December's EU crowdfunding consultation, or the AK Wien high level review of various platforms.

That's a pity, since the UK regulation addresses all the various issues raised in those reports relation to peer-to-peer lending and crowd-investment.

It's interesting that the AK Wien report calls for rewards/donation-based crowdfunding to be regulated like in similar fashion, the UK declined to include that activity - and even the US has excluded donation-based funding from the otherwise all-embracing US securities framework. Perhaps AK's concern is that Europeans won't even start rewards/donation platforms without explicit permission to do so. That would be consistent with the civil law expectation that governments should specify which activities are lawful, rather than the common law view that the law should follow commerce where necessary to resolve issues that arise. But, unfortunately, that's no way to foster the growth of a nascent industry, as the Commission has recognised in its subtle approach to this area so far.

It's encouraging, however, that both the Commission and the ECSF seem to be taking a holistic approach to crowdfunding generally. That also reflects the Commission's approach to regulating payment services, on which the UK industries' self regulatory approach to crowdfunding has been based. At least that may produce a more unified set of rules, rather than the FCA's multiple rule books governing the same operational risks at the platform level. Perhaps a more unified approach will emerge from the FCA's review of the effectiveness of its rules in 2016.

In the meantime, the ECSF should also consider whether there are any tax incentives for personal investors that may be impacting the growth of alternative financial services. Again, the UK policy work in this area should be instructive, as discussed in the Treasury's consultation on proposals for including P2P loans in Individual Savings Account 'wrappers'.


Saturday, 18 October 2014

Now Damages for Searches Revealing Good Memories About Bad Memories

A hat-tip to Miquel Peguera of Stanford for his analysis of a recent Spanish case in which Google Spain SL was ordered to pay compensation to one Sr Domingo for the 10 months it took to prevent access to certain information about him as ordered by the Spanish Data Protection Authority. The case arose from a claim for damages by Sr Domingo under the Spanish equivalent of section 13 of the UK's Data Protection Act 1998.
 
As in the recent Gonz├ílez case in the European Court, the 'bad' information being linked to had been published by law. In fact, in this case the material was a Royal Decree granting a pardon for a previous criminal conviction for violating health regulations. The problem appears to be that the pardon (naturally) referred to the conviction for which the pardon was granted.
 
I'm really struggling here, I must say. 
 
Is there no public interest in being able to locate Royal Decrees generally through search engines?
 
If it is somehow wrong to reveal the details of a pardon, why doesn't the State remove the details of both the previous criminal proceedings and the pardon, so that none of the details are available for search engines - or anyone else - to find?
 
If the pardon and previous conviction must remain a matter of public record, isn't the pardon actually good news?

Maybe the appeals court will make sense of all this. But I'm not holding my breath.

Friday, 17 October 2014

A Short History Of The P2P Marketplace Model in UK Finance

During a recent panel discussion at the annual conference of the Society for Computers and Law, I explained briefly how the online peer-to-peer marketplace, pioneered by eBay in the US, came to be applied in financial services in the UK. The slides are here, and below is a slightly longer written explanation. Note that the focus is on the history, rather than explaining the differences between various types of 'crowdfunding'.

eBay pioneered person-to-person sales of second-hand items in the US from 1995, proving the concept to be hugely attractive. The particular "'Aha!' moment" came when people actually paid for the item they'd agreed to buy, not to mention the delivery of the item.

In 1999, the team at X.com (later PayPal) expanded the eBay model into payments by enabling consumers to pay each other using a credit card. This was rapidly adopted by eBay users (to the point where eBay eventually had to buy PayPal as a defensive measure). Coincidentally, in the same year it became clear to the entrepreneurs who had created PlusLotto, an online lottery in aid of the Red Cross, that the payment part of their system, which enabled people to prepay funds in many different currencies to centralised bank accounts then log-in to their data accounts or 'wallets' to purchase lottery tickets with the balance, should be made available to other merchants. They started Earthport as a separate payments provider the same year, and I was among those asked to join the board of the new entity. The initial strategy was to roll-out the wallet offering directly to consumers and merchants. But in 2000 we raised £25m through a private placement - literally weeks before the DotCom bubble burst - to fund a switch in strategy. The plan was to leverage the marketing budgets of banks, telcos and major Internet portals to offer own-branded wallets to their customers. Of course, those plans ran into the headwind created by the tech slump. But I'm happy to report that Earthport remains alive and well.

