How do the different models vary?

The lending model means that investors can offer to lend to individuals, who might be looking to do home improvements or want a new car; they can lend to small businesses who may need the extra cashflow on a short-term basis or who want to invest in stock or capital expenditure.

An investor can also lend to property developers who need extra finance for their next project.

Investment crowdfunding is when an investor can buy equity or debt, and either sell it back to the borrower, or trade on the secondary market. Alternatively, if the borrower strikes lucky, and they have found the next James Dyson, they can sell if the company is openly traded.

The general principle is that an investor goes online and selects the type of loan they want to make, then the rate they are looking for, which usually determines the type of risk they are happy with.

The different platforms treat this in a variety of ways. If one is looking to lend to a business, then the website will automatically match the lender up with a potential borrower, based on their risk profile, and the borrower will offer details about their business model, their financial situation and reasons for needing the money.

The market will find a supply and demand for the rate. If demand goes up and you get lots of creditworthy people needing loans you will get your higher rate.John Battersby

For people lending to individuals, the borrowers tend to be more anonymous but are graded according to their creditworthiness, ranging from prime to sub-prime, done in a similar fashion to the banks.

Investors will see the creditworthiness of the people they are lending to. Models vary but Zopa, for instance, originally showed lenders the calibre of the people they were lending to.

Now, however, the loans are spread across a variety of risks, and the lender dictates the kind of loan rate they want to lend to and they end up investing in a portfolio of borrowers.

Finding a match

Ratesetter offers a slightly different model in that it operates by supply and demand.

John Battersby, head of communications at Ratesetter, says: "Let's say the market rate is 4 per cent and that's the last matched rate. I'm holding out for 4.2 per cent."

This lender would have to wait until demand has crept back up before people are prepared to pay more to get their loan.

"The market will find a supply and demand for the rate. If demand goes up and you get lots of creditworthy people needing loans you will get your higher rate.

"The matching is done automatically," he says.

An investor will go online and select from a number of different options the type of loan they want to invest in: typically these might be a one-year term, five-year term or a rolling term.

The investor will be repaid interest throughout the course of the loan, and they receive capital back at some point during the loan, either monthly or at the end of the term.

Crowdfunding investment platforms work slightly differently, but in some ways they operate in a similar way to the London Stock Exchange (LSE).

Companies are looking for debt or equity investment, and some platforms treat any new company wanting to come on the platform in a similar way to a float on the stock exchange.

Abundance Investment, a crowdfunding site, has as one of its managing directors a former head of equity capital markets for UBS who has done many initial public offerings (IPOs), in the past.

Founder and joint managing director Bruce Davis says that it issues an offer document in the conventional way.

"With a stock exchange IPO, the LSE does not sign off the prospectus, the prospectus is signed off by a law firm.

"In crowdfunding, the document is signed off by the crowdfunding lawyer."

In addition the offer documents are pitched at the small investor, so are 30 pages long rather than 200 pages.

Risk levels

Default rates are relatively low. According to the University of Cambridge, default rates in 2016 were 2.07 per cent across all models, though this was higher than the previous year's at 1.63 per cent.

According to the report, 17 per cent of people surveyed across the industry anticipated the prospect of default as being 'high-risk' or 'very high risk'; this puts it above the impact of Brexit, but far below the threat of a cybersecurity breach, with 45 per cent perceiving that to be high risk or very high risk.

Most platforms make clear on their website that capital is at risk. For example, most say in a prominent place that the investments are not protected by the FSCS.

Zopa spells this out even further by stating: "If a borrower misses four months’ worth of repayments, their loan is defaulted and your capital may be lost.

"After a default, we still make every effort to recover your capital, and return those funds to you. Your projected return factors in expected defaults, although actual defaults may vary."

Many try to mitigate that risk by spreading the loans across a portfolio of creditworthiness.

Some have even set up a contingency fund, in case borrowers default on their risk. Ratesetter has done this, setting up a contingency fund which charges a percentage from each of its borrowers dependent on their creditworthiness.

Mr Battersby says: "If your loan does default, that Provision Fund will step in and pay all the capital to the investor. Over eight years of operation it's always worked, it's always made sure investors get their money back.

"Let's say I would expect the bad debt to be 3 per cent, we would hold 4 per cent in the Provision Fund."

The FCA has made it clear, however, that it is not happy with the way platforms represent the risks that investors are taking on. As a result, in July it issued a paper outlining changes it wanted to see among platforms, including making the risks clearer to investors.

Regulation and risk is the subject of the next feature.

melanie.tringham@ft.com