FinTech

Peer-to-peer funding platforms and marketplace lending

Australia has seen substantial growth in active FinTech businesses in sectors such as lending (including peer-to-peer (P2P) and marketplace lending), personal and business finance and payment management. There is no strict definition for marketplace lending given the wide variety of entrants and financing techniques involved. The principal characteristics of new marketplace lenders, however, would include:

• operating from or through a non-bank lending platform established as a specialist corporate or special purpose vehicle (SPV) based structure;
• applying technology to leverage and optimize the lending platform and user experience; and
• connecting borrowers and lenders through the platform rather than applying funding arising from a wider deposit-based relationship.

Marketplace lending is available to address most forms of traditional bank funding products. Recently products have included:

• virtual credit cards;
• consumer loans;
• student lending products;
• small and medium-sized enterprises (SME) lending; and
• residential property and commercial property mortgage lending.

It is likely that the volume of lending in these product areas as well as further and additional product areas will significantly increase over the coming years, as financing becomes more readily available to support the marketplace lending sector.

How are marketplace lending platforms funding themselves?

Marketplace lending includes P2P-type structures often operated through an electronic platform provider as well as crowdfunding and also direct-to-retail financing mechanisms. The increase in demand for credit through these marketplace platforms has also been appealing to larger pools of available capital, such as private equity and venture capital funds as well as institutional sponsors. Funding platforms will now often be backed by institutional finance in addition to, or increasingly rather than, individual investors on a traditional P2P basis.

Issues for start-up marketplace lenders

Following the initial incorporation and start-up funding for a new marketplace lending business, there will be a need to establish funding lines which can accommodate growth of the ongoing lending activities of the platform. As the start-up lender will not have an established track record, deposit base or asset pools, the funding structure will often follow the format of a warehouse securitization structure. Origination of new assets will be funded through drawings on a note issuance facility backed by security over the new assets. Each of the new assets will be subject to eligibility criteria determined by reference to the nature of the underlying asset. In order to provide an efficient financing structure, the assets will typically be held through an SPV with origination and servicing provided by the marketplace lender. In order to cover expected losses on the asset pool, the senior facility will be subject to the lending platform maintaining sufficient subordinated capital in the form of equity, or a combination of equity and subordinated debt.

Blockchain, smart contracts and cryptocurrencies

What is blockchain?

Blockchain provides a new approach to holding and authenticating data. It is a database operating through distributed ledger technology in which data is recorded on computers, by way of a P2P mechanism, based on pre-agreed consensus algorithms in the applicable participating network. It is a form of database where data is stored in the chain in either fixed structures called 'blocks' or algorithm functions called 'hashes'.

Each block includes unique features such as its unique block reference number, the time the block was created and a link back to the previous block. Each block is reviewed by a number of nodes and the block is only added to the database if the node reaches consensus that the block only contains valid transactions. Content includes digital assets and instructions which reflect the transactions and parties to those transactions. The ability to track previous blocks in the chain makes it possible to identify transactions back to the first ever transaction completed, enabling parties to verify and establish the authenticity of the assets in the latest block. This makes blockchain exceptionally accurate and secure.

Specialist users on the system apply advanced computing software to identify time stamped blocks, verify the accuracy of the block using sophisticated algorithms and add the verified block to the chain. As the number of participants increases, the replication of the data over a wider base makes it harder for any person to alter the data in the chain. Any attempted addition or modification to the information on a block needs to be approved by all users in the network and verification of any block can only happen through a 'proof of work' process.

As a result, the data is identified and authenticated in near real-time, providing a permanent and incorruptible database sufficiently robust to operate as a store of value (e.g. in the case of cryptocurrencies such as bitcoin) or providing an indisputable record for example relating to securities transfer.

Blockchain is a decentralized system, created and maintained by users of the network rather than being dependent on any central or third party intermediary. It may be public and open ('permissionless' or 'unpermissioned') or structured within a private group ('permissioned').

Permissionless blockchains include bitcoin and ethereum, in which anyone can set up a node that once authorized, can validate, observe and submit transactions. The identities of the participants are not known (other than the unique and random identities known as an 'address'). Permissioned ledgers restrict participation in the network and only the specific participants are given access and are known within the network. The network is private, and only organizations that have been authorized can participate and view transactions.

What are smart contracts and Decentralized Autonomous Organizations (DAOs)?

Developments in blockchain are also providing an ability to transfer and rely on instructions verified within the electronic system in the form of so called 'smart contracts'. These contracts have been converted into code and are then executed and enforced by the blockchain network on the occurrence of an event. This reduces the need for intermediaries to collect, store and act on communicated information.

Smart contracts are essentially pre-written computer codes which are stored and replicated on distributed ledger platforms such as blockchain. Execution takes place over the network, eliminating the need for intermediary parties to confirm the transaction, leading to self-executing contractual provisions. These contracts can be as simple as moving a balance from one account to another or advanced, more-complex interactions with the outside world using so called 'Oracles'. With Oracles, the contract code consults with a service outside of the blockchain network to make a decision. This may entail receiving a confirmation that an event has occurred, such as payment, which automatically executes a further step in the contract, such as the transfer of an asset, which might be in digital form or by delivering instructions to a person or warehouse to release the asset for delivery.

DAOs are essentially online, digital entities that operate through the implementation of pre-coded rules. These entities often need minimal to zero input into their operation and they are used to execute smart contracts, recording activity on the blockchain. DAOs can be particularly challenging to regulate depending on: their software engine, the nature of transactions they are completing or other unique features. Questions of ownership and responsibility for resulting acts of DAOs can also be brought to question if any technical issues arise with their operation.

What is a cryptocurrency?

The European Central Bank definition of a cryptocurrency is that it is a digital representation of value that is neither issued by a central bank or public authority nor necessarily attached to a fiat currency, but is issued by natural or legal persons as a means of exchange and can be transferred, shared or traded economically. The oldest and best-known cryptocurrency is bitcoin (itself based on the bitcoin platform) although many other cryptocurrencies now exist. For example, the most widely-known alternatives to bitcoin include ether based on the ethereum platform and litecoin (these cryptocurrencies are now actively traded with a large developing infrastructure for holding, pricing and exchanging currency).

The ATO has published guidance setting out its views that trading cryptocurrencies are generally subject to Australia’s capital gains tax and the use of cryptocurrencies in businesses may give rise to Australian goods and services tax implications.

Initial coin offerings and token-based products

What is an Initial Coin Offering (ICO)?

ICOs are a form of digital currency or token using blockchain technology. ICOs are often a means by which funds are raised for a new blockchain or cryptocurrency venture (the market for ICOs is currently booming). ICOs come in a wide variety of forms and may be used for a wide range of purposes. Some forms of ICOs may be directed at customers or suppliers as a form of loyalty program or a form of access or purchasing power (preferential or otherwise) in respect of assets of the issuer’s business. Other forms may be more focused on raising initial funding. It is essential to examine the legal and regulatory basis for any ICO as an unauthorized offering of securities is illegal and may result in criminal sanctions in a number of jurisdictions. Legal analysis of the underlying token will determine if it should be treated as a specified investment or form of regulated security or is more appropriately a form of asset that is not itself subject to the regulatory regime.

Typical attributes provided by tokens will include:

• access to the assets or features of a particular project;
• the ability to earn rewards for various forms of participation on the platform; and
• prospective return on the investment.

Key aspects to consider will include the:

• availability and limitations on the total amount of the tokens;
• decision-making process in relation to the rules or ability to change the rules of the scheme;
• nature of the project to which the tokens relate;
• technical milestones applicable to the project;
• basis and security of underlying technology;
• amount of coin or token that is reserved or available to the issuer and its sponsors and the basis of existing rights;
• quality and experience of management; and
• compliance with law and all regulatory requirements.

The nature of the business and the purpose and structure of the token offering will typically be set out in a white paper available to potential purchasers.

Artificial intelligence and robo advisory systems

Automated financial advice tools, also known as 'robo advisors' are software tools driven by artificial intelligence (AI) that provide a variety of investment advice services, from portfolio selection to personal finance planning. The systems are generally operated on a platform/personal dashboard basis; a user can input a set of personalized data to be processed by the AI algorithms which produce optimized outcomes around specified parameters. Although generally of application in the asset management sector, AI and automated advice tools also impact in the banking and private wealth advisor sectors; the implications include decreased human involvement, although recent trends have included a growth in popularity of hybrid structures which combine AI and human inputs.

Data analysis and cloud computing

Cloud computing enables delivery of IT services through internet-based tools and applications, rather than direct connection to a physical server. Cloud-based storage makes it possible to save masses of data to remote servers, accessible through the internet rather than by way of a physical connection. With the vast data processing and storage capabilities offered by cloud computing technology and virtually no infrastructure barriers to entry, there are a number of applications in building and running FinTech businesses and the technology has had a significant impact in recent years.

General financial regulatory regime

ASIC is the financial services regulator in Australia.

