Journal Article Journal 40 nnnn nnnnnnnnnnnnnnnnnnnn Journal Directing the Disruptive: Institutional Investors and the Secondary Market in Peer-to-Peer Loans Sam Price Joseph Abou-Jaoude The Capco Institute Journal of Financial Transformation Recipient of the Apex Awards for Publication Excellence 2002-2014 Cass-Capco Institute Paper Series on Risk #40 10.2014
Journal The Capco Institute Journal of Financial Transformation Recipient of the Apex Awards for Publication Excellence 2002-2014 Editor Prof. Damiano Brigo, Editor-in-Chief of the Capco Journal of Financial Transformation and Head of the Mathematical Finance Research Group, Imperial College London Peter Springett, Managing Editor Sam Price, Assistant Editor Head of the Advisory Board Dr. Peter Leukert, Head of the Capco Institute, Head of the Editorial Board of the Capco Journal of Financial Transformation, and Head of Strategy, FIS Advisory Editor Nick Jackson, Partner, Capco Editorial Board Franklin Allen, Nippon Life Professor of Finance, The Wharton School, University of Pennsylvania Joe Anastasio, Partner, Capco Philippe d Arvisenet, Group Chief Economist, BNP Paribas Rudi Bogni, Bruno Bonati, Strategic Consultant, Bruno Bonati Consulting David Clark, advisor to the FSA Géry Daeninck, former CEO, Robeco Stephen C. Daffron, former Global Head of Operations, Morgan Stanley Douglas W. Diamond, Merton H. Miller Distinguished Service Professor of Finance, Graduate School of Business, University of Chicago Elroy Dimson, Professor Emeritus, London Business School Nicholas Economides, Professor of Economics, Leonard N. Stern School of Business, New York University Michael Enthoven, José Luis Escrivá, Director, Independent Revenue Authority, Spain George Feiger, Former Executive Vice President and Head of Wealth Management Zions Bancorporation Gregorio de Felice, Group Chief Economist, Banca Intesa Hans Geiger, Professor of Banking, Swiss Banking Institute, University of Zurich Peter Gomber, Full Professor, Chair of e-finance, Goethe University Frankfurt Wilfried Hauck, International GmbH Pierre Hillion, de Picciotto Chaired Professor of Alternative Investments and Shell Professor of Finance, INSEAD Thomas Kloet, Mitchel Lenson, former Group Head of IT and Operations, Deutsche Bank Group Donald A. Marchand, Professor of Strategy and Information Management, IMD and Chairman and President of enterpriseiq Colin Mayer, Peter Moores Professor of Management Studies, Saïd Business School, Oxford University Steve Perry, Derek Sach, Head of Global Restructuring, The Royal Bank of Scotland ManMohan S. Sodhi, Professor in Operations & Supply Chain Management, Cass Business School, City University London John Taysom, Founder & Joint CEO, The Reuters Greenhouse Fund Graham Vickery, Head of Information Economy Unit, OECD
HIGH-LEVEL DEBATE Directing the Disruptive: Institutional Investors and the Secondary Market in Peer-to- Peer Loans Sam Price Management Consultant, Capco Joseph Abou-Jaoude Management Consultant, Capco Abstract The growth in peer-to-peer lending, where borrowers are matched with lenders by web-based platforms, is increasingly attracting the attention of the old guard. Initial fears that peer-to-peer lending was a house built on sand foundations have been allayed, for now at least, and traditional institutions are seeking to harness this disruptive innovation to increase their own product offerings. This article discusses the current state of the secondary market in peer-to-peer loans and the contrasting demands of retail investors and traditional institutions. With several successful securitizations completed this paper charts how demand for liquidity and profit can drive the development of a mature secondary market and discusses the impact this will have on the peer-to-peer sector s players. The core theme is that peerto-peer loans will soon become just another asset class for investors. 23
