What’s the growth outlook for marketplace lending?

The year 2015 marks the tenth anniversary of peer-to-peer (P2P) lending. Zopa was launched in the U.K. in 2005, a time when unsecured borrowers were paying more than 15% per annum and bank depositors were earning 5%. Zopa matched borrowers and investors with materially better terms via an easy-to-use Web interface. In June 2005, investors lent £45,000 via the Zopa site; June 2015 saw nearly £45 million of new loans via the same site.

It was quite a personal affair in 2005 — borrowers chose their own usernames, could write a short message explaining their borrowing needs and could even write a thank you note to lenders when the deal was done. For investors, it was more complicated than today. Investors chose from a number of risk categories and maturities, could choose their maximum loan size and post their target interest rate. The site advised investors as to whether their rate was in the “zone of possible agreement,” explaining that rates outside the “zopa” would result in funds being invested at a much slower rate.

Today’s Zopa lenders only have to choose one of two maturity bands and state whether they want repaid funds to be automatically re-invested. Zopa limits an investor’s maximum exposure to any one borrower to ensure diversification and has a first loss facility, which, although not guaranteed, has covered all losses on eligible loans since its launch two years ago.

The Zopa story has been repeated hundreds of times around the world and has extended from consumer unsecured lending to small and medium-sized enterprise (SME) lending, factoring, mortgages and student loans. The role of the “peer” has diminished as institutional investors now dominate the lending, and an increasing proportion of borrowers are SMEs. The alternative name for this sector – Marketplace Lending (MPL) – is therefore more appropriate. The advances in automation and ease of use seen on Zopa’s site have also been mirrored elsewhere with later entrants trying to distinguish themselves using innovative features. However, since the foundations of MPL are built on financial technology, or FinTech, innovations on one platform can be quickly copied by others in ways that the banking sector, mainly operating from legacy systems, can’t match.

Collaborate or compete?

It is the contrast with the banking sector, as much as developments within the MPL ecosystem itself, that interests MPL observers, bank analysts and policy makers. Part of the interest is whether banks and MPLs will collaborate or compete and how the financial performance of each could evolve, but much of the interest is motivated by a genuine need for more lending, particularly in the SME space, to keep the world’s economic recovery moving. Those focused on the latter are less concerned with the structural outcome so long as the result – more lending – is achieved. Those focused on the former have a near-term interest in the investment opportunities associated with a FinTech boom and a longer-term interest in how this could change the profitability of the banking sector. For them, the structural outcome is crucial.

The spectacular growth in lending volumes seen within the MPL sector sends out a very strong message. However, over the last year there has been a noticeable increase in the announcement of strategic partnerships between MPL sites and credit originators; the focus has shifted from finding investors to sourcing origination. Bottom line: the MPL market is finding it harder to originate new loans in order to keep up the growth rates that the industry now seeks. Much of the low-hanging origination fruit has been picked; the MPL market now has to address the reality that most consumers and SMEs don’t log on to a Web browser when they need to borrow.

Deep wells

One of the most obvious sources of origination is, ironically, the banking sector itself. The U.S. and European banking sectors have total assets easily in excess of $30 trillion and continue to see headwinds from de-levering, higher capital and liquidity charges, with management averse to risk-taking. If the MPL markets in Europe and the U.S. could gain access to just a tenth of 1% of bank balance sheets, their origination would roughly double.

The collaboration between banks and MPLs is, therefore, perhaps the most exciting development to monitor over the next few years. It is also more complicated than meets the eye because there is real economic benefit for banks to actively collaborate with MPLs. Passive collaboration takes the form of banks slowing down their lending to consumers, SME, students and the mortgage markets and allowing MPLs (and others) to pick up the slack. Active collaboration is where banks effectively partner with alternative lenders such as MPLs to separate risk from relationship. If banks could enjoy the fee-earning potential of a client relationship without the associated balance sheet and capital cost, the profitability of banks could be transformed.

This isn’t, in itself, a revolution in banking. The appearance of the corporate bond market is a good example of splitting risk from relationship and it makes complete sense in a world where many of the funding needs of borrowers are exactly met by the lending needs of investors. Put another way, just because banks offer the ability to transform risk, liquidity and maturity doesn’t mean that it’s always necessary. Arguably, the transformation services of the banking sector should only be used when they are needed. There is a cost to this service and, where possible, it should be avoided. The economic benefits are clear, as are the systemic risk benefits of a smaller bank sector.