General

To conduct a financial services business in Australia, businesses must hold an AFSL issued by the ASIC. Most FinTech services are captured in the definition of financial services and financial products in the Corporations Act 2001 (Cth) and unless an exemption applies, FinTech companies will require an AFSL. There are limited statutory exemptions available to foreign entities who conduct financial services in Australia.

Additionally, an Australian credit license (ACL) issued by ASIC is required for a business engaging in consumer credit activities in Australia which are captured in the National Consumer Credit Protection Act 2009 (Cth), unless an ASIC exemption applies.

National Innovation and Science Agenda

In December 2015, the Australian Government introduced the National Innovation and Science Agenda (NISA) to facilitate the development of FinTech. NISA, among other things:

• encourages investment in FinTech companies through tax incentives for early-stage investment;
• enables crowdsourced equity funding of public companies (described further below); and
• establishes the FinTech Advisory Group to advise the Treasurer and the ASIC Innovation Hub.

The ASIC Innovation Hub assists FinTech startup companies to navigate the Australian financial regulatory system by engaging with FinTech businesses and providing information to streamline the licensing process.

Electronic payments platforms and regulation of peer-to-peer lenders

Electronic payment platforms

The New Payments Platform (NPP) is an industry initiative to develop a new national infrastructure for fast, versatile, data-rich payments in Australia between financial institutions and their customers. The NPP will connect to all financial institutions and, as a result, to businesses and consumers, allowing funds to be accessible almost immediately upon receipt of a payment. 

Peer-to-peer lenders

Peer-to-peer lending involves a financial service provider (the lending platform) acting as the intermediary between investors and borrowers. Lending platforms are generally set up as managed investment schemes, meaning the platform operator must have an AFSL that allows them to run the scheme. Accordingly, these transactions will be caught by the Corporations Act 2001 (Cth) and must comply with the regulatory regime.

Where the borrower is an individual and not a business, the loan will be a consumer credit contract and the platform operator will be required to comply with the National Consumer Credit Protection Act 2009 (Cth), in addition to holding an AFSL.

Regulation of payment services

The Reserve Bank of Australia

RBA is responsible for the designation and regulation of systems facilitating the transfer of funds in Australia under the Payment Systems (Regulation) Act 1998 (Cth) and the Payment Systems and Netting Act 1998 (Cth). The RBA has established the Payment Systems Board to take responsibility for the payments system policy. The powers of the RBA include designating a payment system as being subject to regulation, imposing an access regime to establish rules of participation in a payment system and setting standards for payment systems to promote safety and efficiency.

To this end, the RBA has established a number of standards for compliance and access regimes applicable to participants in payment systems.

ePayments Code

Consumer electronic payment transactions in Australia are regulated by the ePayments Code, administered by ASIC. The ePayments Code applies to voluntary subscribers, including banks, credit unions and building societies.

The Code, among other things:

• requires subscribers to give consumers clear and unambiguous terms and conditions;
• stipulates how terms and conditions changes (such as fee increases), receipts and statements need to be made;
• sets out the rules for determining who pays for unauthorized transactions; and
• establishes a regime for recovering mistaken internet payments.

Application of data protection and consumer laws

The Privacy Act 1988 (Cth) regulates the use of personal data within Australia. Where a FinTech business provides credit or handles information relevant to credit, the Privacy Act will apply. The Australian Privacy Principles that are set out in the Privacy Act outline the obligations on the collection, use, disclosure and management of personal information. Where a business undertakes an act outside Australia and there is some link to an Australian citizen or organization, or where it carries out business in Australia, the Privacy Act will apply.

The Office of the Australian Information Commissioner (OAIC) is the body responsible for administering the Privacy Act and has the power to investigate non-compliance.

Money laundering regulations

The Anti-money Laundering and Counter-terrorism Financing Act 2006 (Cth) establishes a regime to target and deter money laundering and terrorism financing in designated services. Where a FinTech company provides a designated financial service, such as lending or issuing or selling interests in managed investment schemes, they will become a reporting entity and have obligations under the Anti-money Laundering and Counter-terrorism Financing Act 2006 (Cth). These obligations include compliance reporting and conducting due diligence on customers prior to engaging in any financial services.

Licensing exemption for FinTech testing

ASIC has implemented a FinTech licensing exemption, to facilitate the testing of new FinTech services before requiring a business or start-up to obtain an AFSL or ACL. Based on the regulatory guide published by ASIC, allowing FinTech businesses to test their new products and services before they obtain a license can help alleviate the barriers to innovation (including access to capital and speed to market) by:

• allowing concepts to be validated and refined before businesses spend the time and money associated with obtaining a license; and
• providing increased opportunities for businesses to obtain investment that may assist with meeting the costs of complying with the law.

