January 24, 2016    6 minute read

Financial Engineering 2.0: P2P Platforms

   January 24, 2016    6 minute read

Financial Engineering 2.0: P2P Platforms

“History does not repeat itself, but it does rhyme”

Such reads the famous quote from even a more famous man, Mark Twain. The essence of this quote lies in the repetitive quality of human existence: we tend to look at the past for guidance as how to act into the future and consequently, the future, even though will not be exactly the same as our past, tends to express the same qualities, some good and some bad. As this article will suggest, the world of finance is no exception to this existential cycle.

As marketplace lending pioneering firm, Orchard suggests, the rise of the hedge funds from a ‘club’ of investors with USD 200 billion of assets into a worldwide industry valued at around USD 3 trillion was the primary result of the alchemy between technology and finance. More importantly, proprietary trading platforms, data analysis and real time reporting tools and second by second market information made possible this expansion. Now, technology is ready to boost another ‘small’ but ‘fast growing’ sector: the marketplace lending niche (or Peer-to-Peer Lending market).

In July 2014, Morgan Stanley published a report on the growth and development of marketplace lending, underlying that the business model, at least in the US, has doubled every year since 2010 and reached a total of USD 12bn in 2014. With fast growth in Australia, China and the UK, the report envisages that P2P lending can balloon up and command anywhere from USD 150bn to USD 490bn globally in the next four years.

P2P growth

The support of marketplace lending can also be underlined by the amount of investment that is being allocated towards P2P platforms such as Orchard and by the political attitude of both governments in the US and across the EU and of Wall Street’s big names like Vikram Pandit. However, what is P2P, how does it work and what is the dynamic relationship between risks and benefits that this ‘new’ market is set to offer?

How and why it works

According to a number of well-established financial institutions, the nexus of marketplace lending is the 2008 financial crisis which resulted in a domino-effect economic collapse across the globe. More importantly, from a consumer perspective, the financial institutions entrusted to manage, allocate and save our money failed us: banks, both as traditional lenders and as middlemen of financial transactions, in fostering of culture of risk and reward driven by reckless decision making at the cost of clients’ money, have tainted their image and lost our trust.

It is from this storm of chaotic financial and emotional interaction between people, corporations, progress and technology that P2P lenders have stepped forward. For example, as senior analyst at Morgan Stanley, Smittipon Srethapramote argues, the young generation is used to technology blending into ‘all sorts of things’ and while traditional lenders are still using time consuming check lists to assess loan requirements, P2P lenders use Big Data tools (i.e. data mining software) and propriety algorithms to make a judgment in minutes and offer quicker access to finance.

Peer-to-Peer lending platforms connect loan originators (lenders) with borrowers without the involvement of middlemen that ought to facilitate the transactions. The borrower submits an online application in which the amount of money needed and their purpose is specified and then potential lenders will be allowed to fund the credit requirements by choosing how much of the loan they will fund. In essence, they reduce transaction costs and enables faster and more transparent capital allocation.

Because these new type of lenders have no capital requirements (as they do not use their own money to fund anything) and lower operational costs (they use digital infrastructure which does not require the same amount of capital expenditure annually to sustain business operations and to improve them), P2P lenders are known for offering more attractive interest rates to both sides of the transaction than banks do.

As the literature suggests, the technologies employed by P2P lenders are varied and underline the different approach to the same concept. For example, P2P lending can be seen as social lending supported Internet-based information system (Emergence of financial intermediaries in electronic markets: The case of online P2P, Business Research (2009), as microlending or as crowdfunding (Crowdfunding: Tapping the right crowd, Journal of Business Venturing (2014)). Moreover, the marketplace lending is already starting to diversify with platforms that connect institutional investors with borrowers – such as Orchard while others, such as Prosper allow private investors to tag along and invest a minimum amount of USD 25 into various loans.

We have seen how technology is set on the track to build up this new market by connecting borrowers and lenders online at lower costs and in a less amount of time. However, what dangers does it present?

Dangers Ahead

There are two forms of danger posed to consumers by inadequate development and monitoring of P2P lenders and dangers for the industry not to develop fully due to misunderstood regulatory impediments.

The P2P market is based substantially more on technological development, performance of online platforms and most importantly cybersecurity rules, protocols and defences when compared to traditional lenders. That is not to suggest that banks should not boost their ancient IT systems and take cybersecurity risks seriously – the point is that a bank’s infrastructure is both digital and physical in terms of both completing transactions and depositing assets but a P2P company is entirely digital. Therefore, in case of IT system failures, one can still walk in a bank and sign and complete documentation for a certain transaction that will then be carried on as soon as the software is running again.

Secondly, credit risk assessment procedures need to be more data focused and less like the classical check list and rating system used by traditional bankers. Why? Because P2P lenders use data as their main, if not the only, source of decision making. A recent paper in the European Journal of Operational Research – Instance-based credit risk assessment for investment decisions in P2P lending (2015)- argues that an instance-based framework is data-driven and allows the platform to articulate the risk-return relationship of each loan more clearly than the traditional rating system used, for example, by US rating agencies. This inevitably will result in better investment decisions made by the funding parties as they will have more accurate information. In its essence, an instance-based model uses data comparison tools to build a risk profile for each borrower and then to inform the lenders. Without rigorous credit risk assessments, the 2008 crash can repeat itself.

Finally, the political attitude of regulators will be key in ensuring both the growth of the industry and the safety of investors. Now, risks will always be there, trying to eliminate them is an illusion. However, regulation should welcome new-comers to the financial services industry. Regulators need to sit down with the industry primarily and with academics and politicians secondarily to assess the needs of the credit creation sector, their clients, the risks presented by the technologies they used and then how to provide a legal guideline towards progressive expansion of marketplace lending from a ‘club’ to an ‘industry’.

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