P2P lending, marketplace lending, online lending – call it what you like: the opportunity to earn impressive rates of interest by lending to UK consumers and SMEs should be embraced by any investor looking to improve their returns.
These platforms are proving that, when it comes to matching borrowers and lenders, online is a superior location to the traditional bank branch network. A chunk of bricks and mortar cost has been removed and platforms are able to access new sources of data to determine the expected risk of the loan. This results in better rates for both borrowers and lenders.
On top of this, the borrower is presented with an improved customer experience by providing all the required details in the digital world without the pain of dealing with an analogue branch struggling under the weight of incumbent bank sector spaghetti junction IT.
So far so good. A tech enabled experience for borrowers and, for savers, access to a new asset class that pays better rates than established fixed income instruments without the associated price volatility.
But how do investors determine exactly what rates of return have been earnt historically? And how do they decide which platform to trust with their cash, particularly when the platforms “don’t eat their own cooking” (don’t hold the loans themselves)? This challenge is also of concern to the Financial Conduct Authority (FCA). As part of its recent review into existing sector policy, the regulator proclaimed that: “it is difficult for investors to assess the risks and returns of investing via a platform”.
Platforms are already working hard to meet this challenge. Most offer analysis of historic net returns on their own website and many also disclose a monthly snapshot of their existing loan book. However, the task of extracting historic returns from a series of static loan books is bewilderingly complex. Meanwhile, platforms use a range of different approaches to calculate their own returns, making it impossible to compare one stated return with another.
Thankfully, the market-leading platforms, both in the UK and the US, have significantly developed their approach to disclosure. They recognise that the answer lies in validation and standardisation. They may not eat their own cooking – but they can ensure that their output is subjected to the most intense scrutiny. Zopa, Funding Circle, Ratesetter, Market Invoice, and now Prosper Marketplace in the US, are providing sufficient disclosure to allow third party validation of their lending data, in order to show their returns to a consistent standard.
This allows firms like mine to make like-for-like comparison of historic returns, after fees and any defaults. Furthermore, for those investors who wish to perform a more in-depth analysis – institutional investors, for example – all other relevant metrics can be reviewed and compared against a standard.
This kind of validated and standardised disclosure solves the problem of determining historic rates of return. Just as important, it provides an excellent indication of which platform to trust with an investment. Demonstrating impressive levels of historic net return, over a sustained period, reveals a huge amount about a platform’s processes and competency.
Presenting granular historic data of this kind also demonstrates the correct alignment between platform and investor. Lenders should seek platforms that can demonstrate that their overriding motivation is to originate loans at an interest rate that adequately compensates for the risk of default.
This is particularly important in circumstances where the originator of the loans (the lending platform) does not hold the loans itself. For this originate-to-distribute model to be successful, investors need to know that the platform itself would suffer if loans turned out to be foolishly priced.
Platforms rely on revenues derived from loan origination fees. So, if the status of historic lending can be meaningfully appraised, then continued loan origination fees rely on the performance of historic loans. That results in a genuine alignment between investor and originator because the economic outcomes for both have become inextricably intertwined.
Investors should not just welcome this kind of disclosure. They should demand it. It facilitates the due diligence process. More importantly, it creates the correct alignment between the platform and the investor. Investors should insist that a platform is prepared to be held to account.
Accountability means delivering a level of transparency that allows for meaningful and timely appraisal of ongoing lending performance. Investors should therefore expect to see verified historic loan performance reported to a consistent standard. These platforms may not eat their own cooking, but the restaurant critic should be invited to dine there every night.