How not to lose customers – designing appropriateness tests for P2P lenders
25 July 2019
Compliance for peer-to-peer lenders is getting harder. The FCA’s policy statement outlines new rules covering areas from governance to wind-down planning. These come into force on 9th December. For the most part they are designed to protect retail investors. But making investors jump through too many hoops could put them off altogether.
By understanding the detail of what the FCA is looking for and learning from tests used elsewhere in the industry you can design a process which will not frustrate investors. And the long term impact of investors who really understand your products should help meet the objectives of your business as well as the regulator.
The two areas P2P firms are expected to introduce are:
- An ‘appropriateness test’ to check investors’ knowledge and understanding of the P2P investment
- A ‘restricted investor’ cap which limits most retail customers to investing a maximum of 10% of their net investible assets.
What is an appropriateness test?
Appropriateness tests are used to check that retail consumers have the necessary knowledge and experience to invest in illiquid or complex investments, without first receiving professional advice. This is not a new concept in the retail investment arena. But, historically some firms have relied on flimsy tests that are not fit for purpose, for example in the contracts for difference (CFD) market.
With this in mind, the FCA has gone out of its way to provide detailed guidance to P2P platforms about the standards it expects from firms when they design their appropriateness tests. For example, a tick-box approach (‘I understand that my capital is at risk with a P2P agreement’) is not acceptable. The guidance also cautions against the use of questions with binary Yes/No answers. Instead, the FCA suggests firms should use a range of questions, in a multiple-choice format, designed to test the knowledge and understanding of prospective investors.
What knowledge and understanding should P2P platforms be testing?
The FCA has helpfully provided guidance about the things it expects P2P platforms to cover in their appropriateness tests. Less helpfully, the FCA’s list is so long that it is likely to be tricky for P2P platforms to cover everything on it without constructing an onerous process that might put clients off.
According to the FCA, the tests put together by P2P platforms should assess customers’ understanding of the following concepts and areas:
- Their contractual relationship with the platform and with the borrower
- Their exposure to the credit risk of the borrower
- All capital is at risk
- Investments on the platform are not covered by FSCS
- Returns may vary over time
- P2P lending is not similar to saving in a deposit account
- The characteristics of any risk mitigation measures such as: security, insurance or guarantees over the loans; risk diversification facilitated by the platform; or a contingency fund
- Any such risk mitigation measures can’t guarantee that investors won’t face losses
- If no risk mitigation measures have been adopted by the platform, the extent of any capital loss is likely to be more severe
- Lack of liquidity if the investor wants to exit the P2P agreement early, even if the platform operates a secondary market
- The scope of the platform’s role and services – what it does and doesn’t do on behalf of lenders
- The risk to the management and administration of the investor’s P2P agreements if the platform fails.
That’s at least 12 concepts that need to be covered by the appropriateness test: a significant amount of knowledge for prospective investors to absorb. So designing a test which tests these in the most concise way is key.
Designing an effective appropriateness test
Based on our experience designing appropriateness tests for different investment firms, there are five areas P2P platforms focus on:
- Educating investors
The material you use to educate prospective investors. Does the material cover everything the investor needs to know and understand to pass the test, in an accessible and concise format?
- Keep it short
How can you design the test so that it covers all the concepts in the FCA’s guidance using the smallest number of questions?
- Clear wording
Look at the wording of the questions and of the multiple-choice responses – are they clear and unambiguous? Putting together an effective multiple-choice test is not as easy as you might think.
- Set a pass mark
How do you decide whether prospective investors have passed the test? Do they need to get all the questions right? If not, what is an acceptable pass mark? Are there any ‘killer questions’ that they must answer correctly to pass?
- Dealing with failure
What happens if someone fails the test? Should you ask them to take it again before investing? Should you impose a minimum time delay before they re-take the test, so they have time to re-read the education material? How many times can they fail before you tell them they can’t invest with your platform?
Identifying ‘restricted investors’
As well as passing an appropriateness test, ordinary retail investors have another hoop to jump through before they can invest through a P2P platform. The investors, who have not been assessed as ‘high net worth’ or ‘sophisticated’ in line with FCA definitions, will need to sign a ‘restricted investor’ declaration committing them to invest no more than 10% of their net investible assets in P2P agreements within a 12-month period. Net investible assets don’t include the investor’s home, or money from any loan raised against it, nor assets held in a pension scheme or a qualifying insurance contract. Broadly speaking, that means that retail customers are limited to investing a maximum of 10% of their non-pension related savings and investments on P2P platforms each year.
Up till now, the FCA hasn’t issued any guidance on identifying and limiting restricted investors. For example, should firms do a ‘sense check’ to satisfy themselves that investors aren’t signing a declaration without understanding what it means, or considering whether they really qualify? On past form, it wouldn’t be surprising if the regulator issues guidance on this before too long. In the meantime, it would be wise to include this as part of the application. Prospective investors could be asked a couple of basic questions about the amount they plan to invest and their total net investible assets. If this is included in the testing process for new investors, platforms can’t be accused of just relying on clients casually signing a declaration.
Even if you already have your own appropriate tests, it makes sense to review it against what the FCA is looking for and make sure your tests are supporting, rather than undoing, your marketing efforts.