One of the things you quickly discover when you scratch the surface of UK “peer-to-peer” lending is that things are a bit of a muddle. The things that are supposed to make the sector different from other financial businesses turn out to be illusory, or at least not all that it was made out to be.
And so to the three tenets of online lending above, courtesy of Funding Circle’s Samir Desai at Tuesday’s AltFi conference in London. Each, in their own way, is not as re-assuring as it initially seems.
Let’s start from the bottom and work our way up. The third, inventory or balance sheet participation, is an argument that would equally apply to the shoddy subprime mortgage brokers that funnelled bad loans into the American financial system. And while it is true that Funding Circle does not hold loans on its balance sheet — not something every lender would consider a badge of pride — it also has a listed fund that exclusively buys loans it originates. They don’t have balance sheet participation, instead they have off-balance sheet participation.
The second point, regarding a lack of deposits, is a little stronger. One could argue that online lenders have to treat their investors capital with a little more care than banks, given that their investors cannot rely on deposit protection. But then again, banks themselves are a source of capital for online lenders — Vernon Hill’s Metro Bank buys loans from Zopa, for example. Even if they weren’t, the fondness for provision funds among Funding Circle’s rivals suggest that the sector is selling par protection, a service depositors traditionally expect from banks.
But it is the first point that is most interesting, because maturity transformation is a point of serious controversy in the sector. Desai called it “a recipe for disaster” and though he didn’t name any businesses, it was clear the comment was a jibe at his close competitor, Ratesetter, another of the UK’s “big three” online lenders.
The argument is broadly that maturity transformation — borrowing short and lending long — isn’t supposed to exist in the world of online lending, where investors own a specific loan or fraction of a specific loan and are locked in for the duration of that loan, unless they can find someone to buy it from them. But, to the ire of its rivals, Ratesetter has done maturity transformation for much of its existence.
The online lender, whose quirks include providing credit to other lending businesses, gives investors four options for when to get repaid, the shortest of which is the one-month “Access” product. (If you’re willing to lock your money up for 5 years in the “Growth” bucket you get almost double the yield.)
But Ratesetter doesn’t offer loans to prospective borrowers shorter than one year. In order to fix this duration mismatch, Ratesetter rolls that one-month money over and over until the investor explicitly asks for it back — at that point, Ratesetter has to find another investor to step in, or some other source of short-term liquidity. If it can’t, investors suddenly find their one-month money has turned into something much more long-term — or a bit less money.
Short-term, 30-day money makes up £140m of the £570m that is currently out on loan, according to chief executive Rhydian Lewis, and is used for loan terms of up to 24 months.
More recently, Ratesetter has tweaked its system to reduce the risk from this mismatch. Until January this year, investors investing for 30 days had a contract for that term. Now their contracts are matched to the duration and they just have “access rights”, according to Lewis. In other words, “we’ll give you your money if we can”. “Technically that has stopped maturity [transformation],” says Lewis.
The change brings it closer to Zopa, the third big UK online lender, which offers a similar short-term “access” product to lenders. But it doesn’t necessarily make liquidity management any easier from the point of view of keeping your investors happy — for example, Ratesetter’s have never had to wait to withdraw their money.
(Developing a bigger secondary market for loans would help with this, especially once investors develop a tolerance for floating values on their assets.)
But online lenders are certainly better than banks in one respect. They don’t have branches where their customers can queue up demanding their money back.