The financial crisis of 2008 led many investors to look toward alternative finance. Julia Faurschou takes a look at peer-to-peer lending and crowdfunding platforms
On 29 June this year a shoemaker from Bethnal Green, London, became overwhelmed by his frustrations with the Greek debt negotiations. Political posturing, he thought, had gone too far, and further austerity would not help ordinary Greek citizens. Despite no previous political or financial experience, he decided to take matters into his own hands and started a crowdfunding project on IndieGoGo to raise the e1.6bn that Greece needed to make its debt payments on time.
The project caught the public imagination and had raised e1.9m before it closed on 6 July. Despite this only accounting for less than one per cent of the total amount needed to save Greece, the project gave a complicated matter a simple solution, free of the back and forth of political negotiations and interfering middlemen.
The inefficiencies of banks and other large financial institutions have been questioned by consumers, leading many to look to alternative forms of lending and borrowing. Peer-to-peer (P2P) lending and crowdfunding cut out the role of large financial institutions in the debt market, while offering attractive returns.
No financial baggage
Following the financial crisis of 2008, many people have become sceptical of traditional banking, leading to a boom in alternative lending. Transparency is one of the key elements in both P2P lending and crowdfunding, making clear where the money is coming from and where it is going.
The Librium AltFi Returns Index, the performance of which is shown in Chart 1, tracks the activity of the three largest P2P lenders – Zopa, Ratesetter, and Funding Circle. The Index is constructed using the cash flows from every loan made by the three platforms to ensure maximum accuracy and transparency, and the three providers readily disclose all data. Business has been good, as the Index has returned 16.4 per cent over three years, shown in Table 1.
The 2008 crisis brought to the light the fact many consumers have no idea what happens to their money when it sits in the bank or is loaned out to others. This process becomes even more unclear when complex financial instruments are brought in. Many investors may also overestimate their understanding of some of the complex products they chose.
Giles Andrews, chief executive and cofounder of the world’s first P2P lending platform Zopa, recalls looking at the expansion of the bond market in the early 2000s. The concept of investing in debt was booming, but was not so easily accessible to the average retail investor. Many would have a savings account open at a bank, but not many owned equities directly.
P2P lending emerged as a bond market designed to be accessible to the average consumer. Mr Andrews says, “We offer a better return than banks pay savers and less volatility than investing in the stock market.”
Once the idea was in place, the next step was implementation. The Zopa founders wanted there to be an emphasis on a human element – people working together to get a better deal, similar to platforms like eBay. Costs could be cut by taking out financial institutions as middlemen and connecting individuals directly.
Connecting individuals without the need for large financial institutions is at the heart of both P2P lending and crowdfunding. Ceri Williams, business developer at Ratesetter, called P2P lending “about as pure an exchange as you could possibly get”. The order-driven exchange means that the platform has queues of borrowers and of lenders, so the market rate is set at where the bid and offer prices meet in the middle.
“We are defined by what borrowers are willing to borrow at and what lenders are willing to lend at,” Mr Williams says.
Show me the money
On a P2P platform, lenders transfer money into their online account on a chosen platform, where it is then loaned out in chunks to various different investors. Once the money has been matched with a lender it locks in a fixed rate for the duration of each loan contract.
P2P lending was launched in the UK in 2005 when Zopa came to the market; since then it has lent over £926m to UK consumers, with over £280m in the past year alone. The average amount borrowed is £7,500 and the average amount lent is £6,200, with an average return to lenders of 5 per cent. Of all this, the company has only incurred 0.6 per cent historical bad debt since its launch.
To combat bad debt, Zopa has a Safeguard Fund, currently standing at more than £9m, to protect lenders’ money should the borrower be unable to make repayments. Money in the fund comes from fees paid by borrowers and has a perfect record of protecting against defaults.
Ratesetter, which offers a maximum return of 5.7 per cent over a five-year term, has a similar set-up – the £15m Provision Fund – to prevent lender losses. The current level of cover against claims is 151 per cent, leading it to score a rating of one on FE’s risk rating scale (where cash scores zero and the FTSE 100 scores 100).
Incentives to put money into a crowdfunding project operate in a different way. Crowdfunding can be either rewards- or equity-based. In a rewards-based scheme, investors fund the projects because they wish to reap the benefit at the end, such as a community project or stated reward for each level of donation.
Equity-based crowdfunding is similar to investing in private securities, as investors buy shares in a company and receive returns based on the performance. This is a common route for many start-up companies and small businesses.
Social benefit is a key motivator for investors to consider putting money into a crowdfunding project, and the better the expected returns or reward, the more likely outsiders will be willing to pledge. Dawn Bebe, director of rewards-based platform Crowdfunder, says, “Primarily, they really want to help turn a great idea into reality.”
According to Ms Bebe, project owners who appear to be highly organised tend to be the most successful. A compelling story, a video to explain, appealing rewards, and a solid plan to execute are the keys to sparking investor interest.
Not-so-risky business
Risk in crowdfunding projects tends to be minimal, as investors have an idea of where their money is going before they invest. The greatest risk is that the project falls through or does not reach its funding target, in which case investors are often refunded.
Crowdfunding platforms make a profit by either charging for posting a project or by taking a percentage of the funds once the target is reached. Crowdfunded, for example, takes a 5 per cent fee once the project’s target is met, but does not take any fee if the funding goal is not reached.
Understanding risk is at the core of P2P platforms, according to Mr Williams of Ratesetter, who says, “What’s cool about these platforms is how they mitigate risk. We’re essentially risk managers.”
Most P2P platforms do not distribute lenders’ money as a lump sum, but rather break that lump sum down into smaller components for a number of different borrowers in a process called risk spreading. Just like any investment, this diversification eliminates the chance that one borrower will default on a loan that comes from one lender. Borrowers are charged a fee based on how risky the platform deems them.
Borrowers who use P2P platforms for loans are often misconstrued as being those unable to obtain a loan from a traditional bank, but platforms are quick to emphasise their picky procedure for deciding who to lend to. Providers carry out extensive credit checks before deciding to approve the loan, often only accepting applications from the top third of credit-rated individuals.
The popularity of these platforms is likely to continue to grow, as the Government recently allowed P2P investments and investment trusts that put funds into P2P outlets to be held in Isas.
While alternative finance may not solve all of Greece’s problems, it can offer investors an attractive return in an otherwise low-yield market environment, and a way for borrowers to access funds without having to deal with traditional banks.
