umarsaeed

Peer-to-Peer lending: A beginner’s guide

In Advice, Financial, Fresh on December 2, 2016 at 11:18 AM

Today, when you have money left over after paying your bills, you invest in big and distant corporations. You don’t even think about it. The government incentivizes you to save for your future through RSPs and TSFAs. You invest in stocks, bonds or mutual funds. Basically, all of our money goes to the financial markets. The financial system has been designed to funnel our our collective savings in that direction. As different as you might try to be, we all own a slice of the financial markets at large. Alternatively, you could start your own business or purchase an investment property, but this is a lot of risk, costs more in legal fees and taxes, and most importantly, it may entail work that you don’t have time for. So you invest in passive financial instruments. And until now, passive financial instruments basically meant big corporations. 2016 marks the year where we, individual Canadians, can re-channel some of those investments from large and distant corporations to local small businesses.

Currently, we all invest in the markets, which finances big business. We do not have vehicles to invest in our own communities. We can donate money, but we can’t pool our money together to invest in local businesses. We have, until now, depended on our banks to do this for us. But peer-to-peer (P2P) lending has officially arrived in Canada. If done right, this could spark a wave of new businesses exactly at a time when Ontario is desperate for a renewed economic identity.

Evolution of banking / Stories old people tell

There was a time when you visited your local bank branch and they knew your name. They knew your family, they knew the street you lived on, and they took the time to update your bankbook when you deposited loose change as a child. Most importantly, when you needed to borrow money, they were in a position to make a judgment about you. This was good and bad. It was good because you did not have to explain yourself each time you needed a loan. A history of loyalty used to acquire the bank’s trust. But it was bad because it was much easier for the bank to discriminate. If a bank manager didn’t like you or your family, he could decline the loan request or offer unaffordable terms (like high interest rates). Individual banks and bank management held a tremendous amount of discretion.

Over the past 30 years, technology has completely taken over the banking industry. Today, a local bank manager no longer holds the same level of discretion. The algorithm tells him or her whether to offer you a loan and what the terms of the loan are. This has been good and bad. While the banks still discriminate, it has nothing to do with whether someone likes you or not. It has to do with your assets and your income. A computer discriminates, but it is justified within the context of profit-seeking bank. After all, the bank must assess the risk of a loan before issuing it to any customer. Using your income and assets is a fundamental part of that calculation.

Through all of this automation we have lost our sense of community. Banking wasn’t always global. Our savings used to go to local businesses and mortgages. Money earned in a community was kept in that community. However, there were limits to this type of banking (for example, your local bank in isolation could go bankrupt and you might lose your money in a panic). While there were good reasons for moving toward global banking, we also sacrificed something essential. A community was automatically investing in itself. You saved your money in a deposit account at the local bank or trust. They decided how to use that money. Maybe they would lend it to your neighbor for a mortgage, or to lend it to a coffee shop as a business loan. But as technology accelerated and banking activity consolidated across the country, outside lending opportunities became much more lucrative. Why would banks lend to a mom-and-pop diner and Bathurst and Dupont when they could lend to a real estate developer, who had property as collateral? You can run that scenario 1,000 times and the diner will never receive the loan over the real estate developer. The bank algorithms are consistent. They have no affinity to invest in your community. Their bias is toward profit that poses the least risk.

Enter: Peer-to-Peer Banking

P2P lending allows you to be a bank. Your savings goes directly to the businesses that need loans. It is important to understand the difference between P2P lending and traditional banking. Traditionally, your savings at the bank are insured by the government. The risks that the bank took with your money were not passed on to you. This also explains why a savings account pays a miniscule amount of interest – it is entirely risk free. No risk, no reward. The ultra low interest rates on savings deposits has diminished our incentive to save money the way we used to. We must recognize that the financial system in Canada has given no incentive for people to save their money in an insured bank account. It has left the rational person with no choice but to put their savings at risk in the markets. Add to that the tax incentives the government has created for stock market investments (RSPs, TFSAs, etc).