Introduction Peer-to-Peer (P2P) lending 1 has amassed attention as an alternative to mainstream financial institutions where individuals can invest to obtain returns rather than depositing the money in banks. For this reason, some have suggested P2P lending is an example of disruptive innovation in finance with the potential to change the way the debt markets operate. For instance, Anthony Haldane, a Bank of England Senior Director, noted in relation to P2P loans and small and medium enterprise lending that banking middlemen may in time become surplus links in the chain. Strong returns have also attracted the attention of investment and wealth management functions of traditional financial institutions, which, regardless of potential competition, are eager to increase profits in the tough economic climate. The requirement of sufficient liquidity to enable investors to quickly alter their position necessitates the development of a secondary market. This article explores the state of the secondary market in P2P loans including the opportunities offered by platforms themselves, the increasing prevalence of securitization, and potential further developments. Section II gives an overview of the P2P lending model. Section III then emphasizes the importance of liquidity for investors. Section IV gives a current state analysis of the secondary market in P2P loans for retail investors. Section V provides a complementary analysis setting out the recent developments in the securitization of P2P loans as well as noting the potential implications at a time when the 2007-08 financial crisis still haunts the financial world. Section VI then hypothesizes about future states and the impact of these should P2P continue its current growth. Section VII concludes. The core theme of this article is that, in secondary markets, P2P loans are simply another asset class another opportunity for investors. As the market develops, P2P loans are likely to become increasingly similar to any other financial product. An overview of the peer-to-peer lending model P2P lending is one part of the fast growing P2P finance sector, which also includes crowdfunding, social lending, and other innovations. P2P lending involves web-based platforms matching potential lenders and borrowers. As with any loan origination, credit checks are conducted and borrowers are rated and may be rejected if they do not meet the platform s required standard. Any man on the street can advance a part of the desired loan amount and such contributions may be an extremely small fraction of the loan. As with P2P finance generally, the development of P2P lending is supported by advances in technology. Credit checks involve complex algorithms. The web-based nature of platforms offers increased transparency and accessibility. The divisibility of a loan means prospective investors can choose to advance only a small stake of the principal based on their appetite. The legal structure of P2P loans differs between US and UK firms. In the US, due to the regulatory environment, participants who use platforms to lend money are investors. P2P platforms are direct parties to the loan, along with the borrower. The platform will issue investor notes, backed by loan repayments. In the UK, P2P platforms match borrowers and lenders but are not direct parties to the loan. They do adopt certain contractual responsibilities vis-à-vis the loan, such as pursuing parties in default. Concern over the potential default of platforms is worth addressing. Prosper, a major US platform, has divided origination from servicing of loans; Prosper Marketplace, Inc. originates the loans. These are serviced by Prosper Funding LLC, a separate legal entity. Should Prosper Marketplace become insolvent, the loans will continue to be serviced, protecting retail investors. Lending Club, another US platform, currently offers less protection. Zopa, a UK platform, states that the collection agency Credit Resource Solutions Ltd will continue to collect missed payments should Zopa fail. Money not currently on loan is held in a segregated bank account. Other UK platforms have made similar claims about their ability to oversee performance of existing contractual liabilities by P2P participants should the platform go insolvent. However, insolvency law is complex and commercial mechanisms have been known to fail when tested in the courts. P2P lending has seen an exponential rise in popularity with the number of loans originated reaching 2bn in the UK in 2013, with predictions this will reach 5bn in 2014 for the top five platforms alone [Liberum (2014)]. Liberum suggests that over the next 10 years the loans originated by P2P platforms will reach between 267bn (bear) and 535bn (bull) for consumer finance and the SME market [Liberum (2014)]. Platforms have sought to enhance their reputations to attract investors and UK platforms 24 1 In this article, P2P lending is used to refer collectively to both lending to individuals and businesses as long as it is done so via a recognised P2P platform.
