Alternative finance is very diverse – something we should celebrate as an industry. But as the sector scales up and attracts more mainstream investors, platforms have a job on their hands to help those investors, and these days their advisers, work out where we fit into portfolios and where we sit on the risk curve.
To me, risk is not a dirty word. There is no such thing as investment without risk. That’s what we call savings, though with interest rates this low, in real terms, you are losing money when any interest payments are less than the rate of inflation.
The challenge is to understand what the risks are, and whether they are worth taking for the potential return on offer.
What are the risks with alternative finance?
One of the most important risks when it comes to crowdfunding and online lending, which will be fairly obvious to anyone with investment experience, is asset risk.
This is the risk of the end investment – the person or business who wants your money. What will they do with your money? When can you expect a return? What is the probability that their plan will work out? And what happens if it doesn’t?
Then there is the risk in the instrument. What do you get for your money? Share, bonds, a loan contract? Are there other lenders? Are you senior or junior? Is the investment secured?
But while a spotlight is frequently shone on the role of the investor, an area that does not receive enough focus is the role of the platform itself: to what extent can your regulated crowdfunding platform help you understand, price, spread or limit risk? Or does it in fact do the reverse?
Unfortunately, this can particularly be the case when individuals are lending to businesses – which, at volumes of £4bn a year, is by far the largest subsector in UK crowdfunding.
Crowdfunding should not say it is transparent, but be transparent. You don’t think people are funny because they tell you they are comedians. You think they are funny when they tell you a joke that makes you fall off your seat.
That means being transparent about fees for starters. How does that platform get paid? By the lender, the borrower or a bit of both? When does it get paid, and do they take a spread?
Before I lend my money to get a 5 per cent return, I want to know what rate the borrower is paying as that is a much better indication of the risk profile of that investment than the rate the lender is being offered.
Read more: Peer to peer popularity persists
It also means transparency about how the return was set. What is an A+ versus a B risk? What are the default rates across the board? There are some great examples of platforms publishing entire loan books and others that are more opaque. I am less keen when a platform gets in the way of lenders and borrowers doing direct deals, unless their role is completely explicit and adds clear value.
There has been a lot of innovation in lending to businesses, via bonds or through peer-to-business loan contracts, and mostly for good reasons.
For example, many peer-to-peer finance platforms are built around an automatic bidding process, which comes with the positive of spreading each lender’s funds across multiple borrowers.
However, this also means that lenders are not only totally reliant on the platform to assess risk, but they also sometimes have very little sight of what companies they are actually invested in – or the due diligence criteria used to select these businesses and what led to their credit risk rating.
In contrast, platforms like Downing and others present investors with a smaller number of much bigger offers, increasing single investment risk but also allowing the platform to take a much more upfront approach to due diligence.
This will be set out in an offer document, so all investors can get a feel for how the investee company has been researched and assessed before deciding to take things any further.
Platforms should earn their fees – and yes, those should be completely and clearly set out too.
Appropriateness tests and caps on the amount of investment are just some of the other methods that platforms can implement to help manage risk. Each of these are worth an article in their own right, but the most important thing for investors to be aware of, for now, is that not all platforms offer the same levels of disclosure and protection.
As an industry, we need to give much more transparency to the end investor. Last week’s interim feedback from the Financial Conduct Authority (FCA) called for greater disclosure throughout the sector, and this is something many of us fundamentally support.
Our role as platforms isn’t to stop investors taking risks, or tell them what risks to take, but to help investors understand the risk they are taking and assess whether the investment gives a good enough risk-adjusted return on their money.