By Gareth Vaughan
It's not every time I interview someone that I think "that's exactly what I'd be doing if I was him/her."
But this was the thought that struck me when I spoke with Finance Direct managing director and 70% owner Wayne Croad back in April. Croad is also the sole shareholder and director of Lending Crowd, a new company he's setting up with the aim of becoming a peer-to-peer lender, and this is what I was talking to him about.
Peer-to-peer, or P2P, has the potential to cut a swathe through the world of small, consumer lending focused finance companies like Finance Direct. But it goes much further than that. P2P has the potential to be to banks' consumer and SME lending what Trade Me is to the world of second hand sales and newspaper classified advertising. It also has the potential to have a significant impact on banks' deposit gathering.
Although only in the maternity ward in New Zealand, P2P already has a global presence, with numerous platforms in China, and impressive recent growth in the United States and Britain. In Britain the Government has lent tens of millions of pounds via P2P platforms, and in the US Lending Club, which has been valued at almost US$4 billion, has facilitated more than US$4 billion of loans and is expected to list on the sharemarket later this year.
The diagram below from investment bank Liberum Capital demonstrates just how widespread P2P, in various guises, is already.
Match making & market making
P2P's New Zealand parent is the Financial Markets Conduct Act, which came into force on April 1 and has been described by the Government as a once in a generation shake-up of securities laws. The Financial Markets Authority (FMA) now has the power to issue P2P lending licences, and has so far received applications from two entities - Harmoney and Lendit.
P2P lending licences granted by the FMA will enable successful applicants, as intermediaries, to run websites matching borrowers with lenders and charge fees for doing so. Elaine Campbell, the FMA's head of compliance monitoring, told me in April; "It's a bit like an online dating service. Essentially what they are doing is introducing people wanting to lend money to people wanting to borrow money."
Charles Moldow, a P2P bull from Silicon Valley venture capital firm Foundation Capital and an investor in P2P including Lending Club, points out there's more to it than that. It's also market making. Moldow recently published a report entitled A trillion dollar market by the people, for the people. Here's a taste of what he's saying;
Traditional lending works well. For the banks.
For centuries, banking has remained fundamentally unchanged. In the simplest terms, banks match savers with borrowers. They pay interest for deposits and make loans to businesses and consumers. Depositors see their savings grow, borrowers use the capital. Banks profit handsomely on the spread.
Banks, as intermediaries, have always added to the cost of borrowing and lending – that’s the price we pay as a society for their market-making abilities. That spread represents a price that was accepted because the banks played a part in the community, and served community needs.
Today, they do neither. Consolidation has created national mega-banks that are more financial mega-stores than they are pillars of the community. And following the 2008 financial crisis and the regulation that ensued, lending has dropped precipitously. While volumes have declined, profits have held. Why?
Because banks make a significant, and ever expanding, profit off the spread.
In the 2000s, in the US alone, consumers paid a trillion dollars in credit card interest expense to banks.
But today technology and innovation are making possible a new generation of financial services that are more affordable and more available.
That’s why we believe what we’re calling marketplace lending will be a trillion dollar market by the people, for the people. For the first time in banking, the online marketplace makes it possible for a third party to match idle supply and demand. As a result, lenders and borrowers can now find one another and agree to terms – all without the involvement of retail banks or credit card companies.
By 2025, we predict that $1 trillion in loans will be originated in this manner globally.
We believe that when that lending activity is taken off of the books of big banks, there will be much less need for government to backstop those banks – thereby rendering irrelevant the concept of “too big to fail.”
This new system of lending and credit began as “peer-to-peer” (P2P), but the system is creating so much value that has grown to involve a diversified set of investors. While this system is “disintermediated,” because it removes traditional retail banks and credit card companies from the transaction, it goes beyond that. In fact, the best platforms provide some form of intermediation – such as by scoring borrower quality to enable lenders to make good decisions.
“Marketplace lending” is a better name to describe this new system, which is fundamentally about creating platforms to connect borrowers with lenders.
Liberum issued a report of its own on P2P earlier this year that came to these three key conclusions;
1. P2P sector is the ‘Walmart’/‘Ryanair’ of financial intermediation: costs 60% lower than banks; will help save the UK estimated 2% of GDP or £30bn per annum ($280bn for US) as savers and borrowers connect more efficiently.
2. ISA (individual savings account)-ability of P2P will drive sharp acceleration in UK P2P lending: not unreasonable to expect 48x growth in UK gross P2P balances within 5-10 years to circa £45bn.
3. BUY P2P equity & debt and prepare to SHORT banks. P2P offers 5-10x equity upside by 2024 with sector market cap of $100-200bn+; likely to start negatively impacting bank valuations within 5 years as investors start to extrapolate P2P’s growth trends.
Regulators taking notice
With the growth of P2P it's not surprising that regulators are taking notice. The International Organization of Securities Commissions (IOSCO), the Madrid-based body regarded as the global standard setter for the securities sector, has issued a working paper on crowd funding and P2P that it describes as the first publication tying together a global overview, mapping the regulatory landscape.