The Capco Institute Journal of Financial Transformation Directing the Disruptive: Institutional Investors and the Secondary Market in Peer-to-Peer Loans have welcomed forthcoming regulation [see FCA (2013)], knowing that it will provide a welcome boost to their credibility. Platforms are keenly aware of the importance of reputation and most aim to service high-quality borrowers to maintain low default rates, investing significantly in their credit rating systems. This follows the 2011 insolvency of Quackle, a UK platform [Jones (2014)]. In the Chinese market, a number of platforms have gone bust after adopting a low threshold for accepting prospective borrowers [Rabinovich (2014)]. The restrictive monetary policy employed by the Chinese government is a contributing factor and illustrates the potential risk to Western firms when the stance on monetary policy changes. The basic principle of P2P lending is to match borrowers who require capital with lenders who have spare capital, bypassing the role traditionally played by banks. Technological advances mean it is now cost effective to pool small amounts of money from many different lenders to originate a much larger loan. Although the pooling of lenders is consistent across all P2P platforms, each site offers its own approach for investors. Zopa and RateSetter, UK-based platforms, operate on a comparable basis to that of a fixed rate savings account. An investor chooses an investment period at a rate that is pre-set by the platform; the investor s money is then allocated by the Zopa and Ratesetter team. Funding Circle, which lends to businesses in the UK, uses a more sophisticated approach, closer to that of a retail stock buying site. Investors are provided with detailed information about the company s loan request, along with their financials. Each is assigned a credit rating by the site, although it is up to the investor to offer money at a set rate. This operates as an auction where the best rates for the business (with a floor) are accepted. Most commonly, investors receive interest on a monthly basis. Interest rates are advertised as a headline number; the estimated bad debt provision is also published and, if not already included in the rate, an expected return also taking into account fees is published. Detailed explanations can be found clarifying the calculations of bad debt. Although investors must always be cautious, these figures so far represent a good estimate of rates in prevailing market conditions. The three UK platforms also offer the functionality to automatically reinvest interest payments (once the minimum tranche amount is reached). The exact terms and nature of the loan vary between platforms with some platforms specializing in student loans, some in business loans, and some in property. Frequently, P2P loans do not require security; cross-default clauses, allowing lenders to class the borrower as having defaulted if they default on another loan, are generally absent. Some platforms, Zopa being an example, have instigated funds to protect investors from potential defaults. However, Zopa s fund covers only 1.5% of the loan book [McCrum (2013)]. Investors who do not qualify for government insurance in the UK or US still face significant counterparty risk, particularly in a situation leading to widespread defaults. The importance of liquidity and a secondary market A complete secondary market is attractive to both investors and the platforms originating P2P loans. A fully functioning secondary market will increase the liquidity of P2P loans so increasing demand in the primary market. Investors, perhaps previously wary of being committed to a longterm investment, can participate knowing that they can exit if they wish. Theoretical research has shown secondary markets enhance the efficient allocation of risk [Arrow (1964); Diamond (1967)]. An active secondary market will also increase price efficiency. Additionally, higher liquidity has the effect of depressing the interest rate investors require [CCFR (2011)]. The current state of the peer-to-peer secondary market In the UK, the three most prominent P2P lenders are Ratesetter, Zopa, and Funding Circle. All these organizations have introduced a type of secondary market for their respective platforms. The makeup of each site s offering mirrors the way they offer primary loans. Zopa and Ratesetter offer set rates for different time periods, pooling individual investments themselves and allowing a general sale of investments at a determined price to match this. This is the most basic of secondary market offerings. However, it successfully serves its purpose, offering retail investors a way to exit their loans. Funding Circle, which allows investors to bid on individual loans, applies a similar approach for an investor wishing to sell any loans they have. The loan part (the name Funding Circle assigns to the investor s share of the overall loan) is placed for sale on the site, set at a premium or discount for other investors to purchase. Each platform levies a percentage fee on investors wishing to sell their investments. However, there are restrictions, the most immediate being that the secondary markets are restricted to within each platform; loans can only be sold on from the platform from which they originated. Furthermore, if a loan enters a problem phase it is common policy across all three platforms to remove the ability to sell the loan part. Such drawbacks do mean that the secondary market for P2P loans is far from complete. In the US, the secondary market is more advanced. Foliofn, a brokerage and investment company, provides a secondary market for P2P loans. Loans originated by Lending club and Prosper, the two largest P2P platforms in the US, can now be traded through a platform provided by Foliofn. Orchard, a provider of technology and strategic services, recently backed by ex-citigroup CEO Vikram Pandit, is preparing to launch a secondary market in P2P loans this year [Dugan (2013)]. The current secondary market offering is likely to satisfy the majority of retail investors. However, the volume of newly originated P2P loans continues to grow rapidly and institutional investors are coming to view P2P 25
