Peer-to-peer (P2P) lending, which involves people lending to other people or small businesses via dedicated platforms, has grown phenomenally in recent years, giving those that need capital an alternative to banks, and those with capital a higher-yield and higher-return asset class to invest in.
Returns and yields from the sector have been strong, but this has come with the odd headline-grabbing blow-out – normally due to poor risk management. It became almost inevitable that the Financial Conduct Authority (FCA), the financial services regulator, would keep an eye on the sector. Now it has published findings after an investigation, and is set to limit who can invest in P2P, and how much they can put in.
If all goes to plan, those who invest via P2P platforms may see changes to what they are allowed to do, but also get more detailed information about what they are investing in, helping them make better decisions.
The FCA is consulting on plans to impose marketing restrictions on P2P lending platforms and limit the amount ordinary investors can invest to 10 per cent of their investible portfolio. This is all part of a package of measures to prevent less sophisticated investors being overexposed, as it is concerned some may not fully understand the risks.
P2P models getting more complex
The industry has evolved rapidly in the past few years and now includes different and complex business models, which can be categorised into three groups.
Conduit platforms: Investors pick loanees from a list of investment opportunities. The interest rate of the loan is negotiated directly between the borrower and the investor without the platform’s involvement. This makes up 20 per cent of the industry.
Pricing platforms: This model is similar, in that investors pick the underlying loans, but the platform sets the interest rate. These represent 20 per cent of the industry.
Discretionary platforms: These are the most common, making up 60 per cent, including the leading three companies: Funding Circle, RateSetter and Zopa. These platforms set the price of loans and advertise a target rate of return. They offer investors a blended portfolio of loans, similar to a discretionary manager, but investors cannot choose. Platforms typically have an automated process for selecting loans in line with any risk criteria built into algorithms.
For conduit and pricing services the regulator is worried investors do not understand the true underlying risk and return characteristics of investments. If platforms have not provided accurate and complete information investors will not be able to make informed investment decisions.
For discretionary platforms, the FCA is concerned investors may not understand their returns are dependent on how effective their platform is at assessing risk and managing portfolios. The report says: “If the platform manages a portfolio well, it may achieve a better risk/return trade-off than an investor would achieve if they picked the investments themselves. However, if risk management is inadequate or fails, this could have a material impact on the return to the investor irrespective of the performance of the underlying loans.”
Poor practices
The FCA did identify examples of bad business practice, including poor credit assessment where the interest rate was not linked to the credit risk, unlike how it is done in banking, for example.
"As a P2P platform facilitates the loan arrangements on behalf of an investor and does not lend from its own balance sheet, there is a greater risk of harm if this is not done properly as investors bear the credit risk directly," the FCA says.
Among some discretionary platforms, poor record-keeping was also an issue, with some struggling to identify which loan and which payments related to which investor at any given time.
It also found examples where the information presented to investors on self-select loan platforms was not enough to make informed decisions. “In some cases, this may be because the platform itself may not have the necessary information,” the report adds.
Across all platforms there were issues with poor ongoing information disclosure. For instance, an investor might not be told a borrower within their portfolio had defaulted.
It also flagged issues around costs, where platforms charge borrowers but do not disclose this to investors or only pass on a small amount. It saw cases where investors are receiving less than 3 per cent return but are exposed to borrowers paying around 30 per cent interest. “If the platform retains the difference, the platform is effectively charging a fee of around 27 per cent, or alternatively, the borrower is being overcharged, or both,” the report says.
“The way that fees are structured by the platform can also introduce additional conflicts of interest. Where P2P platforms retain the difference, there could be an incentive to facilitate increasingly risky loans at higher interest rates, and profit for the platform. Investors are being exposed to greater risk without receiving greater reward.”
Poor marketing meant some platforms failed to clearly explain the risks and the potential rewards, the FCA says, while others did not state P2P investments are not covered by the Financial Services Compensation Scheme (FSCS). Contingency funds operated by some P2P platforms – which top up payments to investors if a borrower defaults – “provide a false sense of security”, according to the FCA, as it can lead investors to think platforms are providing a guaranteed rate of return.
It also says platforms that offer secondary markets to allow investors to sell out of their loans early could also foster “false perceptions” about liquidity and investors' ability to exit.
New rules
The FCA is proposing several new rules to address these problems. These are not guaranteed to come into force - and will be consulted, however. The most controversial is restricting the advertising of P2P lending to wealthy or sophisticated investors, those using a financial adviser or those who agree to invest no more than 10 per cent of their net investible portfolio in the asset class.
It is necessary to protect investors from overexposure to P2P, the FCA argues, as they could incur notable losses. A survey of 4,500 P2P investors found 40 per cent had invested more than their total annual income and, of those, half had invested more than double their annual income. The FCA is also suggesting investors operating without a financial adviser fill in an appropriateness test before they first start lending money on a P2P platform.
Platforms that price loans will have to introduce a prescriptive risk-management framework. They will have to gather more information about borrowers to assess credit risk, categorise this risk, and set prices of loans to be reflective.
They will also have to provide a description of their role to investors, including the due diligence they do on borrowers, how loan risk is assessed and whether the platform will be involved in choosing and/or pricing loans for investors.
Pricing and discretionary platforms will need to publish an ‘outcomes statement’ to show the expected and actual default rate of all the P2P loans it facilitated, a summary of the assumptions used in determining its expected future default rates, and the actual return achieved.
Platforms will also have to provide detailed information on each of the loans in investor portfolios, including the price of the P2P agreement, the annual percentage interest rate, when the P2P agreement is due to mature and any fees paid by the investor or the borrower. If the platform has carried out a valuation of the P2P agreement, details of that valuation and an explanation of why the platform conducted the valuation will also be made available. Platforms with contingency funds will be required to display risk warnings indicating these cannot guarantee payments in the event of borrower defaults.
Marketing restrictions: a step too far?
The suggested changes were broadly welcomed by the P2P industry, including industry membership body the UK Crowdfunding Association (which represents both crowdfunders and P2P lenders), as well as platforms such as Zopa, Funding Circle and Octopus Choice. Rhydian Lewis, founder and chief executive of RateSetter, says he supports the bulk of the proposals because it would raise standards and drive out bad actors.
But he added: “Introducing marketing restrictions not only raises questions around personal freedom, fair competition and financial exclusion, but would be disproportionate given the risk profile of P2P. It would be a mis-categorisation of the asset class, as well as a backward step for competition and financial inclusion.”
And some commentators argue that the regulator should be focusing on tackling the problems it has uncovered rather than imposing a blanket restriction.
“P2P lending should be for the people,” says Iain Niblock, chief executive and cofounder at Orca Money, a P2P platform. “It shouldn’t just be for the elite or high net worths or the institutions that are coming increasingly into this space. Market restrictions are a step too far. If you’ve got some platforms that are not operating fairly, that shouldn’t tarnish the whole industry. The FCA should put in place appropriate regulation so those platforms can’t [behave in that way].”
However, others point out investors will still be able to invest in P2P lending even with the marketing restrictions.
Bruce Davis, co-founder and director of Abundance Generation, says: “If you are a normal investor, you probably shouldn’t invest more than 10 per cent as it’s not a good idea to have all your investment eggs in one basket. Making sure people understand that seems sensible. Investors can always apply to become more sophisticated once they’ve been using a platform for a while. But it’s better to make sure consumers learn by doing rather than jumping in feet first.”
The consultation ends on 27 October 2018 and the FCA is planning to publish the new rules six months after that. You can email your responses to cp18-20@fca.org.uk.
In next week's Investors Chronicle, we'll be looking at how to protect yourself from P2P risks.
