The UK’s peer-to-peer loan market is bracing itself for an influx of government-incentivised investment as it struggles with the growing pains of onerous regulation, scandal and prodigious growth.
Peer-to-peer works by creating a marketplace for investors to loan money directly to businesses and individuals. By cutting out traditional high street lenders and having low operating costs these providers can offer better returns for investors and loans with lower interest rates.
The sector has been a phenomenal success story in the UK’s startup scene. The first and some of the largest platforms were launched here. The UK has world-leading alternative finance legislation and, starting with City-based Zopa in 2005, lending has ramped up dramatically over the last five years to reach £7.3bn at the end of 2016.
Investments have qualified for tax advantages through the Innovative Finance ISA (IFISA) since April 2016, which means investors receive interest and capital gains tax-free. IFISAs are expected to pay between 5% and 7% APR - significantly more than the 0.8% offered by the best cash products - and £80bn was invested in ISAs last year; there’s a significant advantage on returns and a huge market to play for.
The IFISA market is yet to come into full effect because the largest platforms are unable to offer the service. At the moment, 17 P2P providers have permission, but this group is limited to relatively small, new platforms. None of the biggest six marketplaces, which stand head and shoulders above the rest of the pack, are included.
BusinessZone’s sources say this will happen in the next two weeks when a number of platforms will receive authorisation to offer the product from HMRC.
Although it’s not clear what platforms are included at this point, it could be a game-changing moment in the development of the sector. The timing is great too: investor interest in ISAs peaks at the end of the tax year as the public rushes to take advantage of the annual tax allowance for these products.
UK P2P platforms have lent £7.3bn to date - it’s possible the influx of cash could be equivalent to half of what the market has lent in its 15-year history.
In the meantime, the platforms that have started actively selling IFISAs have seen a dramatic take-up among investors.
One such business is Crowd2Fund, which launched in 2014 and is currently advertising an ISA product with an estimated return of 8.7% APR. CEO and founder Chris Hancock says investment on the platform has “skyrocketed” since it starting offering the product in April:
“It’s really had a phenomenal response on the investor and business side; it helps legitimise peer-to-peer investing and, as a growing platform, it gives us an opportunity to accelerate past other players.
“We don’t know how big the opportunity is going to be, but we’d like the sector to capture a decent size of the ISA market. There’s £480bn in ISAs at the moment - £80bn is liquid every year - that brings a huge opportunity.”
How big is the opportunity for peer-to-peer ISA products?
It’s worth remembering that P2P lending is already experiencing strong growth in spite of setbacks experienced in 2016, which prompted industry benchmarking site Altfi’s to name its annual report Good Growth in a Tumultuous Year.
The volume of new loans reached another new annual record of £3.9bn, compared with £2.8bn in 2015 (although the growth rate slowed to 36% year-on-year, from 76% in 2015, the sector is still performing well).
Industry figures are generally hesitant to try to quantify the impact the IFISA will have on this growth - but ThinCats founder and chairman Kevin Caley says the “extremely attractive” nature of the product means P2P platforms could attract 5% of the ISA market (£4bn based on last year’s figures).
As mentioned, UK P2P platforms have lent £7.3bn to date - it’s possible the influx of cash could be equivalent to half of what the market has lent in its 15-year history.
“We’re talking about a doubling of the market in the next 12 months,” says Caley. “That’s a huge amount of money coming toward the industry and I don’t know whether we have the capability of handling it.”
What Caley’s talking about is the need to create loans to meet the demand. This could mean increasing the size of loans or lowering standards, potentially altering the risk profile of the P2P market.
At this point, it’s worth a note of caution. Yes, the sector is excited about the prospect of attracting new investors, but platforms continue to stress the importance of growing in a sustainable fashion. Caley is a natural sceptic - he describes himself as an “old, cynical equity investor looking for low-risk investments” - and he’s interested in developing the kind of products you would be happy investing your pensions into.
