How safe is peer-to-peer lending ?
Investors generally associate certain risks with the attractive returns offered by peer-to-peer lending, such as payment delays or defaults. But the development of the European regulatory framework, complemented by sound risk assessment and reinforced by the strong guarantees provided by the platforms, ensures a good level of safety.
Although the question of the safety of our investments is a legitimate one as peer-to-peer lending gains in popularity, these alternatives to traditional investments are based on well-known business models:
- Real estate lending
- Business lending
- Consumer lending
New technologies have simply added to the mix, speeding up processes, cutting operational management costs, and eliminating banking intermediation.
What is peer-to-peer lending?
Peer-to-peer lending, also known as P2P lending, is a practice where individuals or businesses borrow money directly from investors through online platforms without involving traditional financial institutions. These platforms connect lenders with borrowers, offering lower interest rates for borrowers and higher returns for lenders compared to traditional banking products.
Peer-to-peer lending is a form of financial technology (FinTech) that has experienced significant growth since it first appeared in 2005 in the USA.
Since 2015, we observe a steady growth in the number and volume of these platforms in Europe. They are positioning themselves as a viable alternative to conventional lending and investment methods as they offer faster processing and more control to individuals.
How does peer-to-peer lending work?
Peer-to-peer (P2P) lending works by connecting borrowers seeking funding with lenders who offer their capital in exchange for a return on investment.
The role of P2P platforms is to manage the entire investing process for a fee, including rating creditworthiness, loan servicing, reimbursement of the capital and payment of interests.
There are different types of borrowers:
- Operators from the real estate sector renovating or developing projects
- Small and medium size companies that need to fund their equipment
- Traditional loan originators funding consumer loans to individuals
Lenders are individuals or companies with financial capital seeking to grow it at higher rates than in traditional assets, with returns averaging between 10% and 12%.
What are the risks of peer-to-peer lending?
If P2P lending opens the door to more accessible financing options for various borrowers, it appears essential to be aware of the potential risks that come with this lending model for lenders. Essentially, investors may face four types of risks: late payments, default risk, insolvency risk, and fraud risk.
Late payments
The P2P lending market is still relatively new, which makes it vulnerable to market fluctuations and economic downturns. In such circumstances, the risk of borrowers defaulting on their loans could increase, making it even more critical for lenders to carefully evaluate their investments.
As with any lending activity, borrowers may fall behind on their repayments. This doesn’t mean that they won’t repay, but that they simply need extra time to meet their contractual obligations.
This is a very limited risk, since it’s nothing more or less than a rescheduling of their repayment to accommodate a temporary difficulty. Moreover, during this period of delay, investors continue to earn interest.
Default risk
This is the risk that naturally comes to mind when starting a lending activity, since borrowers may face difficulties that prevent them from repaying. It’s a perfectly logical risk that simply needs to be understood in order to counteract it.
This risk is inherent to the P2P lending business and has been anticipated by lending companies for nearly two decades. Their business model takes this risk factor into account, so that the profits generated mechanically cover a structural default rate.
In the case of loans to the real estate sector or to small businesses, loans are secured by land, real estate, equipment, or invoice financing, enabling all or part of the loan to be covered in the event of a default.
Insolvency risk
The business model of P2P lending platforms is essentially based on a small fee that they charge to borrowers on the sums raised. The business model is therefore largely based on the volumes financed via the platform.
Should the profits generated not be sufficient to cover operating costs, then there is a risk of insolvency. For this reason, the experience of the management team is an essential element in controlling this type of risk.
That’s why platforms segregate funds belonging to the company, which uses them to run the platform like any other business, from funds belonging to investors, who are simply passing through.
Fraud risk
Unfortunately, fraud risk cannot be completely ruled out, as unscrupulous people can potentially try to extract money by using the technology of these platforms deceptively. Add to this some very good communication, and even experienced investors can be fooled.
This is what happened a few years ago with platforms such as Envestio, Kuetzal, and Grupeer. But the good news is that these practices have largely disappeared during the Covid period.
These platforms are now being prosecuted, and sums are beginning to be recovered. They have also set an example not to be followed by those tempted by this illicit activity. Today, the P2P lending landscape is much healthier.
Meanwhile, the regulation of P2P lending has developed in an attempt to provide legal responses to a sector that mixes professional platforms with artisanal or even dubious ones.
Legal and Regulatory Aspects
European regulation
At the European level, an autonomous and voluntary regime has emerged with the “Crowdfunding Service Provider” license, which came into force on November 9, 2020 (Regulation (EU) 2020/1503).
The regulation applies to crowdfunding services provided to professional project operators (and not to consumer lending platforms). The total amount of funding offered per project owner must not exceed €5 million per year.
While this legal framework provides some governance and risk management rules for crowdfunding platforms, this is not its main aim. The first objective is to encourage the development of crowdfunding platforms within the European Union.
Obtaining this license enables platforms to offer their services more freely throughout the European Union with a single authorization. This is notably the case for Estateguru and Raizers, both of which have obtained this license.
