[Editor’s note: This is a guest post from Brian Korn, Neil Faden, Benjamin Brickner and June Kim of Manatt, Phelps & Phillips, LLP]
Taking a break after eight brisk years of regulatory and litigious turbulence, the world of fintech and marketplace lending in 2019 was notable for being more business as usual, or what some might call a “ho hum” year of upward growth.
Despite the moderation, 2019 saw growth in nearly all aspects of the fintech ecosystem, including:
Capital flowing to originators, especially payments and AI, but fewer start-ups emerging (big equity bets in Figure Technologies, Goldman Sachs’ investments in Even Financial and Climb Credit)
Retail access to bespoke debt investments and funds growing sharply, with lightning-fast subscription periods (YieldStreet, Cadence, PeerStreet, CrowdStreet, Sharestates, CNote, Fundrise)
Growth of securitization with greater rate and spread stability (15+ unique rated fintech issuers and many issuing $1 billion annually in nearly quarterly ABS transactions)
Established banks swallowing smaller fintech fish and digesting their tech or high-profile banks partnering with fintech (American Express, KeyBank, Goldman Sachs, Barclays, Silicon Valley Bank, Santander)
Credit and warehouse lenders opening the market for upstream origination capital (UpLift, SoFi, Idea Financial, Upgrade, Platinum Autos, CircleUp)
About the only facets of fintech that saw a cooling off were interest in blockchain and cryptocurrency, and the federal regulatory environment.¹
Here are a few key industry trends we observed in 2019 and areas worth watching as we enter 2020:
1. OCC special purpose fintech charter is open for applications, but no takers yet
After the Office of the Comptroller of the Currency (OCC) announced in July 2018 it would begin accepting applications for special-purpose national bank charters for fintech companies, litigation and the threat of further litigation by state regulators have scared away applicants. While the OCC does not publicly disclose applicants, we believe there are none. This belief is based on discussions with industry insiders and the covering press, our own feedback from several would-be charter holders, and the fact that after 18 months no charters have been granted.
Despite a companion OCC policy statement and a Department of the Treasury fact sheet that effectively endorsed marketplace lending and special-purpose fintech banks, the process has stalled. Fintech charters promise a national preemptive lending license that removes the risk of the prevailing bank partnership model and the compliance burden of state-by-state licensing. Several factors have contributed to the delay.
First, a lawsuit by the New York State Department of Financial Services (DFS) and other state regulators challenging the authority of the OCC¹ to grant the charter was dismissed for “ripeness,” since nobody had yet applied. As a result, the first applicant would likely ride shotgun on that lawsuit as a co-defendant and incur significant legal costs. States like New York fiercely contest that a bank charter can be granted to a company that does not accept deposits. The implication is that states believe they are more effective regulators than is the OCC since they are closer to the banking public. There are obvious political overtones to this argument and the intensity of the battle.
Second, the OCC announced that fintech-chartered banks would be subject to the same capital and compliance requirements as other banks. This makes the prospect of running the fintech bank quite expensive, especially if deposits are not part of the business model but nonetheless needed to meet capital requirements.²
Third, the ubiquity of the bank partnership model of loan origination has created a path of least resistance that is difficult for other models to compete with. The industry lawyers and investors have gotten comfortable with several “Madden workarounds,” and the threat of adverse litigation, while still present, is tempered somewhat with an industry track record of origination and repayment. What is called “prime” is actually prime and “subprime” is categorized as such and approached by investors accordingly.
With the promise of greater market access tempered by legal uncertainty, we expected to see a rush to be “second” in line for a fintech charter in 2019. Despite the risks, we believe the OCC stands on solid ground and expect its view ultimately will prevail. But we do not believe there is a long queue to apply for a fintech charter, as originators have nearly all pivoted to the bank partnership model.
