The in-crowd

Following the global financial crisis, businesses of all sizes have struggled to obtain funding. This continues to be a key concern for both lenders and borrowers with the banks unable or unwilling to lend sufficiently to meet demand.

The media has highlighted the opportunities and limitations evolving in this environment, as illustrated by programmes such as Channel 4’s Bank of Dave, building on our growing knowledge and understanding of this area.

It is well documented that in the current tight credit environment, borrowers are struggling to obtain funding at a reasonable price. At the same time, a period of prolonged low interest rates has caused a squeeze on margins for lenders. This has left a gap in the market, and in keeping with tradition, innovation has moved to fill the void.

Wealth management has seen a growing interest in crowdfunding, particularly in peer-to-peer lending. Crowdfunding is defined by the Financial Conduct Authority (FCA) as “a way businesses, organisation and individuals can raise money. Generally, it involves a number of people pooling money through a website, often called a platform.”

Within the crowdfunding arena, there are two models that will fall under FCA regulation: investment-based crowdfunding and loan-based crowdfunding (peer-to-peer lending), both being consumer credit products. Essentially, consumers lend money to companies in return for interest (peer-to-peer lending) or equity (investment based). In April, the FCA will take over the regulation from the Office of Fair Trading.

Cash alternative

Even before the change in regulation authority, both professional advisers and discretionary fund managers (DFM) reported an increased interest in peer-to-peer lending. Each are searching for ways to improve the services offered to their clients, either as a separate lending/borrowing service or potentially as an alternative to cash in an investment portfolio.

For DFMs, there is a growing debate whether peer-to-peer lending could be considered an alternative to cash as a portfolio management tool. Since the financial crisis, the concept of any asset class being risk free, even cash deposited at a bank, has been blown out of the water. Despite this, cash on deposit still offers some protection for the individual from the Financial Services Compensation Scheme (FSCS), which seems unlikely to be offered to peer-to-peer lenders.

Taking the above into account, the challenge for DFMs and advisers is to demonstrate that peer-to-peer lending would be suitable to offer either as a service or as an investment in a portfolio.

In preparation for April, the FCA is revising its rules on this, particularly in relation to platforms. This will certainly provide further checks and balances governing sector growth in mainstream wealth management.

In light of the interest in this sector, checks and balances are even more important given the risks involved, a significant one being considering if the credit/counterparty risk inherent in matching a lender to a borrower. If a borrower defaults on their payment, there appears to be limited recourse.

When challenged, early entrants to the crowdfunding sector have provided several different ways of assessing credit risk, and most have demonstrated low default rates. Under proposed rules, consumers will receive a document outlining key features of the loans and an assessment of the creditworthiness of borrowers. Platforms must be equipped with mechanisms to ensure that loan repayments continue in the event that a crowdfunding firm collapses. There will also be a 14-day cooling-off period.

Assessing suitability

When assessing suitability of this sector, most advisers and DFMs are likely to be analysing for a longer-term track record of low default rates, generated in different economic cycles. Until sufficient time has passed to perform this analysis, they are unlikely to consider peer-to-peer lending as a potential alternative to cash for investment portfolios.

The emergence of potential other services, such as portfolio lending and bridging finance, is likely to see this sector grow in interest, and could become mainstream in wealth management services in the longer term. n

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser

This article was published in the April 2014 issue