After two years of consultation, the government recently announced its highly anticipated plans to strengthen the regulation of interest-free “buy-now-pay-later” (BNPL) credit agreements. BNPL agreements, such as those offered by Klarna and Afterpay, have been called “the future of millennial finance” for their rapid uptake in recent years. However, these agreements are mostly unregulated, provoking fears that their often more vulnerable consumer base needs greater protection to avoid financial detriment.
What are BNPL credit agreements?
BNPL agreements are point-of-sale loans, usually with an interest-free period of 14-30 days. They also come in the form of payments plans, which allow the total price to be divided up into ‘slices’ and repaid over several months. Although typically BNPL plans do not charge interest or fees, more providers are starting to and most already charge late fees. For example, only half of borrowers surveyed by the Consumer Financial Protection Bureau (CFPB; a US Government agency that regulates consumer protection in finance) stated their plan was completely free. Some providers like Clearpay have caps on their late fees at 25% of the purchase price, but for others these fees can quickly add up and cause unexpected financial strain.
Although there are many specific BNPL providers which offer their services online and in store through partnerships with retailers, some retailers like Next and Very offer their own schemes. BNPL can used for almost anything, from luxury items to groceries. Giving a BNPL option to the consumer has quickly become standard practice. In March 2023 Apple debuted ‘Apple Pay Later’, which will allow iPhone users to enter BNPL agreements through the Wallet function to pay for online goods and in-app services. This indicates BNPL agreements will become even more popular.
BNPL providers generate revenue by charging merchants a percentage or fixed fee on each sale, issuing the full cost of the purchase upfront to the retailer, while they collect repayments themselves. This means that BNPL providers take on the risk of default, whereas retailers are guaranteed to generate revenue from the sale. Retailers obligingly pay lenders a generous commission because BNPL makes customers spend more and more often, and attracts new customers.
During the pandemic, the sector nearly quadrupled and has continued to gain traction due to its wide appeal to cash-strapped consumers seeking interest-free ways to spread out their spending habits. This has been particularly beneficial to consumers during this period of rising living costs and lower disposable incomes as a result of inflation. There is a direct link here, with 36% of UK consumers reporting that BNPL has become more appealing since inflation and energy costs began to increase.
What are the issues with BNPL?
The government’s primary concern is that most BNPL products are not regulated by the Financial Conduct Authority (FCA) under consumer credit regulation because they are exempted by Article 60F(2) of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001. This order exempts any borrower-lender-supplier agreement for fixed sum credit where there are no more than 12 repayments, being made over no more than 12 months, and no interest or fees are charged.
The result is that consumers do not have the usual full range of borrower protections when taking out this loan, for example the protection of Section 75 of the Consumer Credit Act 1974 which requires credit card providers, who also provide debt financing, to safeguard purchases of £100 and more. This is worrying given the further concerns over lack of clarity in BNPL terms and conditions and misleading advertisements. However, consumers do still have some protection from unfair commercial practices thanks to the Consumer Rights Act 2015 and the Consumer Protection from Unfair Trading Regulations Act 2008. For example, BNPL providers will be bound by any written or oral statements they make to consumers, and their procedures, for example their complaint handling, can be reviewed.
There is a general perception that consumers are inadequately aware of the risks in BNPL loans, perhaps because of their novelty, ease of use, and younger consumer base compared to traditional lending. It may seem that BNPL is not dangerous, partly because most providers impose loan limits which are much lower than credit cards. For example, Clearpay’s limit is £1,500, although it can increase with a pattern of positive spending habits. However, a report from Australia found that one in six users believed they had experienced a negative impact from using BNPL services, including becoming overdrawn, missing bill payments, and having to borrow money from family. This is because BNPL encourages people to overspend on items they could not afford to pay for upfront. There is also concern that the risk of damage to credit rating if repayments are not made is not widely known or understood, especially because until recently most BNPL providers did not report to credit reference agencies.
