Peer to peer (P2P) lending, like many other sectors, has suffered significantly during the Covid-19 crisis. Usually a way to facilitate loans to individuals or businesses via an online platform that matches the lender to the borrower, the pandemic has only amplified the risk to lenders that P2P can pose.
Niels Pedersen is a senior lecturer at Manchester Metropolitan University and the author of Financial Technology: Case Studies in Fintech Innovation. Here he shares his thoughts on how the P2P meltdown yields valuable lessons for avoiding the next crisis.
About a year ago, peer-to-peer (P2P) lenders suffered a crisis of confidence. This triggered an investor run on the sector, causing some platforms to fold. For those that survived, there is now an opportunity to capture market share and increase resilience in the sector.
As the global economy went into lockdown due to the COVID-19 pandemic, investors rushed to withdraw their funds from P2P platforms. No doubt, during this time, many recalled the long queues outside retail banks during the global financial crisis (‘GFC’) of 2007-09.
In response, several platforms froze investor withdrawals. This left many unable to access their cash, just when they needed it the most. For a sector that held itself out as an alternative to mainstream banking, this was a reputational disaster and unsurprisingly, several P2P brands did not survive the ‘COVID Crash’.
Going full circle
As the P2P sector came into its own in the aftermath of the GFC, it is ironic that its first crisis should be so similar. The 2008 meltdown was a liquidity crisis driven by investors cutting their exposure to mortgage-backed securities. In the spring of 2020, investors wanted out of P2P loans.
What’s more, the two crises have very similar roots: in each case, illiquid investments were distributed to yield-seeking investors. The apparent stability of returns gave investors a false sense of security. Illiquidity was not a problem until investors started worrying about default rates and wanted their money back.
A lesson learned
As it turns out, investor fears were justified: according to the Cambridge Centre for Alternative Finance, default rates on UK digital lending increased by 8% year-on-year in H1 of 2020. At the same time, default rates in North America and the Asia Pacific region increased by 13% and 15%, respectively.
For investors in equities and corporate bonds, such losses are commonplace. Indeed, many may welcome them as a buying opportunity. On the contrary, P2P investors perceive any nominal loss as a disaster.
This is because the P2P model was often marketed on the idea that bank-beating interest rates could be achieved without significant risk to investor capital. As a result, P2P platforms selected for customers who were not prepared to accept losses.
Damaging for some, a benefit for others
Furthermore, P2P investments were promoted as an alternative to savings accounts. This anchored consumer expectations in these products, leading many to assume that P2P investments had similar features, like stable capital values for instance.
As seen in the spring of 2020, any deviation from such expectations can be detrimental to user experiences and lead to untimely withdrawals. Consequently, the worst-hit P2P platforms had to wind down their businesses or close their doors to retail investors.
However, for P2P lenders still operating in the retail investment space, this has become an opportunity to capture market share. But, to avoid future crises, these platforms must become more resilient.
In this regard, we can learn from those that navigated 2020 relatively unscathed. Zopa, which was founded in 2005, is an exemplary case of this. Evidently, it learned a lesson about liquidity risk from the GFC, which many younger P2P lenders failed to do.
What Zopa got right
For starters, Zopa appears to have gotten its marketing right: its website states that investors’ money goes into loans with a maturity of up to five years. Alongside this, Zopa encourages investors to stay invested for at least three years.
The website also makes it clear that withdrawing funds before the underlying loans mature attracts a 1% fee. This discourages investors from taking out their money prematurely.
What’s more, the website informs investors that their capital is at risk. It stresses that better results are achieved by investing over time horizons of least three years. Thus, the company’s disclosures are similar to those of investment managers: these also emphasise the importance of patience and the potential for capital losses.
In this way, Zopa primes its customers to expect some setbacks. Its investment proposition selects for people with at least a medium-term investment horizon. This reduces the risk of untimely excess withdrawals.
Finally, the company makes its loan book publicly available. This allows investors to observe historical default rates. Such transparency reduces investor uncertainty and fundamentally, it was the uncertainty that precipitated the 2020 P2P crisis. Thus, platforms can reduce risk by publishing up-to-date information on their loan books.
Creating a more resilient future
However, even Zopa’s loan book disclosures are not perfect – it reports on a monthly basis when conceivably it could provide this data live via an API.
Investors in the P2P sector expect to see granular reporting regarding platforms’ financial performance. Such transparency would reduce uncertainty and increase trust in P2P platforms. This could make them more resilient in the face of future crises.