2. Securitization (aka “asset-backed securitization” or ABS) has won the battle of secondary distribution
Large originators have made strides on compliance mechanisms in the origination process, aided by bank and warehouse line lenders that watch “eligible loan” criteria and concentration limits very closely. By the time an issuer is ready to sell in an ABS model with the required 5% risk retention by a sponsor, rating agencies are comfortable with the credit and the wide spreads between securitization bonds and underlying yields, often greater than 10% according to KBRA.³
Back in 2015, there was a real debate between which model of secondary distribution would prevail: ABS or a true loan-by-loan secondary market. ABS seemed a long shot due to the large transaction tranches needed to make the time and cost of tapping the capital markets economically viable. Secondary trading, on the other hand, can be structured more efficiently, giving portfolio managers instant liquidity on a small asset pool. No bankers and no lawyers. Just a broker-dealer and two traders, similar to the cryptocurrency trading sites.
Ultimately, ABS came to dominate, mainly because the secondary market was too unwieldy and loans were not sufficiently standardized. The Securities and Exchange Commission (SEC) was also wary of opening a loan exchange market that was not a regulated securities exchange, but the loans were too small and too short in duration to merit obtaining a CUSIP and making a market on a regulated exchange.
3. When will the recession arrive?
A critique of fintech and marketplace lending is that it has yet to experience a “down cycle.” It’s a fair point, given that the underlying economy is largely responsible for consumer and small-business repayment ability and behavior. In the first half of 2019, the consensus was that a recession was coming in 2020. By the end of 2019, those fears had abated as signs of economic resilience continued. The United States had historically low unemployment at 3.5% in November 2019, according to the Bureau of Labor Statistics, down from 10.0% in October 2010.
The consensus now is that a recession may come in late 2020 or beyond, light years away in the fintech world of short- and ultra-short-term maturity products. The 2020 U.S. presidential election will likely put pressure on the Trump administration to maintain economic growth going at least through this year. As such, we remain bullish for the next several months but ever vigilant for changing conditions. Keep a close watch on weaker credit categories that typically show the earliest signs of economic weakness.
4. Credit markets are open for upstream origination capital
The credit market for online lending is deeper and wider than ever before, with several platforms accessing these resources in 2019. Those that previously could not attract institutional funding until at least $100 million in originations now have their choice of facilities at earlier stages of growth. Banks are using platform facilities as early entrees to securitization relationships as they seek to develop footholds further upstream. We see the overlap between recent Structured Finance Industry Group ABS and LendIt conferences as evidence of this trend.
At the same time, U.S. consumers (and to some extent, small businesses and real estate industry members) have shown a willingness to borrow at rates higher than their actual default risk would normally dictate. This affords some platforms greater flexibility to access capital from different sources. Banks tend to lend at mid to high single-digit rates, and we have seen some platforms attract Libor+250 and +200 pricing, down from +450 and +600 one year earlier.
Advance rates are also creeping back over 90%, with less capital needing to be raised from mezzanine funding and equity in order to maximize a facility. Senior lenders are being more flexible about mezz financing closing advance rates, and the 100% no-money-down fintech financing model is no longer uncommon. Family offices, hedge funds and hard-money lenders are still providing facilities to earlier-stage platforms and those with riskier borrowers at rates around 11%—15%, plus 1%—3% warrant coverage. Committed facilities are also a higher percentage of the credit deals we see today, whereas prior years were dominated by forward flow and option loan purchase programs. In other words, if a platform originates within a predetermined definition of eligible loan, the facility gets funded.
5. State regulatory agencies continue to be aggressive; however, class action lawyers have been quiet
State financial agencies continue to wield the hammer in the fintech industry. Strict enforcement of states’ securities laws (often referred to as “blue-sky laws”) is a staple of any fintech legal department, as are frequent notices on failures to license, charging a lawful interest rate, calculating the rate correctly and making required disclosures. Federal consumer lending compliance—including with the Truth in Lending Act, the Fair Credit Reporting Act, and unfair, deceptive or abusive acts or practices—provides important structure to much of the compliance a platform must undertake.
The federal agencies regulating unlawful and unfair lending conduct have noticeably taken their foot off the gas in the past two years. At the same time (and perhaps also as a result), states have become more aggressive in enforcing conduct by members of the financial services industry.
True lender cases have since been decided, even on preliminary motions, that have had wide impact on online lending and the bank partnership model in the states or jurisdictions in which they are brought. The most prominent pending case, now entering its second year, was brought by the Colorado attorney general against Avant and Marlette, with a countersuit by WebBank and Cross River Bank, the two banks that originate loans from borrowers sourced by these platforms. The case is still pending, but we expect a final decision (assuming the parties do not settle) will have far-reaching effects on the industry.