The chart below, from IOSCO's report, shows the growth of P2P lending over the past seven years. The report points out if this rapid growth continues, the lending originated through P2P could hit US$70 billion in five years, highlighting the potential for P2P lending to become a decent sized market in a short timeframe.
IOSCO's cautionary tale & concerns for retail investors
As regulators do, IOSCO makes some cautionary points about P2P and raises some concerns. These include;
In P2P lending there has been a concerted effort by the industry to reduce default rates, which reached a high of 30% in 2009. While there has been some success in reducing the default rate, the actual rate of default in many cases is unknown as many of the platforms have only opened in the last three years and the loans originated by them have only recently started to mature.
Risk of platform closure/failure: Despite the short life of crowd-funding, there has already been a case of a P2P lending platform closing leaving no data on contracts behind and resulting in 100% investment loss. Investors bear a higher risk than in many other types of investments.
Risk of fraud: This is compounded in both P2P lending and equity crowd-funding by the anonymity created by the online aspect of these industries. This is the case for both the lender/investor and borrower/issuer parties, whereby the opportunity to defraud is an ever present reality.
The P2P lending market is very small, accounting for only a fraction of all credit provided to the real economy. However, it is an industry that is almost doubling each year in size. This means that even though the current market size is too small to cause systemic risk, it has the potential to grow to a sizeable market in a short amount of time. There is a lack of liquidity in P2P lending, with relatively few platforms providing a secondary market on which to sell loan portfolios.
There have been recent examples of the securitisation of peer-to-peer unsecured loans. This opens the market to new investment, but also opens the rest of the financial market to exposure to packaged loans which are predominately unsecured in nature. Since this segment of the market is extremely small, it is not currently a source of systemic risk.
P2P lending suffers from the same risks associated with any other credit provision institution, which include: identity theft, money laundering, terrorism financing, consumer privacy, and data protection violations. But, in order to take advantage of the lower costs associated with technology most platforms operate solely through an internet portal or website. This means that there is a higher chance of fraud in both P2P and equity crowd-funding platforms due to the inherent anonymity that the internet offers. In some jurisdictions, the industry itself has taken the initiative for self-regulation in order to mitigate this risk.
Some platforms report that they manually check each borrower for fraudulent motivations before allowing them to advertise for lenders on their sites; others use third party information as well as checking the identity of the borrowers before originating the loans. However, relatively few do similar background checks on the lenders, with most only doing the minimum required to bring them in line with anti-money laundering laws.
The current high rates of return coupled with a lack of safe high-yield investments alternatives, could mainstream this type of investment. Government moves to actively finance business through these sites could dim the perception of risk and stimulate more retail investor interest, thereby increasing market size and the potential impact of any adverse market event. Actual default rates are unknown, increasing the potential for these platforms to fall short of the expectations created through advertising.
As this market grows the likelihood of it posing a systemic risk also increases. The lack of collateral means that if these investments, and their securitised versions, do become undermined by borrower default the result could be grievous, especially for retail investors who might not have the funds to absorb the fallout. For all these reasons, P2P lending raises issues with investor protection.
Though these industries do not currently pose a systemic risk they do raise questions about investor protection. Retail investors are of particular concern. They may not fully understand the investment risks they are undertaking. Both equity crowd-funding and P2P lending are opaque when it comes to disclosing some risks. This and the illiquidity in their secondary markets place retail investors at a disadvantage; if the investment goes bad they may not have the collateral to absorb the loss.
Below is an IOSCO chart on loan default rates at some P2P platforms. However, IOSCO cautions these are the largest, most successful platforms, and even the oldest platforms, which opened before 2008, have only recently started getting data on the overall rate of default.
"Many platforms have only been in existence for a short period of time, and the majority of the loans issued by P2P lending platforms have still to reach maturity; the average maturity is three years," IOSCO says.
In the shadows
Although in New Zealand the FMA has oversight of P2P lending, because it'll be part of the shadow banking world it's something the Reserve Bank should also keep a close eye on. In China, whose shadow banking sector western financial markets watchers are avidly trying to keep tabs on, Liberum says 58 of the 1,000 P2P platforms went bankrupt in the fourth quarter of 2013, although it cites macro-economic problems rather than P2P model issues as the core reasons.
And in its early years of operation Prosper, one of the big US P2P lenders, had a loan default rate above 20%, although this has since been reduced to around 3%. As Moldow puts it; "So many people lost money on Prosper between 2006-2008 that it resulted in a multi-million dollar class-action lawsuit and settlement."
Of further interest to the Reserve Bank is IOSCO's point that if P2P lending offers banks the opportunity to lend off balance sheets, this brings into question the effectiveness of banking regulation. That's because regulation could be circumvented through the use of P2P lending platforms as an intermediary between banks and a borrower.
So what can we expect from P2P lending in New Zealand?
