After a series of loud bankruptcies in the P2P sector, including Lendy, Funding Secure and Wellesley, investors in Europe and elsewhere started to look for lending models and instruments which could protect their funds. The ring-fencing or fund segregation is one of such safeguards, now becoming an industry must-have globally. In the P2P lending context, a ring-fence or ring-fencing is the principle of segregating the investor funds from assets of the platforms. It serves the main purpose of creating a barrier against any claims to a platform itself for the protection of investor funds. Today, the UK and EU legislation requires all payment institutions that operate payment accounts to segregate non-used funds of their users. Although ring-fencing may sound simple in theory and boost investor confidence when declared by a lending platform, it may not always work as planned. To know if your funds are secure, it is necessary to understand ring-fencing and how it protects investors, how it is implemented on various platforms, and to check whether the platform of your choice stands up to its declarations.
Understanding Ring-Fencing and How It Protects Investors
The importance of ring-fencing can hardly be overestimated. In the absence of a virtual or a legal barrier separating platform assets from those of its users, the investor funds become combined with company assets immediately when they are deposited. When the platform faces any financial issues or bankruptcy, the unused portion of investor funds is immediately put at risk. If the investor funds are properly ring-fenced by creating a Special Purpose Vehicle (SPV), a trust or through depositing on escrow accounts in a third-party financial institution, the investor funds do not become a part of the platform's bankruptcy estate. The investors retain ownership of their funds and can draw on the unused portion in an escrow account. For this reason, knowing if and how exactly the platform properly segregates its users' funds from its own assets is crucial in evaluating the risks. This requires an understanding of the business model utilized by the platform and how exactly it implements ring-fencing.
Ring-Fence Implementation on Various Platforms
The exact schemes employed for ring-fencing for P2P lending differ depending on the business model employed by the platform. Meanwhile, all of these schemes are based on the principle of segregating investor's funds from those of the platform using a separate company known as a Special Purpose Vehicle, a trust, or an escrow account with a third party. The main difference in business models operated by P2P platforms lies in how they utilize funding. The primary two types of business models are the traditional lending model and the balance sheet lending model. Meanwhile, there are numerous other hybrid models, which utilize the principles of the mentioned two with various 'add-ons', for example, a guaranteed return to the lenders, credit risk analysis of the borrowers and other services.
Traditional P2P lending model
In this scenario, platforms act as brokers without collecting investor's funds, connecting lenders and borrowers. This type of P2P lending platform is commonplace in the UK, Europe and to some extent in other parts of the world. With the traditional P2P lending model, all investor funds are ring-fenced on escrow accounts in other financial institutions. The platforms often use banks for these purposes, which provides for even stronger protection of investor funds. The downside of this model is that the traditional platform doesn't back up individual loans. This means that the platform guarantees neither the principal nor interest on individual loans if the borrowers cannot repay the loan.
Balance sheet platforms
The balance sheet platforms receive the funding from investors and hold them on their balance before providing financing to borrowers. This model is often utilized by lending platforms in the United States, Canada, and Australia and applied in other countries, including the EU, UK, and China. The balance sheet platforms can invest in loans and, in some cases, back up the deals. At the same time, these platforms can pose a high risk for investors as the investor funds are mixed with platform funds and, in some cases, may fall short of providing effective ring-fence mechanisms.
How to Know if Your P2P Platform Ring-Fences Your Assets
While most jurisdictions, including the EU, UK, and the United States, include requirements demanding lending platforms ring-fence or segregate the investor funds from company funds, the bankruptcies of lending platforms and investor losses demonstrate that not all marketplace lenders were able to ensure compliance. Today, most platforms declare that they "segregate" or "ring-fence" investor funds from the platform's own assets. Still, all investors should do their own due diligence on platforms they use to ensure that their funds are indeed ring-fenced. In doing so, potential investors should always seek an answer to the question of whether all investor funds are stored in segregated bank accounts with no right to use them by the platform. Such obligations on behalf of the platform should be clearly outlined in the platform legal package, such as their Terms of Service or User Agreement, whitepaper, or other legal documentation accompanying platform offering.
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