Meanwhile, in 2003, a team at artistShare in the US adapted the P2P payments model to enable music fans to donate money to fund musicians and music projects. The reason for this donation-based model of 'crowdfunding' was the need to avoid US securities regulation, which is notoriously rigid and complex, and applies expensive registration requirements even to very simple loans. The battle to liberate that regime continues to this day (see below).

At any rate, late in 2003, a small group of executives left Egg, the internet bank (which also happened to be one of Earthport's early customers), to try to reinvent financial services. During their brainstorming process, Dave Nicholson, suggested 'eBay for money' and the idea took hold. Coincidentally, they approached me in the summer of 2004 to see if I could help avoid any US-style regulatory problems. By the time we launched Zopa, the P2P lending platform, in March 2005 we had moved away from the idea of eBay-style 'auctions' to a more automated marketplace for personal loans. Borrowers and lenders had told us they did not want to reveal too much about themselves to each other, but were happy to give Zopa enough information to guard against fraud, assess creditworthiness and match their bids and offers to produce loan contracts directly between them.
 
In 2010, the team at FundingCircle applied the P2P lending model to the small business lending market. They also enabled direct loans between each lender and business entity. But to provide security for the additional risk of lending larger amounts to businesses, they introduced a separate entity that would hold security over the assets of the borrower in trust for the lenders. That trustee entity could then enforce the security on the lenders' behalf if the borrower defaulted under the P2P loans. Since then, this model has also been introduced to the commercial property sector.

It was only a matter of  time before the P2P marketplace model penetrated the investment world. In 2011, Crowdcube launched the concept of enabling many individual investors to finance unlisted start-up companies in return for shares. And a team that included Bruce Davis, an ethnographer who had helped develop both Egg's and Zopa's marketing propositions, launched Abundance Generation to fund alternative energy projects by selling long term debentures to retail investors who could use the returns to pay their own energy bills.
 
The same year, the Peer-to-Peer Finance Association was launched to call for proportionate regulation of the peer-to-peer lending sector.
 
Since 2011 many different types of P2P lending, crowdfunding and crowd-investment platforms have launched. Approximately 30 platforms signed a letter to EU and UK policy makers at a P2P finance policy summit held in London in December 2012, and many others have launched since.
 
In March 2014, the first FCA rules took effect which specifically regulate both peer-to-peer lending and crowd-investment. The EU has since convened a "European Crowdfunding Stakeholders Forum" to help determine whether there is scope for EU regulation to help develop the sector.
 
Clearly we are still witnessing the dawn of this trend. 
 
PS on the US:
 
While this post has focused on the UK, it is worth mentioning that we attempted to launch Zopa's P2P model in the US during 2006-07. However, it was clear from our own regulatory discussions, and the subsequent experience of Prosper.com, that the Securities Exchange Commission was determined to view simple loans as securities that require registration and intermediation using the same model that applies to more complex instruments. Zopa declined to launch that type of model, but it had to be deployed subsequently by Lending Club and Prosper (a similar version was also deployed by Prodigy Finance in the UK, due to the need to support international cross-border lending activity). Essentially, rather than agreeing loans directly with individual borrowers, investors buy bonds that are backed by loans made to those borrowers by a licensed lending entity. The lending entity sells the loans to the bond issuer, which distributes the loan repayments to the bondholders. While the JOBS Act was supposed to liberate crowdfunding in the US, the SEC has been less than enthusiastic in implementing it. Fortunately, UK regulators have been positively supportive and it's important to note that the SEC does not have any responsibility to promote innovation and competition, while the FCA clearly does