Not going away

The users of P2P Lending in 2005 could never have guessed how the market would have grown as well as evolved over the next 10 years and making predictions for the next 10 years is no easier. Nevertheless, a few things are certain. The first is that MPL is here to stay as it genuinely adds value to the process of originating, risk assessing and distributing consumer and SME loans. Secondly, MPL is not going to displace the banking sector, it’s going to complement it. How big a share of the origination pie it grabs is uncertain, but with all parties involved benefiting from a shift from bank balance sheet to MPL balance sheet, it seems likely that the shift will be significant.

Doubtless these topics and others will be hotly debated this fall at Crowdfinance 2015: The Evolution of Global Marketplace Lending on Sept. 28 in New York City

Why Peer to Peer Lending is here to stay

Many commentators of the rapidly growing P2P lending market dwell on the factors behind its birth and development.  Inefficiencies within the banking sector pre-financial crisis and bank regulatory response post-financial crisis are frequently cited.  Does this mean that a more efficient banking sector which is evolving to cope with more stringent leverage, capital and liquidity rules will eventually displace the P2P lending market?

The answer is an emphatic “No”: P2P, also know as Marketplace Lending (“MPL”), is here to stay and is likely to evolve to compliment the banking sector rather than compete with it.  To better understand this bold statement we need to focus on the drivers for growth in MPL and the potential synergies with traditional banking.

Financial technology is one key driver for the rapid acceptance of MPL by both borrowers and lenders.  Not only do the MPL sites actually do what they claim to do, they do it very well, for most of the week and in a way that is appealing to the users.  Borrowers benefit from faster lending decisions via a process that reduces the need for a commitment of time during office hours; lenders benefit from a process that based on ten years of activity uses different data differently to produce attractive risk adjusted returns.

Whilst the borrower experience is compelling, the take up by potential borrowers is slow compared to the take up by investors: right now the market is skewed with too much liquidity chasing too few assets.  The appeal to investors is easy to understand: firstly, consumer loans, SME loans and SME factoring are not generally available to institutional investors; secondly, the absolute returns are very attractive in the current environment and the lack of volatility and correlation to financial markets is appealing.

It’s likely that a normalisation of interest rates will redress the cash/asset imbalance within the MPL market but in the meantime part of that rebalancing is coming from the banks.  Rather than turn down new borrowers, banks are starting to refer their turn downs to MPL sites.  This can be done in a number of ways: the most basic is to merely hand over a name and number to the rejected borrower; the more advanced is to partner with an MPL site and effectively white-label their site.  For the banks leaning toward the latter, the appeal is based on establishing or maintaining relationships without the balance sheet and capital drag of actually lending.

Separating risk from relationship is a relatively new concept in banking.  Until the 1990s most banking relationships started with a loan and that risk, funding and capital requirement stayed on balance sheet until the loan matured.  The only exception was securitisation which allowed periodic large block moves of loan assets to non-bank vehicles.  By the late 1990s the Credit Default Swap (“CDS”) market allowed banks to pass on the risk of positions that couldn’t easily or quickly be securitised.  The combination of the two transformed the way that banks managed risk, capital and balance sheet usage.  Unfortunately the genuine risk management applications of the CDS market were rapidly dwarfed by investor led applications during the 2000s with devastating results.  Whilst the CDS and securitisation markets still exist, the regulatory response to the financial crisis means that their applications are limited compared to pre-financial crisis.

Even if CDS and securitisation were alive and well they had virtually no relevance to consumer credit and SME lending.  The potential tie-up between banks and MPL sites could therefore represent an extension of credit portfolio management to the full spectrum of bank lending.  This isn’t going to happen over-night but such is the demand from investors for more origination that the economics for MPL sites and banks to collaborate are compelling.  One notable example if factoring: the bank capital demands for this sector are now multiples of what they were: a once lucrative business for banks now generates ROEs well below 10%.  For banks to maintain SME relationships and benefit from the associated fees but to partner with an MPL factoring site is a win-win for all.

MPL sites are distinguishing themselves on numerous fronts including the origination, risk assessment and distribution of consumer and SME debt.  The fact that so many institutional investors are happy to take illiquid, long dated, direct exposure on a matched-funded basis is evidence that the risk, liquidity and maturity transformation services of a banks are not always needed in these sectors.  As long as the MPL/P2P markets continue to satisfy the complimentary needs of banks, investors and borrowers then it’s probably here to stay.

P2P Lending versus Bonds

Over the last few years the terms Peer-to-Peer Lending (“P2P” - latterly also referred to as Market Place Lending or “MPL”) has appeared on the fringes of the fixed income world’s radar.  To add to the confusion, some people also refer to it as Debt Crowdfunding. Whatever the name, fixed income investors are starting to look at this new asset class with interest.

