The Impact of COVID-19 on Peer-to-Peer Lending
In the years following the global financial crisis (GFC) of 2007-09, many saw peer-to-peer (P2P) lending as a fintech alternative to mainstream banking. By connecting lenders and borrowers via the web, these platforms were able to cut financial intermediation costs, enabling them to offer higher deposit rates and lower borrowing rates.
Thus, in a world of falling interest rates, P2P lenders became increasingly popular with yield-hungry investors: from 2015 to 2018, the UK’s total volume of alternative finance – of which 60% is P2P lending – more than doubled, from $4.6 billion to $10.4 billion.
Unfortunately, the P2P lending sector faced severe headwinds in the spring of 2020. As national lockdowns swept the globe, investors - including yours truly - rushed to withdraw their funds from P2P lending platforms. Many of us remembered all too well the images of long ques outside Northern Rock. Worse yet, most, if not all, of our P2P investments weren’t covered by deposit insurance.
We were on our own, and we quickly learned the meaning of ‘caveat emptor’ in a very personal way.
The collapse in confidence precipitated a veritable run on the P2P lending sector. In response, platforms froze withdrawals leaving investors unable to access their cash, at a time when many were in desperate need of liquidity. Some platforms sought to protect themselves in other ways; one introduced a temporary cut in interest rates to investors while another increased loan-servicing fees.
For a sector that came into its own during the aftermath of the GFC, it is ironic that its first crisis should be so similar. Though some of the causes may differ, the meltdown in the fall of 2008 was fundamentally a liquidity crisis - investors sought to reduce their exposure to mortgage-backed securities. This time around, they wanted out of P2P loans. Meanwhile, both types of investments were innovative and sold to investors on the promise of higher yields.
Moreover, in the years following the GFC, we witnessed several examples of liquidity crises, albeit on a smaller scale. For instance, several UK property funds had to temporarily halt investor withdrawals following the 2016 Brexit referendum. Following a spike in withdrawals in 2019, the Woodford Equity Income fund, which had significant holdings of unlisted shares, had to close its doors, and was ultimately forced into liquidation.
Though these are different crises, the core problem in each case is the same as that affecting the P2P sector in 2020: illiquid investments were distributed to investors through a structure whose apparent openness gave them a false sense of security. In other words, liquidity was not a problem, until it was needed.
Looking to the future
The 2020 crisis in the P2P sector was a selection event - those platforms that manage to survive will be more resilient than before. For these platforms, the crisis represents an opportunity to set themselves apart from the competition and gain market share.
However, the sector has its work cut out in regard to rebuilding trust with investors. Even though they may lose little or no money, investors will not have been pleased, to say the least, to have been cut off from their funds for months on end.
Indeed, despite getting my money out in time, as an investor, my faith in the P2P sector has diminished considerably. Thus, no platform can afford to ignore the lessons of the COVID crash. Of these, there are three that stand out in particular:
1. The P2P sector must structure its investment products to reduce liquidity risk
The asset management sector achieves this with closed-ended funds quoted on the stock exchange. When investors want their money back, they merely have to sell their stake in the fund to someone else, enabling the investment manager to hold illiquid assets such as unlisted shares or property without the risk of having to liquidate these holdings at inopportune moments because investors want their money back.
Though this structure may not be appropriate for P2P lenders, there are other ways of managing liquidity risk.
For example, Zopa, the original P2P lender, puts a 1% fee on untimely withdrawals, which discourages investors from taking their money out before their loans mature. Moreover, it does not offer an ‘easy access’ account; rather it invests in a diversified portfolio of loans with a horizon of up to five years and encourages investors to stay invested for a least three years. Furthermore, its marketing content makes it clear that funds cannot be withdrawn unless the underlying loans are sold to another investor.
In short, Zopa’s investment proposition self-selects for people with at least a medium-term investment horizon, thereby limiting the platform’s liquidity risk. Little wonder then, that Zopa was one of the few P2P lenders to escape the COVID crash relatively unscathed.
2. P2P lenders must think carefully about the kinds of investors they want
As I withdrew my P2P investments during the spring, I held onto and even added to my portfolio of stocks. On reflection, this is because I was prepared to accept much greater losses in the stock market than in P2P lending. Thus, promoting a P2P investment as ‘safe’ is a non-starter as even a small capital loss - or a fear thereof - can be intensely jarring to an investor who expects, at worst, to break even.
As we saw in the spring of 2020, any deviation from this expectation, will lead to excess withdrawals and/or negative customer experiences. Just as fund houses manage investor expectations by warning them against the potential of capital losses in the stock market, P2P platforms need to train their consumers to expect some setbacks and, from time to time, a temporary loss of liquidity.
3. The P2P sector needs to rebuild investor trust
To this end, the sector must go beyond investing in customer service and building more personalized user experiences, to re-examining its role in society.
The lockdowns have been a disaster for small businesses across the country, and as more people have become aware of this, there is a growing consumer desire to support independent and local commerce. Thus, there is an opportunity for the sector to play a leading role in supporting national economic revival.
Moreover, trust is built on transparency, and so platforms could provide better, more timely and granular data regarding their loan books. As part of this, investors would expect to see honest reporting regarding platforms’ financial and social performance. Such transparency, would reduce uncertainty, and thereby increase customer trust.
The pandemic-induced crisis in the P2P sector will not be the last financial crisis; as history tends to rhyme (rather than repeat itself), there is something to learn each time around. Thus, those platforms that learn from 2020 will emerge better and stronger as a result.
In this way, 2020 will go down as a pivotal year for the P2P sector: one that thinned the herd, leaving more adaptive platforms to provide better customer outcomes in 2021 and beyond.