Peer to peer lending: as good as it looks? 

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Something quite remarkable is going on in the world of finance: the disintermediation of traditional financial services providers.  The internet is revolutionising the way in which consumers access traditional financial services. 

Crowdfunding, for example, sees the middle man (the bank) being replaced by internet based models, matching those who need to borrow money with those who have it and are seeking a return for its use.

Perhaps the most interesting and dominant model is peer-to-peer lending (P2P), where individual lenders are matched with individuals and companies seeking debt financing. 

Since 1 April, 2014, P2P has been regulated by the FCA and the industry now has a body to promote it called the Peer to Peer Finance Association.  Approximately £3.2 billion has been lent so far in the UK, up 150% in the past 3 years, and P2P business lending was the largest category of alternative finance in 2014 (£765m), followed by P2P consumer lending (£575) and Invoice Trading (£270m).  Equity-based crowd-funding, although perhaps higher profile, is insignificant in comparison, at £85m. 

P2P lending is estimated to double in size every six months going forward, with the UK currently dominating the alternative finance space in Europe, representing around 75% of the market.

How does it work?

Each P2P platform has its own way of doing things.  In essence, individual borrowers are matched directly on a contractual basis with individual lenders, using an online platform.  Borrowers can choose the amount and term that they wish to borrow for, and the rate of interest that they will be charged is related to these two factors alongside their perceived credit worthiness. 

Lenders get to choose how much and how long they will lend for and are quoted the interest rate they will receive.  Some platforms allow lenders to choose the risk category of borrowers, which can impact on the rate of interest they will earn. 

What’s the catch?

 It looks like a deposit, feels like a deposit – but it’s most definitely NOT one.  Loans made are not covered by FSCS compensation, and lenders are contractually linked directly to specific borrowers with the consequent direct risk of default on interest, principal or both.

Whilst a number of mitigants are in place to minimise the risk and impact of default including credit screening, diversification of borrowers, loss reserve pools, insurance and in some cases assets backing the lending (e.g. buy-to-let properties and invoices); the reality is that P2P is sub-investment grade (higher risk) lending, where the risk of default is real. 

Individual default rates will rise at times of economic crisis and investors are directly linked to any losses. Understanding the protections in place and how losses are distributed (or not) between lenders is important.  Risks include defaulting borrowers, operational risks of the platform, hacking and internet fraud, fraudulent sites and platform failures. 

It is worth noting that the Innovative Finance ISA was announced in the recent budget, allowing investors to reap interest tax-free from P2P lending, from April 2016.  Getting a tax break may well accelerate P2P lending.

Should you go for it?

Lenders who do their homework, understand the risks, undertake good due diligence and diversify between providers, strategies and borrowers, stand to obtain a higher return on their capital than they are getting in traditional bank and building society products. Thorough research on the platform itself will be very important.  With new entrants, the risk of fraud or corporate failure is a material issue. 

To find out more about P2P lending, check out the latest volume of our Acuity newsletter.
 

Image courtesy of Txopi

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