Galápagos Islands of P2P

The title does have ‘P2P’ in it, but before talking about that, let’s take a few paragraphs about the way the “old fashioned” mainstream does things.

For example, take a typical US home loan. Having decided to take a home equity loan to finance a new garage, you might first respond to a internet advert placed on a home improvement forum, this advert will probably have been placed by third-party marketer hoping to generate commission revenue when they pass you on as a lead. The marketer will then direct you to a broker who will prepare the documentation and assess your credit worthiness. The broker will pass you to an originator, perhaps a small state-level bank, who will then provide the money. After a few payments, the originator will assign your loan to mortgage bank (or other bundler) who will in turn assign the right to service the loan to a servicing company before selling it on to an investment house to be securitised as part of a pool of thousands of other loans. The bonds created to finance the loan pool as it was securitised will then be bought by (amongst others) mutual fund managers. The fund manager might then list the fund on a “funds supermarkets” where you might (re?)purchase them as part of pension through a financial adviser. Should you default on your loan it will be sold to a collections agency, who might then contract out the repossession.

(The excellent Calculated Risk blog goes into incredible detail on US home loans.)

And these “supply chains” are not unique to home loans or to the US.

In UK mutual fund distribution, funds can be invested in a Jupiter fund directly. Or through a fund supermarket, which you would gain access to via an IFA or online share-dealer. Customers who think they are dealing with Jupiter directly, are actually mostly talking to IFDS staff, not to Jupiter employees in London.

Even a simple share purchase for a listed stock usually involves up to twelve entities filling different roles. (See Gendal for an excellent chart.)

There is nothing wrong with these “supply chains”. It is no more inauthentic for a county-level US bank to use a mortgage servicer than for a handy crafts seller on Etsy to send deliveries with DHL. The rapid rise of challenger banks in the UK simply would not have been possible had there not been a broad ecosystem of financial service providers to tap into. (UK banking mobile apps look remarkably similar…)

By comparison, current P2P funding models show extreme vertical integration. A typical platform will internalise everything from marketing to settlement – and do so for both capital raisers and funders. There are several reasons to do this. They might want to control the customer experience, save money through tighter integration or simply to get to market quickly. For most platforms, I expect that the last reason was the strongest. Supplier relationships in finance run deep as they involve greater regulatory and reputation risk. The desire for regulatory cover is very strong. Until recently hard for new alternative investment platforms to even get a bank account.

In many cases it will be easier for a platform to start out by handling its own distribution, underwriting, cash management, etc. None of these functions are hard to carry out on a small scale. New platforms are also often targeting investors who are distrustful of mainstream investment providers. Breaking away from the tyranny of the markets doesn’t chime well with on-boarding new clients through a stockbroker!

There are two problems with long-term vertical integration in financial markets: scaling & governance.

Vertically integrated companies can easily develop bottlenecks. For example, too many credit applications to risk check or raising more capital than can be invested.

It is also usually less efficient to in-house processes, like distribution, than to turn to an external “wholesale” provider. For a venture capital funded startup, this is effectively a scale issue: initially low (even negative) per unit margins are acceptable, but not if volumes rise.

Not to say that the existing plumbing is always a better business decision. Consider Finland, which has a government-issued online ID system and a web service for registered financial services to see the beneficial owner of any bank account. As a result the economics of handling your own distribution are completely different to, for example, England or the US. But in most regions and markets, outsourcing is a sensible cost-effective norm.

Governance is another reason that outside “plumbing” is common. All the parties in the home loan chain above would have given warranties (as with a kettle or car) against defects in the loans and been required to maintain capital to pay them. External custody agents also provide fire-breaks against embezzlement and mis-recording. (Providing it is not allowed to build up to levels that overwhelm the capitalisations of the parties.)

Mainstream financial markets tend to separate the issuance of securities and their selection for an investor. Pooled asset models and auto-lend functionality do create a play-the-house temptation for platform operators, since they could (I’m not suggesting they do) adjust the parameters to bid for the most profitable investment to issue. (The existence of “cushion funds” amongst pooled lenders in the UK is also a little troubling since if the pool is uniform then defaults will be highly correlated, wiping out the fund in the event of a downturn.)

Present P2P platforms represent a Galápagos archipelago of innovation. Each one a tiny complete ecosystem isolated from the wider financial industry. And perhaps culture in the startup community plays a role in this as well as practical considerations. Silicon Valley grew from US defence contractors, while much of the London tech scene rose from new media. There are not as many people striking out into FinTech from jobs managing insurance call centres, although I think this is changing. The future should bring more integrations in the vein of Lending Club and Funding Circle’s embrace of hedge fund capital.

More significantly, mainstream institutions will either adopt, or partner in, “crowdfunding” aspects to their own business as they become proven. Banks in the UK are happily co-operating with the government to direct small business lenders to alternative finance providers. By the nature of their capital requirements banks struggle to lend 5-10 year business development capital. They do appreciate that if their clients can raise this capital elsewhere, they will need larger business overdrafts, commercial mortgages, etc. Big corporates are ultimately in the making money business. They are greedy, not evil. They will open up their loan books if it raises volumes and fees. The cultural barriers to a mainstream financiers investing on P2P platforms are not as large as many suggest. The notion of trading investments in individuals and small businesses is already well established. Look at Citibank’s decision to put $150m through Lending Club.

I think that that anyone looking for the shape of things to come in alternative finance should be seeing Currency Cloud, the FX-as-a-service platform as glimpse at the future. FX is by far the leading segment in embracing new technology, and is only a small part of the entire financial services industry. (There are a few firms attempting P2P-as-a-Service.)

As a thought-experiment, if we were to delist a prime-rate fund [US investment companies that make loans to businesses] from the stock market, would it become a P2P lender simply by moving to a direct funding model? Or would RateSetter become a mutual fund if it was funded through a funds supermarket? If Funding Circle integrated to stockbrokers as just another exchange, is it still alternative? Most importantly, would any of these changes be a good idea?

I would argue that these are practical problems. There is no clear bright line between the old and new. As excitement dies down, current P2P operators will migrate portions of their business model back into the mainstream ecosystem to cut costs and achieve wider distribution. The current vertical integration, with each platform operating largely as a silo, is partly a by-product of the conservative mainstream failing to offer them access – and a desire to re-enforce a brand distinction from the mainstream. Both of these reasons will diminish with time and greater acceptance.

The changes in capital markets resulting from the current wave of P2P platform innovations are far from played out. They will not primarily be in the creation new stand-alone brands, but in how the refactoring of the underlying plumbing shifts business models in the wider capital markets.