There were a few surprise developments ? in 2019, including the filing of lawsuits against securitization trusts seeking to apply Madden to securitizations to prevent the servicing on loans and other assets purchased by the trusts, but that is proving a bridge too far for plaintiff lawyers and would threaten a multitrillion-dollar industry and the efficient flow of credit and capital in the United States.
6. Less attention to cryptocurrency and blockchain
We have seen decidedly less traffic around cryptocurrency and blockchain. The cryptocurrency market has been in a marked slump for the better part of 2019, nowhere near the skyrocketing volatility and valuations seen in 2017 and early 2018. The SEC’s conspicuous position that cryptocurrency is usually not a currency and often a security requiring registration or an exemption (and always requiring compliance and sales to known parties, not account numbers) deflated many industry promoters who perhaps saw a get-rich-quick scheme in the early days. And several people did get rich quick, while many others…
Decentralized ledger is anathema to investor protection at times. Hacking can be unabated, and keypunch errors and lost passwords can spell financial ruin and loss of client funds.4 Regulators, ever risk averse, have little tolerance for investors in anything resembling a regulated asset not being properly protected. Still, the street is filled with tales of woe.5
The SEC has established that tokens and other items of value that derive their value from the efforts of others and are purchased primarily for investment purposes are presumptively securities and therefore must be offered pursuant to effective registration statements or fit within an exemption. Moreover, one who hosts an online exchange of these instruments is required to be a registered broker-dealer, most likely with an “alternative trading system” designation. This burdensome process requires purchasers to be known to sellers and to hold their tokens for a prescribed holding period as set forth in SEC Rule 144 (one year for nonpublic securities).
The SEC has pursued enforcement cases against fraudsters in this space and in 2019 the SEC Staff granted two no-action letters for tokens that were determined not to have been purchased for investment intent, but rather had compelling non-investment uses: one for a private jet card good for travel on a private jet system6 and another for a gaming wallet that was good for use only on the games to which it related.7 In both cases, the companies offered unlimited tokens at a fixed price, thus eliminating the scarcity value a token offering might have. Many felt the facts of these cases made them easy letters for the Staff to write and did little to advance the status of widely available tokens (which typically change hands on unregistered exchange websites) as securities.
It remains to be seen how cryptocurrency will evolve as we enter 2020 and beyond. There is still a valueless downside scenario that scares a lot of investors (e.g., last person holding the bag loses). On the other hand, blockchain systems continue to be used for recordkeeping, especially where investor transparency and ledger access are desired. But whether we will see a wider use of blockchain is still an unknown, and skeptics call it a solution looking for a problem.
¹New York DFS Superintendent Maria T. Vullo stepped down in February 2019 and was succeeded by Linda A. Lacewell. Superintendent Lacewell was previously chief of staff and counselor to Governor Andrew Cuomo. We expect Superintendent Lacewell will stay the course against the OCC Fintech charter that began under Superintendent Vullo. As we noted last year, we believe there is a long queue to be the “second firm” to apply for a Fintech charter, as no prospective applicant is interested in becoming a named defendant in this suit.
² The ability to exclude deposits means that Fintech banks are not required to obtain deposit insurance from the Federal Deposit Insurance Corporation, which for better or worse has been a primary source of federal oversight for the Fintech industry through the examination of banking partners such as WebBank and Cross River Bank.
³ See, e.g., Kroll Bond Rating Agency, “Prosper Marketplace Issuance Trust, Series 2019-4” (Average underlying loan coupon of 14.32% vs. A, B and C Securitization tranches of 2.48%, 3.40% and 4.95%, respectively (subscription required).
4 See, https://www.independent.co.uk/life-style/gadgets-and-tech/news/bitcoin-value-james-howells-newport-landfill-hard-drive-campbell-simpson-laszlo-hanyecz-a8091371.html, and https://markets.businessinsider.com/currencies/news/crypto-ceo-died-with-passwords-to-137-million-but-the-money-is-gone-2019-3-1028009684.
6 Turnkey Jet, Inc. (avail. April 3, 2019).
7 Pocketful of Quarters, Inc. (avail. July 25, 2019).