In this guest contribution, Iain Niblock, chief executive of Orca, looks at the ways in which peer-to-peer lending has evolved in recent years.
There is considerable activity and commentary about non-bank, or alternative, finance, to use one of its many monikers. Recent years have seen the rise of peer-to-peer lending, a business model that involves internet-based platforms matching up borrowers and lenders, with a removal of the traditional bank intermediary. The lack - in the UK - of government-backed depositor protection also raises risks - but also rewards - for depositors. In 2014 the UK's Financial Conduct Authority set out its regulatory approach to P2P lending platforms, and the sector has developed. In this article, a participant in the space, Orca, an independent provider of data, research and analysis on the UK peer-to-peer market, comments on recent developments. The editors of this news service are pleased to share such views but stress that they do not necessarily agree with all points from guest contributors. Email the editor at firstname.lastname@example.org.
Peer-to-peer (P2P) lending is coming of age. This innovative and exciting development, revolutionary in its potential, is well on the way from fringe activity to the investment mainstream.
6 April 2016 was a great day for the P2P industry. Independent financial advisors (IFAs) were permitted for the first time to recommend P2P investment to clients and, on the same date, the “innovative finance ISA” was launched, allowing P2P loans to be included in a new variant of the tax-efficient Individual Savings Account.
Only a couple of years ago, it would have been hard - if not impossible - to imagine official approval for the innovative finance ISA. Rules governing ISA investment were strict, nowhere more so than with regard to the asset types that could be held within an ISA. Furthermore, the regulator was still getting to grips with P2P lending as an asset class.
Although still misunderstood and viewed as the relatively undefined "latest thing", P2P lending is, in one way, the oldest form of business and personal financing that there is – a direct loan from one person or group of people to another.
P2P lending arrived in the UK in 2005 with the advent of the Zopa platform. The growth of the P2P space, however, reached full speed after the financial crisis for three main reasons: the banks restricted their lending; interest rates for savers were at an all-time low; and general distrust for the banking system amplified.
This created a perfect storm for P2P to grow, and in 2010 two further platforms, RateSetter and Funding Circle, launched in the UK.
P2P created substantial market efficiencies, by connecting lenders and borrowers directly, through online technology platforms. Without the large operating costs associated with incumbent banks, lenders could expect a reasonable, risk-adjusted return – about 5 per cent a year – and creditworthy borrowers could expect a quick credit decision.
Since then, the P2P scene has flourished. Little more than a decade later, there are more than 50 P2P platforms, and in the three years 2014-2016 alone, lending grew from £1.25 billion ($1.52 billion) to £3.13 billion.
Within the business lending category, the total of loans surged from £686 million in 2014 to £1.7 billion in 2016, making up 54 per cent of the market in 2016. Within that figure for business lending, property and real estate loans accounted for 37 per cent of loans. On the consumer side, P2P lending grew by 152 per cent from 2014 to 2016, with £1.43 billion of loans.
Orca Analytics data
The scope of lending has grown from consumer loans, to include business lending, invoice financing and property-related loans. P2P providers have further innovated with contingency funds to cover defaults, secondary markets, allowing investors to withdraw their capital early and the inclusion of institutional investors.
With growing complexities in the market, investors need to be cautious in their due diligence approach. Ultimately investors are lending their money to businesses or people, and the primary risk is borrower default. Rising default rates may result from poor economic conditions or a reflection of the P2P providers’ underwriting process.
Currently, Orca Analytics estimates that more than 177,000 retail investors are active in this space. By 2020, it is estimated that 2.7 million people will be investing in P2P lending. The launch of the innovate finance ISA (IFISA) is expected to contribute to this growth.
How does the innovative finance ISA work?
For P2P providers to offer the IFISA they must be fully regulated by the Financial Conduct Authority and approved as ISA plan managers by HMRC, the UK’s tax collector. This is important because there is currently a backlog at the FCA with providers, including the three largest P2P providers - RateSetter, Funding Circle and Zopa - waiting to be fully authorised.
Each individual gets a £15,240 ISA allowance in the current tax year, rising to £20,000 for the year 2017-2018. This can be split in any way the investor chooses among cash, stocks and shares or innovative finance ISAs, whether a third in each, or 100 per cent in one and nothing in the others – or any other permutation.
Capital gains are free of tax, as is income generated inside the ISA. The returns will be yours to keep.
You can transfer current tax year ISA subscriptions from any ISA type to an IFISA. These subscriptions must be within the tax year allowance of £15,240. If you are transferring out of a current IF ISA, you will need to liquidate your P2P investment into cash, before withdrawing. But investors can transfer cash any time, and the latter is only capital tied up in investments that require the sell-out/liquidation process.
You can transfer unlimited ISA subscriptions from any previous years’ ISAs. Again, any ISA type qualifies.
But there are considerations to bear in mind when contemplating the IFISA. One potential problem of putting P2P assets into an IFISA is that investors will naturally draw comparisons to the cash ISA and that this may make it resemble a safe savings product. It is important to remember that P2P lending is not covered by the Financial Services Compensation Scheme and investors’ capital is at risk.
A second consideration is that P2P lending is an illiquid investment compared with shares or bonds. Should someone wish to withdraw from their innovative finance ISA, they are required to sell their loan commitments to other investors on the platform.
This “sell-out” process may take a while and in some instances may not achieve the price expected.
P2P lending and its risk-adjusted returns, however, hold many promises for those willing to take a bit of risk. This is without mentioning other interesting aspects of the asset class, such as its unrivalled transparency and positive social impact - both incredibly important criteria that are increasingly looked at in the investment world today.
In short, P2P lending does and should present a compelling method to diversify a range of investors’ portfolios.