Since Zopa pioneered the P2P lending industry over a decade ago, we have seen a diverse and unique industry expand to include, consumer, business, invoice trading and property lending. There are even dedicated online publications that are devoted to writing about it – take AltFi as one example. Whilst each platform is subtly different, almost all have a shared characteristic – transparency. It is this transparency, along with the disclosure of lending data, that really sets these services apart from the traditional banking model.
To understand why transparency is central to this innovation it is useful to reflect on what has enabled this wave of financial disruption. The principal enabler has been technology, and this has introduced two factors that are helping people bypass the banks.
The end of bricks and mortar
P2P and market place lending is essentially serving the same purpose as banks when it comes to matching money, it’s just P2P platforms are doing it purely online. Investors are still being matched to borrowers but in a more efficient way that provides better value for both parties.
The traditional destination to find and interact with both cohorts used to be a bank and their network of branches – but this has now been replaced by the internet. By removing expensive overheads and fixed costs, these savings can then be shared between the borrower and investor in the form of better rates for both parties.
Introduction of new risk metrics
On top of providing a good avenue for matching borrowers and lenders the internet also serves as an excellent place to source data – and lots of it. Banks have based lending decisions on broadly the same set of criteria for many years. But the internet, and the collection and analysis of big data, allows many more factors to influence a lending decision. This in turn allows risk to be more appropriately priced in the light of the additional information.
One example is Zopa’s partnership with Uber. A bank might be reluctant to lend to an Uber driver based on conventional metrics such as income, home ownership, length of time at current address, prior credit history etc. But, by using Uber’s data, Zopa can make an extremely well-informed decision about a driver who applies for a loan. Critically important factors, such as hours driven per day, revenue per day and passenger satisfaction score, can all enter the decision making process. This allows the risk of default to be sensibly appraised and a loan extended.
When you consider how hard it would be for a bank, hamstrung by legacy IT, to integrate the technology upon which this process is built, you realise the durability of what has been created. Furthermore, more accurate pricing of risk is to the benefit of all in the long run, as is better access to credit for those that represent a reasonable risk.
And whilst overall volumes remain small in absolute terms, the rates of growth make this sector impossible to ignore. Last year the alternative finance industry originated £2.8bn of capital. This is more than the industry had originated in the previous nine years since the sector launched.
No skin in the game
So far, so good. But the naysayers insist that something must be wrong here. Where is the alignment of interest they complain? Where is the lending platforms’ ‘skin in the game’? The major concern to the casual observer is that the platform has no incentive to list sensible risks at sensible prices because the majority of their revenue comes in the form of an arrangement fee, giving no exposure to the viability of the actual loan. i.e. if a loan defaults, the platform doesn’t share directly in the loss.
Except they do. All of the major P2P and marketplace platforms recognise that their skin in the game is actually their track record. As a result, the major platforms publish their loan books in great detail.
With complete transparency they allow the world to see if their loans are performing. And the marketplace is thriving on this transparency. The Liberum AltFi Volume Index clearly illustrates that the most transparent platforms are growing fastest. Essentially, disclosure allows choice. The excess liquidity that is seeking a return can identify, from published loanbooks, where the most appropriate lending is occurring.
Thus far investment capital has consistently proven that it is attracted to the platforms that can most transparently demonstrate good lending performance. In fact, as the chart below demonstrates, the market share of the big five UK platforms is now growing impressively. It strikes us as more than coincidence that these also represent the highest standards of sector transparency.
The sheer weight of new entrants ensured that the big five suffered erosion of their market share to a low of 71% through to August 2014. Since then their share has rebounded strongly now sitting at 81%. The wave of institutional capital that has been flooding the sector since summer 2014 is clearly favouring the platforms that offer transparency.
Society should benefit from this disruption
This transparency should bring a huge benefit to the financial system as a whole with information conveyed more efficiently. Banks offer extremely limited visibility of their loan book. As a result, if losses are climbing, it takes a while before the wider financial system can react. Not so with the advent of online lending.
The UK P2P industry now includes a small but representative sample of consumer, SME, and property loans. The world can now watch the arrears and default metrics in not far off real-time. On top of this, ownership of credit risk is being more widely dispersed. Or put another way, risk is increasingly less concentrated amongst the big banks, upon which we have such an over-reliance that a failure would have such an impact on the financial system as to make it impossible to countenance.
And all of this reflection leads us back to inspect the logic of the ‘skin in the game’ argument. Ultimately the usefulness of the ‘skin’ depends on the brain that put it there. What comfort is it having your interests aligned if the entity you are aligned with makes a poor lending decision? The trouble with the skin in the game argument is that it relies on the owner of the skin making good decisions. Suddenly the choice between:
- transparent capital matching platforms
- banks that are aligned by their own capital but are determinedly opaque
The open publication of P2P and marketplace loan performance allows for the calculation of sector returns. The Liberum AltFi Returns Index reveals the impressive returns available to investors across an increasingly deep pool of loan assets.
The index is made up of the four largest UK platforms by market share. Together these four platforms represent 75% of the UK P2P market. The index represents the net return to an investor and shows that this asset class has delivered a return of 6.19% over the past 12 months.
Equally impressive is the longevity of the track record and the durability of the return. Whilst the sample size was far smaller during the dislocations and stresses of 2008/9, represented only by the pioneering platform Zopa, it is remarkable to note that, net of all defaults and fees, investors still made a healthy return.
Benchmarking creates trust
The unprecedented level of transparency that P2P offers versus incumbent banks can be powerfully advertised with the use of a benchmark. This also improves the visibility of this exciting new asset class and brings both context and validation.
A benchmark provides context by enabling the illustration of available return. In its purest form this means the identification of the excess return versus the risk free rate. In effect how much excess return is on offer by investing in P2P versus in a ‘risk-free’ asset – likely in this case to be an FSCS covered deposit. With the theoretical risk free rate hovering around zero, or a real world proxy at around 1%, 6% is a net return that stacks up well in the face of current alternatives. Effectively 5% is the excess return that compensates for the higher risk of a diversified exposure to SME, consumer and property loans versus a bank deposit.
If correctly constructed and maintained, a benchmark can create validation by highlighting this excess return. The UK P2P sector is extremely fortunate that the major platforms have adopted such impressive levels of disclosure because it allows the return of the asset class to be illustrated with complete credibility. Importantly the Liberum AltFi Returns Index has loan book disclosure as a central criterion of eligibility. This ensures that all of the underlying loan assets are disclosed and subject to peer review. This brings a high level of confidence to the available return that the benchmark represents.
Adoption of benchmarking by asset managers
The next stage of communicating this sector’s return to an increasingly wide pool of investors will be the adoption of a returns benchmark by the specialist asset managers in the sector. These asset managers need to advertise to prospective investors the impressive returns that are available. A benchmark serves this purpose whilst also conveying two further important messages.
Firstly, it allows the asset manager to demonstrate an ability to out-perform the return that an investor might achieve by investing directly. Secondly, it allows the asset manager to demonstrate accountability and the value that they are adding. By advertising performance versus a benchmark the asset manager is acknowledging that a standard exists which they could be reasonably expected to beat – and that they acknowledge the need to do so. As asset managers adopt an industry standard benchmark it will further improve the visibility of the sector and, in so doing, attract further retail and institutional investors to the space.