In a Nesta report entitled ‘Pushing the Boundaries: The 2015 UK Alternative Finance Industry Report’, peer to peer lending platforms recognised that the greatest risk to the continued growth of the asset class was not an increase in regulation or tax-efficient incentives (or lack thereof), but rather the conduct of platforms themselves, specifically: malpractice or cyber security breach. P2P lending is continuing to grow and mature at a healthy rate, but platform risk can often be over-looked and is something the FCA is still in heavy consultation over. We explore this risk and offer an effective solution in the form of platform-level diversification, which, while seemingly simple, can in practice be more problematic.
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Defining ‘platform risk’
Platform risk can be separated into three main categories, outlined below. It’s important for investors to consider these prior to investing across a platform and remember that peer to peer lending is an asset class that is still in its relative infancy, and most platforms, while perhaps performing well, have not suffered an economic downturn and had their stability tested.
Platform failure is the primary category associated with platform risk. While the FCA has rules in place to ensure loan commitments are repaid in the event of insolvency, investors would suffer turbulence should the event occur. Moreover, a number of platform failures in a short period of time due to extreme economic stress would likely have a significant detrimental effect on market sentiment.
Swedish-based TrustBuddy, the first listed P2P lending platform, suspended operations in October 2015 having reported itself to the police due to the discovery of serious misconduct, including misuse of client money. This was the first high-profile incident in the global P2P market.
Transparency is a key pillar of peer to peer lending. Some major UK platforms make their loan books available, enabling analysis to be performed on their credit decisions. This does not prevent fraud occurring, however. The FCA stipulates that platforms must segregate the investor’s cash into a separate client account, thus mitigating risk of fraud.
U.S giant, LendingClub, was exposed in May 2016 after CEO Renauld Laplanche resigned, taking the fall for the mis-selling of loans. The platform’s share price dropped more than 25 per cent upon news breaking.
The FCA’s definition of peer to peer lending is ‘Operating an electronic system in relation to lending is a regulated activity under 36H regulation of the Regulated Activities Order.’ With this in mind, a breach of technological security carries significant risk and is viewed as such by P2P lending platforms (discussed below).
For more on risks associated with P2P, read ‘P2P Risks: Professional Analysis of the Safety of P2P’
P2P market perception of platform risk
As referenced in the opening paragraph, a survey of major players in the UK P2P market concluded that platform conduct is the greatest risk P2P faces. The Nesta report states:
The potential collapse of one or more of the well-known platforms due to malpractice was seen as the highest risk to future growth, with 57% of surveyed platforms considering this factor as a high or very high risk
Here is a breakdown of the top 4 risks in order of riskiest, based on those surveyed by Nesta.
|Risk||% Very High Risk||% High Risk|
|Collapse of platforms due to malpractice||20.8%||36.5%|
|Cyber security breach||18.8%||32.3%|
|Increase in defaults/business failure rates||13.5%||33.3%|
|Fraud involving high profile deals/loans||11.5%||34.4%|
Below you can view Nesta’s table of results more broadly.
Source: Nesta Report
FCA on platform risk
The FCA fully regulated P2P lending in 2014, and expects to complete a review of conduct requirements and develop rule-based alternatives by 2019. This will follow the City watchdog’s post-implementation review which was published in 2016 and was contributed to by peer to peer industry players.
View the FCA’s review here: ‘Interim feedback to the call for input to the post-implementation review of the FCA’s crowdfunding rules’
Within the survey sent out to respondents, the FCA listed a number of concerns that it wished to address, including concerns relating to platform risk, such as:
- The plans some firms have for wind-down in the event of their failure are inadequate to successfully run-off loan books to maturity.
- We have challenged some firms to improve their client money handling standards.
Taking bullet point one into consideration, platform wind-down, or “resolution plans” (as referred to by the FCA), ensure loan repayments will continue to be administered to investors in the event of platform insolvency.
There were 39 respondents to the FCA’s question: ‘Do you have any comments on the resolution plans of firms operating loan-based crowdfunding platforms?’.
- Improving wind-down plans
- 5 respondents believe wind-down should be administered by a backup service provider and not the firm itself
- 4 respondents believe there’s not enough firms in the market capable of servicing wind-downs
- Regulatory requirements for wind-down
- 6 respondents said current FCA rules on wind-down are difficult to understand
- 2 respondents suggested further rules/guidance from the FCA would help
- 1 respondent believes capital requirements for platforms should be higher
Clearly the rules around platform insolvency, and specifically wind-down as a result of insolvency, are not fully understood and accepted by the entire market. In response to the respondents’ comments, the FCA concluded:
We are concerned that, in practice, wind-down plans may not work as expected, and may be inadequate to enable a loan book to be administered to conclusion in the event of platform failure. To help guard against this, we propose to consult on strengthening the rules in this area.
For investors, the main things to digest are: 1- At present, platforms are legally obliged to have plans in place to ensure repayments are made if the platform becomes insolvent. 2- The effectiveness of these plans, however, are largely untested as there have been no high-profile insolvency cases in the UK market yet. 3- It’s comforting that the FCA is addressing this issue and that industry players are also concerned by the current rules around wind-down plans. This can only serve to improve the standards created by the FCA.
But, the argument will remain, that until a mainstream platform proves the efficacy of its wind-down plan (in the unfortunate event of failing as a business), wider audiences can always refer back to this as a reason for not adopting P2P.
Diversifying to mitigate platform risk
Diversification is a primary security measure implemented by many platforms in the UK peer to peer market. Several major platforms adopt an “auto-bid” functionality, enabling investors to automatically spread their money across multiple borrowers, increasing their exposure, and reducing the risk of a single default impacting their investment. This has become a popular choice amongst investors, so much so, major player Funding Circle recently withdrew its manual-bid product in order to concentrate on its auto-bid product.
While diversification at a borrower level is very much achievable in P2P, mitigating the platform risk is not achieved by investing across a single platform. At Orca, we are advocates of platform-level diversification. By developing a portfolio of various platforms, you will be exposed to multiple platforms, potentially multiple markets, and also multiple borrowers.
As a firm proponent of this strategy, Orca will be launching its own investment product in the coming weeks, offering:
- Platform diversification
- Market diversification
- Borrower diversification
We intend to offer increased protection to investors’ portfolios, while retaining the superior returns offered by P2P investments. No compromise, just greater efficiency. More information will be released in the coming weeks, but feel free to get in touch if you have any questions.
Platform risk is a primary consideration for investors. It’s number one on the risk list for industry players, and is cited regularly by the professional investment community as a reason not to get involved. While testing wind-down plans may mean a/some platform(s) will ultimately need to fail, the result – assuming positive – will give confidence to those who require P2P to run a full economic cycle and weather a recession. For others, comfort may be instilled due to the level of scrutiny the FCA is placing on this issue, and more so, the level of participation the UK P2P market is offering to ensure robust standards are developed. For now, there’s always the effective strategy of diversification to mitigate platform risk.