The licence’s primary objective is therefore economic, since it aims to tackle the obstacles to the effective operation of the internal market for crowdfunding services. Investor protection is only mentioned, but only in chapter 4.
Topics covered include: information provided to clients, default rate disclosure, entry knowledge test, simulation of the ability to bear losses, pre-contractual reflection period and key investment information sheets.
National regulations
Prior to this regulation, some countries had already introduced national legislation, either by adopting a traditional approach (extending previous banking or financial regulations such as MiFID II) or by adopting specific legal regimes.
Some are focused on crowdfunding like the Law of November 3, 2016, No XII-2690 on crowdfunding in the Republic of Lithuania. In particular, crowdfunding platform Crowdpear has complied with this national regulation before potentially moving on to comply with the EU regulation.
Other national regulations are perfectly suited to P2P lending, the best known of which is Latvia’s Investment brokerage firm license, which defines companies providing investment services.
In particular, crowdlending platforms such as Mintos, Viainvest, and Twino have obtained this license, which has the merit of legitimizing their activities. But these regulations add a degree of administrative complexity and also lead to additional operating costs.
Moreover, as with European crowdfunding regulations, the main objective is not to protect investors, but rather to prevent the money laundering that some of these investors might engage in.
Risk Assessment and Management
Despite the existence of a legal framework governing certain P2P lending platforms, which essentially protects against the risks of scam and fraud, it remains important to take a number of steps yourself to assess and manage the associated risk.
In particular, you need to carry out some research and checks before investing, mitigate risk by diversifying your investment portfolio, and follow the development of the companies in which you invest by reading their financial reports.
Perform Due Diligence
As we have seen, some platforms, although regulated, have a loss-making business model and offer relatively long payment terms. In contrast, other unregulated platforms not only have a strong financial base, but also offer very short payment terms.
It is therefore essential to check that the investment terms proposed by the platforms, and beyond that by the loan originators and real estate operators, are suitable for us.
Thus, when investors ask me: “Are P2P lending platforms risk-free?”, I invite them to review them more broadly along these 5 main criteria:
- Return on investment
- Security of partner companies
- Solidity of the platforms
- Market liquidity
- Degree of diversification
In fact, it was against these five characteristics, themselves based on a series of 50 criteria, that I assessed the main platforms in this sector.
Review general conditions
When we invest, whatever the asset, we enter into a contractual relationship with a financial services provider, as a result of which we carry out an economic transaction.
Investing in an asset therefore implies establishing a legal link (the contract) which is then materialized by an economic link (the transaction).
But the problem is that investors focus mainly on the economic link, without really paying attention to the legal link, which they sometimes become aware of too late.
However, investing implies being aware of the contractual conditions that define the legal framework in which we operate as investors. The objective is to avoid being surprised by certain specific features of the platforms (such as loan extensions, for example).
Moreover, these contractual conditions may change over time, so that on the same P2P lending platform we may have investments that meet different legal criteria (before and after their modification).
Even if the platforms are legally within their rights (it’s up to investors to accept or reject the contract proposed for each investment), it’s physically impossible to read the contract for each investment (given their sometimes large number).
In this respect, it’s clear that P2P lending platforms still have some way to go in terms of communication and transparency with investors.
But investors also need to be more involved in reading these contractual elements to better understand them and be in a position to accept (or reject) them.
Diversifying P2P Investments
One of the key strategies to manage risk in P2P lending is diversifying investments, which means spreading our investments across various platforms, through different loan types and/or different sectors in varied geographic regions.
By diversifying, we can reduce the impact of a single default or an adverse event on a loan originator, on a platform, in a particular sector or in a country. This approach can help protect our overall investment portfolio from concentrated risks and potential losses.
Diversify your platforms
Contrary to popular belief, diversification in P2P lending does not have to take place at borrower level, but rather at loan company level. Indeed, it is these companies who offer a repurchase guarantee, and therefore bear the risk for the borrowers.
It’s important to understand that, since the buyback guarantee is only as strong as the loan originator, we need to diversify the loan originators we invest with, and therefore mechanically diversify the platforms we position ourselves on.
Sector diversification
Diversification also means diversifying the sectors in which we invest. It’s important not only to invest in short-term loans to individuals, as with Swaper, or medium-term loans, as with Lendermarket.
Sector diversification also means investing in a sector such as real estate, which has a strong presence on platforms such as Crowdpear or Estateguru. Or, even more decorrelated, in the agricultural sector with platforms such as HeavyFinance or LANDE.
Geographic diversification
Finally, diversification can take place geographically, even if we often find the same countries of choice for platforms, such as Poland or Spain. It is also possible to diversify into Northern Europe (Lendermarket), Asia (PeerBerry) or the Middle East, notably Jordan (Esketit).
It is also possible to turn to Africa thanks to Mintos, but I personally feel that this continent is not yet mature enough to offer sufficient security.
