The Old World
Prior to the financial crisis of the noughties the banks had a monopoly on lending money to businesses and individuals. This created a funding gap for new and growing businesses. Small to Medium sized enterprise business (SME) owners could all tell you stories of failed attempts to borrow money from large financial institutions. The roadshow of rejection was common and if a bank did choose to lend money to an SME it was often at very high interest rate. This stifled the growth of the start-up landscape and of growing businesses trying to compete with established ones that had relatively easy access to finance. It also made it very difficult for individuals to borrow money from their bank even if loans were secured against fixed assets such as an individual’s property.
The technological advances of the early 2000s opened up opportunities in many industries. The sharing economy began to form, social media was born and the concept of FinTech surfaced, challenging traditional financial institutions. In 2005 Zopa was founded in the UK as a response to the failure of banks to lend to individuals. The technology that the business built was the first example of P2P lending.
In 2007-08 the financial crisis hit and bank lending to businesses and individuals alike rapidly dried up as banks began to consolidate their positions and tighten their lending due to revised capital reserve constraints. This created a debt funding gap and many businesses followed Zopa’s lead and launched peer to peer (P2P) lending platforms. The P2P lending revolution started to gain momentum.
The New World
P2P lending connects borrowers with lenders directly using a technology platform. This removes the reliance on large middlemen such as banks and other financial institutions. A borrower can be a business or an individual and the same goes for the lender. The loans can be secured against fixed assets like properties or business assets. They can also be unsecured.
Lenders can gain access to higher rates of return compared to traditional investment products like savings accounts or cash ISA’s through P2P lending platforms. However, an investor’s capital is at risk if a borrower fails to repay a loan that has been assigned to them via the P2P platform and furthermore the investments can be illiquid. The platforms will often distribute money to borrowers on behalf of the lenders and can also spread the money lent across multiple borrowers to reduce the risk of the lender losing their money.
Some platforms offer self-select options where lenders can choose the business they want to lend to. However, these investments are for sophisticated and high net worth investors only. A fixed term will often apply for the lender to invest via the platform. This can range from 1 year to 5 years. Early exit is often possible but will involve a fee.
The platform is responsible for collecting interest and repayments from the borrowers on a monthly or annual basis. Borrowers repay the loans plus interest to the platform over the lifetime of the loan. The platform will then arrange for any repayments and interest payments to be made to lenders in line with the interest rates that they signed up to with the platform.
The FCA has approved all platforms on OFF3R but the Financial Services Compensation Scheme (FSCS) does not cover P2P lending meaning a lender’s money is at risk and investors should only invest what they can afford to lose. However, many platforms have established a provision fund to cover defaults to help protect lenders from potentially losing their investment.
The Future of P2P Lending
Greater institutional investors – 45% of platforms reported some form of institutional investment in 2015 according to Nesta’s 2016 report on alternative finance. It is expected that this number will increase in the coming years thus fuelling the growth of the industry.
Collaboration with traditional finance – Banks and traditional financial institutions have now taken notice of the P2P industry. The Government now require banks to refer rejected loans to P2P providers. However, this has also been driven by a realisation that the P2P platforms are not going anywhere anytime soon.
Technology Innovation – The platforms have been relatively simple to date from a technology perspective. Largely acting as the intermediary between the borrower and lender. A greater focus on analytics and trend prediction is likely as platforms look for better ways to match lenders with borrowers and accommodate different interests.
Regulatory Changes – The FCA are paying very close attention to the industry to protect the interests of investors. It is likely that the regulatory landscape will evolve as the industry grows. Therefore, a real unknown variable at present is the FCA and how they intend to regulate the industry in the future. Some form of FSCS protection may also increase the number of investors showing interest in this asset class.
Please head over to our detailed guide on P2P Lending to find out more.