The impact of stricter P2P legislation
The major peer-to-peer platforms still haven’t received full authorisation to operate from the Financial Conduct Authority (FCA) with most operating on interim permissions granted in 2014 when the government body took over regulation of the sector.
And, this is why they can’t offer the IFISA yet. In some cases, the application process has taken more than 15 months. It includes factors such as daily reconciliation; essentially, these platforms will be operating many day-to-day functions at a similar level to a high street bank.
It’s taken the larger, more experienced platforms longer to receive the FCA’s authorisation because of the level of complexity of their existing operations.
Lending Club’s CEO resigned after an internal probe found he sold $22m of loans to an investor that didn’t want them.
While the length of time it's taken the established platforms to receive authorisation has been frustrating, there’s widespread recognition that the path the FCA has taken is a good one. Unlike their American counterparts, the FCA are tailoring regulation specifically for the sector, rather than trying to shoe-horn it into existing standards.
Angus Dent, CEO at ArchOver, started the application process in September 2015. According to him, the regulatory body is working hard to understand the sector in spite of being under-resourced.
“The FCA are making it up as they’re going along - and I mean that in a positive way. They have not tried to take an existing set of regulations and said ‘they’re going to bloody fit’,” says Dent. “On the other hand, it does create frustrations. Not because we’re doing anything wrong or the FCA are doing anything wrong, but they need to make a leap and get ahead of us.”
While these platforms wait for approval, they have prepared the infrastructure to offer IFISAs and many already have landing pages on their websites explaining the products. Both ThinCats and ArchOver, for example, will launch the product as soon as they receive approval.
Public perception of peer-to-peer lending
Recapping the issues the P2P sector faced last year highlights problems common to growth-orientated disruptive sectors that have to answer to VCs and institutional investors. It’s worth remembering these problems when thinking about the impact on the public’s perception and their willingness to invest.
To give a short summary: in May, US-based Lending Club’s CEO Renaud Laplanche - who was described as a “godfather of the industry” - resigned after an internal probe found he sold $22m of loans to an investor that didn’t want them. In Stockholm, TrustBuddy declared bankruptcy in October and lawyers working on the case said in a statement that there is a “high probability that the lenders will not be repaid in full or at all”.
In the UK, problems weren’t as severe, although Zopa temporarily stopped accepting new investments because of a shortage of creditworthy borrowers. Also, Funding Knight, a small platform that had been trading since 2011, was put into administration after a large institutional backer withdrew funding. It was purchased by AIM-listed GLI Finance.
GLI owns seven UK-based peer-to-peer platforms and several more in other countries. Changes in its portfolio demonstrate the kind consolidation that’s taking place among smaller players; two platforms were in the process of closing (Raiseworks and CrowdShed) and Verus 360 ceased operation during its last reporting period.
As well as the potential impact of negative news stories, the IFISA represents a much riskier proposition than a traditional cash ISA and that will weigh on investors’ decisions to use the product. The Financial Services Compensation Scheme covers cash ISAs up to a deposit limit of £75,000 (considerably more than the tax-free lSA limit). It also covers losses in stocks and shares ISAs, although there are more caveats. There is no similar protection for IFISAs.
As John Battersby, RateSetter’s director of communications and policy puts it: “The IFISA is fundamentally different from the cash ISA as it is an investment that carries risk and returns. Some people may consider the low returns provided by cash ISAs are an acceptable price to pay for protecting their capital, but the IFISA offers better returns in exchange for some risk.”
It remains to be seen to what extent investors agree with Battersby's conclusions. What is certain, however, is that disruptive peer-to-peer platforms like RateSetter are on the cusp of a billion-pound-plus stimulus this year.
Dealing with the increase in investment should happen smoothly given the UK’s strong regulatory footing. The sector should also be mature enough to maintain a sensible risk profile, to grow in a sustainable way.
That said, it’s likely small platforms will fail and there may be consolidation among the top tier of operators. And, just like the American railway barons of the 19th century, a select few will get rich, while many others will remain unprofitable.
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