The institutionalisation of marketplace lending
In 2019, three of the top peer-to-peer lenders increased their institutional funding by 90% for Prosper, by 94% for LendingClub’s, and by 64% for Funding Circle. Why? To understand this trend, we have to examine the origin of peer-to-peer loans and how they work /1/.
In 2005, Zopa, a UK based marketplace lender, launched as the first company to ever offer peer-to-peer loans. Prosper and LendingClub followed shortly in the US. After 2008, the sector really took off because banks became more cautious of insolvency risks and gradually reduced the interest rates on savings; borrowers searched for alternative funding sources; and savers searched for higher yielding investments. Peer-to-peer marketplace lending offered the solution since marketplace lenders do not directly take up deposits or lend to borrowers and they take no risk onto their balance sheets. Their income is derived from the fees and commissions paid out by borrowers and investors. Now the industry is incredibly mature. In the UK, one of the most established markets for alternative finance, marketplace lending has risen from £92 million in 2011 to a record of £6.1 billion in 2018 /2/.
Competition for funds
Funding and operational costs both factor in assessing the total cost of issuing a loan. How do banks and marketplace lenders keep both low to stay competitive and what happened in 2019 to tip the scales in favour of one?
Funding costs are expenses that a lender must pay in order to acquire funds and are therefore a major factor in assessing the total cost of issuing a loan. For banks, funds are obtained from client deposits. The bank must attract and maintain deposits and this results in expenses, which are either interest payment related, or non-interest related, such as payment and processing services as well as operating costs. Overall, this usually means that banks have low funding costs when compared to marketplace lenders, as they have inexpensive access to funds due to client accounts. Banks are still able to generate income through cross-selling services even when costs result in low or non-existent profit margins.
On the other hand, in order for marketplace lenders to obtain funding, they must attract investors. The key to this is offering returns that outweigh the risks assumed by the lenders, thereby ensuring a competitive advantage over other platforms. If a marketplace lender is not offering sufficient returns, investors will likely switch to other platforms as there are no significant switching costs. Investors may also shift to more attractive rates offered by banks. In addition, marketplace lender expenses are generally not interest related and emerge from marketing, origination costs, and servicing costs.
Another essential aspect of calculating the total cost of a loan is the operational cost. Banks have historically had complicated multi-channel processes and stringent regulatory restrictions and may have difficulty remaining flexible and accessible when compared to marketplace lenders. The latter are more lightly structured and have a strong focus on developing efficient IT infrastructure, being at the forefront of innovative methods of analysing and issuing loans. Marketplace lenders build online channels of on-boarding and servicing processes and manage to greatly reduce their overall operational costs.
However, it is important to note that as of December 2019, following the insolvencies of peer-to-peer property lenders Lendy and FundingSecure, the UK began regulating the peer-to-peer lending industry by imposing additional regulatory measures, including various compliance requirements, authorisations, and conduct rules. In addition, the FCA has banned retail investors from investing more than 10% of their assets into the sector. These regulatory changes will result in additional costs for marketplace lenders in the UK, diminishing the advantage that they previously enjoyed, namely being less highly regulated than banks. As the UK is the birthplace of peer-to-peer lending, we can anticipate that other jurisdictions will soon move towards increasing regulations for marketplace lenders.
Burden of brand awareness
Over the last decade, marketplace lenders have developed high-level technological capabilities to analyse borrowers’ credit risk. They have built up a positive track record, inspiring the confidence of retail and institutional investors alike. However, marketplace lenders find themselves limited by a lack of scalability and as a result, they have not been able to make the most of their potential.
In order to attract retail investors, marketplace lenders have had to invest significantly in marketing. According to the British Business Bank, only 52% of UK SMEs are aware of peer-to-peer lending /3/. Meanwhile the increasing popularity of price-comparison websites has also pushed up spending. That means marketplace lenders must continuously increase marketing budgets to compete with other marketplace lenders and banks, with banks having the advantage of an extensive consumer pool and across the board advertising.
From peer-to-peer to peer-to-institution
Halfway through 2010, high performing peer-to-peer lenders whose visibility was increasing started to shift towards institutional investors as a way of avoiding the high costs of a traditional peer-to-peer funding strategy and subsequently becoming more profitable. Their origination became partly funded by family offices, pension funds, and sovereign wealth funds, with platforms now securitising these loans, bundling together small amounts and selling them as a whole. For example, 90% of Prosper’s new loans, 94% of LendingClub’s, and 64% of those of Funding Circle, were funded through institutional money in 2019. This is a hybrid model of funding, a mix between regular retail and cheaper institutional funding. For well-established marketplace lenders, we can observe a full conversion to institutional money, closing the door to any retail capital. For instance, in the UK, Thincats and Landbay claimed it was no longer cost-effective to fund loans through retail investors alone and have now made a full switch to institutional funds.
Due to the pandemic, another well-known British peer-to-peer lender, RateSetter, looks to be doing a 180. RateSetter’s CEO Rhydian Lewis commented last month that “everyone may be more comfortable if lending is done by institutions” /4/. While Lewis previously said that he cares about “normal people getting better returns”, RateSetter appears to be following in the footsteps of so many other peer-to-peer lenders who are seeking the stability of institutions in the uncertainty of the pandemic. RateSetter is currently in early takeover talks with Metro bank, an institution that previously partnered with Zopa. Peer-to-peer lenders are quickly becoming thin on the ground.
Last week, London-based lending company Growth Street followed Thincats and Landbay, announcing its decision to close its platform to retail investors, focusing instead on institutional debt funding. The decision to pull out of the retail investor market was made following a 90-day liquidity event, during which the pandemic severely impacted the market. While the shift away from retail investors had formed part of Growth Street’s strategic plan prior to COVID-19, the pandemic certainly accelerated this shift. Growth Street continues to increase its equity funding and is the latest in a succession of peer-to-peer lenders who are shifting over to institutional investments.
Obtaining funding by attracting a high number of retail investments has become more burdensome in terms of costs and therefore, there is a high incentive for marketplace lenders to fund themselves institutionally, thus giving them access to a larger and more stable pool of funds.
With the UK being the model for peer-to-peer lending and given the ever-increasing cost of retail funding and the development of more stringent regulations on marketplace lenders, we can envisage a rising institutionalisation of the sector.
/1/ The Economist, Created to democratise credit, P2P lenders are going after big money, December 2019
/2/ Marketplace Lending Index, Issue I 2019
/3/ British Business Bank, Small Business Finance Markets 2018/19 report, 2018/2019
/4/ Financial Times, Peer-to-peer lenders forced to abandon retail roots, June 2020
