Peer-to-peer lending: Is it for you?

Australia's big four banks are ripe for disruption. After posting a record combined $28.6 billion in cash profits in 2014, commentators began to warn of the looming threat from new, technology-driven rivals.

Peer-to-peer lenders are one such disruptive threat to banks. But while many may ponder the threat posed by peer to peer operators, Eureka Report may subscribers may wish to know a little more about what is being offered by these new players, especially for investors who wish to act as lenders in the system.

Among the key players in the local market there is a significant range of rates on offer for money deposited in the system: Ratesetter is offering returns to investors of up to 10.6% annualised for a five-year term, at the time of writing. Meanwhile, SocietyOne says its investors can expect to earn about 12% a year before defaults in the range of 2% to 4%. By contrast, the big four bank stocks are currently on estimated dividend yields of between 5.2% and 6.5% for fiscal 2015. With returns like this it is no surprise investors are backing peer-to-peer lending. Just last week on Wall Street one of America's biggest peer-to-peer lenders Lending Club listed on the stock market with a 56% first day lift.

How it works

The concept of peer-to-peer lending is simple. An online platform matches investors seeking returns with borrowers seeking personal loans. The platform clips the ticket, charging borrowers a higher rate than is passed on to savers, like a traditional bank. But unlike banks, peer-to-peer lenders don't have the overheads associated with a branch network, meaning they can offer a better deal to both parties and still profit from the transaction.

Peer-to-peer lenders frequently emphasise that they only accept credit-worthy borrowers. They aim to offer investors access to borrowers who will be most likely to repay their loans, based on their credit history. A high rate of repayment helps to build confidence in the platform. (See also Peerless? The emergence of a new funding model, March 17.)

Typically investors' capital is split between several different loans, rather than matched directly to a single borrower. Peer-to-peer lenders say this diversification spreads the risk of borrowers' default between many investors.

Peer-to-peer lending has a longer history in the US and the UK. The newly-listed US-based Lending Club opened in 2007.

Ratesetter: Open to retail investors

For most investors, the attraction of “lending” into the peer-to-peer system will be the ability to act as a financier. This is an option rarely open to investors who do not have access to wholesale markets or the private equity sector.

On the other hand, the fear for most investors is the prospect that money – possibly all money – could be lost putting cash into something that is new and lightly regulated with none of the implicit and explicit guarantees offered within the traditional Australian banking system.

After operating in the UK for four years, and in Australia since October, no lenders operating through Ratesetter's platform have ever lost money, says CEO Daniel Foggo. “Our lenders in the UK and Australia have received every penny and cent of interest and principal owed to them,” Foggo says, since Ratesetter launched in the UK in 2010.

With the aim of protecting investors' capital, Ratesetter has established a provision fund. Ratesetter is clear in its marketing that the fund is not an insurance product or a guarantee. Borrowers pay a fee when they take out their loan, and the fees are pooled and held for lenders in case of a late payment or default. Foggo says the UK's fund covers more than twice the expected defaults, while the multiple in Australia is higher. The default rate in the UK is about 0.6%, compared to a typical rate of 2% to 3% for similar personal loans from banks, which Foggo puts down to a rigorous assessment of borrowers.

Borrowers are vetted using a similar process to a bank, Foggo says, which involves working with credit bureau information to understand a borrower's credit history and asking a borrower to provide bank statements to verify their income and the affordability of the loan. He says in Australia, since an October launch, Ratesetter has received $15 million of loan applications and only matched about half a million dollars. “We only lend to credit-worthy people,” he suggests.

The rate of return available to lenders in peer-to-peer systems varies depending on the length of time that investors choose, with terms available ranging from one month to five years. Rates are also agreed between borrower and lender, meaning that high demand from borrowers can push rates higher, but investors who ask for a higher rate of return than other lenders may be waiting for a match for some time. On December 16, Ratesetter's most recent matched rates for savers were 6.6% per annum for one month, 7.4% pa for one year, 8.1% for three years and 10.6% pa for five years. Borrowers pay a higher rate, and Ratesetter takes the difference in fees.

The appearance of a one-month rate may at first glance prompt concerns that borrowers are using the service for payday loans, but in fact the shortest period on offer to borrowers is six months. Because investor capital can be split between many loans, an investor can contribute money for only one month, which can be combined with other investors who have longer time frames to produce the capital for a borrower who wishes to borrow for a period ranging from six months to five years. The short time frame allows potential investors to dip their toes in the water, trying out the platform before deciding whether to commit further.

Ratesetter is the only peer-to-peer lender open to retail investors in Australia so far. The minimum investment is just $10, which at a rate of 7.4% for one year would return 74 cents. It seems too low to bother, but Foggo says this also allows investors to try the platform out and get comfortable, seeing their money returning to them in regular monthly payments of principal and interest, before lending more over time.

SocietyOne: Backed by big names

Although SocietyOne has been operating in Australia for longer than Ratesetter, it is only open to sophisticated investors (with a gross income above $250,000 or net assets of at least $2.5 million). There are plans to open to retail investors in the new year, but at this stage, there is no product disclosure statement.

And the investors backing SocietyOne are very sophisticated indeed, including Kerry Stokes' private company Australian Capital Equity, James Packer's Consolidated Press Holdings, Rupert Murdoch-chaired News Corporation (publisher of Eureka Report) and Westpac's Reinventure venture capital fund.

SocietyOne CEO Matt Symons says that the rate investors earn depends on the risk profile they choose. There are options to invest only in loans to A-grade borrowers, or to invest in a spectrum of bank-grade credit-worthy borrower.

Generally investors who choose a range of credit classes would expect to earn about 12% a year after the fees that borrowers pay and before defaults, and would expect defaults in the range of 2% to 4%, Symons says. He says individual behaviour is hard to predict, but the behaviour of populations is easier to forecast, and that 2-4% is the amount of all loans Australian banks have typically written off in the unsecured personal lending market.

Investors can be very specific about the borrowers they will accept, such as only taking borrowers employed in certain industries or residing in certain locations. Through risk-based pricing, the platform rewards the most credit-worthy borrowers with the best rates, in the hopes that more and more quality borrowers will decide to move from the banks to SocietyOne to get a better deal, and improving the range of loans available to investors.

So far, SocietyOne offers investors access to unsecured personal loans, and to secured livestock loans, which it presents as a form of diversification. “Traditionally, livestock prices have not moved in lockstep with unemployment rates,” Symons says.

Disrupting banks

Other players are operating in this space too. ThinCats Australia links wholesale investors with small and medium enterprises seeking business loans, while Marketlend is also open to wholesale investors and focuses on small business loans and vehicle loans.

Investments are not without risk. Peer-to-peer lenders are not banks, and investments are not backed by the government guarantee that applies to bank deposits. Further, returns are subject to tax, unlike fully franked dividends paid by the major banks to their shareholders.

Asked about regulation of peer-to-peer lenders, an Australian Securities and Investments Commission spokesman said there was no specific regime for the lenders, although depending on the business model they may require an Australian Credit Licence or Australian Financial Services Licence. ASIC also pointed to a 2013 Treasury consultation on proposals for regulation of peer-to-peer lending. It is worth remembering that ASIC has come into focus in recent times, such as over its slow response to the Commonwealth Bank financial planning scandal.

But over time, competition could encourage banks to refine their own offerings to borrowers and depositors. And the prospect of a 10.6% yield from a disruptive business in a traditionally profitable space is one that is worth examining with your eyes wide open.