Peer to Peer Lending Platforms - Structure and Parameters

Introduction

Peer-to-peer and business-to-business lending primarily use funding from sources other than traditional credit providers or banks to fund loans to borrowers.

These models are sometimes referred to as ‘marketplace lending’ as the market determines the price of the credit, rather than a closed, one-sided traditional credit provider e.g. a bank.

The markets for these models are growing strongly. For example, the Peer-to-peer Finance Association in Britain has estimated that the peer to peer industry lent £1.2 billion in 2014 in the UK alone.

However, the industry is substantially larger in the United States, and by the middle of 2015 Australia had a range of peer-to-peer operators and alternative finance source providers open their doors to the market.

“The value of loans made through peer-to-peer lending platforms in Australia will surge to $22 billion in the next five years, investment bank Morgan Stanley predicts – crimping the profits of the big banks and forcing them to speed up investment in new technology. 

By 2020, peer-to-peer lending to Australian consumers will soar to $10.4 billion and comprise 6 per cent of total consumer lending in Australia.

In addition, peer-to-peer lending to small businesses would grow to $11.4 billion over the same period, Morgan Stanley said, at rates of growth faster than consumer credit, given constraints on big bank lending to SMEs.” 

What is peer-to-peer?

Peer-to-peer lending refers to the practice of individuals lending money to one another through an online platform. Peer-to-peer loans typically involve a number of lenders contributing small amounts to a loan. In this way, lenders limit their exposure to a default by a particular borrower. The promise, for lenders, is that they will receive a higher interest rate on the money that they put into the system than they would by leaving it in a bank account. The promise for borrowers is that peer-to-peer loans are generally less expensive than loans arranged through a bank or traditional financial intermediary.

Recent ASIC Regulator thoughts on peer-to-peer

Greg Tanzer, Commissioner ASIC also recently provided some thoughts on the issue of innovation in financial services in Australia. An extract of his speech follows:

“At a high level, peer-to-peer lending facilitates individuals and sometimes businesses borrowing from retail and wholesale investors through a platform. There is no bespoke regulatory regime for peer-to-peer lending in Australia. The different business models used for peer-to-peer lending will require different regulatory approvals. Many may be managed investment schemes, often with an associated credit facility that requires the operator to also hold an Australian credit licence – however, not all are. Some models may actually involve operating a financial market. This would require the platform operator to hold an Australian markets licence or be covered by an exemption.

To pick up on some of the points I made earlier about investor and consumer trust and confidence, I’d like to talk about disclosure and transparency. As with any new type of financial product, ASIC is keen to ensure that retail investors have a proper understanding of peer-to-peer before they decide to invest in it.

So once a peer-to-peer lender is up and running, what does it mean to be regulated by ASIC?

Disclosure – whether legally mandated through a PDS or by other means – is an important part of helping investors understand what they are getting. It is essential that disclosure covers key risks and benefits in a balanced way, as well as explaining clearly how the peer-to-peer platform works.

Advertising is another area that ASIC is focusing on. Advertising can be very powerful in influencing investors and consumers. Advertising of peer-to-peer products, like any other financial product or service, must not be misleading or likely to mislead.

For example, promotional materials for a peer-to-peer product should not inappropriately compare the product to a traditional banking product. The risk that an investor takes on in a peer-to-peer product is far different to those in a banking product. This includes:

• credit risk from borrowers
• risk of losing their entire investment, and
• a risk of failure of the product provider.

To avoid being misleading, or potentially misleading, promotional material relating to peer-to-peer products should be clear, accurate and balanced. ASIC has published good practice guidance on advertising by product issuers and distributors in Regulatory Guide 234 Advertising financial products and advice services including credit: Good practice guidance (RG 234).”

Peer-to-peer model in Australia – consumer lending

In Australia, any consumer lending conducted in connection with a business is regulated under the National Consumer Credit Protection Act 2009.

In Australia a peer-to-peer platform accumulates investor funds in a Managed Investment Scheme (MIS), and on-lends the funds through the platform’s Australian Credit Licence.

In order to offer a regulated lending through a peer to peer program in Australia, the program needs to operate under:

• an Australian Financial Services Licence (AFSL) to operate a managed investment scheme (MIS) to generate the investment, and
• an Australian Credit Licence (ACL) to lend regulated credit.

Impact of a MIS – Is it a wholesale or retail MIS?

It is essential to understand the basics of a MIS when it is part of a peer-to-peer lending structure.

