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Peer-to-peer lending was always meant to shake up the traditional banking world. But investors using the UK’s biggest platforms remain frustrated that they still cannot hold their investments within a tax-free Isa wrapper.
Last April, legislation was enacted to create the Innovative Finance Isa. But regulatory approval has yet to be granted to the four largest platforms — and there are no guarantees this will arrive before the start of this year’s Isa season. So what are regulators concerned about?
In its original form, peer-to-peer lending was simply a way to connect borrowers with lenders through a website. Funding Circle, the largest UK lender, says it wants to “revolutionise the outdated banking system”, aiming to cut banks out from the lending equation.
Investors willing to lend through one of the four largest websites — Zopa, Funding Circle, RateSetter or MarketInvoice — can expect returns of more than 5 per cent a year, according to figures compiled by Liberum, the investment bank, and data provider AltFi Data. This will vary according to how much you are lending, and for how long — but looks very attractive compared to traditional savings products. However, your capital is at risk if the borrower defaults and cash balances are not protected by the Financial Services Compensation Scheme.
Zopa, the earliest player, was launched in 2005, but peer-to-peer lending really took off in the aftermath of the financial crisis, when banks became averse to lending and investors were getting tiny returns on more traditional forms of saving and investing.
Peer-to-peer has come a long way since. Various new entrants have pioneered a string of modifications to the basic model, including balance sheet lending (issuing loans from their own cash), “provision funds” (an insurance-like fund to compensate lenders for losses) and selling loans to hedge funds (which has been criticised as being unfair to retail investors).
The sector’s experiments have not gone unnoticed by the regulator, which said in a recent report that peer-to-peer lenders were “testing the boundaries” of what was allowed under the interim permissions from the Financial Conduct Authority (FCA) under which they currently operate. The watchdog said it feared there were “inadequate rules about risk and loan performance”, and pointed out that some lenders had deliberately misled investors about loan performance by hiding default rates.
Maturity transformation — the practice of allowing borrowing for longer time periods than money was originally lent for — has also come under fire. RateSetter, one of the three largest UK lenders, ceased doing this last January.
Andrew Bailey, FCA chief executive, last year compared peer-to-peer lending with failed bank Northern Rock and argued that earning fees without taking the risk of loans on to a balance sheet was like the securitisation of subprime loans before the financial crisis.
Lenders reject this, arguing that their incentives are aligned with investors as they only earn ongoing fees on performing loans. RateSetter says the company does not earn fees on underperforming loans as two-thirds of the fees are spread throughout the loans’ lifetime.
It is against this backdrop that the major lenders are battling through the FCA’s authorisation process for the Innovative Finance Isa.
Investors keen to put peer-to-peer loans into their Isa can still do so despite the absence of a product from the big lenders. According to the FCA, 22 smaller lenders have been granted authorisation and have, or will, apply to the tax authorities to launch Isas. However, obtaining FCA authorisation does not make this form of investing risk-free.
The watchdog declined to issue an updated list of the 22 companies. A year ago, just eight companies had been granted authorisation to launch an Isa. Seven of these were brand new to the peer-to-peer lending market — yet lenders with a much longer record and a history of being scrutinised by institutional investors remained unregulated.
One fund manager with a professional interest in the peer-to-peer lending market said it was “kind of bizarre” that smaller companies with a shorter record would be able to launch an Isa before more established companies.
“There’s an unintended consequence from the FCA’s behaviour in that it’s incentivising the retail investor to take more risk than they otherwise would because they’re getting a tax break for going for these unproven [lenders],” said the fund manager.
The FCA, meanwhile, said the timing and complexity of the application were factors affecting how long authorisation would take.
According to those in the industry, one of the issues the watchdog is investigating is whether peer-to-peer lenders are effectively acting like banks but with less regulation. One lender said that giving the nod to peer-to-peer lenders at this point would set a precedent for what was acceptable and what was not. “They’re drawing the line quite carefully between what is alternative finance and what is banking,” he said.
In the meantime, investors can use the Innovative Finance Isa wrapper to invest in “crowd bonds”, which are asset-backed bonds. Unlike peer-to-peer loans, investors will be backing one business rather multiple consumer or small business borrowers.
Bonds have so far been issued by care homes, hydroelectric power stations, solar farms, wind farms and pubs. The bonds usually offer fixed returns of between 4 to 7 per cent. Existing bonds have been issued in a range of maturities, between 5 and 19 years.
There are some crucial differences between “crowd bonds” and mini-bonds, several of which have collapsed, leaving investors battling the regulator. While investors in mini-bonds are usually at the mercy of unregulated companies, those in crowd bonds are normally considered a customer of the crowdfunder by the regulator. Although a technicality, this small difference means investors can report the crowdfunder to the financial ombudsman if they have been negligent in carrying out due diligence on the bonds.
Investors will have to judge individual companies on their balance sheet strength, so this form of Isa investment is not for everybody.