P2P lending platforms disrupt the traditional lending systems the same way Uber disrupted the taxi business or Airbnb disrupted the hotel business. It’s such a cliche, but it’s also the truth.
In 2005, when Zopa, the first social lending platform, launched in the UK, the p2p loans market was worth a bit over 100 million USD worth worldwide. In 2018, the market is worth more than 10 billion USD in the UK only and some analysts expect the p2p global market to rise to 1 trillion USD in 2024.
What helped P2P lending gain popularity
P2P lending existed for a long time. People would borrow money to their neighbours since long ago. What changed is that now p2p lending is done at a much larger scale through the use of technology.
There are multiple factors that contributed to the rise of p2p lending platforms.
Technology is the main piece in the p2p lending market. It connects the lenders and borrowers in an easy way through an online platform. This couldn’t have been possible a few decades ago.
As a borrower, it’s easy for me to submit a few papers online and then wait for the platform to approve my loan. When it is approved, I receive money in my account. I can pay my monthly instalments and settle my loan – all this being done online.
As a lender, it takes from a few hours to a few days to top up my account. And then that’s it, I can browse through the available loans and choose in which ones I want to invest. It can’t get easier than that.
Low-interest rates on savings
After the 2008 crisis, it became almost impossible to keep your money in safe options like bank deposits and government bonds. The low interests made people look for alternative investments if they didn’t want to lose money to inflation. There’s no point in saving when your money will be worth less 1 year from now.
The credit crunch
The banks stopped lending after 2008 so the borrowers had to look for alternative sources. With a much lightweight structure, the p2p lending platforms capitalized on that. By offering competitive rates and less hassle, they became a good alternative to the traditional lending markets.
Negative sentiments toward banks
The 2008 credit crisis and the bailouts that followed led to an increased anti-banks sentiment and distrust of traditional finance systems. P2P lending market wasn’t the only one that capitalized on that. There’s a series of challenger banks in Europe that provide an alternative to the traditional banks: Revolut, N26, Monzo. Mintos, a p2p lending platform, is planning to offer its investors a personal IBAN account and a debit card.
Why invest in p2p lending platforms
The world has a long history of offering loans as an investment. The only innovation p2p lending platforms brought to the table is that they offer a more efficient and cheaper way to access credit. They still perform credit assessments and choose the loans in a similar way the banking system does.
Returns based on the risk taken
Based on your risk profile you can choose to invest in riskier loans if you want to. Many p2p lending platforms show the risk level of the loan and set the interest rate accordingly. You risk more and you get higher returns.
P2P investments are expected to perform better than stocks and bonds during an economic recession. They’re not listed on any exchange, so they don’t share the high volatility of the stock market.
Diversification of your investments
You can diversify your portfolio by investing in a different asset class. Even more, by investing small amounts into multiple loans, you reduce the risk of borrower default. You can spread your investments even further by investing in loans from different countries, so you’re not linked to any one economy.
Easy to invest
The entry barrier is very low. There’s no need for large amounts of money to enter the p2p lending market. You can start investing with even as little as 1 EUR on Bondora. Of course, you wouldn’t get much return from that, but the point still stands, you don’t need 1000s of EUR to access the market.
You can even choose from actively selecting your investments or set up an auto-invest profile that many platforms offer and let it choose the investments for you.
What risks are there
While p2p lending platforms offer a source of steady income, they’re not by far as safe a bank deposit. There’re multiple types of risk involved, and some of them I’m listing here.
You risk losing money
The borrower may default because of larger economic conditions (loss of job due to economic recession) or poor initial credit decision (they didn’t think through when they took the loan and don’t have the means to pay). Some platforms offer some protective measures for the investors, like buyback and payment guaranteed policies. This reduces the risk of losing your money, but it still doesn’t eliminate it. In the end, you’ll only receive payments if the lending platform has enough money to pay.
P2P lending platforms can become bankrupt. Your money is not protected in the same way special funds protect your bank deposits. Most of the platforms do have some protective measures like keeping investors’ assets in accounts that are separated from the platform assets.
Another way to mitigate the platform risk is also to diversify your portfolio across multiple p2p lending platforms.
Your money sits idle
P2P lending platforms create a marketplace where borrowers and lenders meet. If there are more lenders than borrowers on the platform, there will be a lot fewer loans to invest in. You run the risk of keeping your money idle in a p2p lending platform due to missed opportunity cost. You could have invested your money somewhere else with at least some returns.
Everything related to your investment is online and thus is susceptible to cyber attacks. Easy to guess passwords, same passwords used on multiple accounts, these are gateways through which an attacker could gain access to your account.
Furthermore, the platform may have implemented poor security measures and it could be the victim of a security breach itself.
When choosing a p2p lending platform, the quality of loans offered, and the interest rates shouldn’t be the only criteria to consider. The quality of the platform matters as well.
Does it let you withdraw money to any account without asking you for proof of ownership for the new bank account? That’s a warning sign.