loans as an attractive asset class in which to be involved [Alloway and Massoudi (2014)]. A fully functioning and liquid secondary market is desirable to institutional investors. This is possible through both securitization and the development of exchange trading of P2P assets. Securitization of P2P holdings Securitization is one method for creating a secondary market that is gaining traction. With 60% of the P2P industry s loans being purchased by institutions as of February 10, 2014 [Alloway and Massoudi (2014)], securitization of P2P loans is likely to gain in popularity. Securitization involves the issuance of debt securities by a special purpose vehicle (SPV). The income from this vehicle is used to purchase rights in relation to other financial obligations, namely the obligation of a debtor to repay a loan. Generally, the loan may still be held by the originator, but in the case of P2P lending, it will have been purchased by another party. 2 The receivables (payments made under the original loans) are used to fund the SPV s obligation to investors, as well as covering incidental costs. The securitized assets and the firm which initiated the securitization are rendered legally separate by the process. If this is carried out correctly, assets are immune from the seller s insolvency and the seller retains no legal rights [Hudson (2009); Bavoso (2013)]. Receive loan Borrowers Peer-to-Peer Platforms Provide loan amount Pay interest Transfer interest payments, less fees Securitizer (creates SPV) Issue debt securities (payment contingent on receivables) Sells rights to payment from receivables Purchases right to payment from receivables Investors Purchase debt securities Special Purpose Vehicle The diagram is intended to show only the direction of rights and obligations within the process. Many of the details of the securitization process such as tranching securities, creating liquidity support, and so on, are not covered here. Figure 1 Transfer of rights and obligations in securitization 26 Securitization provides another mechanism for financial institutions to become involved in the P2P market, a mechanism which retail investors cannot use as effectively. For institutions that purchase large holdings, securitization offers liquidity since risk and revenue can be redistributed. Institutions wishing to be involved on a smaller scale that still require high liquidity have the option to become an investor in an SPV and can resell the debt securities. The size of loans originated on P2P platforms is growing with a 4.1m loan being offered in January on LendInvest to fund a London property development, more than double the previous 1.75m record [Moore and Sharman (2014)]. As more wealth management firms look for opportunities in this sector, securitization will become increasingly prevalent. The investment firm Eaglewood Capital securitized $53 million in P2P loans from the platform Lending Club in October 2013. In November 2013, Insikt securitized $10 million of P2P loans from the platform Prosper. Social Finance Inc., a platform specializing in P2P student loans, securitized $152m in loans in late 2013. Of particular note, the securitization received a public rating an A-rating from DBRS, the fourth largest credit rating agency in the world, and the resulting securities were sold to institutional investors. Student loans are not discharged by bankruptcy proceedings, so the rating of such loans is more palatable to credit rating agencies. But with institutional investors purchasing more P2P loans and with existing securitized loans selling well, rated securitizations of P2P loans have the potential to become more prevalent. P2P loans are new so credit rating agencies have a limited reputational stake if there is a misjudgment and if a sufficient volume of P2P loans is being securitized. But there is an incentive to gain a reputation in the product-type [Hunt (2009)]. The securitization of P2P loans opens up a realm of possibilities. The securitized loans could be re-securitized. Derivative contracts can be formed that relate to these products. There is potential for the development of exchange trading which is discussed below. If exchange trading does become prevalent, derivative trading is highly likely. If P2P loans become more mature as an asset class, and if these financial innovations occur, it is worth asking whether a repeat of the problems caused by collateralized debt obligations (CDOs) is likely to occur and how this can be prevented. P2P platforms have not been involved directly in securitization. This has been the remit of banks and asset management firms for whom securitization is an opportunity to sell a stake in P2P loans to willing investors. Securitization is less appealing to P2P platforms, which are trying to improve their legitimacy and credibility. They are wary of having services associated with something that was a major cause of the 2007-08 financial crisis. Their current aversion to loose lending was discussed above. Furthermore, for secondary market participants P2P loans are just another asset class and another opportunity for profit. 2 The legal structure of P2P platforms differs between US and UK firms where US firms act as lenders who issue securities and UK firms merely facilitate the loan.
