PEER TO PEER LENDING
In the current low yield environment, some investors have been looking for an alternative. Here, John Royden, Head of Fixed Income Research at JM Finn & Co, explores the growing online P2P market.
Peer to Peer (or P2P) lending is a fast–growing alternative finance practice of lending money to individuals and/or businesses via an online platform that matches lenders directly with borrowers. Attracted by yields higher than most conventional high-quality bonds, it has sparked the imagination of many an investor.
I invested small sums with four of the leading UK P2P websites to get a taste: Funding Circle, RateSetter, Wellesley and Zopa. At the outset I was struck by the lack of clarity over the bid / offer spread, thus rendering it unclear what margin the P2P lenders were making; Zopa was the only platform that showed a tight bid / offer spread of 3.8% to 3.9% for three-year money and 4.8% to 5% for five-year money.
Some of the P2P websites appeared to be offering amortising loans where your cashflow is driven by interest, plus monthly repayment of capital, whereas others appeared to be interest-only loans with a repayment of capital at the end of the term. This does make comparing the rates more difficult.
If you want to sell your loans early, then the P2P websites achieve this by selling your loans to new investors, which is by no means guaranteed and existing loans can sometimes take days, with varying levels of early exit fees charged. If interest rates go up and the value of your loan goes down, you get charged a fee, but you don’t get a credit if the opposite occurs.
Zopa and RateSetter both have default funds which compensate investors for defaults by lenders. So far they have covered defaults, but in the event of a large-scale default, my main concern across the sector is that they might fail.
The best measure of success, in my opinion, would be looking at default statistics, but unfortunately, these cover a benign period of economic stability from the 2009 lows of the previous recession. If the current stock market weakness is foretelling another recession, I doubt that the statistics of the past will match what could be about to come.
My main concern is that the lack of transparency means that rates being offered to investors don’t reflect the underlying risk. If you earn 10% for five years and then lose 40% on defaults in a recession, you are up a net 10%. But if you only get paid 5% for five years and lose 40%, you are down 15%.
The Armageddon scenario is a tsunami of tweets and Facebook status updates which act to crystallise a mass default by borrowers; which then bankrupts the P2P websites and leaves them unable to finance recovery litigation.
More than 1 million people in the UK invested, donated or lent using P2P lending or crowdfunding platforms in 2015Source: Nesta, Cambridge University & KPMG
I think successful P2P lending requires plenty of time and some expertise in risk pricing and the ability to control your lending on a case by case basis. In addition, the lack of clarity and transparency suggests care should be taken to ensure you understand the risks in their entirety. It is also worth noting, that whilst the peer-to-peer industry adheres to standards set by the Financial Conduct Authority (FCA), depositors do not qualify for protection from the Financial Services Compensation Scheme (FSCS).