Risk vs. reward is a principal consideration for every investment decision. With peer-to-peer lending (P2P) platforms advertising rates ranging from 3% to 19% the reward can be easily visualised. The challenge, however, relates to assessing the level of risk acceptable to the reward. The nature of lending money to individuals and/or businesses creates unique risks in comparison to traditional asset classes that investors should be aware of.
It’s worth noting that lending money through peer-to-peer lending platforms is an investment and for this reason funds are not covered by the Financial Services Compensation Scheme (FSCS). Ultimately, without FSCS coverage, investors’ capital and interest are at risk.
Risks can largely be categorised into: Performance Risk, Platform Risk, Market Risk, and Liquidity risk.
Although some P2P providers have put in place features to recover losses such as provision funds and asset security, there is a fundamental risk that a large number of borrowers default on their loans.
A further performance risk exists when an investor’s cash sits idle in their account waiting to be matched to borrowers.
Borrower default may result from a poor initial credit decision or economic factors (see market risk). Investors are advised to diversify across a large number of borrowers to ensure that the effects of one borrower defaulting are minimal on the overall investment. A large number of borrowers defaulting on their loan commitments remains a risk even after diversification.
P2P platforms create a marketplace of borrowers and lenders. Where an imbalance exists of more borrowers than lenders, investors’ capital may sit idle waiting to be lent. This can significantly reduce returns.
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A number of risks exist at a platform level including insolvency, fraud and security. If a significant platform was to fail, found to be fraudulent, or if there was a significant cyber security breach, market sentiment would decline.
If a platform was to become insolvent the loan contracts between lenders and borrowers would still exist and contractually repayments should continue. FCA rules dictate that P2P platforms need to have a sufficient plan in place to ensure borrower repayments continue, independent of whether the platform is solvent or not. To a certain extent this does protect investors, however, if a P2P platform was to become insolvent this would create significant turbulence for investors and its possible losses would be incurred.
Platform fraud is a significant risk to the sector. Essentially, platforms must deliver on their promises. Nesta reported in the 2015 report ‘Pushing Boundaries’ the potential collapse of one or more of the well-known platforms due to malpractice was the biggest risk to the growth of the sector. In a bid to mitigate platform fraud the FCA stipulates that P2P platforms must hold client funds in a segregated client account, separated from their own operating cash.
Similar to fraud risk, 51% of P2P platforms surveyed by Nesta in 2015 regarded cyber security as a factor that could have a detrimental effect on the sector. Given that the entire P2P industry is based online, a severe cyber security breach is a real risk.
Market risks relate to macro-economic factors that may affect the ability of a borrower to repay their loan or for the capital to be recovered post default. Similarly to fixed income investments, an interest rate risk also exists.
If interest rates were to rise, the interest rate paid by a borrower might not appear attractive in comparison to other forms of investments. For example, if Cash ISA rates were to rise to pre-recession levels of 5%, being locked in to a P2P agreement which pays between 5-6% may not be worth the risk.
With interest rates holding record-low levels since 2009, the P2P sector has largely grown in a low yield environment.
The question is clear: can P2P investing still deliver value in an environment of higher interest rates. Well, the good news is that if interest rates were to rise, borrower rates would also rise. In theory both the lender and borrower rate would rise.
Unemployment Rates – Consumer lending
In the consumer lending space, if unemployment rates were to rise, the risk of borrower default would also rise. It’s well documented that Zopa endured the 2007/2008 recession and during this period its default rate rose from 0.49% in 2007 to 5.10% in 2008. A rising default rate caused by unemployment would decrease investor returns and possibly lead to a loss of capital.
Property Prices – Property Lending
In 2016, 19% of the P2P sector related to some form of property lending. Whether borrowing for a property development, as bridging finance or for buy to let purposes, property generally secures the loan. If a loan moves into default the P2P provider has the ability to sell the property held as security. Two things are important here. Firstly, how easy will it be for the property to be sold and what value will the property or asset be sold at.
If property prices were to drop, the capital realised from the sale of the property price may be lower than expected. Typically, P2P platforms will not lend at 100% of the value of the property (LTV). Landbay for example will lend at a maximum LTV of 80% and an average of 68%. This should provide sufficient coverage providing the asset is correctly valued at the outset and the market does not drastically drop in value.
Investors are contractually obliged to lend funds to borrowers over the term of the loan. The inherent nature of lending is therefore illiquid unless the loan can be sold to a new investor. Depending on the P2P platform it may be possible to sell loan commitments on a secondary market. Generally, the larger the P2P platform in terms of loan volumes the more active or liquid the secondary market is. For example, there is currently high demand for loans on Zopa, RateSetter and Funding Circle, resulting in investors being able to sell their loan commitments and withdraw funds relatively quickly.
Investing in the peer-to-peer lending sector can deliver risk-adjusted, predictable returns, however there are unique risks that investors should be aware of. The illiquid nature of lending means investors should be prepared to commit for the term duration or be aware of the P2P platforms secondary market. Borrowers defaulting on their loans is an obvious risk that investors need to assess. However, further market and platform risks should also be evaluated when considering investing in the sector.