Samir Desai, CEO of Funding Circle, first described how three powerful trends have created a perfect environment for peer-to-peer lending (P2P) to grow. Post 2008, financial institutions’ appetite for lending reduced and as a result the Bank of England cut interest rates to a record low, leaving investors starved of yield. At the same time, Internet Marketplaces, such as Uber and Airbnb distributed massive traditional industries. We believe that there is a fourth trend which spurred growth in the peer-to-peer lending sector, stemmed from consumer distrust within financial services, particularly when considering major banks.
We’re entering a Golden Age for Peer to Peer Lending
-Samir Desai, Funding Circle CEO (October 2016)
We’ve revisited these trends to understand if market conditions still hold true today and to make predictions on what will catalyse further growth in the industry.
Peer-to-peer Lending Growth
12 years after the first loan was originated on the Zopa platform, peer-to-peer lending has grown to a £9.6bn lending market. Although Zopa operated from March 2005, it was not until Funding Circle and RateSetter joined the market in 2010 that the asset class saw explosive growth.
Figure 1: UK Peer to Peer Lending Growth
Since 2010 the P2P market has grown cumulatively by over 7000% with over £1bn lent through P2P platforms in Q1 2017 alone. With the exception of Q4 2010, Q2 2011, Q2 2012 and Q2 2016 we have seen growth in the P2P market each quarter since 2010. A decrease in Q2 lending volumes is expected, given people generally organise their finances in time for the tax year ending at the start of Q2.
With over 25 new peer-to-peer lending platforms entering the market since 2010 and a wave of institutional investors funding loans since 2014, it’s unsurprising that the quarterly growth rate has been volatile. The rate of growth has been stabilising, hopefully to a sustainable level.
Figure 2: P2P Growth Rates
Besides the difficulty of sustaining such a high growth rate, it’s necessary to examine other factors influencing growth to make predictions on the future. Revisiting the mega trends that spurred P2P growth and testing if these still hold true today is a good basis for evaluating current conditions.
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Mega Trend 1: Low Yield Environment
To rejuvenate the economy after 2008 the Bank of England reduced interest rates from a high of 5.75% in 2007 to 0.25% in 2017. This caused a drop in saving rates and fixed income investments as highlighted by the Cash ISA rates and 10 Year Gilt Rates displayed alongside the BoE base rate below.
Figure 3: Cash ISA Rates, 10 Year Gilt and BoE Base Rate
Taking into account inflation returns on 10 Year Gilts, and Cash ISA rates sitting below 0%, this presents a major issue for savers, pensions and the fixed income industry.
Does this trend still hold true today?
Absolutely, this trend is more prominent today than it was five years ago and there is little evidence indicating that a rise in the base rates is likely in the foreseeable future.
Howard Archer, economist at the consultancy firm IHS Markit, told the Guardian in March 2017:
While we believe the next move in interest rates will be up, we do not see this happening before 2019 and it could well be delayed further by prolonged economic and political uncertainties.
Offering attractive, predictable, almost fixed income returns of between 5-6% P2P has prospered in this low yield environment. With institutional capital and a continued, strong demand from retail investors the availability of capital is not prohibiting growth in the market. In both December 2016 and spring 2017, popularity of Zopa grew so much that it had to stop new investors lending across the platform. In other platforms, particularly RateSetter, we have seen a compression of yield as the balance of lenders and borrowers has a direct implication on the returns earned.
Mega Trend 2: The Banks Stopped Lending
The Bank of England attempted to encourage lending by dropping the base rate to historic lows. In reality, after 2008, the over leveraged banks’ appetite for lending drastically reduced. They were further forced to hold larger capital reserves driving up the cost of lending.
Outstanding capital in the Consumer Credit markets excluding student loans has grown since a low in 2012.
Figure 4: Monthly consumer lending (including credit cards, excluding mortgages and student loans ). Source Bank of England.
In the consumer lending market we have seen growth not just from the major banks but also relatively new entrants such as Hitachi Personal Finance, Tesco Bank, Sainsbury’s Bank and the AA. The market is becoming increasingly competitive particularly for prime borrowers which in turn has driven down investor yields in the P2P market. Good for borrowers, bad for lenders. As an example, Sainsbury’s Bank offers loans from 2.8% APR, making it hard for P2P platforms to compete, given they must also take their margin and any other fees, such as provision fund contributions.
Focusing on UK SME lending, Bank of England data shows the amount of loans outstanding has continued to drop since 2011. Comparing today’s conditions to 2011 we can see that there is 17% less capital outstanding within the SME lending markets.
Figure 5: Outstanding Business Loans. Source: Bank of England
Does the trend still hold true today?
The consumer lending market, where Zopa, RateSetter and Lending Works play, has become increasingly competitive. With consumer lending accounting for 46% of the UK P2P lending market in 2016, this rise in competition is the principal reason we are seeing a slow in growth throughout the total P2P market.
Within the business lending market, P2P lending – in particular Funding Circle – appear to have found a niche of lending below a million pounds and on average below £100,000. This level of lending, targeting SME businesses, is below the size which attracts large financial institutions. Research by the Centre of Economics and Business Research in 2016 found that it costs the banks the same amount to underwrite and process a £50,000 loan as it does a £3million loan. The costs of servicing SMEs with loans is simply too high for the banks to serve.
For the P2P market this has meant Funding Circle has emerged as the largest UK communitive P2P lender with £2.33bn of loans originated across the platform. Although Zopa had a five-year head start after being established in 2005, its cumulative lending totals £2.31bn.
Mega Trend 3: Growth in Technology
At the turn of the millennium, widespread adoption of home computing took off. This resulted in direct innovations within personal finance as more and more people took to their computers to manage their finances. Technology is at the core of P2P lending, connecting lender and borrower seamlessly on an online platform. Just like Uber disturbed the taxi market and Airbnb the hotel, peer-to-peer lending has disrupted lending markets.
The underlying lending product, cash, offered by traditional financial institutions is no different to P2P lending platforms. Often the credit assessment process is very similar with P2P platforms recruiting ex-bankers to manage their risk teams. The true differential between P2P platforms and traditional finance providers is the user experience and specifically the speed at which a credit decision can be made.
A CEBR report commissioned by Funding Circle found that 72% of Funding Circle borrowers found the experience of obtaining a loan was faster than that of other providers they considered. This helps to explain why 77% initially shopped around for finance, but 94% would come back to Funding Circle first in the future.
An ecosystem of technology businesses is further evolving around the peer-to-peer lending market, both aiding borrower and lender origination. Orca helps educate retail investors and financial advisers with independent due diligence. On the borrower side, we have seen a wave of partnerships with new banking apps such as Revolut and Pariti referring borrowers to P2P platforms.
Does the trend still hold true today?
Although the user experience of financial institutions’ technology is getting better, legacy systems and prohibitive organisational structures prevent these large businesses from technologically excelling.
P2P platforms will continue to use technology to their advantage and this will continue to be a key, differentiating factor. Fundamentally, P2P platforms offer a better experience for borrowers.
Mega Trend 4: Anti-Bank Sentiment
Following the 2008 credit crisis and further scandals such as the miss-selling of PPI, negative sentiment and general distrust across financial services grew. One of the longest running surveys on consumer trust is the Edelman’s Trust Barometer. In 2017, only 45% of UK consumers stated that they have trust in financial institutions. Although this is a distinct increase from 2010 where only 21% of people had trust in financial institutions, 45% is still a low figure.
Figure 6: Trust in Financial Services, Edelman Barometer
Research by the FSCS demonstrated that consumers typically believe financial services firms can deliver what they promise but do not believe that they would do something for consumers’ benefit if it were not also in the firm’s immediate self-interest to do so.
With such a poor level of trust throughout the financial services, consumers searched for alternatives. Funding Circle’s vision statement directly appeals to this sentiment:
We’re building a better financial world
Funding Circle was created with a big idea: To revolutionise the outdated banking system and secure a better deal for everyone.
The level of mistrust within financial services led the marketing teams of fintech businesses to latch on to this sentiment. Brewdog famously drove a tank towards the Bank of England during their crowdfunding campaign.
Figure 7: Brewdog Equity CrowdFunding Campaign
TransferWise similarly stripped in New York’s financial district as part of a marketing campaign back in 2015. Audacious, but powerful.
Figure 8: Transfer Wise marketing campaign
Does the trend still hold true today?
Clearly consumer trust for traditional financial institutions is growing and the days of wide scale bank bashing are over. Customers want differentiated products and choice. When comparing major banks’ products, it’s difficult to identify any differences, from process to marketing, they are very much the same. There is no clear differentiator between a Barclays current account to an RBS current account for example. Customers are frustrated with their banks and this continues in today’s market.
Will growth continue?
In short, yes. There is no sign of growth stopping, although in today’s conditions growth rates will slow and reach a sustainable level. This growth is likely to be fuelled in large by the business and property sections of the P2P market.
Only another recession would propel P2P lending back to the growth rates previously experienced. Negative economic conditions would again reduce the appetite for banks to lend and borrowers would have no other choice but to seek alternative sources of capital. Although returns within the P2P market would be reduced due to an increase in unemployment; a fall in house prices; and rise in bankruptcies, largely, investors would still generate returns, uncorrelated to the market and the volatility associated with it. Zopa did go through the 2007/2008 credit cycle and still delivered investors 4% annual returns in 2008. As a small, niche lender, pioneering a new asset class, this went largely unnoticed. Next time around, with equity holdings in meltdown, P2P investments will be seen as the shining light of any investor’s portfolio.
Looking to the future
In the consumer space, competition needs to be resolved for growth rates to return. All lenders within the consumer space – whether banks, P2P platforms or other new entrants – are fighting over the same low-risk, prime borrowers. The industry is split with lenders either seeking super prime borrowers or payday lenders who are happy to take the risk on just about anyone. There is a middle ground where the price of risk is much trickier to estimate and it’s here that we may see a new wave of lending occur.
There is no shortfall of investment capital, especially for the large P2P platforms who have built up strong track records. If demand continues to increase and the platforms fail to originate a sufficient quantity of borrowers, investors may look to foreign markets, particularly Europe to lend. Generally, P2P is unregulated in European markets but this is likely to change in the coming years, instilling confidence in UK investors. We’ve seen a number of European platforms gain regulation in the UK but, to-date, none have gained significant market share.
In conclusion, P2P lending is a beautiful financial innovation which delivers true value to both investors and borrowers. There is no sign of this changing and with this we do not expect growth to stop. Providing investors conduct sufficient due diligence and understand the risk as well as the rewards, P2P can help diversify investors portfolios.
If you have any comments on this article please email CEO of Orca, Iain Niblock on [email protected].