Monday, June 9, 2014

Financial innovation or threat to the financial system? - The IOSCO introduces to crowd funding

Crowd funding means a large number of investors spends small amounts of money to fund projects through web-based platforms.

By focusing on a fraction of the [bank] services, we can provide those services, and those services alone, cheaper.
Giles Andrews – Zopa – February 14, 2013

What is commercial crowd funding?

Commercial crowd funding (also called financial return crowd-funding or FR crowd-funding) can take two forms, peer-to-peer lending and equity crowd funding.

Peer-to-peer lending

Peer-to-peer lending is like traditional lending. Simply, people use on-line platforms to match lenders’ and borrowers’ demands.

Peer-to-peer lending platforms can follow two business models. In the client segregated account model, one individual lends directly to the other. The platform is simply a service, helping collect loan payments. In the notary model, a bank lends to the borrower. The peer-to-peer platform then refinances the loan by issuing notes which individual peer-to-peer lenders buy through the platform.

Equity crowd-funding

Today, there are only very few equity crowd-funding platforms, with the majority focusing on angel investors or sophisticated investors.

When you are involved in the on-line finance business, there is a pressure to grow very quickly.
Anil Stocker – Market Invoice – February 14, 2013

Commercial crowd funding market

Today’s total global market size is 6.4 BUSD. Since its beginning in 2006 in the U.K., the market grows very fast. This is mainly due to technological innovation and the inability of traditional credit providers to lend, in the aftermath of the financial crisis, to the real economy. However, despite strong growth, the commercial crowd funding market is still small, as compared to total bank-originated credit. For example, peer-to-peer lending only represents 0.01 % of the total bank lending market in 2013.

Most platforms act locally, in individual jurisdictions.

Pros and cons

Commercial crowd funding has five advantages:

  • It spreads risk.
  • It lowers the cost of capital for borrowers and increases returns for investors.
  • It contributes to economic recovery by financing small and medium enterprises.
  • It creates a new assets class, allowing investors to diversify.
  • As it is entirely internet-based, it is cost efficient.

The banks have this philosophy that for every service there should be a charge. And the charge has got nothing to do with the cost to doing this particular service.
Michael Joseph – Vodaphone – February 14, 2014

On the other hand, commercial crowd funding entails seven major risks:

  • Risk of borrower’s default: As such, this is nothing special, a borrower can always default. However, if you lend through a crowd funding web site, you don't have necessarily all appropriate information to invest. Available statistical data can be biased towards big platforms and, if carried out by the platform, the financial analysis of the borrower might not be critically worked through.
  • Risk of platform closure: If the platform is the only link between lender and borrower, this can directly lead to default, simply because contracts and payment systems disappear.
  • Risk of illiquidity: Today, there is no secondary market for crowd funding instruments, meaning that investors cannot sell their participations.
  • Risk of cyber-attack: If FR-crowd funding markets are on-line, this risk is obvious.
  • Risk of fraud: Identity theft, money laundering, and data protection violations are common problem in any lending business. However, as the Internet is particularly anonymous, they are enhanced in commercial crowd funding.
  • Systemic risk: Today, the industry is not big enough to threaten the financial system. But this might change in the future...
  • Circumvention of banking regulation: In my view, this can be bad if investor protection is abandoned or conflicts of interest of the platform are not properly addressed. However, as lender and borrower are directly connected, I don't see any potential problem for the economy at large.

Should we regulate commercial crowd funding?

The spectrum of possible regulation ranges from no regulation at all (for example Brazil, United Kingdom, and South Korea) to complete prohibition (for example Israel and Japan).

We have spent the last three years lobbying for regulation which is ironic.
Giles Andrews – Zopa – February 14, 2013

In-between, you can treat peer-to-peer lending platforms either as brokers, as banks (for example France, Germany, and Italy), or as collective investment schemes.

The IOSCO report is a very good introduction to crowd and definitely worth reading.