A managed investment scheme is essentially a pool of funds that is used for a common purpose when the original owners of the funds do not have day to day control over the funds and the investment activity. The investors usually purchase units in the MIS trust. The investment manager invests the funds to achieve a return for all unit holders.

The MIS can either be a wholesale or retail scheme. Investors in a wholesale scheme need to be wholesale investors, within the definition contained in the Corporations Act. Usually (but not all the time) interests in wholesale schemes are offered by way of an information memorandum to investors.

Retail investors are anyone else who is not held to be a wholesale investor for the purposes of the Corporations Act. Interests offered to retail investors in a MIS are usually offered by way of a product disclosure statement (PDS) where disclosure is governed by various requirements specifically contained in the Corporations Act. A retail investor also obtains greater protection under the law. For example, the constitution of retail schemes must also be registered with ASIC and must contain certain provisions before it will be registered by ASIC.

Society One is an example of an Australian peer-to-peer MIS that currently only offers investment opportunities to wholesale investors, with a view to offer retail investment in the future. Ratesetter is an example of an Australian peer-to-peer MIS that offers interests to retail investors. DirectMoney is an example of the marketplace lending model which offers investment to retail investors via a PDS

Retail investors and peer-to-peer platforms

Under a peer-to-peer model, the financial risk is placed onto the investor – if a loan goes bad, the investor may (subject to the structure) lose their investment. Depending on the structure, investors don’t have control over how their money is invested, and so the lender needs to have a robust lending and collection practice.

MIS promoters must operate a tight lending business because any bad debts will normally reduce investors’ return (absent any protection mechanism, e.g. a provision fund) and could eventually become unviable. For example, in the US, peer-to-peer lending has been around for quite a few years, but even larger companies such as Prospa ran into trouble in the GFC when the number borrowers who could not afford to repay their loans increased.

Investor Risks

Australian law requires a substantial amount of disclosure when AFSL holders want to sell financial products, particularly when offering a financial product to retail investors. Regulatory Guidance RG234 requires a licensee to give as much prominence to the product risks as to the product benefits.

In the UK, the British Business Bank Program through the Department for Business, Innovation & Skill made a £40million investment through Lending Circle’s peer-to-peer platform to lend to small business. This is a wonderful demonstration of support for innovation and new business, but has been criticised as conveying the message to the public that peer-to-peer is ‘safe’ or has a stamp of approval, when in fact, it does carry risk.

What types of protection mechanisms are usually available to a MIS on loan default?

Peer-to-peers can use mechanisms such as a provision trust to protect investors. RateSetter charges borrowers a ‘risk assurance’ charge, and allocates the additional funds to a provision trust. The trust may investors who suffer loss as a result of borrower default. DirectMoney operates a Loan Investment Reserve Account (LIRA) which may be accessed by the responsible entity to meet any shortfall on the sale of defaulting loans to a third party (this mechanism is strictly limited to the amount of any funds held in the LIRA).

Pooling investment funds or limiting the amount that can be matched to individual loans can also reduce risk.

Overall, peer-to-peer lending has resulted in a wider selection of financial products for investors, and an innovative source of borrowing and investment. Given what it is, what are some potential benefits and disadvantages of peer to peer lending?

Advantages and Disadvantages

For lenders

A benefit is that the interest rate (rate of return) that you receive on your funds may be higher than a cash deposit rate through a bank, building society or credit union. In the current low-return environment, this can be appealing.

A disadvantage is that your money is not guaranteed; the Australian government’s financial claims scheme only applies to banks, building societies and credit unions that are authorised by the Australian Prudential Regulation Authority (APRA). These institutions are known as authorised deposit-taking institutions (ADIs).

Lenders need to be comfortable with the platform operator’s credit approval and collection processes, any disclosure around historical or expected default rates and any loan default protection mechanisms and how they might operate in a rising default environment.

For borrowers

The interest rates on offer are also a benefit for borrowers as you may be able to secure a personal loan at a lower rate than your bank will offer. Don’t take that for granted though – it’s important to thoroughly research all your options.

The speed of the application process is also a benefit. peer-to-peer lending is essentially a digital disruption of the institutionalised banking system and the internet is its home. As such the online processes tend to be quicker, smoother and more efficient.

One disadvantage of peer-to-peer lending is that it’s limited as to where loans are made. Currently in Australia peer-to-peer lending for general consumers is limited to personal loans and SME business lending. As such if you want to purchase a house, it’s off to the ‘old school’ financial institutions.