The Capco Institute Journal of Financial Transformation Directing the Disruptive: Institutional Investors and the Secondary Market in Peer-to-Peer Loans Is it possible to avoid the problems caused by CDOs? Analyses of the financial crisis suggest major contributing factors were banks holding risky positions and being highly leveraged. Others have criticized capital adequacy ratios for being too low leading to regulations such as Basel III, implemented in the European Union through the Capital Requirements Directive IV and Capital Requirements Regulation. Taking an optimistic standpoint, it could be argued that the barrage of regulation in the aftermath of the crisis has targeted these areas. But risk-taking is cyclical and, although counter-cyclical regulation may try to dampen potential bank exuberance, there remains the real possibility that banks and asset management firms will pursue high risk, high reward behavior. Securitization of P2P loans and investment in risky tranches of such debt offers scope for this behavior. industry s legitimacy. If exchanges do develop, as they likely will, then any individual will be able to trade P2P products providing they have access. However, past experience indicates that individual retail participation in the market will decline while institutional giants will dominate [Allen and Santomero (1998)]. Not only are there barriers to exchange trading for individual retail investors, lower interest rates are discouraging. While lower rates still appeal to institutions that can sufficiently diversify their portfolios, individual retail investors with limited access to other assets for diversification, and with an entire investment to lose compared to the safe haven of an insured bank deposit, may decide that P2P lending is not worth the risk. Liquidity is also less valuable when active portfolio management is not desired. P2P platforms have the power to mitigate this risk up to a point. They have already sought to keep default rates low and to build strong credit checking algorithms to minimize risky loans. Lenders themselves are the ones who choose to advance loans. They certainly rely on the credibility of credit checks but beyond that P2P platforms play a facilitation only role. Some commentators have argued that moral hazard exists if platforms do not have an interest in P2P loans. This overlooks two key points. Firstly, P2P platforms, as a new product, have a huge stake in developing their reputation and keeping default rates low as has been discussed. Secondly, it is by no means clear that P2P platforms having skin in the game is beneficial. For example, when banks held on to the riskiest tranches of securitized mortgages they had skin in the game but were still willing to take risks. And if P2P platforms did this, they would jeopardize the functioning and continued servicing of all the safe loans that they facilitated. Instead, P2P platforms should remain neutral facilitators who are relatively remote from the risk associated with individual loans. The development and impact of exchange trading Over-the-counter agreements to trade P2P holdings, basic or securitized, are unprofitable for smaller investors due to transaction costs. However, major institutions may find it profitable to broker a deal to transfer holdings or revenue streams should they, or their clients, no longer want large P2P loan holdings on their books. P2P loans are simply another asset to trade or invest in. The associated transaction costs are likely to be discouraging unless P2P holdings are extremely large. However, the derivatives market illustrates that with sufficient standardization and sufficient demand, exchange trading can easily develop. And the secondary market in debt, particularly syndicated loans, indicates that demand can drive standardization of a product. Credit ratings processes, maturities, loan terms, and similar factors can be standardized and loans can be stratified by type (student loans, small business loans, and so on). Institutional interest in the P2P sector is growing and expected regulation of the sector [FCA (2013)] is likely to enhance interest by increasing the One further illustration of the way that P2P is just another asset class is the potential for exchange-traded notes (ETNs) in P2P loans (although this is not necessarily a secondary market product). ETN issuing has been considered by the Chief Executive of QuarterSpot, a small business P2P lender [Alloway and Radnovich (2013)]. ETNs are a type of debt security issued by firms and have a specified maturity date. They are unsubordinated and unsecured. ETNs perform the same function as an exchange-traded fund (ETF) with an extra risk that the issuer may default. Since, theoretically, any benchmark can be chosen, a portfolio of P2P loans could be constructed. Individual platforms could issue ETNs based on a portfolio of their own loans. Any institution could be the issuer assuming there is sufficient transparency surrounding