P2P Lending: How are interest rates set?

Everybody talks about the win-win situation p2p lending offers for lenders and borrowers. By cutting out the large spread a bank takes when making a loan, the lender can get a higher interest rate, than he might in a savings account and the borrower may get a lower interest rate, than using his credit card. But who does actually decide what the interest rate for a p2p loan will be?

Several market mechanisms have developed. P2P lending services use combinations of these to built their platforms. I’ll describe some of the elements:

Individual Loan Listings vs Markets: With Listings (e.g. Prosper, Lending Club, Auxmoney, Isepankur) lenders can look at individual loan listings and see multiple parameters (e.g. credit grade, income, DTI, occupation, location,…). The lender can select (“filter”) loans based on his strategy. This is not necessarily a manual process as he can opt to use automatic bidding tools that make the selection for him based on criteria he set in advance. Other p2p lending services use Markets (e.g. Zopa, Ratesetter) which combine loans based on broader criteria (e.g. loan term, or credit grade). Here a lender can only decide which market to invest into, but does not pick individual loans.

Close at Funding vs Auctions: Some p2p lending services close loan listings once they are 100% funded. The loan is then originated. Others uses an auction process where the listing is open for bidding for a set time. If the loan amount is 100% funded then the bidding continues for the remaining auction period. New bids at lower interest rates push out old bids at higher interest rates, thereby lowering the final interest rate for the borrower. Some p2p lending services allow loan listings of both types or let the borrower prematurely end an auction (e.g. Rebuildingsociety, Isepankur, Assetz Capital).

Uniform vs Mixed Lender Rates: After an auction the interest rate for the borrower can be set at the rate of the highest successful bid. In this case all lenders on the same loan get the same uniform interest rate (e.g. Isepankur). Another option is to calculate the interest rate as an aggregate of all successful auction bids. In this case each lender gets the rate he did bid – there will be a wide mix of lender interest rates on the same loan (e.g. Rebuildingsociety).

Who does decide what the interest rate will be on a p2p loan

I. Borrower sets interest rate

The borrower decides, what (maximum) interest rate he is willing to pay (e.g. Smava, Auxmoney, Isepankur). The lenders can then decide, if they want to fund this specific loan at that rate or not. If there is an auction and lender demand is strong, then the borrower may get the loan for a lower interest rate then specified. Obviously lenders will fund loans with most attractive rates first and other loans will go unfunded. These borrowers can react by relisting at a higher interest rate. Continue reading

Thoughts on Future Pricing for P2P Lending Services

Multi-sided platform are platforms that need to attract two or more customer groups in order to create value. They interconnect these groups serving as intermediary setting the rules. The platform need to achieve satisfactory results for both/all sides.

One example are video game console manufactures. The product will only attract enough buyers if enough games are at available. Developers on the other hand will prefer those manufactures, that already sold large numbers of consoles and thereby offer a large potential of customers.

Another example is Google. One customer group are the users. The value proposition here is ‘free search’.  With the huge audience Google has and the algorithms for matching, Google can offer targeted ads to advertisers.

So Google gives away search for free, in order to make profit from charging advertisers.  In this case there was not much alternative in deciding which customer segment to charge. But sometimes both customer segments are charged and it is hard to decide which side to charge (more).

P2P Lending services are obviously multi-sided platforms, too. They need to match borrowers and lenders. Ideally there will be roughly the same level of demand as of supply of capital.

The current situation is that most p2p lending services charge borrowers more fees than lenders.

Possible causes for this are:

  • At the inception of p2p lending services, opinion was that it is harder to convenience lenders to trust this unproven model and unknown new company running the service – therefore lenders were charged nothing or little to not build entrance barriers
  • Orientation on established models for loans – banks charge borrowers fees too, therefore borrowers will accept these as usual
  • Cost-bast pricing: In vetting a borrower the service will incur costs, whereas a new bid by a lender will incur close to zero costs as it can be processed automatically. Even higher than the vetting costs are the customer acquisition (marketing) costs to obtain borrowers.

Now years after launch, most p2p lending service are “short” of (good) borrowers. Their lenders have a surplus of capital that could be lend out, would there be more loan applications on the platform. And typically customer acquisition costs are much higher for winning new borrowers than for winning new lenders. Furthermore borrowers must be acquired over and over again, whereas lenders remain customers for longer periods of time and reinvest capital.

