The promise and pitfalls of peer-to-peer lending
Peer-to-peer consumer lending is the largest component of the alternative online lending market in Continental Europe, making up 72% of the total in 2016. And it’s a growing market – the peer-to-peer lending industry experienced 26% industry growth between 2015 and 2016. These stats beg the question: Are these players starting to tread on the toes of banks in the loans and savings space?
Peer-to-peer lending (P2P) is one of the two main forms of alternative finance – the other being crowdfunding. Peer-to-peer lending platforms first appeared in the UK in 2005, innovatively matching borrowers and lenders together and bypassing the banks. It is for this matching service and the sourcing of borrowers that P2P platforms charge a fee, which is factored into the interest rates that lenders receive and borrowers pay.
So why would people choose to invest or borrow money through a peer-to-peer website over a trusted incumbent bank? Well, the theory behind P2P lenders is that all parties get a better rate; because the bank is cut out of the equation, borrowers pay less interest than they would on a bank loan, while lenders receive better interest on their investment than they would from a bank’s savings account. As of 5 May, for example, P2P platform RateSetter was offering a rate of 2.7% on its ‘Rolling market’ investment – its equivalent of an instant access account. Meanwhile the best easy access savings account advertised on price comparison site Money Supermarket paid just 1.1%.
The need for speed
Another advantage that many P2P platforms claim is that borrowers will get approval and receive funds quickly. For example, SME P2P provider Funding Circle states on its website that, typically, applications take under 10 minutes, are assessed within two working days, and funds are received within a week.
In contrast, a smooth and slick process is something the incumbent banks have struggled with in the past. When Mapa asked three leading incumbents for typical SME loan timeframes in late 2016, their estimates ranged between 12 and 15 days for the SME to receive funds.
We know this is something that banks are currently working to address. NatWest, for example, recently announced the launch of a new digital site called ‘Esme’, providing instant-access business loans to SMEs, while HSBC has begun the global rollout of LinkScreen, a virtual platform that will allow businesses to complete business loan applications whether they’re in the office, at home or on the road. But if customer perceptions are that bank loans will take a long time then P2P lenders can use this to their advantage.
Higher reward comes with higher risk
While it may be growing, P2P still has some way to go before it can compete with banks in terms of volume. So why don’t more savers and borrowers use P2P services over banks? In terms of a way to get returns on your deposits, P2P savings appear closer to traditional cash savings accounts than investments in funds or shares. Like cash savings, they pay an interest rate that is agreed up front rather than returns being entirely dependent on market performance (which can go down as well as up).
Well, firstly, P2P platforms do come with a higher degree of risk than conventional bank investments, as there is no iron-clad guarantee that loans will be repaid if the borrower defaults. While to date there have been no major issues, any funds lent through a peer-to-peer website are not covered by the government-backed FSCS (Financial Services Compensation Scheme), which protects bank savers up to £85,000. P2P may look very similar to cash savings, but as there’s no savings safety guarantee yet, it may be considered more like a middle ground between savings and investments.
And peer-to-peer lending is an ever-growing industry, so much so that in some cases the amount lenders want to invest is greater than the money borrowed. For example, from March to the time of writing, Zopa (the UK’s first P2P website, founded in 2005) has frozen applications to new lenders due to high demand. Balancing the amount of money lent and borrowed may prove to be difficult for P2P lenders as they continue to expand their business, as Zopa has found out.
From a borrower’s perspective, while peer-to-peer offers an alternative to banks that is well worth considering, there’s no guarantee that the rate you’ll be offered will be better than that you could get from a bank – particularly if you’re considered a high risk – or that you’ll secure a loan at all if your credit history is poor.
Meanwhile, trust will remain an issue for many, especially in a sector in which – until recently – there has been little or no regulation. The FCA only started regulating P2P lending in 2014, stating that they must present information clearly, be transparent about risks, and have a contingency plan if things go wrong.
Since April 2017, P2P firms are legally required to incorporate an emergency fund of at least £50,000 should the company be hit with financial shocks or difficulty. Whilst having an emergency fund as a legal requirement shows that P2Ps are making regulatory progress, £50,000 is still a comparatively small figure when compared to the huge sums that are lent via P2Ps every year.
In May 2017, Zopa announced that it had been granted full FCA authorisation for peer-to-peer lending. This is a major step to becoming a regulated financial institute, which offers a range of new financial products such as the Innovative Finance ISAs (IFISA), and Zopa will also seek permission from HMRC to become an ISA Manager.
Competing with incumbents
Even putting regulatory concerns aside, a major challenge for P2Ps is that they lack both the brand recognition and consumer trust that incumbent banks have. It doesn’t matter how much more money borrowers and investors can save by using a P2P website compared to incumbent banks, if they’re not trusted then people won’t use them.
After the financial crisis in 2008, consumer trust in banks was at an all-time low. If P2Ps such as Zopa couldn’t make more considerable market advances at that point, then why would they now? If they’re going to prosper then they need to do more to get their concept and brand names out to reach a wider audience, as this will build consumer trust and encourage people to go to them.
One of the ways in which they can do this may be to partner up with other financial organisations, so financial institutions’ loan offerings can be ‘powered’ by the associated P2P company. An example of this is Zopa’s partnership with UK-based money management app Pariti in 2016. Based on each individual’s financial situation, Pariti may direct customers paying high interest rates on their debt to apply for a consolidation loan with Zopa.
The user experience of this journey is smooth, and Zopa’s integration is seamless. Users have to fill out some personal details and state how much they want to borrow over a time period, then they are told how much the consolidation loan will save them.
Another example of a partnership between a bank and P2P is Revolut’s link up with Lending Works, where Revolut customers can use Lending Works to provide customers with instant credit. Partnerships such as this can benefit both parties’ revenues, as well as saving customers money and the time of having to set up an account with the partnered P2P, as customer’s information is retrieved from the financial institution.
As yet, P2P platforms’ partnerships in the UK have been with financial organisations that are relatively new to the scene themselves, rather than incumbents, but there’s the potential for this to change. The implementation of PSD2 and Open Banking will also make it easier for customer data to flow between partners, which may encourage more relationships with P2P platforms.
Of course, there is also the possibility that incumbent banks will acquire, rather than partner with, the big P2P websites, causing much of the P2P industry to merge with the banking industry. Or incumbents may even choose to build their own P2P services, as Commerzbank in Germany has done with its Main Funders platform. However, with the P2P industry ever-growing and increasing in revenue, it would be a surprise to see some of the market-leading P2Ps up for sale.
The future of peer-to-peer lending
Despite their expansion, peer-to-peer lenders haven’t consistently been profitable. According to a July 2016 analysis by Business Insider, the UK’s two biggest P2P lenders – Zopa and Funding Circle – had reportedly lost at least £50.5 million since the first platform opened up in 2005. The argument from both Zopa and Funding Circle was that the losses were down to investment in growth, which is a fair argument for relatively new ventures. The same report noted that two other P2P platforms – RateSetter and MarketInvoice – were already profitable, and Business Insider reported later in 2016 that Zopa had subsequently started to turn a profit.
If P2Ps get their trust-building tactics right – including investigating and following up on partnership opportunities – their future looks bright. The onus on incumbents will be to improve their own loans and savings offerings, whether that’s through building their own competitive products and improving customer experience, or through partnering with the P2P platforms. If banks do up their game, P2P platforms will need to stay one step ahead to avoid fading into insignificance.