Retail Investor Abandonment Raises Risks With Online Lending
The first in a two-part series examining destabilizing trends in the lending industry in the market. Read part 2 here.
From humble roots, peer-to-peer lending is becoming a global phenomenon. Technology-driven lenders are rapidly modernizing both the credit application experience and the loan application approval process, and forcing banks to follow suit.
But along the way, the financial structure of the booming sector changed. What started as a techno-utopian dream – ten years ago, the rationale was that the Internet’s decentralized architecture would directly connect savers and borrowers – quickly grew into a much less revolutionary business.
Today, the major companies, known in the United States as Market Lenders, cater primarily to hedge funds, banks, and other institutional investors. This change of course has enabled the industry to grow rapidly, but it has also made credit platforms more vulnerable to external shocks.
“Everything in finance is pushed to the limit. Then it breaks. There is a release. And people who have been careful survive,” said Rhydian Lewis, managing director of RateSetter, a peer-to-peer based in the United States. UK. lender who has become an outlier by remaining heavily dependent on retail investors. “I have no doubt that the peer-to-peer lending industry, or lending in the market, will be different.”
As 2016 dawns, marketplace lenders face a major challenge: can they pivot again to start relying more on individual investor money? More retail money would mean a more stable funding base, which could prove essential in times of turbulence, as many industry players recognize.
“Retail investors have been very loyal to the platform,” Lending Club CEO Renaud Laplanche told an investor conference in September. “Overall, they are very predictable, very reliable.”
In contrast, hedge funds have been drawn to the industry in large part because they are looking for yield at a time when interest rates are at their lowest. They could make a quick exit now that rates have started to rise.
The next spike in unemployment could also cause upheaval among institutional investors, as more borrowers start to default on unsecured personal loans offered by online platforms.
These scenarios suggest that market lenders would be cautious in seeking more retail money. However, there are structural obstacles to the massive influx of retail liquidity into the industry, particularly in the United States. In addition, it is uncertain whether the demand from ordinary investors can keep pace with the industry’s substantial appetite for growth.
“Heavy and unnecessary process”
Between the third quarter of 2014 and the same period this year, Lending Club loan origination increased by 92%. Yet over the same one-year period, the percentage of the San Francisco-based company’s loans that were purchased by self-directed individual investors fell from 19% to 15%.
However, Lending Club has a significantly more diverse funding base than many of its competitors, which fund their loans with lines of credit from other financial institutions.
Among the large companies in the industry, only Lending Club and Prosper Marketplace are open to the vast majority of individual savers, who do not meet the income and net worth requirements to become qualified investors. In order to meet Securities and Exchange Commission rules for selling to unaccredited investors, both companies must register each loan as collateral.
“This is a cumbersome and unnecessary process that benefits no one,” Lend Academy, which educates investors about the sector, wrote earlier this year in comments to the Treasury Department. “Most platforms don’t offer investment to retail customers due to regulations that make the cost prohibitive. “
Another constraint on the prevalence of retail investors relates to taxes. Profits that individual investors derive from loans issued on the platforms are treated as ordinary income, while losses are treated as losses of capital.
“It’s a horrible deal,” said Matt Burton, CEO of Orchard Platform, a technology provider, at a recent industry conference.
Unfavorable US regulations are not the only factor behind the move to institutional money. The same trend is now happening in Europe, where different rules apply.
Bondora, a platform that issues consumer loans in Spain, Estonia and Finland, currently obtains around 90% of its funding from retail investors. But CEO Pärtel Tomberg said he expects that number to drop over time to around 20% as the company increases institutional money in a bid to grow faster.
The problem with retail investors is that attracting them requires significant marketing expenses, Tomberg said. “The business model doesn’t really hold up for the long term.”
“Nobody understands it”
An additional factor is also limiting the growth of retail investment in market lending: Building a loan portfolio is a tedious task that is more suitable for amateurs than for traditional savers.
Lending Club has recently sought to overcome this reality by allowing investment advisers and brokers to offer platform loans directly to clients through their websites.
But the long-awaited arrival of industry-focused lending mutual funds in the market is more likely to have a big impact. Such funds could provide a large, relatively stable funding base for lending platforms that do not benefit from federally insured deposits. They could also allow uninformed individual investors to access a new asset class.
“There is a whole industry of financial advisers who sell mutual fund products,” said Jahan Sharifi, lawyer at Richards Kibbe & Orbe. “They’re easy to deal with. It’s not that the Lending Club or Prosper platforms are hard to use – in fact, they’re easy to use – but you have to learn how to use them.”
Over the summer, applications were filed with the SEC to establish two mutual funds focused on lending in the market. Both requests were for closed-end funds, which raise fixed capital and are not allowed to continue to issue shares to new investors.
The funds were expected to start operating in the third quarter, but as the end of 2015 approaches, the requests have yet to be approved by the SEC. The two companies that filed the claims, RiverNorth Capital Management and Van Eck Global, declined to comment on their status.
Outside observers have said asset managers are struggling to find the right vehicle to catalyze retail investment in the sector. Their efforts were hampered by a lack of secondary market liquidity for market loans, making it more difficult for investors to exit their positions quickly.
Bill Kassul, partner at Ranger Capital Group, said his company decided to set up a listed market loan fund in London because it couldn’t find a structure for retail investors that made financial sense in the United States. .
“I know there are a lot of people watching it, and nobody gets it, which is not a good thing,” he said. “I think if someone finds the perfect vehicle, you will see a flow of funds then.”
In August, an Atlanta-based company called Groundfloor gained SEC approval to join Lending Club and Prosper in selling market loans to unaccredited individual investors.
The company allows middle-class investors to buy installments of mortgage loans as low as $ 10. At this time, Groundfloor is open to investors in eight states plus the District of Columbia.
CEO Brian Dally said he doesn’t believe everyday savers need the help of Wall Street fund managers in figuring out where to invest their money. “People can have their own investment thesis and decide what is the best value for their money,” he said. “We believe that when you give them the right tools, people are more than smart enough. “
But Groundfloor appears to be swimming against the tide, as larger companies like Avant and Kabbage continue to use institutional liquidity to fuel rapid growth.
A similar trend has recently taken place in the UK, despite efforts by UK regulators to encourage the involvement of ordinary savers.
London-based RateSetter, which still receives around 90% of its funding from retail investors, expects that number to drop to 60 to 70% over the next two years, CEO Lewis said during a conference in November. It would still be a much higher percentage than other major platforms, but it represents a deviation from the company’s original path.
In an interview, Lewis said that a diverse funding base, which includes both retail and institutional money, will provide resilience to RateSetter through economic cycles.
At the same time, Lewis bemoaned recent developments in the financing of the loan industry in the market. He said some lending platforms are motivated by “short-term greed” to “seek maximum investment for loans, regardless of the long-term impact.”
“Performance obviously plays out over many years,” Lewis warned.
Coming in Part 2: The growing use of leverage brings new risks to the online lending industry.