How to get the Win-Win-Win back into Peer to Peer Lending

Part 1 - How and why has it lost its way? The key issues.

In this series of blogs, I hope to show how the laudable aims of the Peer to Peer Lending (P2PL) industry can play their part in the profitable future of Online Direct Lending (ODL), with an industry-wide solution to benefit all players.  First, we need to get to grips with the decisions made that have really held this promising industry back.

Setting the Scene

15 years ago, the peer to peer lending and borrowing industry was created under the banner of "Social Lending".  Not many people noticed at the time!  However, due to the financial crisis, the "Credit Crunch" of 2008, the banks stopped lending and interest rates were reduced to 0.5%.  This meant that savers/investors were searching for yield and borrowers were in need of loans.  P2PL then became noticed as borrowers turned to their peers (savers, investors and lenders) in the hope of a loan, and the nascent industry took off.

This inspired the creation of many start-ups in P2PL in the following years, as there appeared to be space in the market.  The P2PL market was promising, in that the firms were growing by offering loans to borrowers at competitive rates, and, at the same time, acceptable interest rates for savers, lenders and investors - a win-win-win situation!  The sales proposition was that online technology had enabled reduced overheads, cutting down the costs of providing the loans, compared with banks with bloated overheads in the form of staffing, branches and ancient technology.

As we look back on the progress of P2P Lending so far, it is clear that many of the start-ups that rushed to get their business up and running, neglected to determine what was important in building a business that was capable of delivering sustainable profitability.

Impact of the Initial Technology Approach

Many new P2PL firms struggled because of the outdated notion that they had to own the software and therefore had to build it in-house.  At a stroke, that added at least a year to their time to market and added a few million to their start-up capital requirement.  In this case, recruitment of an IT team is required.  This is where the next fundamental mistake occurred!

The best IT teams in financial services include people who have worked in the relevant financial sector (in the P2PL case, in borrowing, lending, investment and regulatory compliance) as well as having the relevant IT system delivery skills.  Unfortunately, in many cases this did not occur, resulting in overspending on IT and the delivery of sub-standard systems.  Some were only "recording systems", rather than "fully automated transaction processing systems", barely scratching the surface of the automation required to run an online business profitably.  In P2PL the bulk of the processing is carried out in the back-office, loan servicing and settlement, but too many times the focus and technology spend was heavily biased towards front-end user experience.  This meant more staff were needed to fill the gaps left in the back office administration systems, and bigger offices were needed to accommodate them, meaning significant unnecessary overhead.

Upfront Investment and Costs Over the Operational Life of the System

The next common error was overlooking the fact that the cost of acquisition of an IT system is its cost over the useable life of that system, and not just the up-front costs.  Depending on how the system is built, and other factors, this could be five to ten years or more.  Because systems need to be constantly updated to keep up with the inevitable changes in the business and its regulations, a portion of the IT build team needs to be retained over the period.  Again, this is expensive for the company in terms of staff and their related office and overhead costs.  This was exacerbated by many of the start-ups not fully understanding the finer technical aspects of the nascent business, and/or its regulations and consequently wasting money developing unnecessary features.

Being faced with the opportunity to launch a P2PL business, many opted to get the bare minimum tech to start the ball rolling, only to find out this would lead to much higher costs in updates and fixes in the future.  This conclusion was borne out by the Prudential Regulation Authority (PRA) in a recent consultation, citing new banks who were outgrowing their control environment, having to retrospectively invest in control functions, costing them more in the long run because of the extensive remediation activity needed.

"Recording" Systems versus "Process Automation"

When there is a lack of automation, particularly in what I refer to as "recording systems", the result is that many processes have to be performed manually.  The inevitable consequence of this leads to large teams of employees working day to day on tasks that could have been executed by a well-designed piece of software in minutes.  The knock-on effect is the need for large offices, usually chosen in expensive central financial city areas, increasing overheads substantially and unnecessarily.

The one remaining major brake on the progress of automation in the UK market, more particularly, in the area of collection of borrowers' loan repayments, is the ancient and flawed system of Direct Debits.  This is where real-time processing stops and what takes over is a major bank controlled, complex, costly, time consuming, three-day process of uploading and downloading files of transactions.  Liquidity is one of the prime drivers of an efficient lending and borrowing operation.  The UK Direct Debit system holes liquidity below the waterline for lenders, money in some cases taking up to seven days to move.

Costs, Funding & Critical Mass

Perhaps the biggest overhead for P2PL companies, particularly at start-up, is the cost of customer acquisition (including sales and marketing). Large overheads, such as those outlined above, eat into the capital and the slim margins that P2PL companies can make on loans, and as a result, most have been incurring year on year losses.  As the struggle to stay afloat in the competitive market continued into the new decade, many could not keep up with the high costs and, as usual, turned to shareholders and investors for further fundraising rounds to keep their businesses running, yet still with no promise or proof of short-, medium- or even long-term profitability.

The most recent and rather unfortunate development is that retail investors are now being abandoned in favour of businesses and institutions.  These are the very people to whom the original marketplace was aimed.  The retail investor is an important part of the investment environment, and the level playing field has always been a goal.  Now, as in 2008, retail investors are looking for opportunities where risk and reward are at acceptable levels, not the poor returns currently being offered by banks.

The scale at which the major P2PL companies have been processing loans was probably what most would consider "critical mass" but they are still struggling to turn a profit.  As a relatively new industry, scepticism is growing on whether it is possible to achieve a safe and compliant business model and maintain long term profitability.  It certainly hasn't yet been proven, but the potential is there!

The next in this series of blogs will look in depth at "What needs to be done to get P2PL/ODL back on track for profitability and sustainability" concluding with an industry-wide proposition.