Why so many P2P lending platforms? Why now?

Disclaimer: I used to work at Zopa a long time ago. I still hold a sizeable [to me] number of shares.

There are many start-up financing platforms styling themselves as "social lending", "p2p lending" and so on. Always centred around an online loans exchange, some sort of specialised money transfer system, and, a perfectly accurate, emphasis on the "real people" on the other side of the loan. I've had a ring-side seat to some of this, and don't get me wrong it is on the most significant things happening in finance today, but I think some of the Facebook+Credit=Profit cheer-leading is muddled. P2P lending is not an asset class. It is a continuation of the way computer networks have been shifting bottlenecks in finance for over 30 years.

To begin with, there is no such thing as "Social Lending". Or, more accurately, all lending is social by definition. Bond road shows, mortgage defaulters being morally chided by banks, dwarf tossing among fund managers, investing has always been between people and about trust. This is nothing new. Mainstream banks also can, and sometimes do, publish human interest stories about where the money you deposit is being lent. This does not make banks a similar financial asset to P2P loans. Assets can only be considered the same class if they are substitutable and competing. This is question of cash flows and risks. Money placed into personal loans at Zopa exposed to a very different set of risk to money placed into a small manufacturing business through Funding Circle. Some P2P platforms might be competing, many are not. As asset classes, many P2P platforms are closer to some mutual funds.

To look at Facebook or MySpace or Twitter is also not that helpful. The social ties that money flows down tend to (in the Western world at least, see WebMoney for a possible Russian exception) be more distant and handled differently to our immediate social circles. (And in London or San Francisco I can buy doughnuts branded with a deep sense of community and authenticity :-) )

In practice, there are two shifts in economic structure that are driving the new P2P platforms: information processing is effectively free at an individual level, and real rates offered by bank deposits are negative. The present state of the banking system does not allow for efficient credit intermediation and banks are failing to transmit saved funds into the real economy. Technology changes are permanent, no one will un-invent the internet or laptops. Negative rates have perhaps a decade or more to run. Banks have a long history, they are necessary for our monetary system, have historically allocated capital well and many of the people who work at them are very smart - they are here to stay.

I am talking about the role of negative rates first, although as a techie this is the less interesting shift, simply because it is the major driver of alternative finance today in 2015. Low bank rates are a global phenomenon and several episodes have occurred before.

Today low-rates are probably most pronounced in China where this has been true for over a decade, despite ample private investment opportunities. In response to this a large 'wealth management' industry has grown to facilitate private investment by wealthy households. These products range from conservative money market funds (ex. Alibaba's fund) to investment bonds to complex structured funds. (In the West, there is a corresponding growth in 'direct lending' by institutions [family offices, pension funds, etc] also driven by low real rates.) China (and the world)'s largest P2P lender, CreditEase, is also deeply involved in the Chinese wealth management industry.

Similar circumstances existed in the US during the 60s and 70s under Regulation Q, which capped the interest rate commercial banks could offer savers. This also led to the development of alternative financing arrangements, such as money market funds, which lent short-term money to major corporations and aimed to never 'break-the-buck', e.g. never have net loses. They still exist today. (Interestingly, Merrill Lynch, the brokerage house which pioneered a money market fund that could be used as a regular checking account, has today "reverted" to being a large integrated banking group.) Also introduced in the 1980s, were floating rate funds which take higher risks with smaller borrowers and accept occasional losses. These funds are regaining their popularity post-Lehmans.

Pooled P2P lending platforms (ex. RateSetter) are not exactly equivalent to these direct lending products since they are capable of detailed tracking and investor reporting on individual loans, so there is potentially a higher level of transparency, but the purpose and intended risks are broadly the same. (P2P platforms also usually target small business and individuals directly, rather than mid-sized firms.) In both cases investor funds are aggregated and then lent much as a bank would but without insuring them. The investor bears the all the risk and receives all the income. The growing use of "repayment insurance funds" also points to some pooled P2P lenders marketing themselves as money market fund substitutes.

Although low real rates are driving interest in all alternative financial assets, pooled P2P loans, where the lending client does not exercise a meaningful choice of individual loan (or credit name) and standard consumer credit analytics are used, are particularly a product of this environment, since no additional information is brought into the credit selection. Lender in these cases are simply lending into a FICO/Equifax score - not an individual name. The addition of proprietary credit analysis might improve returns over naive credit scoring, but also makes risks more opaque to the lending client.

The mainstream financial press sometimes expresses reservations around the pooled P2P models in these terms, but as long as the lender is fully informed, I don't see an issue. It is simply another investment opportunity which an informed consumer may participate in or decline. However it would be rational to see these platforms acquired by mainstream asset managers or adopt mutual fund structures over time, especially as interest rate normalisation reduces investor interest. Depression-era America, 90s Russia and post-crisis Argentina also saw a proliferation of alternative financing arrangements (even currencies) which rolled back as the banking system re-stabilised. That is not to say that significant institutions were not created in those periods and endured.

"The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth - he could at the same time and by the same means adventure his wealth in the natural resources and new enterprise of any quarter of the world - he could secure forthwith, if he wished, cheap and comfortable means of transit to any country or climate without passport or other formality." - John Maynard Keynes

The longer wave is the ubiquity of IT in the modern world. And I mean information technology in the broadest sense, not just computers but the telegraph and penny post. In 11th century England, the majority of the population were illiterate, printing did not exist and the only nationally traded credit name was the king. Because secure printing had yet to be developed, royal debts were represented as tally sticks: split wooden rods, the King's treasury kept one half and matched the wood grain to check authenticity. With regular couriers, mass literacy and printing, the bourses in Amsterdam and London began to trade the debts and shares of limited companies. Telegrams allowed cheap long distance securities trading. The introduction of data terminals (like Bloomberg) enabled an explosion in mid-sized bond issuance in the early 80s, often called marketisation.

It would be strange not to expect the introduction of a potential market terminal on every desk (and increasingly every pocket) not to cause another large expansion in the number of credit names issuing securities and the distances over which they can be marketed. Today most viable small businesses (and most individuals) have an easily checkable histories and cash flows. P2P platforms trading individual credit names like Funding Circle, Crowdcube or Seedrs, could not have existed economically in the 90s. The costs of processing the repayments back to investors, disseminating a prospectus and so on, without the internet would have swamped any possible revenue. It would be strange for this not to lead to a similar marketisation of these smaller credit names, just as Bloomberg terminals did for mid-cap corporations.

This still leaves a number of questions over the future of the industry. Are the information costs of marketing small credits the true barrier to lending at a that level - or is it the mental transaction cost of dealing with such a small investment? Where are the natural breaks in the P2P lending value chain? (Some P2P platforms use finance brokers, others are entirely integrated.) How will lending pools fit into the existing credit marketplace when interest rates normalise? Should companies ignore platforms and go directly to market like BrewDog? To what degree will investors accept a buyer-beware policy from platforms? (Prosper's previous problems suggest they do not.)

Join me for my next blog post in a few weeks where I will try to summarize current P2P lending models, relate them to their old-finance equivalents and make a few predictions!