Does it offer two-factor authentication when logging into the platform? When you enter your password, do you also need to provide a code received through SMS, email, or generated by some other platform like Google Authenticator? That’s a good sign. All the modern platforms should have that.
If the economy performs badly and the unemployment rate rises, the risk of borrower default will also rise. This, in turn, would lead to lower returns for p2p lending market investors. In 2008, at the start of the recession, the UK platform Zopa default rates rose from 0.5% to 5%.
Property backed loans are safer but during a recession, there are still risks associated with them. Is the property easy to sell? Will the value of the property at that time be enough to cover loan? When looking into property-backed loans, the loan to value ratio is an important aspect to consider.
Your money is illiquid
You have your money locked on the platform for the period of the loan unless the platform offers a way to sell your loans to other investors. This can be a big problem if you need money right away. Most of the platforms offer a secondary market where you can sell your investment to other investors. Some platforms even buy the loan from you, sometimes with a fee.
What measures p2p lending platforms take to reduce the risks
Credit risk assessments
P2P lending platforms have a direct interest in reducing the risk for its investors. They take a commission out of every loan. This means providing bad loans on the market would reduce their income too. They conduct credit risk assessments similar to the ones used by traditional lenders and the rate of defaults is in line with the traditional ones.
Furthermore, p2p lending platforms run the risk of losing reputation if they provide loans with high default rates. On the long term, they would lose their investors. This would be bad for business.
Skin in the game
Some p2p lending platforms also invest in the loans published on the platform, to increase the trust of the investors. For loans originated outside the platform, they require loan originators to keep a per cent of the loan to themselves. This way, the loan issuer has more incentives to only accept loans that have a low default probability.
Interest rates linked to risk level
The interest rates offered are according to the risk level, so the rate of defaults would need to be very high in order to produce negative returns for the investors. At the start of the recession, in 2008, Zopa had default rates at around 5% but its investors still had returns around 5%.
Some platforms, like Neo Finance, offer provision funds to cover the risk of default. Some offer buyback policies if the borrower is late with their payments.
Most of the p2p lending platforms provide a secondary market where the investors can exit their investment before the loan term by selling it to other investors.
Investors money are kept outside the platform
The p2p lending platforms keep the investor funds in accounts separated from the platform. The investor money is not linked to the platform if it goes bankrupt. Some, like Neo Finance, even offer investors their personal IBAN account where their funds are kept. Even more, p2p lending platforms should have sufficient measures in place that if the platform failed the loan contracts have sufficient ongoing fees to fund the loan servicing after.
P2P lending market regulations in the EU
There is no unified legal framework at EU level regarding p2p lending platforms. Each country has its own specific rules for lending platforms and financial institutions that apply to p2p lending platforms as well.
Some countries, like the UK, have specific regulations for p2p lending markets. The UK has special regulations for p2p lending platforms since 2014, created by the Financial Conduct Authority (FCA).
Some of the rules imposed to p2p lending platforms by the FCA are:
- Capital requirements – p2p lending platforms need to keep available capital based on the amount in loans they offered
- 50.000 GBP or 0.3% of the loans issued up to 50 million GBP (whichever is higher)
- 0.2% of the loans issued for the next 450 million GBP
- 0.1% of the money lent above 500 million GBP
- Investors’ money protection – p2p lending platforms are required to ensure “adequate protection of client money” when the platform is responsible for it
- Dispute resolution – investors have the right to complain, first to the p2p lending platform and if the dispute is not solved, to the Financial Ombudsman Service.
- Bankruptcy – if the p2p lending platform goes out of business, it needs to ensure loans issued or facilitated on the platform will continue to be managed and administered
- Conduct – all communication needs to be fair and not misleading, so the investors have all the necessary information needed to make informed decisions
Other EU countries have institutions that cover a larger set of activities along with p2p lending. The Estonian Financial Supervision Authority (FSA) oversees all banks, credit providers, credit intermediaries, investment firms.
In Germany, only banks can issue credits. So, p2p lending platforms need to partner with a bank in order to operate. Lithuania has a Law of Crowdfunding adopted in 2016.
This was a rather long article, but I hope it was at least informative. I’m in no way an authority in this domain, so treat this article as such.
Some of the sources I’ve used for research are
- Peer to peer lending investor guide https://www.orcamoney.com/guides/p2p-lending-guide
- The economics of peer to peer lending https://www.oxera.com/publications/the-economics-of-peer-to-peer-lending/
- The business models and economics of peer to peer lending https://www.ceps.eu/publications/business-models-and-economics-peer-peer-lending
- Marketplace lending – A temporary phenomenon? https://www2.deloitte.com/uk/en/pages/financial-services/articles/marketplace-lending.html
- EU consumer credit directive https://ec.europa.eu/info/business-economy-euro/banking-and-finance/consumer-finance-and-payments/consumer-financial-services/credit/consumer-credit_en