When was the last time you stood in a long line outside your bank branch, patiently waiting to deposit money into your savings account? Imagining a scene like that seems ridiculous at a time with near-zero interest rates in an increasingly large number of developed countries.
But there where you would least expect it, in the Fintech world of fast-moving bits, some startups actually are imposing measures to throttle influx of investor money in order to balance it with borrower demand. Welcome to p2p lending (short for peer-to-peer lending). The sector is experiencing tremendous growth rates. With attractive yields for investors some platforms struggle to acquire new borrowers fast enough for loan demand to match the ever-rising available investor demand.
One challenging factor is deeply ingrained in the business model of p2p lending marketplaces: once a new investor is onboarded and found the product satisfactory, he is most likely to stay a customer for years to come and reinvest repayments received and maybe the interest also. On the other hand the majority of borrowers are one-time customers. They take out a loan typically just once. While it may take years for the borrower to repay that loan, in most instances there is no repeat business for the marketplaces. So the marketplaces have to constantly fire on all marketing cylinders to win new borrowers in order to keep up and grow loan origination volume.
This has sparked some outside of the box thinking, e.g. the partnership of Ratesetter with CommuterClub to win their loan volume, which is in fact mostly repeat business.
Winning investors has been relatively easy for many of the p2p lending services in the recent past. Investors are attracted typically through press articles or word of mouth. One UK CEO told me he never spent a marketing penny ever to acquire investors.
But what happens on the marketplace, when there are so many investors waiting to invest their money in loans, but loans are in short supply?
- If the marketplace does nothing or little to steer it, then those investors that react the fastest, when new loans are available, will be able to bid and invest their money. This is the situation e.g. on Prosper, Lending Club and Saving Stream.
- The marketplace has some kind of queuing mechanism. This is typically coupled with an auto-bid functionality. Examples of this are Zopa, Ratesetter and Bondora.
- The investors are competing during an auction period by underbidding each other through lower interest rates. Examples of p2p lending services with this model are Funding Circle, Rebuilding Society and Investly.
- The marketplace can lower overall interest rates to attract more borrowers while the resulting lower yields slow investor money influx.
The UK p2p lending sector is eagerly awaiting the sector to become eligible for the new ISA wrapper. Inclusion into the popular tax-efficient wrapper will attract an avalanche of new investor money to the platforms.
“That’s going to be a challenge for the industry,” said Giles Andrews, CEO of Zopa. “Once the dates are worked out, the industry will need to plan for that together, and we may have to do something we have never done before, which is to limit the supply of money. It’s not good to have people’s money lying around [awaiting new borrowers] or to lower standards of borrowers.”
So there is some speculation that UK p2p lending services could impose temporary limits on new investments.
The investor viewpoint
The aim of the investor is to lend the deposited money easy and speedy into those loans that match his selected criteria/risk appetite. Idle cash earns no interest and will impact yields achieved (aka cash drag).
For the retail investor none of the above mentioned mechanisms are ideal. The “fastest bidder wins” scenario means he would either have to sit in front of the computer most of the time or be lucky to be logged in just as new loans arrive. The queuing mechanisms are disliked as they can prove to be very slow in lending out the funds and can be perceived as nontransparent (see the lengthy and numerous forum discussions on the Zopa queuing mechanism). Underbidding in auctions does provide the chance to lend fast, but at the risk of setting the interest rate too low and this requires a strategy and can also be time consuming.
So what can the investor do? The answer for the medium and larger retail investor may lie in automation (for the institutional investor it is required anyway). In the US there are several third party services that offer automation of loan selection and bidding for Prosper and Lending Club investors. Examples are NickelSteamroller, Lendingrobot, BlueVestment, Peer Cube and PeerTrader.
These tools allow an automation based on more parameters than are available for auto-bids on the platforms themselves. They work using the APIs offered by the platforms.
I personally am a huge fan of letting the market forces balance demand and supply. I like the reverse auction model, which many p2p lending marketplaces used in the nascent era of the sector but some abandoned since. I understand why they did it. Fixed interest rates give more control to the marketplace, allow faster loan originations and they feared that investors would misjudge and underprice default risks (see also ‘How interest rates are set’). One note on mispricing risk: If the provisions fund and safeguards scheme work as intended – and so far they seem to – then the risk of underpricing by the investor is effectively minimized or even eliminated.
I still think a mechanism that would allow interest rates to fluctuate based on demand and supply would help the industry through the coming accelerated growth phase. While it may be viewed that e.g. the Ratesetter mechanism allows the rates to fluctuate, it is in my view not granular enough. It can already be observed that the speed and ease of lending out the money is one determining factor for retail lenders choosing marketplaces and allocating funds.
With the coming tax incentives and the resulting lending money boost, I’d also expect that those UK platforms, that set or influence the interest rates themselves , will lower it considerably to heighten attractiveness of their loan offers to borrowers.
I am also curious how market developments in the UK will influence p2p lending in the rest of Europe. There is already a clear trend to cross border lending and that could be boosted should a) p2p lending yields on UK platforms sink or b) there be offers under which lending on non-UK platforms would be eligible under the new ISA tax wrapper too.