Crowdfunding in Europe is starting to emerge as an alternative to traditional financing, and the European crowdfunding market has developed increasingly since the early 2000s with documented, impressive growth rates since 2014.
However, the worldwide statistics for crowdfunding clearly show that the EU market for crowdfunding is still only a fraction of crowdfunding in China and the US. According to the European Commission, the reason why crowdfunding in the EU is underdeveloped can be attributed to a lack of common rules for crowdfunding the EU, as this makes it difficult for crowdfunding platforms to expand their services across borders because of increased operational and compliance costs.
As an attempt to address this issue, in March 2018 the European Commission presented a proposal for a regulation on crowdfunding service providers as part of its Fintech action plan. In this article, we will explain the regulatory context of crowdfunding in Europe and what investors should be aware of when investing on European P2P platforms.
Crowdfunding in a European Context
Crowdfunding is split between four main types of crowdfunding:
- Lending-based crowdfunding (peer-to-peer lending/crowdlending)
- Equity-based crowdfunding (also in some instances referred to as investment-based crowdfunding by the European Commission)
- Reward-based crowdfunding
- Donation-based crowdfunding
Crowdfunding is by many perceived to be mostly about donation and reward but looking at the numbers reveals that this is a very wrong assumption. The most recent data presented by the Cambridge Centre for Alternative Finance shows that crowdfunding in Europe is divided between 79.1% lending-based crowdfunding, 13.9% equity-based crowdfunding, 4.7% reward-based crowdfunding, and 1.6% donation-based crowdfunding.
Each category of crowdfunding can be split into subcategories that you can read more about here. The largest financing models in Europe are P2P consumer lending, invoice trading, p2p business lending, and real estate crowdfunding.
How are European P2P Platforms Regulated Today?
Regulation of crowdfunding in the EU is still primarily based on national legislation. Consequently, peer-to-peer platforms operating in Europe will need to comply with fragmented and conflicting regulatory regimes depending on the country of operation. At the same time, crowdfunding business models are constantly evolving and cover a wide range of operational structures the activities of platforms can also be subject to different pieces of EU legislation. Several countries in the EU have adopted bespoke regimes for P2P lending and equity-based crowdfunding, whereas others allow equity-based crowdfunding to be provided under the rules specified in the Markets in Financial Instruments Directive.
An overview of crowdfunding regulatory frameworks in a selection of EU Member States can be found in annex 4 of the impact assessment accompanying the legislative proposal for an EU framework on crowd and peer to peer finance.
Crowdfunding Models Affected by the European Commission Regulation Proposal
The regulation proposed by the Commission is aimed at crowdfunding services that provide a financial return for investors, which means that the crowdfunding types affected are lending-based crowdfunding (P2P lending/crowdlending) and investment-based crowdfunding (equity-based crowdfunding/crowdinvesting). However, it is worth noting that P2P consumer lending is not part of the proposal, as this lending type is already covered by other EU legislation (e.g. the Consumer Credit Directive or the Mortgage Credit Directive).
Donation-based crowdfunding and reward-based crowdfunding are not part of the regulation since they cannot be regarded as financial services. Also, crowdfunding campaigns above €1,000,000 over 12 months fall outside the scope of the proposal, as these are covered by the Prospectus Regulation and The Markets in Financial Instruments Directive (MiFID II) rules.
Main Objectives of the EU Regulative Framework on Crowd and P2P Finance
The two main objectives of the regulation proposal on crowdfunding are to:
- Enable European Crowdfunding platforms to scale up by making it easier for crowdfunding platforms to operate across the EU.
- Increase investors’ trust to engage in platforms operating across borders by increasing transparency and strengthening the integrity of platforms.
To fix the problem of crowdfunding platforms having to comply with different regulatory regimes based on national legislation, the Commission suggests an optional EU licensing regime, where platforms must deal with only one set of rules in both their home market and other Member States without further authorisation. As a result, both the pool of investors and fundraisers are increased, which allow the European P2P platforms to scale up and offer more opportunities for investors.
To increase the trust of investors and provide legal certainty as regards to the protection rules, a common investor protection regime and a simple template for disclosure of key characteristics of projects and financial products sold is part of the legislative proposal. If European crowdfunding becomes more transparent and trustworthy, this could engage more people and money in crowdfunding.
Implementation of the EU Regulation on Crowdfunding
The preferred solution by the Commission to implement regulation on crowdfunding in the EU works under the label of a European Crowdfunding Service Provider (ECSP), which is a voluntary standalone European crowdfunding regime. This means that P2P platforms would choose the ECSP when wanting to offer their services on across borders.
However, as an entity holding an ECSP license is not allowed to hold another license (a license for the provision of Payment Services is an exception), crowdfunding platforms will have to choose between a European licence (the ECSP) or a national license.
The ECSP would work through an authorisation system, where platforms can be authorised once and passport this authorisation across the European market. To achieve the authorisation a platform must live up to certain key requirements, like providing a Key Investment Information Sheet (KIIS), a standardised template with information about characteristics of the instruments being sold (e.g. a loan agreement or a share) and risk.
Other key requirements include rules dealing with governance and operations of P2P platforms, such as conflict of interest rules, no capital requirements, a communication channel between investor and fund seeker, rules on the protection of personal data, fit and properness requirements, light record keeping, and KYC (know your customer) due diligence.
The authority in charge of authorising and supervising crowdfunding platforms with an ECSP license will be the European Securities and Markets Authority (ESMA), whose three main objectives are investor protection, orderly markets, and financial stability.