In addition, there is an increased risk of getting into greater debt with BNPL agreements compared to conventional loans. This is because these services rely on minimal credit checks and are not required to give key information to borrowers, leading the Economic Secretary of HM Treasury to fear people may borrow more than they can afford to repay. When applying for traditional loans, borrowers are subject to a ‘hard’ credit check which is marked on your credit file for other lenders to see. BNPL typically uses ‘soft’ checks which are invisible, risking creating a knock-on effect that other lenders won’t realise the borrower is already in debt. As Matthew Upton, director of policy at Citizens Advice explains, ‘Buy Now Pay Later borrowing can be like quicksand - easy to slip into and very difficult to get out of.’
These concerns led the FCA to conclude in its 2021 Woolard Review that BNPL poses ‘significant potential for consumer harm’ and found that greater regulation was essential for consumer protection. Relying on this report, the government promised reform but has been very slow to act. The most recent consultation, which was published in February 2023, has provided draft legislation and a comprehensive plan to enact change. These proposals are expected to become law before the end of 2023, although there will be a two-year transition period.
What are the proposed changes?
The key change is that the Article 60F(2) exemption will be significantly narrowed. First, agreements which would fall within the exemption will be regulated where the lender and supplier are not the same person. This will bring most BNPL businesses under FCA regulation. Second, agreements where the lender purchases products from the supplier and resells them to the consumer on finance will be regulated. This will serve as an anti-avoidance measure to prevent the reduction of tax by legal arrangements.
Lenders now caught within regulation must comply with various regulatory requirements and consumer credit rules, including the upcoming Consumer Duty and financial promotions regime, which will introduce stronger rules to protect consumers from illegal, unfair, or misleading financial marketing. Additionally, lenders will need to be approved by the Financial Conduct Authority and borrowers will be able make complaints to the Financial Ombudsman Service. They will also be required to carry out affordability checks to ensure the loans offered are affordable for the consumer.
Some types of BNPL agreements will remain exempt. These include higher value business lending to sole traders, small partnerships, and unincorporated associations. The government has also been careful not to impact firms’ ability to offer invoicing and trade credit outside the scope of regulation. Loans financing contracts of insurance, for example spreading the cost of an annual premium over 12 months, and loans to employees will not be affected either. This is because these types of agreement have been judged to be low risk, or at least justified by the commercial utility of the agreement because regulation would adversely impact day-to-day business.
What will the impact of the changes be?
The greatest impact is that the FCA’s remit will be widened. This indicates the ‘direction of travel for consumer credit reforms more broadly’, according to financial regulation lawyers at Pinsent Masons. This suggests a move towards prioritising stronger consumer protection in a pragmatic way that still allows for competition and innovation in the market. It is anticipated that the FCA will be able to better protect more vulnerable consumers and monitor BNPL firms more closely, particularly regarding their financial promotions and fair treatment of consumers.
It is hoped that these reforms will have positive wider commercial impact by ‘fostering the safe growth of this innovative market in the UK’, according to the Chief Secretary to the Treasury, John Glen. The government has aimed to make proportionate changes which strike the right balance between innovation, creating a level playing field for all credit providers, and consumer protection. However, there are concerns that these reforms will significantly damage competition and stifle innovation in this sector, which may have the knock-on effect of negatively affecting consumer choice and outcomes.
Osbourne Clarke believes these changes will ‘signal the end of BNPL as we know it’. They predict that some currently exempt BNPL lenders may decide to either withdraw entirely from the market rather than face the increased operational burden and costs of FCA regulation, or to obtain FCA authorisation for lending but later realise it is not a cost-effective model to offer credit without interest and charges to customers. While this view is an informative warning, the government considered these risks in their consultation and judged that this potential commercial detriment is justified by the need to protect consumers.
The government believes millions of people in the UK will be protected due to the plans to strengthen the regulation of BNPL agreements. This move will aim to ensure BNPL loans are more affordable and that consumers will have a greater level of protection than currently exists. It is, however, likely that there will be some negative commercial impact of the move to regulation. However, it is difficult to justify the current unregulated status of BNPL agreements given their widespread use, particularly among more vulnerable consumer groups.