So we don’t save the way we used to. We invest. We are into stocks, bonds, mutual funds, ETFs and so on. But the difference in risk between a savings account and the stock market is enormous. This is like learning that your new diet of kale salads twice a day is not improving your health, so you start smoking. The point is, there is room in the middle in terms of risks and rewards. The appeal for us is that P2P is not correlated with the stock market. Sure, you can diversify between stocks and bonds, between technology firms and insurance companies, but you are still in the financial markets. As long as all your long term savings are in the financial markets, you can never diversify the risk that the entire market will tumble when you need the money.

This is precisely where P2P lending has entered the market. They provide an alternative to financial markets. Providing a loan to a local café is not strongly correlated with the financial markets. In other words, when the euro-zone has its next existential crisis about sustainability, your market investments cannot be insulated from the shock, but a loan to a local café will be. People will still buy coffee the next day. Your money is still at risk with P2P lending, but it will be a different type of risk. This is true diversity.

P2P proposition

We can see why people would invest in P2P lending, but why are businesses borrowing from peer groups instead of banks? With each and every loan, there are two possibilities. First, the business is too risky to offer a loan in general. The bank ran its calculations and there are not enough assets or income associated with the business to extend a competitive loan. You shouldn’t be lending to that business either. The second possibility is that the banks ran the numbers and the loan is too risky for them, but it may be a viable business loan for you. Like the way gas stations in a city offer the exact same price, the banks have settled into an oligopoly where without explicitly colluding, they have stopped competing with each other. They don’t need to take risks to endear themselves to the small business community. Small businesses need them, not the other way around. If they do take risks, they will give a business a loan that resembles a credit card (small sum of money, incredibly high interest rate), because they want to be thoroughly compensated for their risk. Their algorithms all tell them the same thing. It’s not that they can’t dig further to find good lending opportunities and develop small businesses. They just don’t need to.

Some businesses may have good potential but no assets for collateral. Some businesses may have collateral, but the interest rates banks are charging them are terrible. There is a middle ground here. There are companies that don’t suit the bank’s calculations but may prove to solid investing opportunities for the P2P market. Time will tell how much of P2P loans were good loans and how many never should have been offered in the first place. However, in the business of banking, you don’t have to be right 100% of the time. You just have to be compensated enough each time you are right to cover the failures.

How it works

Peer-to-peer lending is new to Canada but it has been thriving in the United Kingdom and the United States for at least a decade. P2P platforms are not actual banks. Your deposits are loans (often referred to as “notes”). Every dollar is at risk. There’s no deposit insurance, although there are some foreign P2P services that are starting to self insure to provide some security to their investors.

You choose where your money is invested. The P2P platform takes a slice of the interest that you collect for arranging the transaction. Let’s assume the arrangement fee is 1.5%. That means if you lend to a local coffee shop at 10% interest, that coffee shop pays 10% interest, you receive 8.5% and the P2P platform keeps 1.5%. This is remarkably different from the current model. Traditionally, you save your money in an insured savings account and receive 0.1% interest on that account. The bank decides who to lend that money to. And if some bank decided to lend to that coffee shop, it may not be yours, and it will likely be at a higher rate than 10%. By cutting the banks out of the lending equation, the borrower saves money and the investor (you) makes money.

Risks

Unlike depositing money in a savings account at a bank, the risk associated with P2P lending is much higher. With each loan there are two possible realities. First, that the bank was right to not offer them a loan in the first place. Second, the bank could have leant money to the business, but chose not to. One reality results in a loss no matter who extends the loan. The other will not. However, we may be willing to take on this risk because the nature of this risk is different from our stock market investments. We may be willing to accept this risk (and the potential reward that comes with it) because we can diversify a small part of our portfolio.

Liquidity

The second biggest risk you must accept before you lend through P2P lending is that you will lose liquidity. The financial markets provide the most liquidity to an investor. You are able to sell your stocks and cash out your funds with a click of the button. If you need the money on demand, P2P is not a good choice. Your money is locked up until the loan has matured, which may be 2-5 years. However, because you are willing to sacrifice the ability to cash in at a moment’s notice, you are also able to earn a greater return on your investment. Ultimately, you are paying for liquidity with your market investments whether you want to or not.

