What would a world without banks look like? Converts to peer-to-peer websites such as Zopa and RateSetter believe we’re already there; Risk and reward in the p2p revolution

July 26, 2013 6:01 pm

Risk and reward in the p2p revolution

By Elaine Moore

What would a world without banks look like? Converts to peer-to-peer websites such as Zopa and RateSetter believe we’re already there – and it’s a utopia of 5 per cent returns, affordable loans to trustworthy borrowers and no hard selling of extra products. The UK government, Google and hard-nosed former Morgan Stanley chairman John Mack appear convinced, putting money behind the sector, and high street bank Santander is now considering a partnership with a peer-to-peer lender. But with interest rates almost double the equivalent offered by banks, what exactly are investors accepting in exchange for a lift in returns?Peer-to-peer lending is the product of both the digital revolution and the credit crunch. As interest rates fell and banks pulled back from lending, web-based intermediaries have exploited both the gap and the rise in online banking. In less than a decade the sector has gone from an internet curiosity to a government-supported funding alternative.

Yet for all the excitement and goodwill surrounding the sector there is a very good reason that you may not have heard of it. In the UK peer-to-peer lending is not due to be regulated until next April, which means financial advisers are mostly wary of recommending it.

If you are one of the uninitiated it may help to think of peer-to-peer lending as a sort of banking version of eBay in which borrowers and lenders deal with one another through websites that act as loan brokers.

Because the intermediaries don’t need physical branches and are not dealing with creaky old infrastructure, they have fewer staff, faster processes and lower costs.

A study by McKinsey, the management consultancy, estimates that US peer-to-peer platform Lending Club has a 425 basis point (4.25 percentage point) cost advantage over a typical bank.

This, say the platforms, is why rates for both lenders and borrowers are so much more competitive than those offered by banks.

Right now, the best interest rate that money can earn in a bank is 3.5 per cent from a seven-year fixed-rate bond available from Skipton Building Society.

Zopa, the largest and oldest platform in the UK, boasts an average annual return of 4.5 per cent for investors who lend their money to individuals. Funding Circle, which facilitates loans to small businesses, advertises an average net return of 5.8 per cent, rising to 14 per cent if investors accept more risk. RateSetter’s current return is set at 4.3 per cent.

Money invested in Zopa and Ratesetter, two of the largest platforms in the UK, is split and divided between individual borrowers who present varying levels of risk.

Investments are held first in a bank account, RBS and Barclays respectively, before they are allocated to borrowers. The sites use credit checks before accepting borrowers – but bad debts, and fraud, are risks taken on by investors, not the site. Both companies have a protection fund which is used to cover losses, but it does not guarantee returns. However, default rates for both sites are so far less than 1 per cent.

RateSetter was set up in 2009 by Rhydian Lewis, an investment banker from Lazard, and is based in London. Alex Gower, a director at RateSetter, says that there is a misconception that peer-to-peer finance is about the super wealthy lending to the very poor. In fact, he says, it’s savers who want a better rate of interest lending to borrowers who are also looking for better rates. “Our borrowers are 40 years old on average and have an income of £35,000,” he said.

Zopa recently altered its investment model so that instead of choosing who they lend to, investors’ funds are pooled. This was partly in response to the fact that losses incurred by investors from individual bad debts cannot be offset against tax charged on the interest earned. By grouping debts, Zopa can include the effect of losses in final returns, meaning investors won’t pay tax on them.

New investors who don’t understand the sites and are concerned about risk should start with small amounts, spreading their investments across a number of loans, suggests Claus Lehmann, who runs peer-to-peer research site P2P-banking.

“Furthermore, if the service has a busy secondary market, that is an advantage – adding liquidity and allowing early exits for lenders, in case the money is suddenly needed for other purposes,” he adds.

Funding Circle, which facilitates loans to businesses and allows lenders to choose who they want to lend to, also offers a secondary market for investors. Savers can sell their loan to the platform for a 0.25 per cent fee.

Funding Circle groups businesses by risk from A+ to C and gives estimates of bad debt per category. It covers the majority of the peer-to-business market in the UK, although new entrant Thin Cats has also started to receive attention.

Dennis Hall, a chartered financial planner at Yellowtail Financial Planning, says that the rates available on peer-to-peer sites are so attention-grabbing that he has talked about them with clients, though none has chosen to invest so far.

“You can’t make a straight comparison between these sites and a bank or building society account because they lack the Financial Services Compensation Scheme protection,” he says. “So you are dependent on the company’s risk assessment and we’ll only know if they’ve got them right over time. I can see why people who are reliant on a good rate of interest are looking at them. Though in an odd way I think these sites appeal most to those who can least afford the risk.”