price movements of the portfolio. This transparency could be provided by the openness of a P2P platform. Alternatively, if P2P loans develop as described above, ETNs can track P2P securitizations. Again, ETNs are just one more tool for speculation vis-à-vis P2P loans and as interest and the potential profit within the sector increase, the secondary market will grow stronger. Concluding remarks Peer-to-peer lending is growing as a sector and platforms are receiving enhanced recognition. The developments outlined above show that P2P loans are becoming an increasingly mature asset class with rapid change on the horizon. Investor appetite for involvement in the sector has led to several securitizations and if demand holds this will continue to drive such financial innovation. This article posits several conclusions from the analysis. Demand for P2P loans is strong and institutional investors will contribute to the continued growth of the sector. However, this growth has the potential to alter the course that the sector will follow. High demand will lower interest rates and scant returns will act as a deterrent to retail investor involvement, particularly as the sector is untested against systemic crises and offers no government insurance. Interest breeds innovation, and securitization is only one of many potential transformations that P2P products may 27
undergo. Demand, if sufficient, may also drive standardization and exchange trading, as was the case with derivatives. More thematically, the analysis indicates that disruptive innovation can be harnessed and molded by the very parties for whom it is thought to be a threat. For investors, P2P loans are just another financial product. References Allen, F. and A. M. Santomero, 1998, The theory of financial intermediation, Journal of Banking and Finance, 21: 1461-1485 Alloway, T. and A. Massoudi, 2014, P2P Lenders Install investor speed bumps, Financial Times, February 10 (available at: http://www.ft.com/cms/s/0/4c55ae50-9035-11e3-a776-00144feab7de.html and accessed July 31, 2014) Alloway, T. and C. Radnovich, 2013, Fledgling P2P industry eyes progress, Financial Times, June 20 (available at: http://www.ft.com/cms/s/0/63c6af24-d9bc-11e2-bab1-00144feab7de. html#axzz2v294mg40 and accessed July 31, 2014) Arrow, K. J., 1964, The Role of Securities in the Optimal Allocation of Risk-bearing, Review of Economic Studies, 31(2): 91 96 Bavoso, 2013, Financial Innovation and Structured Finance: the case of securitization, Company Law, 34(1): 3-12 The China Center for Financial Research (CCFR), 2011, Does the Secondary Market Reduce Borrowing Costs? Working paper, Tsinghua University (available at: http://www.ccfr.org.cn/ cicf2011/papers/20110109041408.pdf and accessed March 5, 2014) Diamond P. A., 1967, The role of a stock market in a general equilibrium model with technological uncertainty, American Economic Review, 57: 753-76 Dugan, I. J., 2013, Old Guard of Banking Sets Out to Disrupt it, The Wall Street Journal, December 4 (available at: http://online.wsj.com/news/articles/sb100014240527023037221045 79238600929163132 and accessed March 25, 2014) Financial Conduct Authority (FCA), 2013, The Financial Conduct Authority outlines how it will regulate crowdfunding, press release, November 24 (available at: http://www.fca.org.uk/ news/the-financial-conduct-authority-outlines-how-it-will-regulate-crowdfunding and accessed March 4, 2014) Hudson A., 2009, Law of Finance, London: Sweet & Maxwell (first edition) Hunt J. P., 2009, Credit Rating Agencies and the Worldwide Credit Crisis : The limits of reputation, the insufficiency of reform and a proposal for improvement, Columbia Business Law Review, 1: 109-209 Jones, R., 2014, Quakle collapse serves as warning to peer-to-peer investors, Guardian, February 15 (available at: http://www.theguardian.com/money/2014/feb/15/quakle-collapsewarning-peer-to-peer-investors) Liberum, 2014, P2P Lending: Opportunity and how to invest, March 11 (available at: http:// www.lendacademy.com/wp-content/uploads/2014/03/liberum-altfi-pres-11th-mar-14.pdf and accessed August 12, 2014) McCrum, D., 2013, The Peer Problem for Peer-to-Peer Lenders (update), Financial Times, December 5 (available at: http://ftalphaville.ft.com/2013/12/05/1713142/the-peer-problem-forpeer-to-peer-lenders/ and accessed March 23, 2014) Moore, E. and A. Sharman, 2014, London developer takes on largest P2P loan, Financial Times, January 23 (available at: http://www.ft.com/cms/s/0/0c8587a8-835d-11e3-aa65-00144feab7de.html#axzz2v294mg40 and accessed July 30 2014) Rabinovitch, S., 2014, Reversal of fortune in China s peer-to-peer lending boom, Financial Times, January 12 (available at: http://www.ft.com/cms/s/0/6348c35e-79d8-11e3-a3e6-00144feabdc0.html#axzz2xkbwynrg and accessed March 2, 2014) 28
Amsterdam Antwerp Bangalore Bratislava Charlotte Chicago Düsseldorf Frankfurt Geneva Hong Kong Johannesburg London New York Orlando Paris San Francisco Singapore Toronto Washington, D.C. Zurich CAPCO.COM