Moral Hazard

You should also choose your platform wisely. The company that asks for the loan cannot provide you a reliable assessment about its own ability to repay the loan. They will do their best to spin their financial information in a positive light. This leaves a tremendous responsibility with the P2P platform to perform the initial due diligence. This is your moral hazard: How do you know that all the loans being presented to you are not simply junk? Consider, the P2P agent makes their commission based on you extending a loan to a business. There is no penalty for suckering us into bad loans. We are particularly susceptible to this risk when there are many more investors (lenders) than businesses who need money. When there is an excess supply of funds to lend or invest, the P2P platform may be enticed to find a home for our money without considering the quality of the borrower and the business.

There is a counterargument here. Early on, the P2P platform needs to create a reputation. If the first ten loans it helped to fund went bankrupt, they would not be able to establish themselves in a market that has tremendous potential. However, there needs to be long term transparency on the part of every P2P platform, inspired by government regulation. They should report annually how many of the loans they select on behalf of investors go bad. The bad loan percentage can be compared to traditional small business bank loans and other P2P platforms. It would be easier to sniff out which P2P lenders have strong standards and which ones don’t. We need to ensure they are earning that 1.5% fee they charge per transaction.

Adverse Selection

Another problem: How do we know that we are seeing all available loans at any given time? Does the P2P platform decide which loans we see? Perhaps when you first log on, you only see two loans available for investment. The platform may frame your investment choices so that while you are seeing two of the most unpopular loans overall, one seems like a better choice than the other. Once you invest in the better loan of the two, the P2P platform might show you other loans – all better than the two that you had spent most of your time examining. We bear the risk to begin with, but we should not be subject to manipulation by the P2P platform. All P2P platforms must always present all available loan opportunities to all investors at the same time. There is great power in designing the choice architecture for the sale of any product. But this is no place for such behavioural creativity. There is a fundamental element of fairness at stake here and regulators need to monitor this.

In the United States, large institutional investors have gotten into the game as lenders. For the P2P company, this is fantastic. It allows them to legitimately compete with bigger banks at issuing commercial loans. However, this may also lead to adverse selection for us, the individuals that want to invest in our own community. In the same way Walmart bullies its suppliers into reducing costs until they no longer have any profits left, hedge funds and big investors will bully the P2P platform into make sure they get the first look at all good quality loans. We would unfortunately get the “rest.” One way to place a control over this is to limit the total amount that can be invested in any given loan to a small amount, like $25,000.

Mitigating the risk

To mitigate these risks, we have to first trust the platform. They are the first line of defense for identifying a bad loan. They screen the loans before they are made available to you and it is important that they understand banking in order to do this properly. They present information about the company you would assume to be true. If they only present choices that are garbage loans to you, then you will lose regardless of how much diligence you perform on the companies. As more P2P platforms pop up, it would be useful for them to post their screening success. What percentage of the loans that they make available for investment goes belly-up? This would ensure that our money goes to the P2P platform that takes the most care in loan selection.

Beyond that, it is up to you to perform some diligence on the specific loans. You can go and be a customer to understand their business proposition, location and evaluate their customer service. You can also use these Government of Canada statistics to put small business numbers into perspective, by industry, by city. Start with small amounts until you feel comfortable that the platform is selecting good loans to offer you.

It would help if the Canadian government eventually made P2P loans RSP/TSFA eligible. While this doesn’t mitigate the risk of the loans, it would help your overall rate of return. It also provides incentives for people to invest in small businesses. Governments are currently in search of jobs across the country. Perhaps providing tax incentives to this market will create some.

Conclusions

This article in the Globe & Mail talks about Lending Loop and some other potential P2P lenders emerging in Canada. Below are some links to some great articles from the Economist magazine on P2P lending from around the world. By changing the way we finance things, we change the things we end up financing. We have the opportunity to change the business community around us. In addition to earning a good rate of interest on your investment, we can also play a small part in shaping our communities. This opportunity does not come without risk, but that’s okay – we just need to make an algorithm that works for us.

Further readings

We are just scratching the surface with P2P platforms in Canada. See what is going in other countries:

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