After PPI, could crowdfunding be the next big investment scandal?

Financial Conduct Authority to investigate crowdfunding industry, as fears grow that investors' cash could be at risk

Following the crowd: more than £2.7bn was raised through crowdfunding in 2015 (James Moy Photography/PA Images)

The UK’s crowdfunding industry is one of the great success stories of the so-called FinTech (financial technology) sector. But while the launch of almost 100 internet-based crowdfunding platforms – each one bringing together people with money to lend or invest with consumers and businesses looking for funds – is a story of explosive growth, there has been increasing concern that a scandal could be brewing. Now the Financial Conduct Authority, the chief City regulator, is stepping in for the second time in two years.

The FCA formally began regulating crowdfunding in 2014. It set down one set of rules for loan-based crowdfunding, where investors lend money to consumers or businesses and then get their money back in monthly instalments over the period of the loan. Equity-based crowdfunding, where investors buy shares in businesses raising money in the hope that they’ll one day make handsome returns, was subjected to a different set of more exacting rules, on the grounds that it’s riskier, with no guarantees of any pay-out ever.

Two years on, Christopher Woolard, director of strategy and competition at the FCA, says that while the regulator doesn’t want to inhibit innovation, it is now keen to make sure the increasing numbers of ordinary savers and investors putting money into crowdfunding aren’t going to get caught out. Last year alone, the sector raised about £2.7bn, more than five times as much as in 2013.

“We want to explore concerns that have been expressed about developments in some aspects of the market,” says Mr Woolard. “We believe now is the right time to consider whether our requirements remain appropriate and that we have the right rules to support the development of this dynamic market by ensuring consumers are adequately protected.”

If you think that sounds like a diplomatic way of saying the regulator thinks crowdfunding could be an accident waiting to happen, you’re right. While the FCA always intended to revisit the regulation introduced in 2014, there’s little doubt the regulator has been spooked by a number of warning signs flashing up in different places across the sector.

One of those signs was a high-profile intervention from a former boss of the regulator itself. Earlier this year, Lord Adair Turner warned that many investors on loan-based crowdfunding platforms had little idea how much risk they were exposed to. He warned the sector could end up generating losses on a level that would “make the worst banker look like absolute lending geniuses”.

A major row at Lending Club, one of the largest crowdfunding platforms in the US, has also unnerved many people. Shares in that company collapsed after accounting irregularities came to light and the chief executive resigned. While the US crowdfunding sector is a very different beast to its UK equivalent, the problems of Lending Club have resonated here.

Nor has the bankruptcy of claims management company Rebus done much for confidence. It raised £800,000 last year via Crowdcube, one of the biggest equity-based crowdfunding platform – more than 100 investors now look set to lose their money.

At the same time, the FCA is also aware that Government backing for the sector has given it credibility and legitimacy with investors who probably would have steered clear in the early days. A range of generous tax reliefs is on offer to investors in crowdfunding. Loan-based crowdfunding is even now an eligible holding for your tax-free individual savings account (Isa) allowance, under the Innovative Finance Isas that became available in April.

So should investors be worried? Well, it’s worth noting that many in the crowdfunding sector profess themselves delighted at the FCA’s intervention – they think a tightening of the rules might alleviate some of the concerns that have been mounting up and threatening to undermine their platforms’ appeal.

For example, Kevin Caley, the founder of ThinCats, says: “The crowdfunding sector is relatively new so it’s important that people are given clear benchmarks and guidance from which to make financial decisions.” Rhydian Lewis, chief executive of RateSetter adds: “This review is a fantastic opportunity to look at the issues that really matter”.

It’s also important to underline the huge difference between loan-based crowdfunding – often known as peer-to-peer lending – and the equity-based variety. The longest established of the loan-based platforms, Zopa, now has a decade under its belt, with very low default rates in every year of its operation. Rivals such as Funding Circle, RateSetter and ThinCats report similarly low levels of defaults. By contrast, equity-based crowdfunding really is a shot in the dark – the platforms themselves, including Crowdcube and Seedrs, warn investors they are likely to see many losing bets.

Nevertheless, the very rapid growth in the crowdfunding sector does make it more likely that pockets of excess have developed, even amongst the loan-based platforms. Moreover, that growth has seen the business model in the sector change somewhat – with pooling of risk, for example, and institutional investments with the potential to create conflicts of interest or cross-subsidy.

At the least, investors should tread carefully, avoiding too much exposure to any one platform, or to crowdfunding as a proportion of all of their investments. All the more so because despite being regulated by the FCA, the sector is not covered by the Financial Services Compensation Scheme, which pays out to victims of scandals in other areas of the financial services industry. Lose money and you probably won’t get it back