Understanding the risks of peer-to-peer lending

by John Fitzsimons on 22 November 2011  |  9 comments
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Guest blogger Alex Gowar of peer-to-peer lender RateSetter explains why peer-to-peer lending is not as risky as it may seem.

In the aftermath of the Abruzzo earthquake in 2009, Silvio Berlusconi told a German TV station when asked about the survivors: “Well their lodgings are a bit temporary. They should see it like a weekend of camping”.

It’s easy to feel sometimes that our political and financial leaders have taken a similarly blasé approach to the fortunes of savers since the financial crisis. Ruinous inflation and rock bottom interest rates have ensured that those who have cautiously saved during the good times are some of the hardest hit in the crisis.

A growing market

As bank APRs and AERs have undergone a messy divorce, the world of peer-to-peer lending has mushroomed. No article can be written that doesn’t reference Zopa, which started our young industry in 2005. Its model has been often aped, but rarely bettered, and continues to deliver one of the best community-driven ways of lending your money out to those looking to borrow.

It’s fair to say that, of the thirty or so peer-to-peer operators around the world, most have themselves borrowed from Zopa quite directly!

The past 18 months has seen a raft of new competitors enter the space. Funding Circle offers lending to small businesses, Crowdcube offers peer-to-peer seed investment, Market Invoice is offering businesses peer-to-peer loans secured against future income. At RateSetter, we have a unique model; we spread the risk across all borrowers with a Provision Fund that shields lenders from bad debt.

Importantly though, the sector is constantly evolving and finding increasingly ingenious ways of offering peer-to-peer investment.

I want great returns, but no risk

For those looking to dip a toe into peer to peer, these disparate models can be confusing.

What then is the unifying aspect? Peer to peer is all about consumer platforms that offer the risks and rewards of undercutting the traditional models of borrowing and lending. OK it’s a dry interpretation, but the point is that you can still get inflation-beating returns if you’re prepared to engage with the prospect of accepting a moderate amount of risk.

It’s a twenty-first century renewal of the oldest asset class of all – direct borrowing and lending.

I argued on our blog recently that, in the good times, a false economy had developed which set an expectation that savers could beat inflation without taking any risk. The naysayers of peer to peer still leap to their feet and cry “It’s too risky!” They are attuned to the world of no risk, and increasingly they must accept that if there is no risk, there will be little or no return.

In fact, this week, news emerged that Swiss rate-setters are considering negative interest rates – the price of certainty perhaps?

Understanding risk

Those with a traditional approach to savings and investments are understandably distraught as they watch their savings savaged by inflation (one in five UK savings accounts is paying 0.1% or less) and the vagaries of the stock market.  

Every financial system has some level of risk. What’s important is that savers understand the risks of any investment, that the operators are open and transparent about those risks, and that the media fairly represent those risks. For this reason, RateSetter, along with Zopa and Funding Circle, recently founded the P2P Finance Association. Members are required to adhere to minimum standards which protect consumers, and give consumers a level of confidence the businesses and the risks are carefully managed.

The models are different and, like any investment, require careful consideration and research before investing. RateSetter’s savers enjoy the benefits of a Provision Fund, a capital pot funded by borrowers, which has allowed us to ensure that every saver has received every penny of expected capital and interest, a unique achievement in peer-to-peer lending. 

A fair return for a carefully managed risk - by coming together, perhaps we can avert another crisis.

Alex Gowar is marketing director of RateSetter.com