"Skin in the game” is an expression thrown around a lot in the P2P industry. Platforms don’t have banking licences and the majority don’t lend off their own balance sheets. So the question for some time now has been “what loss position will the platform take in the event of loan failure?”
With increasing talk of an economic downturn, concerns over deteriorating credit quality, and securitisation becoming more frequent – Funding Circle announced the European market’s first securitisation last week – it doesn’t look likely to go away any time soon.
Being the first to lose money if the borrower defaults seems a fool-proof way of proving that the platform has full confidence in the borrower – because, as an investor, you’re putting money in alongside the platform. But the question of “skin in the game” can only be applied once you have an accurate notion of how platforms differ.
A Question of definitions
As Robert Wardrop, executive director at the Cambridge Centre for Alternative Finance at Cambridge Judge Business School, explains, the industry is diverging. “The question now is, ‘is a platform playing it like a bank or like an asset manager?’” While many platforms are becoming more like tech-enabled investment managers – 44 per cent of UK lenders on platforms opt to use auto-bid tools – others are deploying both their own capital and that of lenders in the way a bank would: “they are recycling your capital to reduce the cost of funding”.
Wardrop points out that intermediation has become more sophisticated and intense in the industry, so this divergence will only become more obvious as time goes on. “It also means that all the questions you would have of a bank lender or an asset manager, you should also ask of platforms. The skin in the game question is different [between platforms], and so then is the transparency question.”
Rupert Taylor, co-founder of industry data firm Alt Fi, believes that the level of transparency platforms have shown “has been and can continue to be their skin in the game”. To date, he says, transparent processes have fuelled their growth. By demonstrating their lending track record, they become aligned with investors, as poor performance would lead to investors leaving the platform.
The emergence of funds
Aside from the traditional P2P model, matching lenders and borrowers, a new breed of P2P funds is emerging. Rather than lending money through the platform to a borrower, an investor puts their money into the fund, which then lends it on. As the industry grows, increasing numbers of these funds are springing up, run by external managers and by the platforms themselves.
Taylor thinks the managers of these funds also need to demonstrate alignment, and that this can be done through externally benchmarking performance. “Benchmarking would allow them to demonstrate good net asset value performance and accountability. By illustrating the impressive performance of the underlying asset class, it could even help to close the discount that these funds are trading at versus NAV.”
But not everyone thinks this need be the answer. Speaking at LendIt USA last week, one fund manager told me that, while they think it’s an appropriate idea in theory, they wouldn’t necessarily want to be beholden to a benchmark at this stage. Moreover, being listed, they argue, brings with it a huge amount of accountability anyway.
Louise Beaumont of GLI Finance explains that running fund mandates for other people, as asset managers do, means you need to be pretty clear about how you’re doing it from the outset – from running detailed due diligence on platforms to getting regular management accounts from them, and from augmenting algorithmic credit assessment with human credit analysis to running a credit committee process on individual loans.
“We have a portfolio of 20 platforms. There may not be an industry-wide standard definition of non-performing loans and defaults, but we certainly have standard definitions and rigorous processes. While investing in loans originated by a single platform may benefit from reference to an external benchmark,” she continues, “having a sizeable, well-diversified portfolio goes quite some way to mitigating that need.”
For platforms that are already lending their own capital alongside other investors, their activities look increasingly “bank-like”. “The difference is that banks make a regulatory trade-off [in the form of capital requirements]. Marketplace lenders don’t,” says Wardrop.
This would lead to further questions about P2P lenders with banking licences. Investors should, says Wardrop, look at the skin in the game owners of those platforms have. “How much skin in the game would they have in loans? Further transparency could just reveal how little.”
This is a debate you’ll hear in the industry on the back of all this: whether the endgame for some platforms will be getting licences and becoming banks. The regulatory requirements may be cumbersome, but it “might be the way some platforms go into balance sheet lending,” says Wardrop.
If and when this happens, many feel these P2P banks would do well to emulate industry best practice. Several platforms, for instance, don’t just publish their loan book, but updates on repayments and the margin investors are receiving. Because banks can sell securities which are not always fully secured by the loans they fund, this level of transparency could help lenders to mitigate losses.
The way the industry is going, says Wardrop, as a platform, “either you’re going to say, ‘I’m going to specialise in the client service side’ and move towards investment management, or you’re going to drive your cost of funding as low as possible. If you can’t access deposit money, you’ll need enormous scale to achieve that and remain competitive.”