Do the rewards of P2P investing justify the risks?
Until the early 2000s, banks held almost a monopoly in credit. Around that time, enabled by the emergence of the internet a new type of digital lending started to emerge and with it a new way to invest in private debt: peer-to-peer (P2P) lending. This innovation allowed retail investors to put their money in small loans so that consumers could achieve their financial goals. We spoke to Kimmo Rytkönen, CEO and Founder of Income Marketplace about the rewards of P2P investing.
Back then investments into private debt portfolios were only done by established institutions and were not available for small investors. On the borrower side, consumers had just a handful of opportunities to find a financial institution granting them credit and handing out money. The rise of digital P2P lending platforms brought up new opportunities for investors to invest in loans online and for borrowers to an option to borrow without going to a bank.
The way P2P lending works
Modern P2P marketplace lending comes in two forms. There are companies that originate the loans themselves and connect the investors and borrowers and there are companies that co-operate with credit companies that originate loans. In both cases, the party originating the loan to the borrower places the loan on a marketplace for investors to invest in. Essentially, the investment means buying a share in a loan granted by the credit company to an individual borrower.
The average ROI (in case there are no credit losses) on many European platforms is between 10 and 12 percent per year, which is quite attractive in times of zero or even negative interest rates. This is one of the reasons why P2P lending has started to boom recently around the world, not only in Europe and America but also in South East Asia. Another clear reason is the rigidness of incumbent banks in these regions as well as the regulatory landscape that is supportive of P2P lending.
The risks of P2P lending
Basically, there are always four parties involved in the P2P lending process: the borrower, the loan originator, the investor, and the loan marketplace.
One of the most obvious risks is credit loss, which materialises when the borrower does not pay back the loan. Modern P2P marketplaces often offer a buyback guarantee, which means that the LO purchases back any bad debt from the investor. If there is no buyback guarantee, as was often the case in the first generation of P2P lending platforms, investors will need to deal with bad debt which takes time and drives down the yields.
The second generation of P2P marketplaces was the first to introduce buyback guarantees, a very important step in making investments feel safer and attracting a large pool of investors to invest in private debt. Unfortunately, these buyback guarantees did not provide sufficient protection to investors, which became especially evident during the Covid-19 crisis.
The second main risk of modern marketplace lending is that loan originators themselves are unable to honour their agreements and go themselves into default. This was seen widely happening throughout 2020 on major marketplaces and this is one of the reasons Income Marketplace’s founding team started thinking about how to protect P2P investors better.
Income Marketplace was built as the third generation of P2P lending platforms in order to make it even safer and more transparent for both institutions as well as retail investors to invest in loans on Income. The marketplace was designed to specifically safeguard against the above-mentioned risks and in addition to buyback guarantees, Income introduced an institutional level security element and structure called cashflow buffer which essentially enables Income Marketplace to protect the recovery of investor funds in case of an LO default. Income Marketplace also uses very stringent due diligence procedures to check the operational continuity of loan originators and thereby makes sure that default scenarios do not occur in the first place.
Are P2P marketplaces worth the risk?
It’s not black and white. On the one hand, if the security structure of the investments is weak then even attractive yields of 10-12% are not enough to compensate for losses, so investors should be aware of this.
On the other hand, if security is taken care of and risks are minimised properly by the marketplace then private debt can be a great investable asset that produces monthly cashflow and this makes it a very attractive alternative to stocks, cryptocurrencies, and ETFs. Marketplace lending can also help diversify a person’s investment portfolio. If you are considering investing in P2P it’s worth reading a bit about the marketplace you are considering. I’d personally look first at the team behind the marketplace and how well they’ve covered possible risks on the website. At Income Marketplace, we try to inform and educate investors to make for a better investment experience.