Ask the CEO of any investment bank for a top-five list of challenges facing the industry in 2014 and competition from peer-to-peer (P2P) lending firms is unlikely to feature. But the next year could be a defining period for a phenomenon also known as crowdfunding.
The ambition of UK-based firms such as Zopa, Ratesetter and Funding Circle is to create an alternative to bank lending as financial institutions have shed assets and cut their balance sheets after the financial crisis. These P2P companies have created a new asset class by opening up the loan market for small and medium-sized companies to retail investors.
The P2P companies work by matching up individuals who want to lend with borrowers looking for funds. This has proved extremely popular for investors, who, in a low-rate environment, can earn as much as 6%, while it has provided an avenue of funding for small companies that have been starved since the financial crisis as banks have reined in lending to protect their capital and liquidity.
More than £500 million has been successfully "matched" since P2P arrived in the UK with the launch of Zopa in 2005. “Banks brush aside this new wave of funders as too small to fill the liquidity gap – and they don’t regard them as a competitive threat,” says one consultant.
But there are signs that the sound of the crowdfunders is starting to drown out the sceptics. In the US, the industry has attracted the big guns of finance. Lending Club, one of the leading P2P lending platforms in the US, boasts former US Treasury secretary Lawrence Summers and ex-Morgan Stanley CEO John Mack as directors and expects to lend around $1.5 billion this year. In October, US hedge fund Eaglewood Capital took some of its Lending Club loans and sold them in a $53 million securitization deal, with the buyer understood to be a large insurance company. The Eaglewood securitization succeeded in giving institutional investors exposure to SME loans for the first time.
The UK might be some way off this, but momentum is building. Chancellor of the exchequer George Osborne announced in his autumn statement that returns from P2P lending can be included in Individual Savings Accounts (ISAs) from 2015. “This is a seminal moment in our industry,” says James Meekings, co-founder of Funding Circle. “The move from becoming unregulated to gaining tax treatment as a recognized asset under ISAs will push our model further into the mainstream.”
By the time the new rules kick in, the industry will also have gained formal recognition from the regulator. The UK’s three peer-to-peer lenders, Zopa, Ratesetter and The Funding Circle, are currently self-regulated after forming the P2P Finance Association. From April 2014, the industry will be regulated by the UK’s Financial Conduct Authority, a move that is welcomed by the leading triumvirate and one that will force less scrupulous crowdfunders out of business.
The ISA ruling will move the asset class into the mainstream, but there is another development that banks should take note of – the prospect of the UK following the US and attracting institutional participants. Funding Circle wants to provide more institutional investors with opportunities to invest their money.
Meekings says: “Individual investors are at our core, but can only fulfil a certain amount of demand. What will be important is having a diverse set of investors which will create a stable ecosystem and better alternative to bank lending.
“We have strong interest from individual insurance companies and pension funds, which are saying they have £100 million to invest in the next six months. There is not the demand for that from businesses at the moment, but there soon will be.”
This is not an empty promise. Currently P2P companies are restricted in the types of companies they can lend to because of the types of risks they can measure. That is changing, says Meekings. “We are looking to grow by introducing new products for borrowers, such as property developers. We also want to grow the asset finance space. Both of these participants require us to develop different risk models, which we're currently working on.”
These developments are innovative, but P2P funding is not ready to furrow the brow of the banking executive. The size of the P2P market pales in comparison to the massive deleveraging by Europe’s banks, which have cut more than $3 trillion in assets. This trend has pushed more companies to alternative sources of funding such as the capital markets. But the Eaglewood deal offers institutional investors exposure to a high-yielding asset class that banks cannot provide. Meanwhile, the test for the crowdfunders might come as global interest rates rise, offering investors better returns elsewhere.