Peering into Peer to Peer Lending

This is the first of two posts that are going to be long on detail and short on humour,  but the subject matter is important and I don’t think it’s been covered very well for retail investors unless you happen to read the FT on a regular basis.

This year is setting up to be a transformative year for peer-to-peer lending (p2p) – an area of finance that began matching individual lenders and borrowers using the advantages of the internet.

It now has its own body, The Peer-to-Peer Finance Association, which announced at the end of July that UK lending platforms had arranged over £500 million in new loans in the first half of the year. And, after much lobbying from the p2p industry, it became regulated by the FCA on the 1st April.

But the biggest impetus for growth was highlighted by Giles Andrews, Chief Executive of one of the market leaders, Zopa. In a Reuters article he noted, “The peer-to-peer industry is growing faster than ever and we’re looking forward to offering new products like ISAs in the near future”. He was referring to the Spring Budget when it was announced that p2p loans would be eligible investments for ISAs from April next year, although the exact structure has yet to be announced.

Zopa pioneered the model for p2p in 2004 by providing the original platform where personal savers could be matched with personal borrowers. In doing so, by cutting out banks, both savers and borrowers could get better rates. But there is naturally a concern about the risk of default involved in this direct funding model, especially as these are personal loans and they are unsecured (not guaranteed against an asset).

If you are making unsecured loans, your first defence is that you know enough about the borrower and that you are the getting the right rate of interest. But Zopa does more than screen borrowers for their chance of default, it also allows loans to be split between many borrowers to spread risk. And an internet based platform is ideal for bringing all those factors together.

It also means you can tailor pools of loans with different risk profiles for lenders with different appetites for risk. And this was the dominant model until 2010 when a competitor called RateSetter was launched.

It offered simplicity and an additional way to help manage risk to reassure lenders further. It charges borrowers a small fee that together add up to what it calls its Provision Fund to meet the likely costs of default. And since launch that fund has been sufficient to meet any losses.

RateSetter also looks more like a saving site. And now so does Zopa, which since May of last year has its own default protection fund called Safeguard. Again, it has met all its default claims so far. Both companies explicitly state that loans/savings are not covered by the Financial Services Compensation Scheme, but they are doing their best to give you peace of mind with this part of their overall offering.

So what to make of this relatively new and rapidly growing part of the investment landscape?

Well, I first have to state my admiration for those involved in getting these companies to where they are now. There have been some small failures at other companies, but these two are well established, regulated and growing. I should also point out that there are other p2p companies specialising in areas other than retail loans – one called Funding Circle has a successful model lending to smaller businesses.

They are all, no doubt, benefitting from a general desire to move away from banks. But I think that does them a disservice. Their main attractiveness is price and the nature of their service – lenders and borrowers are getting better rates.

And the p2p industry clearly wants to bring this to as broad a market as possible. Hence the innovations by RateSetter to look more savings friendly, which have been mirrored by Zopa. Both their headline returns of just over 5% look enticing, especially if put in an ISA. And the ISA development is important, because outside of an ISA tax is charged on the interest earned and default losses, if there are any, aren’t deductible from those earnings.

But, as ever, there are several important things to consider. Some are to do with risk and some to do with how the market develops.

Clearly the main point is that funds are not covered by the Financial Services Compensation Scheme, but I’ll cover the other substantial points in my next blog. And it’ll be a bit different to the marketing information found on the p2p company websites.

In finance we love growth, but if you see one of these growing in your garden don't smoke it.
In finance we love growth, but if you see one of these growing in your garden don’t smoke it.

All this talk of rapid growth is reminding me that I need to remove a rather large weed from outside our bedroom window that my wife and I thought we’d let develop as we’d never seen anything like it before. It turns out to be a plant called Jameson weed or ‘datura strarmonium’ to give it its proper name. Apparently, it is a powerful hallucinogen and deliriant. And I thought our chickens that share the same area were just getting paranoid.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing