Peer-to-Peer Lending: An IFA's Dilemma
There is a strange paradox amongst the IFA community when considering peer-to-peer lending (P2P). On the one hand, it is considered extremely risky and only suitable for a finite number of clients who have a very high suitability to risk. On the other hand, we’ve heard P2P being refereed to as a ‘cash plus’ product, a step above a savings account with no FSCS cover. In our opinion neither are correct, so what is going on?
Firstly, peer-to-peer lending is not the catastrophe waiting to happen which will destroy the economy through rising defaults, client capital losses and the ombudsman clamping down on rogue IFAs. Self-directed retail investors of various degrees of sophistication have driven the growth of this £10 bn* asset class. It’s worth noting that over £2 bn was lent in the first half of 2017, four times the size of the total 2016 VCT market. Over 175,000 retail investors have gained comfort from 12 years of historical P2P data, enabling in-depth due diligence to be conducted. They’ve taken the time to understand the intricacies of this asset class and benefited from the stable, risk-adjusted returns on offer.
The question remains: why have mainstream IFAs shunned this asset class as unacceptably risky when a proportion of their clients have adopted P2P without professional help? The profile of a P2P investor is, after all, very similar to that of an IFA client.
The word ‘risk’ within the advice market can often be confused between investment risk and an adviser’s own business risk. Post Retail Distribution Review (RDR), advisers are required by the regulator to match clients to suitable investments. On the surface, this has created a system where the client is protected to some degree and the advice process has been standardised. In practice, advisers abide by these guidelines through a suitability scoring system where clients are asked a series of questions to determine their suitability to risk. The outcome is a score on a scale, normally 1-5 or 1-10. On the other side of the suitability fence, investment products are assessed by the same companies that provide the client suitability questionnaire. Again, a 1-5 or 1-10 score is the outcome. Sadly, a large proportion of advisers that we’ve spoken to simply match these scores and present a recommendation to their client. If an adviser is further constrained by a network which is a growing result of RDR they will only be permitted to advise on a selected number of products which have been approved by the network. If a client were to complain in years to come for the advice given, then this risk scoring process protects the adviser to some degree.
There are, of course, examples of assets that fall out of this scoring system, namely tax-efficient products such as EISs, VCTs and BPRs, however, suitability for these products often relate to tax advantages. The major benefit of P2P is yield, resembling a fixed income asset class so advisers cannot rely on a tax advantage to justify allocating a proportion of a client’s portfolio away from traditional products.
A major issue exists with the scoring system: only products assessed by the scoring agencies can be matched. This creates a lucrative business for the likes of Distribution Technology, Defaqto and FinaMetrics who charge product providers fees to be scored. For product providers, this is extremely important in order to gain traction in the IFA market. However, this creates a significant barrier which clashes with a pillar of financial advice; whole market coverage.
Peer-to-peer lending is fundamentally a different asset class to equities or bonds and the performance metrics that substantiate P2P assets are quite different. Although not impossible, this means scoring P2P on a similar scale as traditional assets is difficult – although not impossible.
Ultimately, the adviser is responsible and accountable for the advice he/she gives. Providing they can justify the advice they provide is suitable to their client, they are permitted by the FCA to recommend P2P. However, without this scoring system in place the regulatory risk is potentially too large to justify a recommendation.
So, where does P2P sit within the current scoring system? Well it doesn’t, so the default position is ‘off the scale’ in terms of risk. It’s important to remember that this is not an investment risk, this is purely a business risk. P2P is only considered for the finite group of clients who have a very high suitability to risk and not because of the fundamentals of this asset class, but because of the tools an adviser has to hand. The strange paradox exists when an IFA considers P2P for these clients; free from a substantial regulatory risk they can start to add value to their client, drawing comparison to the fixed income market or, as one adviser noted, a ‘cash plus’ saving product. This isn’t dissimilar to how direct retail investors who have adopted this asset class view P2P.
The more innovate of IFA we’ve spoken to understand this dilemma and want to offer value to their clients. Often their clients have asked about P2P and, as their trusted financial adviser, they expect an opinion. Some IFAs have indicated that they’ve performed informal research, often for free, and presented different options outwith the more formal advice process. They’ve then instructed the client to invest themselves, ultimately losing AUM but in the process mitigating their own personal business risk. This is not good for the adviser, who has to place self-preservation above delivering client value, and for the client who is forced to invest without advice.
So, is P2P a risky asset class? Well yes, it is, but more as a business risk to IFAs and not as an investment. There are two solutions we can see: either change needs to come from the top, with technology providers and networks properly serving their advisers or, on the other hand, advisers need to demand this from their service providers.
From our experience of talking to adviser technology providers they will not change until advisers demand this service. If they don’t, there is a potential greater risk brewing in the financial advice market: the growth of technologically enabled investment products and a significant increase in self-directed investors. Unless the adviser can cover the whole market, they will lose AUM.
As a closing comment, peer-to-peer lending can be assessed through independent research and, at Orca, we are eager to support the financial advice market. Please contact Iain Niblock at ‘[email protected]’ to discuss how we can help support advisers.
*Cumulative lending since market establishment (2005). Source: Orca