The logical consequence would be for the p2p lending marketplace to change the pricing. By charging borrowers less and charging lenders more, the value proposition to borrowers would be lower APRs, attracting more borrowers.

A counter-argument voiced against this, is that pricing would not change, because lenders would just raise the interest rates they offer to cover the higher fees. This will happen to some degree, but I think how much is dependent on the model the p2p lending marketplace works. In a market place where lenders do set interest rates themselves (e.g. Ratesetter) this will in my opinion be likelier than in a markplace where the operator sets the interest rates (e.g. Lending Club) or where the initial rate is set by the borrower (e.g. Smava) and can possibly be bidden down (e.g. Isepankur). Furthermore even if costs for borrowers overall would not change, the marketing-message could – ‘fee-free loans’ will be more appealing.

This change would need to be a gradual shift as existing lenders are accustomed to current prices and will resent higher fees. For the p2p lending service the effect per loan could be neutral. The amount of fees earned per loan would stay the same, just the proportion of the parts payed by lenders vs. borrowers would change. Continue reading

What is Fidorpay and how is it Relevant to P2P Lending

Notice the headline of the article. I have chosen it, because I found it hard to describe what Fidorpay is. And Fidor itself meets the broad scope of questions, that the novelty service provokes, with a main FAQ of no less than 115 questions and answers. But I’ll try my best:

Fidorpay is a prepaid e-wallet that can be used via web or mobile apps (they currently have an iPhone app and are working on android). Once a user has transferred money into this account he can send money to other Fidor Pay users.

Sounds like Paypal? There are important differences:

  1. The Fidorpay system works nearly in real-time. That means money is credited to the receiver’s account within a very short time frame and can be used by him then. (Paypal offers fast notification, but it takes much longer for the money to be actually available in the recipient’s account for future transactions).
  2. Sending (and receiving) money is fee free
  3. Starting February, 1st 2011 Fidorpay users can now lend money via Fidorpay to ‘friends’

So how does the lending part work?

A Fidorpay user can ‘lend’ any amount between 5 and 500 Euro to anyone. This is possible even if the recipient does not (yet) have an account but his email-address or mobile phone number is know to the lender. Loans are interest-free. They do not have a fixed term, instead the lender can send the friend a request to repay anytime. Unlike sending money, lending is not fee-free; Fidorpay charges a one time fee of 0.49 EUR (approx. 0.68 US$).

Is this p2p lending then?

It is in a pure technical/infrastructural way, since it does enable one person to lend another person money (over a distance) via internet or mobile phone.

But it is not the p2p lending in the sense it is most commonly used in this blog for it lacks any marketplace and validation aspect. It only takes a lending process that would have offline taken place with cash handed over to a convenient online level. If the borrower refuses to repay the loan Fidorpay itself does not enforce the repayment in any way.

How is it relevant to p2p lending then?

Fidor with Fidorpay shows how an infrastructural footing for p2p lending could look that omits most of the conventional banking structure. Since Fidor has a banking license, some of the regulation requirements are solved. If all lenders and borrowers of a p2p marketplace would (mandatory) become Fidorpay users then all payments and repayments could take place inside the Fidorpay system. The process would become faster and transactions could possibly be cheaper.

Are we there yet?

Far from it. I think Fidorpay gives a glimpse of what mechanisms could be used in the p2p lending marketplace of the future. Since it is currently not a main banking connection of the customers, amounts in the wallets are small. And maximum transaction amounts are limited for security and regulation reasons.

But ‘conventional’ banks should watch out and p2p marketplaces should think and review what possibilities Fidorpay and potentially evolving similar services will offer them to advance their service.

Key data about Fidor and Fidorpay

Founded 2003 Fidor Bank AG commenced its banking activities in December 2009 and brands itself as a ‘community bank’ using web 2.0 instruments in combination with latest technology. Related video: Speech by Matthias Kröner at Finovate, London. Fidor Bank states 19,600 users at the end of 2010. The current number of users is approx. 23,000. It is unclear from the press statements if all users are paying customers.

Fidorpay is available to residents of Germany with a German bank account.