Understanding P2P Lending

P2P lending (peer-to-peer lending) is the practice of lending money between individuals. While informal lending between people has existed since the advent of trade and commerce, technology has changed the face of informal lending.

By leveraging the marketplace platform common in eCommerce, one individual borrower can access funding from many individuals online. The lending takes place on P2P lending companies’ websites using various different lending platforms and credit analysis tools. The borrower and the lenders do not meet physically and are often strangers.

P2P lending is not defined as any of the 3 traditional types of financial descriptions: banking term-deposit, investment or insurance. P2P lending is often described as an alternative financial service.

History of P2P Lending

Zopa, a company founded in the UK in 2005, was the first in the world to offer P2P lending. In 2006, US-based company Prosper was launched, followed by many more over the years.

The GFC in about 2008 saw many people turn to P2P lending as confidence in established banking and finance dwindled. Banks were reluctant to offer new loans and offered interest rates which were virtually 0% to savers. Because of this, borrowers had to look for alternative sources of loans and savers actively looked for higher yielding investments.

In China, P2P lending has rapidly grown with technology. The practise in the country was common long before the advent of the Internet and so is more easily accepted by society. China as a whole may eclipse the rest of the world in the value of loans originated in the P2P lending market.

The Loans

Most P2P loans are unsecured personal loans, however, some larger amounts are lent to businesses. Other forms of peer-to-peer lending include:

• student loans
• commercial and real-estate loans
• payday loans
• factoring and leasing

Some platforms also offer secured loans accepting jewellery or property as collateral. However, these models have scalability issues.

Loan Application Process

Different platforms have different application processes, but most include:

• Registration on the site by the applicant
• The platform verifies the applicant’s identity and analyzes applicant’s creditworthiness.
• If qualified, the borrower’s loan is posted to the marketplace and lenders can start funding the loan

Some platforms use different types of analytics and some do not assess credit but rely on your online reputation. Some depend on third-party providers to perform a background check on borrowers.

How Transactions Take Place

P2P lending platforms generally adopt three kinds of transaction matching methods:

– Pure Marketplace

• Lenders and borrowers are free to set interest rates.
• Loans are “opened for auction” for a certain number of days and the borrower sets his desired interest rates.
• Lenders are free to submit their bid amount and interest rates.
• At the end of the auction period, the system pools the best-priced bids into the funds for the borrower, while the rest of the bids are refunded to lenders.
• The rate that the borrower pays is the weighted average of the bids.
• This model usually also allows the borrower to close the auction early if they are willing to pay for the current rates that the lenders are offering, often higher than the desired interest rate.

– Fixed Interest Market

• The platform usually sets the interest rates for the loans, often based on the level of risk.
• The lenders then purchase the parts of the loans that they like until the loan is fully sold.
• This model assumes that the platform has better expertise and so helps lenders in judging the risk and reward of each loan.
• It also usually allows for quicker matching than the pure marketplace model.

– Fully Managed Funds

• Lenders give the platform full authority to manage their funds, which are then managed as a pool of funds.
• The lender then decides which loans get funding and what interest rates and allocate the funds accordingly.
• This model does offer advantages in the form of even quicker loan funding and helps users reinvest their idle funds.

Market Size of P2P Lending

According to Stastia, P2P lending reached US$25 billion in 2014, and is expected to reach US$1 trillion by 2050. While there are still reservations about the product in general, in the US the product is gaining acceptance. Institutions have already started to enter the space to invest in whole loans and are starting to represent a large chunk of the loan originations.

Risk & Return

Banks earn their income from the interest rate spread they get from their borrowers and their savers. Banks essentially borrow money from savers to lend to borrowers.

Savers earn interest for the money they keep in the bank. However, because of the effect of inflation, savers usually lose money because the interest rates are often too low, so savers often have to invest their funds in assets that are higher yielding.

Higher perceived risk usually requires a higher return. While it is not always the case, this is the norm.

• While saving deposits and government bonds are considered safer assets, they also offer the lowest potential returns.
• Stocks or equities are then the next level of risk/reward lever, with complex financial products such as derivatives with the highest level of risk/reward.
• P2P lending falls between risk/reward level of deposit / bonds and stocks. It offers higher interest rates than deposits, but with less volatility than stocks.

If you reinvest your monthly interest, your interest generates its own interest, earning you higher interest over the whole year.

Compound interest is interest added to the principal of a deposit or loan so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. Compared with simple interest where only the principal earns interest, compound interest gives more benefit for lenders.

Default is common in lending. If you have a P2P platform, it is important to factor in the possibility that some or all of your borrowers will default on the funds you lent them. If you choose to lend through a P2P platform, you should only lend an amount which you can afford to lose.