Peer-to-peer lending has become an important part of the real estate landscape. How can it be regulated without stifling innovation?
Mark Wilding, Journalist
13 August 2018
In the wake of the global financial crisis, a new generation of lenders emerged. At a time when the flow of credit from the banks had slowed to a trickle, and rock-bottom interest rates were prompting investors to seek out new opportunities, “alternative finance” provided a solution. The term referred to a wide range of peer-to-peer lending and crowdfunding platforms. Borrowers struggling to access credit by traditional means could for the first time be connected with individual investors prepared to put their money where the banks would not.
From the outset, the real estate market was a significant beneficiary of this fast-growing industry. Research by the Cambridge Centre for Alternative Finance revealed that more than $5.5bn was lent in China against real estate assets through alternative finance platforms in 2015. That same year, a study by the University of Oxford found that almost £700m was invested in UK property through peer-to-peer and crowdfunding platforms, making real estate the country’s most popular alternative finance sector.
For many years, both countries have allowed an innovative source of real estate financing to flourish, unencumbered by the yoke of legislation. The UK has promised tighter rules in a bid to protect investors. In China last year the authorities announced a series of measures aimed at reining in the industry after a series of high-profile platform failures. Both governments have signalled a need for more stringent regulation, but at the same time neither wants to halt the growth of an increasingly important industry. The dilemma leaves regulators attempting to walk a tightrope – protecting consumers while encouraging financial innovation.
In Britain, the authorities have sought to play the role of a supportive, but critical, friend. The government has encouraged peer-to-peer lending, investing £85m in small businesses via the sector. However, regulators have, at times, been less positive. In February 2016, former Financial Services Authority chair Lord Adair Turner raised concerns about the checks being conducted on borrowers, telling the BBC: “The losses that will emerge from peer-to-peer lending over the next 10 years will make the bankers look like geniuses.” In December 2016, the Financial Conduct Authority (FCA) queried whether investors were being exposed to risks that “may not be sufficiently understood”.
China’s more laissez-faire approach was as much by accident as it was design, suggests Wei Hou, a senior analyst at AllianceBernstein in Hong Kong. “Regulators did not know who should be responsible,” he says. “Peer-to-peer lenders were classified as technology companies in China, so no one was regulating them.”
Alongside a ready supply of borrowers who had long been denied credit by the traditional banking sector, this lax regulatory environment allowed the industry to balloon in size. The Chinese alternative finance market now dwarfs all others in the Asia-Pacific region. Take Hong Kong, a centre of international finance which has nevertheless seen peer-to-peer lenders and crowdfunding platforms struggle to gain a foothold.
Leo Lo MRICS, director at Crowe Horwath, says both peer-to-peer lending and crowdfunding “are still governed by old sets of licences as both traditional banking and securities activities” in Hong Kong, a situation that has made “the growth and innovation of these sectors sluggish”.
But, if a lack of regulation has helped China’s alternative finance sector to grow, it has also had catastrophic consequences. In February 2016, the police arrested 21 executives at Ezubao, the country’s largest peer-to-peer lending platform, when evidence emerged that the company was in fact a giant Ponzi scheme. More than 900,000 investors, who had collectively committed more than £5bn based on promised returns of up to 14% a year, look likely to be left with nothing. And Ezubao was not the only one. In less than 10 years, close to 4,000 peer-to-peer and crowdfunding platforms had emerged in China as the alternative finance market ballooned. Most were legitimate businesses. However, Hou says: “Some of them were just pure fraud.”
Following the collapse of Ezubao, the Chinese authorities introduced a series of rules that were aimed at cleaning up the alternative finance sector. Peer-to-peer platforms are now required to use third-party banks as a custodian for customers’ funds. Caps have been placed on the amount that can be lent to a single customer and the number of platforms from which customers can borrow. “The intention is to protect customers,” says Hou. “It’s not to say that peer-to-peer is a bad business model. The general tone is that [the government wants the industry] to be complementary to the pure banking sector.” Hou believes this process will kickstart a process of consolidation.
Unlike China, the regulatory environment for alternative finance in Britain has evolved gradually. Originally overseen by the Office of Fair Trading, responsibility for the sector transferred to the FCA in April 2014. Firms already trading at that time were allowed to continue under interim permissions, pending full authorisation from the FCA. The move towards becoming a fully regulated industry seems to have had little impact on the sector’s growth prospects, as new lenders continue to enter the market.
Gillian Roche-Saunders, head of compliance at law firm BWB in London, believes FCA authorisation will help the sector to grow. “You’re seen as safer if you’re regulated by the FCA,” she says.
Property lending platform Landbay was one of the first to receive FCA authorisation, a process that took 15 months. CEO John Goodall agrees with Roche-Saunders’ view. “A lot of our partners are FCA regulated and I think they get comfort from that.” Likewise, authorisation could open avenues to a new source of clients. “To my knowledge, independent financial advisers have not looked at peer-to-peer in any serious depth,” he says. “Now that it has become an authorised product, it makes it a little easier.”
Despite some obvious benefits, there have been suggestions that the move towards greater regulation has disproportionately affected some of the more innovative platforms. While a handful of firms have received authorisation, many are still waiting. Roche-Saunders says: “The FCA wants a firm to stay still while it judges whether the business plan is stable. That’s quite difficult when everyone’s trying to grab the consumer’s imagination.” Among those still waiting, “a good chunk are the firms that have done more innovation”, she adds.
Some of the more innovative solutions have also found themselves the subject of FCA scrutiny. To date, investments made via peer-to-peer platforms have not been covered by the Financial Services Compensation Scheme, which protects customers of other financial services firms. The industry’s response was to create provision funds, where platforms set aside a portion of fees to compensate lenders in the event of borrower default. The FCA has raised concerns that these funds may “introduce risks to investors not adequately disclosed and not sufficiently understood”.
Despite this tension, at least some established peer-to-peer lenders are calling for regulatory measures to go further. The Peer-to-Peer Finance Association, a group of nine lenders that includes property-based platforms Landbay and LendInvest, believes more rules should be put in place to protect consumers. Goodall says: “We’ve always taken the view that people need to understand the risk, and be able to be compensated for that risk.”
The FCA indicated in early 2017 its intention to provide “adequate investor protection while allowing for innovation and growth in the market”. For some lenders, these changes will provide the industry with validation. But it seems likely that something might also be lost.
“I always think there is a cost to regulation,” says Roche-Saunders. “There’s no doubt you won’t be able to innovate and grow in an unfettered manner.”
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