Three components are necessary in this regard:

• existing flexibility in the regulatory framework or exemptions provided by the law which means that a license is not required;
• tailored, individual licensing exemptions granted by the ASIC to a particular business to facilitate product or service testing (individual exemptions of this nature are similar to the regulatory sandbox frameworks established by financial services regulators in other jurisdictions); and
• ASIC’s ‘FinTech licensing exemption’ – provided under ASIC Corporations (Concept Validation Licensing Exemption) Instrument 2016/1175 and ASIC Credit (Concept Validation Licensing Exemption) Instrument 2016/1176, which apply to certain products or services (FinTech Exemption).

Under the FinTech exemption, a business may, without needing to hold an AFSL, give financial product advice in relation to (or deal in) the following products:

• listed or quoted Australian securities;
• debentures, stocks or bonds issued or proposed to be issued by the Australian Government;
• simple managed investment schemes;
• deposit products;
• some kinds of general insurance products; and
• payment products issued by Australian banks.

Initial Coin Offerings

The ASIC is due to release guidelines in relation to Initial Coin Offerings (ICOs) (which have not been released to date). It is expected that the ASIC will follow the lead of the US, Canada and Hong Kong regulators by including the fundraising method within the regulatory framework governing Initial Public Offerings. The ASIC is reportedly working with advocates in the startup community (including FinTech Australia), to develop guidelines although it is expected that the ASIC may take the view that many of the 'tokens' currently being issued through ICOs would fall within ASIC definitions of 'securities'.

Crowdfunding in Australia

Australia’s previous regulatory requirements generally created a barrier to widespread use of crowdsourced equity funding. However changes are underway to make it easier and less expensive for businesses, including start-ups, to raise equity from the general public up to A$5 million in any 12-month period, while ensuring adequate investor protection. However, the Australian Parliament has enacted the Corporations Amendment (Crowd-sourced Funding) Act 2017 (Cth), which will allow eligible Australian businesses (including start-ups) to access crowdsourced equity investments through a licensed online portal.

For companies to access the benefits of the new crowdsourced funding regime, providers of crowdsourced funding services must hold an AFSL issued by ASIC. ASIC accepts applications from potential crowdsourced funding intermediaries for AFSL authorizations to provide crowdfunding services.

The following general restrictions apply:

• Individuals seeking to invest using a crowdsourced funding platform can contribute up to AUD10,000 per year, per company.
• Crowdsourced funding will also be available to Australian public companies with turnover/gross assets less than AUD25 million.
• Proprietary companies will be subject to additional governance and reporting requirements (including the provision of annual financial reports to shareholders).

Early stage

Seed investment

Initial investment in FinTech businesses may be provided by family and friends of the founders and other high-net-worth individuals (often known as business angels) in return for an equity stake. Such seed investment is often used to fund the establishment and early growth of the business before larger investment is available. The investing individuals may also provide know-how and expertise to assist in the company's development. The seed investors would typically not require the same controls over the business as, for example, venture capital providers.

Crowdfunding

The crowdfunding sector is well established, and may be appropriate for a FinTech business in the early stages. It involves members of the public investing in a business by pooling their resources through an intermediary platform, such as Equitise and Pozible. Significant changes have recently been made in the Australian regulatory landscape to make crowdfunding more accessible. (For further information, please see FinTech products and uses – particular rules.)

There are two main types of crowdfunding: equity and reward-based.

• Equity crowdfunding involves company shares being given in exchange for investment in the business.
• Reward-based crowdfunding provides investors with a tangible benefit, such as early access to a platform or application that the business is developing.

Crowdfunding offers a large number of private investors an opportunity to make small-scale investments in early-stage businesses to which they may otherwise not have had access.

Accelerators

There are various incubators or accelerators in the Australia market which offer support, facilities and funding for startups, often in return for an equity stake.

Venture capital and debt

Venture capital (VC) funding is a type of equity investment usually targeted at early-stage FinTech companies with an established business and some trading history. VC provides a viable alternative to traditional lending, given that the business is unlikely to have the tangible asset base or long track record needed to attract traditional debt funding from financial institutions. Australian VC funds include Blackbird Ventures, Carthona Capital, Our Innovation Fund and Squarepeg Capital.

Corporate venture capital (CVC) is a type of VC and involves an equity investment by a corporate fund, examples of which includes Reinventure, NAB Ventures and Telstra Ventures. The benefit of having a CVC as an investor for a FinTech start-up is that the fund is able to share its knowledge and expertise of the FinTech sector with the company and act as an advisor.

