Wed. Jul 17th, 2019

Planet Compliance

Innovation & Regulation in Finance

Financial Innovation = Risky Business? First lessons from the LCF mini-bond scandal

6 min read

When the UK’s Financial Conduct Authority (FCA) published a statement before Christmas that announced that it had directed London Capital & Finance plc (LCF) to withdraw all of its existing marketing materials in relation to LCF’s Fixed Rate ISA or Bond, it marked the beginning of the end of the company and the hopes of investors to recoup their money back alike. It is also the beginning of a case that raises questions of the FCA’s supervisory practices as well as the general risk of financial innovation and a regulators response.

Are we back in the days where regulatory supervision didn’t deserve the name as it too often turned a blind eye or did not understand the risk that was building up right under the authorities’ noses? Certainly not. But it is a first stain on the FCA’s reputation as the leading regulator in FinTech questions thanks to its proactive and flexible approach. It also highlights the risks of financial innovation and the need for diligent supervision. This means that the authorities need to have a solid understanding of the latest trends in financial innovation. Considering that even in the best of times this is a constant cat and mouse game, you can’t help but feel a little bit sympathetic for the authorities and their staff who regularly are underpaid in comparison to their peers at private organisations. This in turn often leads to regulators taking jobs at financial institutions, which can on one hand create a knowledge shortage at the authorities whilst on the other one giving these private organisations a valuable lead in this race.

But back to the case of LCF and the case that raises these questions.

What happened?

Approximately 14,000 customers had fallen for what cannot be called other than a scam. LCF had issued mini-bonds, which it stated it used to make loans to corporate borrowers to provide capital for further investment. The success in the uptake of these mini-bonds was based on two aspects: first, that they promised an annual interest rate between 6.5% and 8.95% depending on the term of the fixed rate instruments and secondly, that they claimed to be ISA eligible. Or as the marketing material stated: “The interest on our innovative finance ISAs is tax free”. In the opinion of the FCA, these statements were misleading, not fair and not clear, in breach of FCA’s COBS rules since mini-bonds cannot be held in an ISA.

Just to explain, a mini-bond is an unlisted debt security and can be attractive to investors because of the interest rates on offer. Since it is usually issued by small businesses to raise funds that cannot tap more mature bond markets, it comes with significant risk since mini-bonds are usually illiquid as they are not transferable, unlike listed retail bonds, which they are often compared to. The FCA also explains that mini-bonds can also be high risk, as the failure rate of small businesses can be high, nor is there any Financial Services Compensation Scheme (FSCS) protection if the issuer fails.

The key problem here is though that the issuing of mini-bonds itself is not regulated (unlike the issuance of corporate bonds), but only the promotion of such instruments. LCF was a FCA authorised firm for other activities though and seemed to have used this as a kind of stamp of approval to further mislead investors into believing that the instruments carried less risk than they actually did. While the issuance of the mini-bonds was not subject to regulatory approval, LCF had to ensure that the materials were in line with FCA rules that the financial promotion is fair, clear and not misleading, i.e. that risks are appropriately communicated.

Following the first Supervisory Notice on 10 December, the FCA issued a second  on 17 January 2019. Subsequently, LCF went into administration and on18 March 2019, the Serious Fraud Office announced that they had commenced an investigationin to various individuals associated with LCF.

Two weeks ago then the FCA announcedthat it had taken a decision that there should be an investigation by an independent person into the issues raised by the failure of LCF to cover two questions:

– whether the existing regulatory system adequately protects retail purchasers of mini-bonds from unacceptable levels of harm;

– the FCA’s supervision of LC&F.

Reputational Risk of Financial Innovation

It is difficult to judge without having the full knowledge of the details of the affair and we are far from drawing any hasty conclusion or lay the blame on the FCA It is interesting to read though that the UK Crowdfunding Association has publicly blamed its supervisory authority for a lack of oversight. According to an article in the Times on Sunday  (subscription required), the trade body for 28 platforms that includes Crowdcube and Seedrs, has written to the FCA “to express alarm over the quality of supervision in the innovative finance sector”. Traditional financial advisors must be angry with the FCA for not acting earlier (as investors are) since it makes their job more difficult when they cannot promise similar (but unrealistic) returns. If the UK Crowdfunding Association decides to attack the regulator, it shows the threat to the alternative (i.e. innovative) finance sector. One of the biggest threats to financial innovation, for example, in the form of equity crowdfunding  or debt trading platforms is that they are perceived as too risky to touch. When retail investors are scared off by tales of scams and fraudsters, innovative solutions will find it difficult to prosper.

Therefore, regardless of its responsibility towards investors and market integrity, regulators also have an obligation towards those innovators that aim to change the financial system for the better.

 

 

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