As for Latin America, while several platforms, such as Robocash, are exploring this market, there are currently very few collaborations.
Means of protection against risk
P2P lending platforms offer various measures to mitigate the risks associated with their investment activities: buyback guarantees, group guarantees and collateral. These methods aim to provide additional security and to better ensure the safety of the investments made in this alternative financial market.
Buyback guarantee
A buyback guarantee is an additional security layer that many loan originators offer to the P2P lending investors. In the event a borrower fails to repay their loan within a specified period, the loan originator commits to buy back the loan, repaying the invested amount to the lender as well as the interest.
This buyback guarantee is a mean to make the risk of loss disappear for investors in case of borrower defaults. However, it’s crucial to understand that the guarantee is only as strong as the loan originator providing it, so due diligence is essential when evaluating this protection mechanism.
Group guarantee
A group guarantee is a risk-sharing mechanism that involves multiple loan originators joining together to vouch for each other’s loans. If a member of the group defaults on the loans they are in charge, the remaining members are responsible for covering the outstanding debt.
This system encourages responsible repayment behaviour, as each member is held accountable for the group’s overall loan performance.
Although group guarantees help reduce credit risk in P2P lending, investors need to understand that they depend on the performance of the group and therefore on the financial stability of its individual members. We find such group guarantees on platforms like PeerBerry and Esketit.
Collateral
Some P2P lending platforms propose another mean of mitigating risk in P2P lending using collateral. Collateralized loans require the borrower to pledge an asset (such as real estate or a vehicle) as security for the loan.
If the borrower defaults on the loan, the loan originator has the right to seize the collateral and sell it to recover the investment made.
Investors appreciate collateralized loans as they are backed by a land or other real estate as on Crowdpear, or by a vehicle or equipment as on HeavyFinance. However, the valuation and liquidation of the collateral pose some challenges, and lenders should be aware of these potential issues before investing in collateral-backed loans.
What are the benefits of peer-to-peer lending?
When it comes to P2P lending, there are three benefits that make it an appealing option for investors who wish to use such platforms. Apart from the higher returns compared to other assets, P2P lending is easily accessible online from anywhere and does not need an institutionalized middleman as traditional assets do.
One major benefit of P2P lending is its potential for higher returns for investors. Since P2P platforms connect individual investors directly with loan originators and real estate developers, cutting out traditional financial institutions, investors can often enjoy higher returns relative to other types of investments.
P2P lending platforms also typically offer a streamlined and user-friendly online application process. Investors can register in few minutes after successfully going through the Know-Your-Client (KYC) step and directly invest their savings.
On many platforms, the first returns on investment come after only one month of investing. This speed and simplicity make P2P lending an attractive option for those seeking fast and convenient investment.
Another advantage of P2P lending is connecting investors with loan originators without the traditional banks and financial institutions, making operational costs lower.
To remove this middleman also lightens the weight of the process and consequently reduce the time between when the borrower expresses their need for funding and when the investor brings their funding.
How much should I invest in peer-to-peer lending?
When considering investments in P2P lending, we can get started on a platform for as little as €10 with no maximum limit. While there’s no one-size-fits-all approach, it’s essential to determine how much you should invest based on your individual circumstances, risk tolerance, and investment goals.
Firstly, it’s essential to view P2P lending as a part of your diversified overall investment portfolio rather than the entire investment. Just like with any other investment, you shouldn’t put all your eggs in one basket, and diversify your investments among different platforms.
Next, assess your risk tolerance before deciding how much to invest in P2P lending. If you’re a conservative investor, you may invest on highly secured but low-yield platforms. On the other hand, if you’re an aggressive investor with a high tolerance for risk, you might decide to invest on high-yield platforms with lower security.
Another factor to consider is your investment goals and time horizon. If you’re looking to achieve short-term financial objectives, you need to consider platforms offering short-term loans but if you have long-term investment goals, loans proposed on one or two years will suit your strategy.
Is P2P lending safe?
Considering that P2P lending is a mature and profitable market, the high yields observed attract thousands of investors every month who position this asset as a pillar of their portfolio. As with any investment, there are certain risks, but they can be limited thanks to risk management and various means of protection.
P2P lending is simply a traditional sector consisting of lending money to individuals and companies, but where online technologies, simplified organizational modalities, and additional safety measures are implemented. Therefore, P2P lending appears as an interesting alternative to traditional sectors.
When you wonder “Is P2P lending risk-free?”, remember that loan originators and P2P lending platforms perform thorough credit checks and evaluations of potential borrowers, account for various risk factors, and assign interest rates accordingly.
P2P platforms are key players that stepped in to simplify and speed up both the lending and the investing processes, bringing benefits to both lenders and investors.
However, the level of safety provided by P2P lending depends on the specific platform and its risk management practices. It’s essential for users to research and compare platforms before deciding to engage in P2P lending. Regulatory oversight and platform stability are crucial factors to consider when evaluating the safety of a P2P lending platform.