An additional funding option is venture debt, which is typically structured as a three-year term loan (or series of loans), which is secured against a company's assets and includes an equity element (i.e. a warrant) allowing the debt provider to purchase shares in the company. However, venture debt providers will usually only invest into companies that have already received investment through VC. At the time of writing, venture debt is increasingly a source of funding in the Australian market with about 5 regular providers of venture debt locally. However, the venture debt industry is still nascent as compared to the United States.

Warehouse and platform funding

Warehouse financing may be suitable for FinTech companies which own a portfolio of assets. Funding is often provided by way of a loan from a small number of lenders to an SPV. The loan is secured on the assets acquired by the SPV from the originator. The lenders will only fund a portion of the assets, with the remainder being financed by way of subordinated lending from the originator.

One recent example of warehouse financing involves Zip Money Limited, a listed Australian non-bank consumer financier, which involved a two-year asset-backed securitization warehouse in relation to its consumer receivables loan book.

Senior bank debt and capital markets funding

Senior bank debt

Once a FinTech company is established and has a track record, bank debt becomes a more viable source of funding, either on a secured or unsecured basis depending on the creditworthiness and asset base of the business. In contrast to capital markets funding which is often covenant-lite, bank funding will generally involve the imposition of financial covenants and controls that will apply over the life of the facility. Bank finance may be particularly important for working capital, overdraft, accounts management and general liquidity purposes.

Capital markets funding

Australia has both debt and equity capital markets which are accessible to businesses (usually of a certain size).

Raising finance by way of an Initial Public Offering (IPO) is a popular funding arrangement for FinTech companies that have grown to a certain size. An IPO is the initial sale of company shares on a public exchange, such as the Australian Securities Exchange. 

Convertible bonds/loan notes

A popular funding tool for fast-growing FinTech businesses is to issue convertible bonds or loan notes which are essentially a hybrid between debt and equity. Convertible instruments begin as a loan accruing interest and are convertible into shares in the issuing company at prescribed prices in certain circumstances.

Initial Coin Offerings

An Initial Coin Offering (ICO) is an alternative to a share market IPO, crowdfunding or venture capital funding round for a startup with a blockchain-based platform or project. A startup looking to undertake an ICO will first produce a 'white paper' and then market itself to potential investors, much in the same way as a company undertaking an IPO.

ICOs are not common in Australia however there is a growing demand for this method of fundraising in Australia, particularly for startups with blockchain-based platforms that are looking to raise money fast.

In late 2017, Perth-based blockchain energy start-up Power Ledger become the first Australian company to undertake an ICO – raising AUD17 million in three days.

It is likely that, in most circumstances, Australian ICOs will involve the issue of securities and therefore fall under existing regulations for the offer of securities. This means ICOs will be subject to the same reporting obligations and regulations as an IPO.

Incentives and reliefs

Incentives for early stage innovation start ups

Incentives are available for startups (known as 'Early Stage Innovation Companies') which:

• are less than three years' old;
• have income less than AUD200,000 and expenses less than AUD1 million; and
• have businesses that are eligible (meaning that they have scalability, potential for growth and are undertaking research and development (R&D)).

Investments (less than 30% of the equity in an Early Stage Innovation Company) would generally qualify for a 20% non-refundable tax offset (capped at AUD200,000 per investor) and a ten-year exemption to capital gains tax.

Eligible venture capital limited partnerships

Investment funds investing into FinTech growth companies may be structured as venture capital limited partnerships (VCLPs) or early stage venture capital limited partnerships (ESVCLPs) to receive favorable tax treatment for the funds limited partners and with regard to carried interest payable to the funds general partner. For VCLPs, benefits include tax exemptions for foreign investors (eligible foreign limited partners) from capital gains tax on their share of any profits made by the partnership. For ESVCLPs, an income tax exemption applies to both resident and non-resident investors, plus a 10% non-refundable tax offset is available for new capital invested.

FinTech incentives

The R&D Tax Incentive program is available for entities incurring eligible expenditure on R&D activities, including certain software R&D activities commonly conducted by FinTech/tech-growth companies. Claimants under the R&D Tax Incentive may be eligible for:

• small businesses (< AUD20 million aggregated turnover) – 43.5% refundable tax offset of the first AUD100 million of eligible R&D expenditure; and
• other businesses – a 38.5% non-refundable tax offset.

Generally, eligible R&D activities include experimental activities whose outcome cannot be known in advance and are undertaken for the purposes of acquiring new knowledge (known as 'core R&D activities'), and supporting activities directly related to core R&D activities (known as 'supporting R&D activities').