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‘I’d put my pension on p2p’

Giles Trollope, 64, has lent out more than £23,000 through Zopa in the past three years, earning an average annual return of 4.7 per cent on his investments. He has never used any other peer-to-peer platform.

“I first heard about Zopa from an article in the FT and then I went to look at the website. At the time the banks were offering 1 per cent returns on income and Zopa was offering 5 per cent, that’s what attracted me.

“I wouldn’t say I’m an early adopter of new technology or have any particular interest in start-up sectors. I am a cautious investor – I don’t hold stocks and shares – and I was looking for guaranteed returns from an investment that wouldn’t go up and down.

“The nice thing about Zopa is that you can call the company up – it’s a website but there’s none of that “email us and we’ll get back to you” nonsense. You can get your money out – for a small charge, and so far I think I’ve lost money on three bad debts – each of which were £10.

“The regulation will be extra security but it wouldn’t make me suddenly invest more. I don’t feel unsafe putting my money with the website at the moment.

“The only way that you can lose your money in Zopa is if the managers abscond to the Bahamas, or all of the borrowers stop repaying their loans. The only thing that would instigate that is a collapse of the wider financial system, and the governments aren’t letting that happen.

“I do trust them. They have a terrific record in my view. Of course you are a bit apprehensive when you put the money in at first but over the years I have been delighted with the return. I’m due to get my pension soon, I’d be more than happy if I could put that in Zopa too.”

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Next stop property

Could the principles of peer-to-peer lending be applied to property investment?

Websites such as emove and tepilo are already trying to oust estate agents from their traditional role, so why shouldn’t investors take the place of banks to fund mortgages?

Peter Renton, founder of peer-to-peer research organisation Lend Academy, believes P2P property sites have tremendous potential.

“They are in their infancy but I think eventually this will morph into a full-blown asset class because it brings many of the benefits of real estate investing to everyday investors without any of the hassles,” he said.

So far the sites mostly focus on commercial property, not residential, but Mr Renton expects it to expand across the sector in future.

Investing in property via a peer-to-peer site could mean lower fees as borrowers generally pay for charges and the opportunity to spread risk by dividing money between projects. Average prices for commercial property are still well below their 2007 peak, offering the potential for capital growth as well as average yields of more than 5 per cent.

Relendex, which launched in May, calls itself the world’s first peer-to-peer lending exchange for commercial property loans and is being marketed to individuals, pension funds and companies.

Returns are projected between 5 per cent and 7.5 per cent a year and loans of up to £10m can be divided into £1,000 chunks.

Offering a more specific service is Folk2Folk, launched in February, a service extending interest-only loans on buy to let, holiday homes and commercial property in Cornwall and Devon.

Investors need a minimum investment of £25,000 and quoted interest rates range from 6 to 9 per cent.

Assetz Capital, a platform set up in April by buy-to-let broker Assetz, hopes to lend £50m this year. So far its biggest deal has been a £1.5m loan to fund a hall of residence in Nottingham.

Double-digit returns are the target, and developers who apply for a loan will be put through stringent checks and must provide security against the debt, which should cut the chance of loss.

However, analysts warn that this is a very new sector which presents multiple risks to investors. In addition to liquidity issues – property isn’t easy to sell in a hurry – and the risk that borrowers will not repay their loan is the question of what might happen in the event of a default that involves multiple lenders.

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From graduates to jewels

If the idea of lending money to a group of individuals sounds too tame, how about taking a bet on the future earnings of an American postgraduate student?

As the peer-to-peer sector grows, potential borrowers are growing ever more esoteric, which means new risks and rewards for investors.

Prodigy Finance was set up in 2007 by three MBA graduates who struggled to get funding. They came up with the idea of tapping alumni for the money directly, offering 5 per cent a year interest in return. Since inception, more than £37m has been provided to more than 800 students – all of whom have repaid the money in full – and the site is now advertising itself to global investors. In the UK Gradurates aims to replicate the model.

Many of the peer-to-peer platforms that have launched this year have opted to focus on secured loans, in the hope that this will reduce default rates.

In addition to the cluster of property-related peer-to-peer platforms is FundingSecure, which acts as an online pawnbroker, allowing individuals to borrow up to £100,000 secured against high-value personal assets, such as jewellery. Assets are valued by an auction service and then posted to FundingSecure which stores them. So far, the 92 lenders who have used the service have set interest rates of just below 12 per cent.

Among the new peer-to-business lenders to arrive in the UK is RebuildingSociety, which funded its first deal at the start of this year and promotes a return of more than 16 per cent to investors.

But the expansion of the sector has also led to an increase in the number of companies that have failed. So far, The Lending Well, Big Carrots and Quakle have all ceased trading. And Funding Secured, which launched in March and advertised itself as a peer-to-business platform that would only lend to established companies, appeared to have removed its website at the time this article went to press.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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