|Summary: P2P lending provides the potential for lower interest rates for borrowers as well as better investor returns, thanks to its use of smart technology to match borrowers and lenders, and its ability to avoid the co-mingling of risk that bedevils traditional banks.|
|Key take-out: Society One, an Australian peer-to-peer lender - matches prospective lenders and borrowers, with a credit scoring system to help both parties find their “perfect match”.|
|Key beneficiaries: General investors. Category: Economics and Investment strategy.|
Peer-to-peer (P2P) lending is poised to smash the traditional banking sector, as potentially powerfully as the disruptive technology of the internet has been to the communication sector. Using smart technology to match borrowers and lenders, without the co-mingling of risk that bedevils traditional banks, P2P lending provides the potential for lower interest rates for borrowers as well as better investor returns. P2P lending avoids the layers of costs, massive capital backing and complex business systems that traditional banks use to protect investors. It’s no wonder that Westpac recently invested $5m into start up Australian P2P lender Society One – emulating the rapid growth of P2P lending in the US and Europe: www.societyone.com.au ). Unfortunately the mechanism chosen by Society One to deliver its service adds some risk above that which ideally should exist in the “pure” P2P model – and potential investors need to be aware of how this can affect them.
Society One was launched in 2012 and provides consumer loans backed by funds provided by sophisticated investors. The rates offered to borrowers vary based on the credit score allocated to prospects by the Society One platform, which posts information about customers seeking to borrow up to $30,000 for terms up to 3 years. Prospective lenders can use the smart search engine technology on the Society One platform to locate and build a portfolio spread across a number of borrowers: the platform then matches prospective borrowers and lenders, with loan approvals and drawdowns happening within a short period of time.
Key Elements of the SocietyOne Platform
Imagine a prospective lender (investor) who could choose to lend only to a specific type of borrower, say for example a borrower with an impeccable credit history with no prior history of defaults, and no prospect of defaulting in the future. Imagine also that lender could further reduce their risk by spreading their investment across multiple borrowers of that quality. Two benefits would flow from this approach:
- the lender bears the risk of loss (and not the traditional bank which would otherwise intermediate between lender and borrower);
- the lender can target the specific risk they desire as well as reduce that risk by portfolio diversification.
The resulting capital and cost reductions are shared, in the P2P business model, between both lenders and borrowers – offering better rates and returns compared to traditional banks. More detail is available at www.peer2peerlending.org.
The Society One platform combines two key components, reflecting the P2P business proposition. It showcases and matches prospective lenders and borrowers, with a credit scoring system to help both parties find their “perfect match.” Secondly, it offers a facility for parties to transact with each other – although it uses a somewhat cumbersome mechanism to do this (involving more “intermediation” than the pure P2P model would ideally adopt).
How does SocietyOne “Intermediate”?
P2P lending confounds securities regulators, because in the pure form (where two retail investors deal directly with each other) it would be impractical to require each party to prepare a fully conforming product disclosure statement. How could each prospect prepare, and the regulator assess conformity, of potentially thousands of such PDS? Let’s look at how the SEC in the USA has responded to this issue (a critical one for lenders whose hard earned capital is at risk in the P2P business model).
P2P lenders like Prosper and Lending Club have transacted several billion dollars of loans in the US, with Prosper launching in 2006 followed by Lending Club in 2007. In 2008, the growth of the P2P industry was slowed by the SEC which suspended their activities pending the re-design of the disclosure documents backing the P2P business platforms. The SEC insisted that P2P businesses create formal security disclosure documents – even though the essence of the P2P concept is that there is no intermediary between lender and borrower.
The US approach permits the issue by the P2P platform of “member payment contingent notes” – where the liability to make payment on the note issued by the platform is entirely contingent on/backed by specific underlying loans. The SEC approach means that mandated levels of disclosure regarding the design and accuracy of the P2P’s credit scoring system is provided to investors, (hopefully) allowing them to make properly informed decisions.
The approach taken by Society One is unfortunately far more cumbersome – relying on a wholesale “unregistered” managed investment scheme (“MIS”) to house loans and issue securities. MIS are required where assets and investors are commingled, and the costs and complexity of issuing units from MIS reflect the risks arising from this commingling. In the case of Society One, lenders (investors) are potentially exposed to the risks of default of borrowers beyond those they choose to be linked to.
As a result, Society One only makes available investment (loans) sourced from sophisticated (wholesale) investors: thereby avoiding the need for a retail PDS. Under current Australian regulations, SMSF’s don’t qualify as sophisticated investors! So the massive pool of money which resides in the SMSF sector, and which typically suffers from the paltry returns paid on cash deposits by the major banks, is deprived of access to this revolutionary technology.
Society One utilizes a number of service providers to deliver its service:
- Perpetual acts as the custodian of the Society One MIS (ie it holds the assets of the MIS, and is the conduit for payments between lenders and borrowers)
- Macquarie provides payment and banking/clearing services
- Ironbark (a boutique funds management business) provides the Australian Financial Services license for the platform
- Veda provides the credit data used by the Society One credit scoring system
- ClearMatch provides the P2P software
- Green ID provides electronic identity verification software
- Australian Receivables Limited acts as debt collector for loans in default
Where to from here?
Current indicative interest rates available through the Society One platform are around 1.5% less than traditional banks charge – and investor returns are measurably higher than compared to bank deposits. Other players are moving to enter the market, including Queensland based Lending Exchange, which expects to launch in mid-2014. The investment and social benefit of P2P lending will be significantly improved as and when SMSF-eligible investments are made available. It is to be hoped that Joe Hockey’s Financial System Inquiry recognizes and facilitates this by clear regulation.
Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals. He provides asset consulting and financial product services but does not receive any benefit in relation to the product reviewed. Twitter: @TonyRumble.
* For more on the P2P market see David Gilmour's Peerless: the emergence of a new funding model.