Thursday, October 31, 2013

Sad Mad and Bad - or why the FCA is wrong in its crowdfunding proposals

I have said for a long time now that one of the greatest problems bedeviling crowdfunding is a lack of understanding, beyond the superficial, of the fundamental principles that underpin it, and that its greatest threat is in the fact that vested interests and institutions are some of the least informed around. The FCA proposals for the regulation of crowdfunding have unquestionably proved me entirely correct and whilst in some cases it can be nice to say “I told you so” I take no pleasure in that on this occasion.

There are many pieces I would take issue with in the consultation paper and I shall be participating in the response process - although I have limited hope that it will make a whole lot of difference. But, in the interests of brevity let me just point out a couple of the really truly idiotic aspects of their proposals, those being the notion of  gating equity crowdfunding to only “sophisticated investors” and promoting the mediation of “financial advisors.”

Why is the constraint of participation wrong? Well it’s wrong on a range of counts but for a starter it kills the supply of capital. One of the guiding principles of crowdfunding, in fact its greatest offer, is the democratisation of capital and that is delivered by allowing people to participate who have previously been excluded. By constraining participation you constrain capital flow. This flow must be maintained  otherwise crowdfunding does not bring additional capital into the marketplace and without that crowdfunding is not expanding the offer to businesses and addressing a need. A need, we should remind ourselves, that was greatly increased by the failure of the traditional “sophisticated” investment market to run itself very well.  In fact it did it so badly that it needed to be saved by significant contributions from the "unsophisticated".

At the same time lowering barriers to participation is a fundamental principle that underpins the transformational nature of the online world. It by passes gatekeepers, it embraces innvoation, it is a force for equality of opportunity, and it allows people to re imagine themselves into roles that have previously been denied to them. By applying constraints you curtail that transformation and reign in freedoms.

Secondly, what constitutes a sophisticated investor?  I had an interesting chat with a financier the other day who proudly described himself as a sophisticated. However he was one that clearly had no real understanding of crowdfunding and seemed unconcerned when I pointed out that Lehman Brothers were considered pretty sophisticated in the time before they took a multi billion dollar fall from their sophisticated heights.

One of the fundamental criteria used  to define oneself as a “sophisticated investor” is individual wealth and income. It makes no distinction as to how this wealth is acquired and, I have to say, based on my experience the holding of wealth has never been a good indicator of  either sophistication, intelligence or judgment. One outcome from the proposal would, of course, be to help ensure those with wealth have the best chance of retaining and increasing it.

A key idea behind crowdfunding is that, by opening up participation, it brings in a much more broadly based set of evaluation criteria and, importantly, a breadth of different motivations to invest. This means that the traditional investors with their existing lense, often aggressive expectation of return, short termism and limited motivations can continue to turn their gaze away from investments they do not consider suitable, and this is fine. But by stopping new participant from engaging it threatens to prevent those same opportunities from being considered by investors with a different set of criteria who may find something of value in the proposition and invest in an idea that would otherwise have stalled.

The availability of this alternative assessment model  is absolutely imperative at a time when banks - the major source of business investment in the UK - have systematically deskilled themselves in this area. I would, and have, argue this is to the extent that they are largely incapable of making suitable decisions at a local level now and frankly lack the level of local autonomy to change that arrangement in the short term anyway.

Of course making retail investments of the type offered through crowdfunding brings with it risks for the investor, but so do all investments. And it’s not as if the track record of our sophisticated investors is infallible.

To suggest that people are so dumb that they don't recognise the risk to their investment is patronising in the extreme. Amazing though it may seem to the FCA but to the best of my knowledge pretty much everyone in the local branch of betfred (other betting shops are available) seem to understand that their little flutter on the 3 o’clock at Aintree is not a sure thing and they don't ask for their bet back when their chosen nag comes in last. Of course drawing such an analogy to the attention of the FCA - as I have - tends to get the lame response of “we are not responsible for regulating the horseracing industry”. My response would be THANK GOD FOR THAT! They are not responsible for house purchasing either and it seems entirely possible to make the largest investment in most people's lives without the intervention of a regulated body - estate agents famously aren't of course - and to even own that asset without insurance.

My point is that I have greater faith in people to make the sensible choices than the regulators it seems but, more importantly, the introduction of alternative evaluation criteria is key to the crowdfunding model and by gating participation to only “the usual suspects” you are removing one of its most important characteristics. I also believe this is because the FCA don't recognise the value of, or understand, this concept.

Lets consider the second point of issue - easier participation for those who take financial advice. The lunatics really have taken over the asylum on this one. These would be the financial wizards that advised so many people take out the hopeless endowment mortgages, or advise on those those ISA or pension investments that have performed so catastrophically recently.To take our horse racing analogy a little further it  seems the message is better not invest more than 10% of ones net investible protfolio down the bookie mate - unless of course you happen to have a quick chat with Arthur Dayley first of course. I have no issue with people taking advice that wish to but to actively encourage it, no lets re phrase that, to actively favour those that do is barking.

The arrogance of their stance is that what they are tacitly saying is that you should not be allowed to lose your own money, you have to give it to a “sophisticated” fool to lose it on your behalf! If the financial crisis taught us anything it was that the financial emperor really did have no clothes.

The conspiracists amongst you might think they, the FCA, have been got at by lobby groups on the part of a financial industry bruised and threatened by a new upstart. For what is worth I love a good conspiracy but this one I don't buy. I hear lots of voices from traditional finance huffing and puffing but I don't believe they feel threatened, and nor should they. No, this is a case of a body given a task to which they are either unsuited, unwilling  or unable to apply themselves effectively.

For all the ideas around secondary markets (which I heartily endorse) and other froth to squarely challenge the most fundamental principle of crowdfunding - lowering the barrier to participate - is a case of the most monstrous vandalism of a growing asset and an appalling misjudgement.

It is deeply ironic that the uniqueness of the light touch approach that has allowed crowdfunding to thrive in the UK to now and establish this country as the leading exponent of the form is now being reigned in by group of dullards on little evidence of anything being wrong whilst at the same time other countries are clamoring to liberalise their rules in order to access a resource we already have. Sadly this would have us destined to coalesce in the middle and the parting on the left will simply become a parting on the right.

As a historian  by training I look at this as reminiscent of the journey of the great emancipation and reform acts of the 19th Century. The rigid resistance and arrogance of anti reformists then read, from todays relative freedoms, like the ravings of lunacy , and the FCA might one day go down with with unrepentant pomposity of a Viscount Sherbrooke declaring that  “we must educate our masters”. But be sure of this - we will mount the barricades, we shall overcome, and financial emancipation will come - one day!