For those following the marketplace lending sector, also called P2P lending or alternative finance, one question being asked is whether a bubble in unsecured debt is emerging?
At the heart of this new lending trend are technology efficiency advancements that connect borrowers and lenders. The technology is similar to other electronic marketplace such as eBay or over the counter (OTC) exchanges that are replacing previous formats of connecting participants.
Unique selling points for marketplace lending include borrowers gaining access to a global audience of investors, reduced time needed to apply and receive loan funds, alternative non-credit score risk profiling of borrowers for investors to analyze, diversity of loan types for investors, and last but not least are interest rate terms that are often better than those available to borrowers from banks of investors from traditional fixed income securities. Thanks to these features, marketplace lending has grown to a loan market in the tens of billions of dollars
However, much of the transactions are unsecured debt such as debt consolidation, home improvement and student loans or short-term financing for small and medium size businesses (SMBs). As such, marketplace lending isn’t only providing an efficient alternative for borrowers, but also creating a new class of investors that are directly investing in debt.
Like any wave of investors entering a new market, questions arise of the suitability of these investments and whether participants understand the risks. For the retail market, an example was the dot com bust of 2000, when many investors entered late into the technology bull market as it was topping in 1998 and 1999, only to be subsequently burned. However, with retail investors remaining a small portion of the marketplace lending market, perhaps a better example are the hot investments that were targeted by institutional investors prior to the 2008/08 global finance crisis.
Similarly, institutional funds now dominate the vast majority of money being lent on P2P platforms. While institutions may be more sophisticated and have greater understanding of fixed income debt than retail investors, for many of them, this is their first foray of direct lending to the SMEs and consumers.
Speaking to industry insiders of the lending sector, one of the cautionary items being cited is inexperience of credit cycles. Currently, the loan market is being driven by low interest rates around the world which provide cheap financing. However, as the loan market is driven by interest rates, any moves higher in rates could increase default rates of borrowers. In addition, increased risk may cause investors to back off from providing funds to marketplace platforms. For new entrants, how they handle these credit cycle changes remains to be seen.
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Despite the obvious risks, there are those who believe things will be different this time around. Specifically, founders of P2P lending platforms as well as fintech professionals have cited to Finance Magnates one important change taking place; data. Believed to be often overlooked when analyzing the industry, borrower data is viewed as the differentiator allowing marketplace providers to profile risk and keep default rates low, while matching correct yields to individual loans.
How did banks lend money in the past without all the new data?
Instead of credit scores which are only available in a select group of countries, marketplace lending providers of unsecured loans are analyzing other borrower data. Examples are social footprints and user interests that can be used to rank credibility. The higher the credibility score, the more likely a borrower will act to refrain from missing payments and defaulting on their loan. In addition, platforms review borrower demographics such as the university they attended, neighborhood they live in, and other related data.
As one fintech professional explained to Finance Magnates, the question shouldn’t be whether marketplace platforms are risky, but “How did banks lend money in the past without all of the new data being using to profile borrower risk?”
Another aspect that helps remove loan risk are niche sectors that marketplace platforms target. Even though many of the largest platforms are branching out to offer new loan types, this has typically only been the case after first specializing in a specific sector. An example is SoFi which launched P2P lending for student loans in 2012. After achieving several billion dollars in student loans, they branched out to include personal loans this past February.
The advantage of focusing on specific niches such as loan type, borrowers (consumer or business) or country, is that platform providers able to gain domain expertise of evaluating risk in these individual markets. As more data is collected from borrowers, it can then be used to better understand loan risks in the future.
Overall, driven by better data and focusing on niche loans, marketplace lenders believe ‘this time will be different’ and any worries of an unsecured credit bubble are being overblown.
Fintech Spotlight is a new column on Finance Magnates devoted to reviewing innovative financial technology companies and sector trends.