There has been a lot written about Peer to Peer (P2P) lending, and it’s fair to say it is becoming more mainstream; the Government is considering allowing investments in ISAs to be made into P2P lending. I have significant concern although the sector has been regulated since 2014, P2P offers very little in the way of consumer control, financial protection and there is also a false perception of security, security that is often not there.
One of the issues with Peer to Peer lending is that it covers a multitude of different strategies each with their own different risks attached, although they share some common factors.
The three main ways Peer to Peer investments are structured in the UK are:
- Lending to other consumers
- Lending to companies
- Purchase of equity
I have tried to stay clear at looking at specific providers and what they offer and instead keep this generic but in some circumstances I have given an examples, which are clearly not recommendations but highlight some of the firms that are specialising in each of these core areas.
General Risks
Some of the activities conducted by Peer to Peer firms are regulated by the Financial Conduct Authority, but whilst many give the illusion of security approaching that of a bank, nothing can be further from the truth. In the event of the insolvency of any Peer to Peer firm your funds are at risk, although the more scrupulous firms have segregated client funds – this should provide additional security, but is no guarantee.
Due to the significant excess of available funds (supply) and the current take up of loans or stock (demand) it is possible that investors may not be fairly rewarded for their risk. There is also the perverse incentive that the P2P platform is remunerated for investing greater funds, yet does not actually put it’s own capital at risk. This is, in my view, an effective conflict of interest.
Peer to Peer Lending (Peer to Consumer)
Example: Zopa
In this case your funds are split into many units which are lent out to a variety of other individuals. Most lenders will make some assessment to credit reference their applicants but as I explain above, my concern would be that this is not as vigorous as it would be if the firm were lending their own funds. There is some evidence of this as P2P rates tend to be keener than average bank rates (suggesting the risk premium on private lenders is lower than bank lenders).
The principal risk given in the “General Risks” section above would apply to Peer to Consumer, but generally this option may be lower risk than the others given below due to the large number of individuals that are borrowing money, though of course this is no guarantee. Spreading money between funding platforms would naturally reduce risk in the event a platform failed taking lender funds with it.
Peer to Peer Lending (Peer to Business)
Example: Funding Circle
In this case an individual will lend their funds often to one single corporation, though in some cases a variety of corporations.
The fewer the different corporations they are lent to the greater the risk as in the event of the business failing the bond’s holder would be an unsecured creditor and may receive nothing after the subordinate debt is paid off.
Again, the general risks above apply.
Purchase of equities
Example: Crowdcube
Often covered by Peer to Peer Lending, the purchase of an equity gives no security at all; nor any fixed period of time when the money would be paid back. Nevertheless many class these in the “P2P” category as they have benefited from the rise in these platforms.
There can be some additional tax breaks for these investments if they qualify for “Enterprise Investment Scheme” (EIS) or “Seed EIS” status; though a loss of all your funds is a total loss, irrespective of the tax breaks.
The potential returns are clearly far greater than the interest paid under the preceding two types of funding, but the losses are more likely too. Any of these options can lose total capital, but it is a well-publicised fact that start-ups are at significant risk of total failure.
Conclusions
Not all “Peer to Peer” platforms are the same, the options above are significantly different in terms of risk and potential reward. I am concerned that in an environment of low interest rates many investors are taking more risk than they perceive they are. Also these platforms are largely untested and never has the adage “past performance is no guide to the future” been more true – until a platform fails, taking it with investor funds, we can only estimate the probability and magnitude of losses.