As with any form of money lending, there's risk. Loans will go bad and people will lose money. A key thing New Zealanders keen to partake in P2P as either lenders or borrowers, or both, ought to remember is don't bite off more than you can chew. And make sure you understand what you're getting yourself into, and what the risks are.
P2P is a very exciting development, but it won't be for everyone. I'm hoping to see steady, rather than spectacular, growth as P2P lending gets underway in New Zealand. I want to see the industry walk before it tries to run. The regulators will also need to be alert, and cautious about who they give licences to. With the meltdown of the finance company sector still fresh in many minds, a new wild west is something the New Zealand investment scene does not need.
Harmoney, which looks likely to be the first cab off the rank, plans to limit lenders' risk through the use of fractionalisation. This makes good sense because it means investors'/lenders' money will be broken down into $25 lots and spread around different borrowers. You can see more about Harmoney in this video interview with founder and CEO Neil Roberts.
In the New Zealand scenario, P2P loans will have be legally binding and enforceable, and P2P platform operators are required to have a debt collection process. Some loans are likely to be secured, others not. P2P platform operators require "adequate and effective" processes, and controls for conducting background checks on borrowers and assessing the risks of non-payment, such as via a credit check. They will also have to publish information about the rate of default by borrowers in a "fair, clear and transparent" manner.
Borrowers by law won't be allowed to borrow more than $2 million annually through P2P platforms.
Harmoney also plans to price interest rates via a scorecard with a risk grading system featuring 30 grades ranging from A at the top to G at the bottom. This is similar to how Lending Club prices risk. The diagram below comes from Lending Club's website. See more on Lending Club's pricing details here.
Like many business models centred on the internet P2P promises to be very efficient and transparent.
Here's Moldow again;
By moving lending online, marketplace lenders generate cost advantages of over 400 basis points compared to traditional banks. Branch offices consume 30-35% of most banks’ total operational expenditure; additionally, their originations practices are less efficient than online marketplaces. This built-in cost advantage enables marketplaces to out-compete retail banks on price, over and over again.
Bill Gates was right two decades ago when he observed banking is necessary but banks are not. Marketplace lending is now poised to demonstrate how accurate that observation was. Yes, banking is still largely being provided by banks. But marketplace lending is changing that. We see transformational change ahead not just for lending, but for the entire financial services industry, from consumer and SMB (small and medium business) finance to payments to equity, insurance and beyond.
Full Transparency: Anyone can download Lending Club’s complete loan book directly from their website
And here's Liberum;
• Lending Club expects to be 60% more efficient than the equivalent banking business, on costs as % of loan balances, by 2015e
• P2P has no expensive branches/legacy systems/ expensive regulatory capital to service.
Liberum also details the fees overseas P2P platform operators' charge borrowers and lenders, which are likely to be similar in New Zealand.
Platform revenue from borrowers: Upfront 2-5% of principal. Approx equivalent to 1% per annum on balances over life of loan.
Platform revenue from lenders: Annual fee of typically 1% of loan balances (details vary slightly by platform).
And here's a Liberum diagram detailing this.
Where banks fit in
Overseas P2P is certainly getting noticed by banks, bankers and institutional investors. Barclays has bought 49% of South Africa's RainFin, Westpac took a minority stake in Australia's SocietyOne for A$5 million, and Spain's Santander is partnering with Britain's Funding Circle. In the US Lending Club and Prosper now say more than half their loans are being bought by institutional investors such as hedge funds and pension companies. And New York-based Eaglewood Capital sliced and diced (securitised) US$53 million worth of P2P loans, selling them as bonds.
The current low interest rate environment has definitely helped the development of P2P. Lenders/investors receiving fixed interest rates will need to consider how the fixed rates will look if interest rates rise. Another thing to watch will be credit card delinquency trends. In the US P2P lending as debt consolidation comprises 83% of Lending Club's loans, and 52% of Prosper's loans. New Zealand's current buoyant economy suggests it's a good time to launch a P2P platform, but, as ever, the economy will fluctuate.
P2P lenders will, of course, also face competitive moves but not only from traditional financial service providers. Liberum notes Facebook's ‘Agree It’ app which is freely downloadable and offers a form of P2P lending between friends. Facebook gets revenue from this app through advertising rather than charging users fees. Google's clearly watching P2P given it owns an 8% stake in Lending Club.
And I'd expect regulations to tighten over time for P2P.
As with most challenges to entrenched players in a market, traditional financial service providers can view P2P as an opportunity or threat. If New Zealand banks want to embrace it, they have the option of buying P2P platforms, getting licences for their own ones, and using their capital to fund loans via P2P platforms which the likes of Titan Bank and Congressional Bank are already doing in the US.
There's no getting past the fact that P2P has the potential to reshape banking, especially retail banking. As a journalist in the late 1990s and early 2000s I recall newspaper publishers not taking the internet seriously. Time has shown that to be a poor judgment. Because as Croad put it; "you can't stop progress."
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