To Lend or Not to Lend? Peer-to-Peer Lending in the Age of Economic Discontents

A decade of pitifully low interest rates in Europe has forced investors to stray away from their saving account in search of investments with higher returns. This growth in demand and the credit crunch has given birth to the peer-to-peer lending industry (P2P), which after its legalisation by the FCA in April 2014, has significantly grew into a £9.6bn industry in 2017. By eliminating banks from the lending process, P2P lending directly connected retail lenders and borrowers through a sophisticated credit management platform in a way that ordinary consumers can also be a lender. Consequently, P2P lending is an alternative cash source for borrowers whose credits are too risky for banks and offer higher than average returns to lenders in proportion to the level of risk they carried. In addition, the £20,000 tax-free allowance via the Innovative Finance ISA (IFSA) has made P2P lending an attractive venture to yield-hungry investors who crave for a flexible interest rate environment.

The most important principle when investing in P2P lending is to search for a platform with high credibility. With the uncertainty of Brexit and the prospect of economic shock, cautious investors may demand a platform with a better track record to minimize the probability of massive defaults. The grandfather of P2P, Zopa, might prove to be a viable investment, as it was able to withstand the 2008 recession while maintaining a positive annualised return of 34% above the FTSE 100. The platform was also able to consistently meet or exceed its expected return targets after 2008, thus indicating a strong performance and effective credit risk management.

Despite its secured lending environment, Zopa expected return is far lower than Proplend or other dynamic platforms with the highest rate of 5.2% on its riskier account, Zopa Plus. The root of this problem stemmed from the platform’s business model of targeting the riskier section of the consumer market by offering an alternative solution to loan-seekers whose credits have been let down by banks. Hence, with large risks of default overtaking the risk premium investors receive, most P2P lenders in this market often struggled to generate more than 5% return realistically.

Zopa’s default rate, although is unlikely to cause the platform to collapse, has also been on the rise in recent years. Initially, Zopa expected 4.14% of its 2016 loans to default over its lifespan but this approximation has been revised upward to 4.93%. According to Andrew Lawson, chief product officer, Zopa’s rising default rate and lower return compared to the years pre-2016 are due to the inclusion of low-risk and low-return loans to Zopa Plus which was added alongside D- and E-rated loans in order to safeguard against the poor consumer credit conditions by diversifying risk. This coupled with the rapid expansion of the market has naturally made it impossible for P2P firms to focus on only super-prime borrowers, thus lower-tier borrowers with a higher likelihood of default are also being welcomed into the platform.

Even though it is arguably true that the P2P platform has struggled to keep its rate competitive against banks, IFSA was very well received by lenders and this has caused demand to soar. In 2017, Zopa closed its platform to new lenders and created a waiting list to restore the mismatch between investors and borrowers.

Beside from Zopa, lenders should also diversify their risk by investing across different platforms. One alternative industry challenger to consider is Proplend, a platform that focuses on loans backed by commercial properties. The platform currently facilitate £23 million worth of loans and offers a healthy return of between 5%-12% annually. Investors can choose between tranches A, B and/or C; tranche C is the riskiest loan category, but offers around 11.38% annual return before bad debts and taxes. With detailed data on performance and no investor losses to date, Proplend is probably one of the most secure P2P platforms. However, the downsides are its high minimum investment of £1,000 and low number of loans as it is still in its nascent stage, which implies fewer choices for investors.

Overall, with rising inflation and deteriorating credit environment, P2P platforms have become more risk averse in recent years. While increasing the proportion of low-risk loans can be an effective hedge against risk, future cuts in dealings with high risk borrowers can make P2P rates uncompetitive against banks in the long run. With GDP expected to fall by 8% in a no deal Brexit, the consumer market may potentially crash. Therefore, lenders’ capital are at risk since none of the P2P platforms are covered by the Financial Services Compensation Scheme (FSCS). Even though Zopa has proved to be an effective frontier against the 2008 recession, the default risk that lenders must bear may be greater than the reward. Therefore, lenders are discouraged to invest in P2P until the UK economy stabilizes after Brexit, but for those who have high risk appetite, both of the mentioned platforms are recommended after taking their historical performance into consideration.