Technically it’s not a new sector as the underlying assets – consumer and SME loans – have been around for centuries.  But the appearance and rapid growth of this new market has made these assets available to institutional investors in a form which, ten years ago, just didn’t exist.

Investors in MPL see returns in the range of 5%-15% - where high yield used to be – from income paying assets similar to bonds both in structure and from a risk perspective.  Despite numerous differences (discussed below) the key similarities are enough to bring a steady flow of bonds investors to the MPL sites. To understand how this came about we need to go back about ten years to the first P2P site in the UK.

The launch of the UK company Zopa in 2005 was partly driven by a banking sector which, at that time, took deposits at 5% and lent them unsecured at 15%.  Zopa argued, successfully as it happened, that by very careful screening of borrowers and using diversification to limit idiosyncratic risk, they could take funds from investors at around 9% and lend them at around 11%. Zopa drew heavily on advances in financial technology (“fintech”) to not only provide users with an impressive user experience and interface but also to use data differently to limit credit losses.

Zopa’s business model was emulated around the world and soon grew from consumer lending to SME financing (both lending and factoring).  Names such as Lending Club, Prosper, Funding Circle and RateSetter are now associated with a new non-bank lending market.  This global market has originated approximately $40 billion of debt instruments – small by banking standards, but big enough and growing fast enough to attract institutional investor interest.  At the same time a market for equity or equity-like financing has also grown with names such as Kick Starter becoming better known than most of the MPL companies.

The rapid growth of the MPL market has been accompanied by significant yield compression within fixed income markets.  High yield returns have moved to the area once occupied by high grade which in turn has displaced government bond returns.  The appearance of a new debt market offering returns in the range of 5%-15% was bound to get noticed by institutional investors stuck in a world where high yields returns in the US and Europe are between 4% and 7%.  In the space of just a few years the “crowd” and “peer” characteristics of this new lending market have been replaced by institutions, now thought to provide over 75% of all funding to MPL sites.

Such has been the rush of institutional money into the MPL space that there is now a material imbalance between the supply of funds and the origination of loans.  This has caused some spread compression within the MPL sector; it has also created what looks like an efficient secondary market. Furthermore, due in part to careful borrower selection by MPL originators and in part to a very benign interest rate environment, default rates continue to be very low.  This ensures that retail investors find the sector increasingly attractive though some market commentators worry that low default rates and good liquidity year after year have created an artificial environment.

Despite the attractive returns and debt-like characteristics, investing via MPL is not the same as investing in bonds.  In fact, aside from the return characteristics and the fact that both deal in debt instruments, the two markets have little in common.  MPL, for now, focuses on consumer and SME loans which may be secured, sometimes by real estate.  The loan sizes tend to be tens of thousands of USD equivalent for consumer loans and up to a few hundred thousand USD equivalent for SMEs.  In the US, MPL issues notes to investors backed by loan assignment from a bank that has extended a loan facility to the borrower; elsewhere the investor directly lends to the borrower.  In both cases the debt instruments held by the investors are transferable but there is no established secondary market and no institutions making markets. 

Analysis of the risks of MPL differs materially from the bond market.  For consumer loans, investors are relying on the MPL sites to provide identity and fraud checking and, where available, credit scoring information.  On some sites investor funds are allocated to large diversified pools of loans, on others investors specify lending criteria such as minimum credit score, base salary etc. and are allocated loans that meet their criteria.  Clearly the investors are not doing individual risk assessment. 

For SME loans, whilst the MPL sites provided the same identity and fraud checks, investors are given varying amounts of financial, commercial and strategic information by the SME allowing them to perform rudimentary credit analysis.  In many cases the MPL sites will initiate a dialogue with the SME and may even visit the business location.  Whilst the package of information made available to investors enables some analysis, the absence of input from a rating agency, industry comparables etc. makes the process very different from the bond market equivalent.  Furthermore, due to the very small deal sizes, an institutional investor will need hundreds of positions for even a small portfolio where the fund economics just want justify a large research group performing detailed analysis.  As a result, diversification based on simple filtering criteria is the only realistic strategy for most investors.

It is likely that MPL will continue to grow and evolve at a rapid pace.  The sector is transparent, easy to understand and is mainly unlevered.  With millions of participants exposed to millions of relatively small risk positions, it is hard right now to point to any systemic event that could affect financial markets.  Even the failure or closure of a large MPL site would be contained by putting its matched book into run off.  If the sector continues to deliver returns in the 5%-15% range then it is bound to intrude further into the world of bond market investors.