Part 1: Alternative Finance Regulation: Biggest Hurdle or Opportunity? You Decide:

You already know that the alternative finance industry is booming.  This is true for all sectors, regardless of whether it’s peer to peer lending, peer to business lending, invoice financing, crowdfunding, or alternate forms of currency exchange and asset management models.  According to the Liberium AltFi Volume Index UK, the Peer to Peer lending market stands at £3.3 billion (exceeding 100% year on year growth) and Crowdfunding at £97 million (exceeding 300% year on year growth).  Nesta research predicts this market to grow to £4.4 billion in UK by year end 2015.

If you already operate an alternative finance business – Congratulations for getting in early!  If you are just getting into it, or haven’t started as yet, don’t despair, relative to the financial services industry, this segment is still in its infancy and has room for further growth and introduction of new players, new business models and more innovation.

This is a first in a series of four articles exploring alternative finance regulation.  We specifically focus on the regulatory gateway, or what the regulator, the Financial Conduct Authority’s (FCA), refer to as the “authorisation process”.    We discuss the different regulations that apply to the different types of alternative finance business and ways to prepare for a successful FCA authorisation.

Regulation – Boon or a Curse – you decide?

Generally speaking, no one likes regulation.   A PWC report last year, which showcased the views of 175 banking and capital market CEO’s across 54 countries, highlighted over regulation as one of the major risks facing this sector.  CEO’s interviewed, considered regulations as being a likely barrier to business growth.

For the alternative finance sector however, I would argue that the very same regulations may actually have contributed to its rapid growth.   Surprised?  Let me explain.

A closer look at the Liberium AltFi Volume Index UK, shows a marked turning point for both Peer to Peer lending and Crowdfunding volumes around the latter part of 2013.  This is particularly noticeable for the crowdfunding sector that only started to gain traction during this year.

This turning point coincides with the release of FCA’s first consultation paper on crowdfunding (collectively referring to both equity crowdfunding peer to peer lending) on 24th of October 2013?  The final regulations came into force in April 2014.

Government support and technological advances also played a key role in fuelling the rapid growth of this sector.

Financial services is built on trust and credibility.  The introduction of regulation, by a tough and intrusive regulator, may well have brought about greater levels of certainty, credibility and trust in this innovative sector, fuelling greater levels of investment by both individual and institutional investors, especially with the promise of higher returns.

Regulations may also bring other benefits such as:

  • Competitive advantage, as weaker players are weeded out, or lose market share because of non-compliance;
  • Improved systems and controls required by regulations, leading to greater operational efficiency and enhanced profitability;
  • Better treatment of customers imposed by the regulations, that enhance customer loyalty and improves overall customer experience; and
  • Increased company valuation (for an exit) because of well defined, documented and embedded processes vetted by the regulators, stronger governance and focus on risk management, and robust feedback loops through upward and outward regulatory reporting.

However, it is always going to be difficult to convince some people of the benefits regulations can bring.  I leave you to make the decision.  Remember however, that getting through the regulatory process is going to be time, resource and capital intensive.  In this case, shouldn’t you be seeking maximum return on your investment?

Deciding the Fate of an Alternative Finance Business

Whilst a benefit to the overall industry (or at least as we believe), regulation can also be the biggest risk.  They present a formidable barrier to entry or threaten continued operation, once firms get through the barrier.

They represent a barrier because the FCA require firm to get through a tough “gateway” (authorisation) to carry on regulated activities.    Failing to get through this gateway successfully will mean that new firms will have to abandon the hopes of starting regulated activities and existing firms operating under an interim permission, will be forced to close down regulated parts of their business.

Briefly, authorisation will require firms to prove to the FCA that they:

  • Have adequate financial and human resources to run their business;
  • Have robust systems and controls in place to identify and manage risks;
  • Put fair treatment of customers are the heart of their business;
  • Have strong governance arrangements, providing adequate checks and balances; and
  • Have fit and proper leaders in their business, striving to protect customers, manage risks, creating a compliant culture, and doing the right things.

The process is deliberately designed by the FCA to be a gruelling one, ensuring that only the strongest firms get through.  FCA will require a substantial set of evidentiary documents demonstrating compliant behaviours, systems and processes.  Key management will need to undergo a separate approval process and FCA may well decide to put them through a gruelling interview process.

Getting through the authorisation process is not like passing an exam, where you maintain your hard earned certificate forever.  Firms will have to comply on an ongoing basis or face regulatory censure, investigation, fines, customer redress, or closure through withdrawal of their authorisation.

Avoiding Alternative Finance Regulation

The regulations sound too burdensome for us, is there any way we can tap into this sector without being caught in the regulatory net?

The simple answer is YES.  Donation and reward based crowdfunding are not currently regulated, and some aspects of invoice financing are still outside the regulatory net if structured in the correct way (although this gap may close).

The regulatory framework also offer certain exemptions which have to be carefully worked through for the firm to stay outside of the regulatory framework.  This will require stringent processes and controls to ensure that the business activities do not inadvertently stray into the regulated sphere.

Remember, that the regulator can also retrospectively regulate activities that previously fell outside the net.  So pursue exempt models with this in mind.

Another way to avoid being directly regulated by the FCA is to become an appointed representative of a firm that is already authorised.  Under this arrangement, the Principal firm (the authorised firm) takes full responsibility for the regulated activities of the appointed representative.  In effect the FCA entrust the Principal to “regulate” the activities of the appointed representative.  The FCA view any regulatory breech by the appointed representative as a direct breech by the Principal.

Principals may well have more stringent requirement compared to the FCA, given the regulatory and reputational risk they expose themselves to.  The appointed representative may also find that their business is vastly restricted under the control of a Principal, pushing them towards their own direct FCA authorisation anyway.

If you decide to pursue the regulated route, then watch out for the next article in this series.  We take a closer look at specific regulations impacting the different types of alternative finance businesses and delve deeper into the requirements of the authorisation process.

This is  the first in a four part series of articles published by AltFi.  Link to this article here

Jay Tikam is the Managing Director of Vedanvi, a Risk and Regulatory Consultancy focusing exclusively on the alternative finance sector.  

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