Crowdfunding - Some thoughts

Crowdfunding has morphed into many forms. Many crowdfunding initiatives have charitable or socio-political objectives. Such types of crowdfunding are not the focus here. It is the "investment-based crowdfunding" exercises that I wish to examine.

Malaysia is one of the jurisdictions that has established investment guidelines on crowdfunding. As such, the current swirls of discussion on the matter of crowdfunding is highly relevant.

On 21.12.2015 the International Organization of Securities Commissions (IOSCO) published a survey update on crowdfunding some key observations that I set out further down in this post.

Disclosure-Based Regulations (DBR) versus Merit-Based Regulations (MBR)

I have always maintained that Malaysia still needs a large degree of Merit-Based Regulations (MBR) largely due to the rustic mindset of many investors. The retail investor is still indolent and very susceptible to market noise. That is why Malaysia's regulators need to maintain guidelines and regulations that require regulatory scrutiny and some degree of regulatory prescription.

HKex has an excellent paper that critically examines DBR versus MBR and there is, therefore, no need for me to delve too much into it. Read the paper here if you are interested to understand these policy principles in greater detail. 

In the past decade we have witnessed the Securities Commission (SC) make attempts to institute the Disclosure-Based Regime (DBR). Officially, the SC has shifted from the MBR to the DBR as stated in a guidance note here.

But, with everything said and done, we have IOSCO reminding regulators and investors alike that while DBR still holds as the prevailing principle, I would submit that there is clearly a need for some degree of MBR-type prescription especially when the IOSCO has flagged the ever-present issue of "information asymmetry" which may be loosely defined as-

A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Sourced here.

IOSCO's timely survey findings on Crowdfunding
  

Here are excerpts of what IOSCO's report says-

The goal (of the report) is to achieve a balance between promoting crowdfunding and ensuring investor protection and market integrity.  Some of the regulatory measures described in the Crowdfunding Report include-

• Customizing entry, registration, or licensing requirements;
• Setting disclosure requirements for issuers and funding portals;
• Limiting the services  that may be provided  by  crowdfunding platforms;
• Requiring the appointment of a third party custodian to hold investor assets;
• Imposing measures to favour the channeling of resources into local businesses;
• Addressing crossborder issues.

The report also seeks to raise investors’ understanding of crowdfunding, e.g., that crowdfunding may differ from investing in more traditional securities products. In addition to take note of risks common in traditional finance such as conflicts of risks, data protection and fraud, it suggests that investors pay attention to certain key aspects, including:

•  Information asymmetry: Risk of default or high failures is often associated with start-up businesses. The risk of fraud may be high in case of internet offers. Investors should review disclosure and education materials to further their understanding of the essential features and main risks of the crowdfunding offer and see if third party custodians are being used.

• Platform failure: There is risk of platform failure for crowdfunding portals. Portals should be evaluated based on their credibility and soundness, including if it has the proper IT systems, back-up facilities and procedures to ensure continued service.

• Investing limits: Investors should consider if the investment amount is appropriate for their net worth.

• Rescission, cancellation: Investors should be informed of and understand the investment terms including cancellation or rescission rights.

• Illiquidity: As restrictions could be put on the resale of crowdfunding securities, investors should pay attention on warnings and information regarding liquidity and the availability of secondary market.

• Suitability: Investors should consider that a crowdfunding offer may not be suitable and consistent with their investment objectives and risk profile.