"One important distinction of crowd bonds is that the FSCS investment protection scheme may apply but not FSCS deposit protection."
Many people still associate the term ‘crowdfunding’ with websites like Kickstarter or early-equity investments but in fact 88% of the market in 2015 was debt-based.
Last year P2P loans received a lot of attention following the launch of the new Innovative Finance ISA, which allows investors to earn tax-free interest. Research by agency 4thWay predicts a 50% growth in the P2P market in 2017 , partly due to the introduction of the IFISA.
But in November 2016 the new ISA was extended to include a type of investment-based crowdfunding: debt-based securities, also known as crowd bonds for short.
While the difference between a bond and a loan may seem to be one of semantics, there are some crucial differences in both regulation and investor protection which merit a closer look.
So just what are crowd bonds?
Crowd bonds are debt-based securities that are listed on an FCA authorised crowdfunding platform rather than a stock exchange. These platforms have always had to be authorised to arrange deals, but in 2014 firms running these platforms picked up two additional investor protections:
1. Investors must be categorised as HNWIs, sophisticated investors, or be advised. If not then their investment is capped at 10% of their net investable assets.
2. Investors have to pass an appropriateness test demonstrating they understand the risks involved.
Crowd bonds tend to be larger than loans – 11 x the average P2B loan size in 2015 - which should allow the platform to carry out more in-depth due diligence.
Crowd bonds are marketed via an offer document, which should include sufficient information for advisers to assess both risks and potential returns.
However, typically there are fewer crowd bonds available on a platform, increasing concentration risk, which makes it harder for investors to diversify. So, over time, advisers will have to create a portfolio of a range of bonds for their clients.
One important distinction of crowd bonds is that the FSCS investment protection scheme may apply but not FSCS deposit protection. There may be circumstances where crowd bond investors can claim up to £50,000 in compensation if a firm is unlikely or unable to meet its legal obligations (e.g. claims for fraud or misrepresentation). However, investors will not be able to claim under FSCS simply because a Bond fails to repay capital or pay interest.
So how does this differ from P2P?
In contrast, P2B and other forms of loan-based crowdfunding are not covered at all by FSCS. In fact, this area of activity is a new one for the FCA, and many P2P platforms, including the biggest three, have yet to become fully authorised.
Significantly, the investor protection requirements (10% cap on investment and the appropriateness test) do not apply.
Many of the platforms do their own credit checks; set the lender rates; and offer auto-lend functionality for lenders who really don’t want the hassle of choosing for themselves.
Provision funds (where a % of the loan book is set aside to help cover lender loses) are also unique to P2P/P2B platforms and may offer some lender protection in the case of isolated loan defaults.
Key questions for advisers:
The two forms of crowd lending have their own strengths and weaknesses, but the key questions for advisers considering this for their clients remain the same:
1. What rate is the borrower paying? This can be a much better indication of the risk profile than the interest rate offered to lenders.
2. How much due diligence has the platform done on a loan or bond? And is there sufficient disclosure for you to assess the platform itself.
3. How is the platform being paid? By lenders or by the borrower? Up front or on results?
4. Is the loan or bond secured? Does the platform hold security? Can the borrower take on new debt before they pay my clients back?
5. What happens if the loan or bond goes into default? What is the loan-to-value ratio of the investment? And are my clients first in the line to get paid?
With interest rates on deposits at an all time low, returns from crowd bonds and P2P loans are hard to ignore.
But platforms must do more to help advisers navigate the world of crowdfunding effectively, and fully understand how the different areas of our industry can fit with their clients’ wider portfolio, financial goals and appetite for risk.