The benefits and costs for investors according to the proposal are presented below:
Benefits for Investors:
- Greater transparency (direct) resulting in lower access costs
- Moderate protection against wrongdoing (direct)
- More risk diversification (direct) as a result of greater geographical reach
Costs for Investors:
- None (however, there has been criticism from investors – see the section below)
Benefits for P2P Platforms:
- Less regulatory uncertainty, which may also reduce compliance costs (direct)
- Significantly lower cross-border market entry costs (direct)
- Greater ability for platforms to adapt their business models over time (indirect)
Cost for P2P Platforms:
- Greater compliance costs, especially for domestic players (direct)
A more comprehensive description of the proposal can be found under section 4.5 (“A complementary service-based solution: a regime for `European Crowdfunding Service Providers’ (ECSPs; option 4) in the impact assessment of the legislative proposal for an EU framework on crowd peer to peer finance.
Investor Criticism of the Regulation Proposal on Crowdfunding
The main concern raised by investors/consumers is that the regulation on crowdfunding proposed by the European Commission is based on a voluntary license (the ECSP license described earlier). This concern is expressly raised by the European Consumer Organisation (BEUC), who in a publication from September 2018 characterises the “Proposal for a European Crowdfunding (ECSP) for Business” as a missed opportunity.
BEUC aims to represent European consumers and defend their interests at EU level by acting as an umbrella group for 45 independent national consumer organisations. They investigate how EU decisions and developments will affect consumers, with financial services as one of their five focus areas.
The BEUC welcomes the initiative to introduce regulation at the EU level, but fears that the regulation will primarily serve the interest of the crowdfunding platforms and function as a way for platforms to avoid the stricter investor protection requirements already in place in some EU countries.
Because it is optional for platforms if they want to hold the label of European Crowdfunding Service Provider (ECSP), a minimum standard for investor protection across the European Union will not be achieved. To protect the interest of investors and make sure the regulation proposal lives up to the aims specified above, the BEUC is, therefore, proposing a non-voluntary, binding regulative framework that must ensure that all crowdfunding platforms in the European Union are subject to the same harmonised minimum protections for investors. According to the BEUC, this will create a level playing field for crowdfunding platforms in Europe and at the same time fulfil the aim of improving scalability and across-country operations.
Furthermore, the BEUC pinpoints six areas where changes should be made to the European Commission regulation proposal on crowdfunding. These are described in brief terms below.
Disclosure of Overall Default Rate
To provide investors with an additional tool (besides the Key Investor Information Sheet (KIIS) described above) in their risk assessment, the BEUC wants to make it a requirement for crowdfunding platforms to disclose the default rates of the projects offered on their platform. This should happen on a regular basis and be placed on a prominent place on the webpage. Other effects of this proposal could be a reduction of ‘cherry-picking’ of the displayed information by the platforms and a stronger incitement to provide quality projects.
Mandatory Knowledge Test of Investors
The proposal on crowdfunding regulation by the European Commission contains a proposal of a knowledge test. According to the BEUC, this knowledge test should be made mandatory and investors should not be able to invest if they are assessed to have insufficient knowledge – not just receive a risk warning, which is the case under the current proposal.
Mandatory Maximum Investment Amounts
To reduce exposure to risky investments and to enhance diversification of investments, the BEUC calls for a maximum investment of €3,000 on each crowdfunding project. You can read more about diversification in P2P lending here.
Minimum Due Diligence Requirements
Due diligence is essential to secure investor protection. It should, therefore, be obligatory for crowdfunding platforms to conduct a minimum level of due diligence of the projects presented on their platforms. Steps proposed by the BEUC include thorough background checks on project owners, checks on the good standing of the company, and a reviewal of the business plans by an appropriate third party.
Protection Against Crowdfunding Platform Insolvency
Like with all other businesses there is a risk that crowdfunding platforms can go bankrupt. To make it possible for investors to assess the risk of platform insolvency, crowdfunding platforms should be required to draw up and publish their business continuity plans. Also, arrangements must be put in to place to ensure that investors will not lose their investment in the case of a platform bankruptcy.
Minimum Capital Requirements
To ensure sustainable growth of the crowdfunding sector and limit regulatory arbitrage, the BEUC suggests that crowdfunding platforms should comply with minimum capital requirements of €50,000 to apply for the ECSP label.
Why Investors Should Care About Regulation
With the nominal fall returns of traditional saving products, the yield offered by many crowdfunding platforms appears attractive to investors. Nevertheless, it is important to remember that p2p lending and crowdinvesting still have a long way to go before they become established financing models for businesses. As such, investing in crowdfunding also comes with substantial risks that can be hard to assess for investors.
Most businesses seeking finance through crowdfunding are start-ups or young companies. Investing in this type of businesses is particularly high and it will often be difficult for individual investors to perform the due diligence necessary to assess the risk involved in a specific project. An investigation about the business demography statistics in Europe carried out by Eurostat in 2017, for example, shows that the one-year survival rate for businesses in Europe is about 80%, whereas less than 50% are still in existence after 5 years. Roughly the same numbers apply for the US market. The information asymmetry between lenders and borrowers in p2p lending and crowdinvesting means that investors are often dependent on the business/project screening carried out by the platforms.
Regulation is part of the maturation of early-stage industry, and – if done right – regulation in crowdfunding can bring more transparency and security for investors.