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Most of us are increasingly aware of the social and environmental impacts of our daily lives; we may recycle, avoid buying products from certain companies and try to cut our carbon footprint.  In reality though, we make compromises.  How does this work when it comes to our portfolio investments?  What are the challenges and options for those to whom these issues matter?

Peer-to-peer lending – a fad or the future?

 Something quite remarkable is going on in the world of finance; it is the disintermediation of traditional financial services providers.  The internet is revolutionising the way in which consumers access traditional financial services.  Crowdfunding is one such area where the middle man (the bank) is being replaced by internet based models.  Put simply, crowdfunding is about matching those who need to borrow money with those who have it and are seeking a return for its use, using an internet-based platform to do so.

Perhaps the most interesting and dominant model is loan-based crowdfunding, which is also known as peer-to-peer lending (P2P).  This is where individual lenders are matched with individuals and companies seeking debt financing.  This brief note focuses specifically on this area.

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The first peer-to-peer lender in the world was Zopa, who set up in 2005.  Since 1 April, 2014, P2P has been regulated by the FCA and the industry now has an body to promote it called the Peer to Peer Finance Association (purchase acyclovir).  Approximately £3.2 billion has been lent so far in the UK and in the past 3 years lending has grown by over 150%purchase aciclovir tablets.  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 (£85m)order acyclovir online.  Industry estimates suggest that P2P lending will double in size every six months going forward.  In 2014 around £1.2 billion was lent via online P2P platforms in the UK.  The UK currently dominates the alternative finance space in Europe, representing around 75% of the market.

Current major players (definitely not recommendations!) include Zopa, RateSetter and Funding Circle.  A quick look at the P2PFA website (above) provides a brief oversight of who the key players are and what they do.

How does it work?

The reality is that each P2P platform has its own, slightly different 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.  Borrowers’ motivation might be to refinance their credit card debts, to consolidate other debts, to make home improvements, to buy a car or a buy-to-let property, or to finance trade invoices (if a business).

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.  P2P providers take a fee for matching borrowers and lenders, usually from borrowers, but sometimes from both parties.  Different platforms tend to focus on different types of borrower – diversification by strategy makes very good sense.

Although this has the look and feel of a deposit, it most certainly is not.  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. This is very different to placing a deposit with a bank, where loans on the books are assets and deposits are liabilities, and shareholder capital acts as a buffer against loan defaults.  FSCS compensation stands as the line of last resort.

In P2P transactions 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).

What are the risks?

The reality of P2P is that it 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.  What is evident is that there are more risks to be concerned about relative to placing a deposit with a bank.  As such, P2P lending should be regarded as investment rather than saving.

It is worth noting that ‘The Innovative Finance ISA’ was announced in the recent budget, which allows investors to reap interest tax-free from P2P lending, from April 2016.  The new ISA is not required to allow withdrawal within 30 days, unlike currency ISAs. Getting a tax break may well accelerate P2P lending.

Conclusion

This is an exciting innovation and the disintermediation of the banks is a welcome development.  Our conclusion is that P2P lending is definitely not the same as placing a deposit with a bank; it is a high yield fixed income play with real risks to both capital and interest, operating through new companies and new technology, with very little track record.  That said, 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. Due diligence on the platform itself will be very important.  With new entrants, the risk of fraud or corporate failure is a material issue.

This is an area of finance that we will put on a watching brief and will provide further updates as the market develops.  As ever, please do not hesitate to call if you have any questions of comments.

Caveat

It important to note that any P2P platforms mentioned in this note are simply used to provide examples and insights into the P2P world.  References to them are most definitely not recommendations to either invest this way or to use any specific providers.  These are really early days in a new, exciting and largely untested area of finance.  Caveat emptor!

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