Have you ever lent a friend ten dollars? Congratulations, you’re a market disruptor! Or at least, you’re engaging in the same lending behaviour a new breed of FinTech companies known as Peer-to-Peer lenders facilitate – matching lenders like you with borrowers like your friend.
Peer-to-Peer (P2P) lending is a growing alternative to begging cap-in-hand for a loan from your local bank branch. P2P Platforms match investors to borrowers for a small fee.
Borrowers might seek loans from P2P Platforms to consolidate their personal debt, assist their existing business or for any other number of reasons.
It has seen some success in the US with one platform, Lending Club, floating on the New York Stock Exchange in December 2014 and recording almost US$16B in total loans funded by the final quarter of 2015.
So the P2P model works. But who is involved and how does it work?
Who is Involved?
Peer-to-peer transactions involve three key parties.
- Investors are people or institutions with excess capital, seeking returns.
- Borrowers are people or businesses with insufficient capital, willing to pay a premium to access to capital.
- The P2P platform is an organisation and website designed to match investors with cash to borrowers who need it. The platform assesses the riskiness of the borrower, facilitates the transfer of funds and allows investors to perform analysis on their portfolio.
Investors in P2P loans are anyone with excess capital, looking for predictable returns above the bank deposit rate. Investors earn a fixed interest rate (similar to the coupon rate of a bond), paid by the borrower, based on the risk profile of the borrower. Interest rates on loans are meant to reflect the risk to the investor that the borrower will default on the loan. So a savvy investor will demand a higher interest rate from a borrower he/she perceives more likely to default.
“Peer-to-peer” may be a misnomer as it implies that the loans are between retail investors and retail borrowers (i.e. ‘mum-and-dad’ investors and borrowers). The reality is that a significant amount of funds invested are from institutions (i.e. big banks and other financial firms). Although there is currently a mix of retail and institutional investors in the USA, it is still illegal for retail investors in Australia to lend through a P2P Platform. This means that P2P lending is currently more a marketplace for institutions to meet borrowers in a less traditional format.
Previously, retail borrowers had few options. They either borrowed from the bank or wrote a pleading letter to their wealthy uncle.
P2P offers an alternative and is attractive for two reasons:
- It’s cheaper – interest rates on unsecured P2P loans are generally lower than interest rates on credit cards, the most readily available alternative; and
- It’s more lenient – P2P platforms are willing to offer loans to borrowers deemed too risky for big banks.
Prospective borrowers apply to be listed on the P2P Platform’s database. The Platform assesses the borrower’s suitability based on a number of factors (more on this below).
The types of borrowers that are approved for a P2P loan will vary depending on the platform to which the borrower applies. The Lending Club website indicates that the average borrower has an income more than AU$100,000 and debt equal to approximately 18% of their income (exlcuding mortgages). This suggests that borrowers tend to have relatively high income – a good sign for investors.
The P2P Platform
A P2P platform acts as a marketplace for investors to meet borrowers. The P2P Platform categorises the risk of each loan. It also facilitates the payments between parties. It takes a fee for performing this service, usually a percentage of each loan, charged to the borrower.
How Does it Work?
Potential borrowers submit an application to the P2P Platform and their credit risk is assessed based on factors such as their debt-income ratio, credit history, age, income and other financial commitments.
If successful, the borrower’s debt is graded based on their ability to make repayments. This grading is then used to determine the interest rate at which they may borrow and the return that an investor will receive.
Each platform has its own proprietary rating system. Some even use an applicant’s social media accounts to assess credit worthiness!
Once the applicant’s ability to repay has been assessed, it is listed on the platform and investors can fund the loan. Some platforms require that a single investor fund a single loan. However, increasingly, P2P platforms are allowing investors to fund small shares or ‘slices’ of loans. This allows investors to spread their funds across a large number of loans.
Imagine an investor with $1,000 is seeking to invest in P2P loans. The investor can fund a single loan of $1000. Alternatively, she can fund one hundred ‘slices’ of different loans, each valued at $10. This means the default risk is spread across one hundred borrowers. In other words, if a single borrower defaults, the loss to the investor is only $10, or 1% of the invested money.
This is referred to as diversification. Investors like to diversify their portfolios to reduce their exposure to a single negative event (like the default of one borrower).
Investing in a bundle of small ‘slices’ of loans is reminiscent of the process of securitisation. Securitisation refers to the bundling of debts (usually home loans) in a pool and the selling of ‘slices’ of the pool to investors. This functions similar to a bond – the investor pays cash for the right to receive periodical principal and interest repayments. This provides retail investors with the option to buy a small slice, instead of an entire loan and creates liquidity in the market -a benefit of peer-to-peer lending proponents often tout.
Risks of P2P Lending
P2P Lending is not without its risks.
Chief among them is the misalignment of incentives between the three parties involved. That is, the fact that the P2P Platform assesses the borrower’s credit risk without actually taking on any credit risk is problematic, especially for the investor.
Consider a P2P Platform that charges borrowers an upfront fee for the right to use the services. Here, the Platform itself bears none of the risk of a borrower defaulting – the entire risk falls on the investor. That is, if the borrower defaults, the platform still receives its upfront fee, but the investor can no longer claim repayments from a defaulting borrower.
In fact, a P2P Platform may even be incentivised to overstate the credit rating of borrowers to attract more investors and therefore, more upfront fees.
The Lending Club addresses this issue by charging fees on each monthly repayment, rather than just one upfront fee on each loan. This provides an incentive to Lending Club to ensure the quality of each borrower remains high otherwise its revenue stream will dry up. It also increases investor confidence by demonstrating that both the platform and the investors will have a financial interest in ensuring the repayments keep flowing in.
P2P or Marketplace Lending provides an alternative. For borrowers, an alternative to the big banks whose credit assessment process can be restrictive and time-consuming. For investors, it offers an alternative way to deploy excess capital to earn a fixed return.
P2P is still a nacent concept in Australia. As such, it is highly regulated. However, as regulation relaxes – in line with the US and the UK – as is expected, investors and borrowers will need to be cognisant of inherent and structural risks involved.
Questions about peer-to-peer or online lending? Get in touch with our banking and finance lawyers on 1330 544 755.