Peer-to-peer lending - game-changer or business as usual?

Will peer-to-peer lending change the personal loans market beyond recognition? Or will increasing regulation and overheads erode its differentiators? Traditional savings products are not attractive at the moment, with typical interest rates for one-year cash ISAs at less than 2%. At the same time, peer-to-peer lenders such as RateSetter and Zopa suggest their lenders can receive long-term returns of 4% or higher. So it is no surprise that the UK peer-to-peer lending market is growing exponentially, with £ 221m of loans in 2012, and an estimated £ 522m of loans in 2013.

Remembering that there is no such thing as a free lunch, you might expect the high returns forecast by peer-to-peer platforms to come with some strings attached. And, indeed, they do.

The first string is credit risk. In the pure peer-to-peer model, credit risk lies entirely with the lenders and the platform provider carries no credit exposure. Peer-to-peer loans are usually unsecured, so if a borrower defaults on their loan, lenders stand to lose all of the capital that they have lent to that borrower—plus any unpaid interest. To understand this credit risk, lenders need access to credit information on prospective borrowers.

The second string is the need to manage a lending account actively. To maximize returns, payments of interest and capital back to a lender must be quickly reinvested in new loans. Unlent funds earn little or no interest.

The third string is liquidity. Peer-to-peer loans are made for a fixed term, and a lender cannot unilaterally decide to withdraw their funds before a loan ends. Even if they could sell their participation in the loan to another investor, they may have to sell at a loss.

Peer-to-peer platform providers are addressing these issues. Most providers supply investors with some credit background on potential borrowers. Some providers mitigate credit risk by creating a ‘compensation fund’ that covers a proportion of losses due to defaulting borrowers. Automated reinvestment reduces the time required to manage a lending account. And an active secondary market in loan notes improves liquidity.

All of these developments make peer-to-peer platforms more attractive to lenders. But at the same time they increase platform providers' overheads. Higher overheads must be covered by higher fees.

In April 2014, responsibility for consumer credit regulation will be transferred from the UK financial services watchdog the Office of Fair Trading (OFT) to the Financial Conduct Authority (FCA). The FCA has announced that it will enhance protection for both borrowers and lenders using peer-to-peer platforms. Although it is not yet clear what form this enhanced protection will take, we can predict that additional regulation will also increase overheads.

As the P2P market becomes more regulated, platforms develop more infrastructure, and overheads rise, will lenders' returns drop? And will P2P platforms eventually become indistinguishable from small online banks? For the time being, it looks as if the system is catching up – at least until the next peer-to-peer innovator develops a model that succeeds in neutralizing these costs.

References 

Peer-to-Peer: Filling the Lending Gap, Datamonitor, July 2013

High-level proposals for an FCA regime for consumer credit, FCA Consultation Paper CP13/7, March 2013

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