History in the making: the rise of Peer-to-Peer Lending
Peer-to-peer lending has an inherently ‘geeky’ sound about it. Somehow the domain of Mac users, digital early adopters – a very online thing, a million miles from the high street. And yet in just over five years, in the personal loans arena, it looks set to threaten the dominance of that most ‘everyman’ of institutions – the high street bank.
If we use its other moniker, that of “Social Lending”, then the impact that this new financial services model is having seems to make more sense. Given the meteoric rise of FaceBook and Twitter, after the slightly slower-burning but ultimately huge victory that is eBay’s success, then a five year history seems more than long enough to have achieved something remarkable.
So what is peer-to-peer (p2p) lending? In its broadest definition it is of course as old as the hills – and much older than banking. For thousands of years people have lent money to other people, whether within families, tribes, villages or working environments.
But in its modern guise, it is an online service, which allows the connection between people to be much more distant, virtual, even effectively anonymous. Although the nature of financial regulation ensures that each p2p lending business is constrained to within the boundaries of the given country, that is its only limitation in reach. So unlike credit unions, which do have some conceptual similarities, membership of a p2p lending group can be much wider – theoretically the entire population of that country.
P2p lending works through the marketplace concept. The p2p lending website is where the two sides of the transaction – people with spare money to lend for a return, and creditworthy people who want to borrow – come together and do business at a rate they agree between themselves. Although the business models and propositions vary considerably across the more than forty p2p lenders set up across the globe, most offer some level of credit and affordability checking of would-be borrowers. This is vital to ensure that lenders – who are ordinary people, not credit experts – are not taking disproportionate risk in lending via these marketplaces.
This is where the pivotal difference is from banking. Rather than a bank taking in deposits – on to their balance sheet – that they agree to pay interest on, whilst using that and other monies to lend to others at another rate, there is no linkage at all between the two. The size of the difference or ‘spread’ is entirely at the banks discretion and is the measure that determines the relative strength – or weakness – of the offer.
Since the worst moments of the banking crisis, these spreads have hit record levels, as the banks seek to profit by paying out interest at very low levels (also driven by very low Bank of England rates) while charging very high levels of interest on loans. These very large spreads have undoubtedly helped the p2p lending concept attract significant media and consumer attention, as the much lower charges taken by these new marketplaces ensure that both the borrower and lender end up with a far better deal.
The very first p2p lender anywhere in the world was Zopa.com, built and launched in the UK in March 2005. In the Zopa model, all borrowers are checked very thoroughly through credit agencies and if of sufficient quality are placed in one of five ‘markets’ (A*, A, B, C and Young) based on the risk level they represent. Lenders then make offers into those markets of how much they are prepared to lend, over what term and at what interest rate. The technology carries out the matching process, assembling the best value loan for each individual borrower from the money offered by lenders on the marketplace, while spreading each lender’s money across at least 50 different borrowers to spread risk. If the borrower likes the rate they accept it, and that money is immediately ring fenced for them. Further borrower checks are made at that stage – mainly to check that the borrower can readily afford to repay the loan – and if successful the loan is made at the rate originally offered. Capital and interest payments are then made by direct debit from the borrower back to the client holding account where the payments are allocated to each of the borrower’s many individual lenders.
Five and a half years after launch this first p2p model is proving very successful. More than £110 million of loans have been arranged, at rates agreed by borrowers and lenders between themselves through the marketplace. Stringent credit and affordability checks have kept the loan default rate below 1%, while borrowers have secured interest rates at typically 20% less than the best they could have got from a bank. Over the last 12 months, those lending through the Zopa markets have enjoyed an average return from their lending of 8.1%, after charges, but before any bad debt and personal taxation. In terms of market share, Zopa loans now represent about 1.5% of the new unsecured personal loans taken out in the UK.
A number of new entrants have launched into the UK p2p market recently, including Rate Setter, Quakle and Funding Circle. The latter is of particular interest as it arranges loans from ordinary people to small companies rather than to other individuals. Given the high profile debate in Westminster and the media about banks failing to support SMEs through their reluctance to lend, this new p2p lending variant is attracting much attention.
P2p lending has also made a significant impact in the USA, although it is fair to say the road has been rockier. Much of this has been down to the fact that the regulator – the Securities and Exchange Commission (SEC) – has taken the polar opposite approach to the UK’s FSA. In brief, the FSA has deemed p2p lending to be outside its jurisdiction, leaving only the borrowing side of p2p lending regulated; by the OFT and the Consumer Credit Act. In the USA, the SEC has been far more active and has actually closed more than one operation due to regulatory concerns.
This is perhaps not surprising given that the earliest models opened in the USA took a much more ‘gung ho’ approach to their offer. They allowed far riskier borrowers to seek loans, and without much if any credit checking by the p2p lending marketplace. This created the dangerous situation where lending looked more attractive because of the higher interest rates accepted by these borrowers. As a result a large amount of lending was done, but only for much of that money to be lost when these borrowers defaulted on a massive scale.
The SEC has taken steps to protect people lending through the p2p concept now, although some commentators fear its regulation is inappropriate and that in reacting to the flawed early models, it has gone too far, and damaged the ability of the p2p model to work effectively.
Turning back to the UK, it is interesting to note that a number of the p2p lending firms are – in the absence of regulation – coming together to set up a code of conduct to help both consumer protection and the reputation of this new emerging sector. In the absence of any regulatory barriers to entry, they fear a less scrupulous or unprofessional new entrant would be free to emulate the mistakes made in the USA, causing considerable consumer detriment and damage to the image and standing of the p2p lending concept. Although these plans are currently at an early stage, some operations have already lobbied the FSA and HM Treasury to put in place appropriate regulation for the sector before a rogue new entrant is allowed to cause consumer detriment and spoil the image of this new financial service.
In seeking to assess the potential for p2p lending, the views of many traditional bankers have been rather dismissive. Their response has often been to simply point out the tiny relative size of these new businesses. This of course is understandable, but then again, the same could have been said by the big retailers of eBay in its early years, and now eBay is the largest retailer in the world.
The truth is that it is early days for p2p lending and its future is certainly not guaranteed. However, as banks around the world continue to lick their wounds from the recent crisis, and continue to struggle with their reputation amongst their consumer audiences, the time has never been more right for a new alternative to make significant inroads.
