The rise of a digital financial ecosystem

Sukhwinder Shoker is a research analyst at LendingWell, an Innovative Finance ISA wrap platform for independent financial advisers. He tells Peer-to-Peer Finance News why the development of a P2P ecosystem will boost trust in the industry

Unlike the natural world where evolution has allowed dynamic ecosystems to develop organically, the peer-to-peer lending world must embrace and actively develop processes that govern its formation and connectivity between various providers to optimize multiple funding channels.

Since the advent of unsecured P2P consumer lending in 2005, the industry has seen tremendous growth, particularly in recent years. This has been largely characterised by differences in business models, the emergence of new lending verticals and an increasing global presence. However, annualised growth has slowed. Whilst industry developments have, on the whole, been positive and the investment case for P2P remains compelling, the landscape for the majority of advisers and private investors has become ever more complex and difficult to navigate.

Initially, a fragmented trajectory seemed to sit quite comfortably with loan origination platforms; however, events that rocked the industry in the first half of 2016 have shaped an alternative view – one that champions the burgeoning P2P ecosystem. The establishment of industry trade bodies, data and analytics outfits and aggregators have all emerged as part of the nascent P2P ecosystem.

The next growth phase of P2P will rely heavily on the development and sustainability of providers within the wider ecosystem that support the requirements of a heterogeneous investor landscape. This ecosystem will foster an environment which will act as an enabler for achieving liquidity as multiple and varied sources of funding are channelled to loan originators that have demonstrated excellent credit underwriting, market-leading loan servicing and strong internal controls. Price discovery in marketplaces becomes more sophisticated with scale and scale comes from liquidity.

Let’s explore some of the factors which will contribute to the success of the ecosystem:

• Transparency incubates trust – an essential attribute of any well-functioning marketplace. The absence of standardisation and third-party data analytics does not bode well for a typically time-poor retail investor who wishes to make a rational investment decision when comparing products on an apples-to-apples basis. Whilst efforts by the likes of Orchard have helped to boost visibility and transparency for institutional investors, less has been developed to cater specifically for a retail capital base. Marketplaces such as eBay and Uber have developed trust through market participants providing recommendations and reviews which drive a feedback loop system. In P2P, third-party data and net return verification will, undoubtedly, help to further education and trust which, in turn, allows platforms to scale and enjoy economies of scale. Where there is a break in the feedback loop, trust vanishes, and marketplaces fail to scale.

• Increased P2P product choice. P2P lending should not be viewed as a homogeneous asset class. Globally, several sub-asset classes have opened through the P2P model, including consumer, business and property loans as well as invoice financing. As larger pools of capital enter the market, supported by a well-established ecosystem, we could see other asset classes such as infrastructure, healthcare and renewable energy proliferate. In an expanding universe, ecosystem providers can deliver essential educational tools, news and analysis to further guide investors to execute informed and timely investment decisions.

• Effective, but not overly burdensome, regulatory oversight. In the UK’s saving market, the Annual Equivalent Rate (AER) was imposed by regulators to specifically allow ease of comparison between savings products. A similar approach may be considered by the regulator in the P2P market, where current net return methodologies vary between platforms – thus making like-for-like comparisons difficult, if not impossible.

• Secondary market exchange. P2P loans are generally considered as illiquid long-term investments, although a fully functioning secondary market provides the opportunity for an early exit if required. We could potentially see some of the dedicated closed-ended direct lending funds emerge as active liquidity providers for such a market as they seek to take advantage of any arbitrage opportunities that might exist.

P2P has the potential not only to contribute positively to economic growth but also carries with it the promise of a more secure financial system through the emergence of an alternative asset class that is competitive with traditional retail banking products. The Centre for Economics and Business Research recently released a report examining the wider economic impact of lending facilitated by Funding Circle’s SME loan exchange. The report states a £2.7bn total boost to the UK economy since 2010, with 40,000 jobs created as a result of businesses tapping into Funding Circle SME loans. For P2P platforms, the ecosystem presents an exciting opportunity to secure larger and more diversified sources of funding.

Going forward, one of the greatest challenges for the industry is not awareness of P2P, but gaining the trust of investors and borrowers in the integrity of the marketplace. It cannot be stressed enough: trust is singularly the most important binding relationship a marketplace has with all of its participants. And it is trust, particularly for financial services companies, which takes years if not decades to build.

The establishment of a well-organised and efficient ecosystem will, undoubtedly, go a long way to helping P2P move up the rungs of the trust ladder for existing and future investors. If the formation of the ecosystem stalls, the promising future and enormous opportunity ahead for P2P will fail to materialise. A coherent ecosystem is potentially disruptive, a fragmented one may not be.