The role of retail
Individual investors are the lifeblood of the peer-to-peer lending industry. But will they get pushed aside by City institutions as platforms pursue serious scale?
Retail investors are the foundation on which today’s thriving peer-to-peer lending industry was built. The whole concept of P2P lending was created with retail investors in mind, based as it was on a desire to cut out the middlemen and open a direct line between individual lenders and borrowers.
But a trickle of institutional money into the sector has now become a flood. With this has come some clear benefits, such as the potential for growth, but it also raises questions about the role retail investors will play in the future of P2P. Can they remain the key focus for platforms, or will institutional cash prove too alluring?
The world’s oldest P2P lender Zopa launched 13 years ago, but P2P really took off in the aftermath of the financial crisis, filling the funding gap when traditional bank lending dried up.Iain Niblock, chief executive of P2P research provider and investment platform Orca Money, notes that retail investors were the first to adopt P2P lending and are still the largest source of lender capital. Platforms like them because they tend to stay put longer than institutional investors, causing fewer problems for cashflow.
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“It has been said that retail investors are more reliable and stickier than institutional investors,” says Niblock. “If a large institution withdraws from a platform, the impact would be significant. If a retail investor withdraws £15,000, the impact would be marginal.”
The ability to scale up and become more profitable is a major attraction of institutional investment in the eyes of P2P platforms, but there is also added prestige. Gaining the ‘seal of approval’ from an institution proves a platform can stand up to scrutiny.
Niblock says this extra layer of reassurance can help platforms attract more retail investment too. “The presence of institutional capital may further add comfort to retail investors knowing that a large institution has conducted in-depth due diligence on the platform,” he explains.
There is also the issue of diversification of funding, which was an important lesson from the global financial crisis, notes Jonathan Segal, partner and head of fintech at law firm Fox Williams. “A lot of platforms started off as pure P2P but realised that, to get any meaningful scalability, they had to look at institutional investors as well. It is also about having a solid funding base: one thing to come out of the financial crisis was the importance of not relying on one source of money.”
Although retail investors bring obvious benefits to platforms, they also come with particular regulatory requirements to satisfy the Financial Conduct Authority (FCA). For example, P2P lenders have to adhere to the regulator’s rules on financial promotions and treating customers fairly. They are expected to have clear and transparent marketing material to explain risks to investors.
They must also be careful not to imply that having a provision fund to cover bad debts means lending is risk free. The City watchdog is still in the process of reviewing the P2P sector, which has evolved rapidly in the last few years and become much more sophisticated.
If the rules on how platforms deal with retail investors are tightened, this could make institutional money look more appealing, says Segal. He notes that, to get FCA permission, platforms have to prioritise their treatment of retail investors. One big issue is about the selection of loans, although there is no specific regulation around cherry-picking, where institutions might get their choice of the best loans (whether highest return or lowest risk).
“Fundamentally, what the FCA is worried about is if there are losses on the platform – will retail investors suffer them and institutional investors be protected?” he says. “If the rules get tightened up, clearly the reaction to it may be to take more institutional money.”
On the downside, however, taking institutional money can put pressure on P2P platforms to change their lending criteria in order to suit their big investors who want greater control over what the platform does. And if there is too much institutional involvement, can a platform still call itself P2P?
The whole point of P2P was to connect lenders with borrowers directly. But now, platforms including Zopa and Funding Circle have started to securitise loans, adding back in layers of complexity and charges in a process of ‘reintermediation’.
This is one reason why RateSetter says it is focusing on retail money, which accounts for 95 per cent of its loan book. Data from Orca Money reveals institutions lent £38m through RateSetter in 2016, compared to £626m from retail investors. In 2017, institutional funding shrank to £13m.
Read more: The biggest P2P funding deals of 2017
“That’s a choice we’ve made; we’ve had lots of conversations with institutions but we haven’t felt minded to introduce more institutional money into the mixture,” says John Battersby, head of communications and policy.
“There are lots of reasons for that. Primarily, our goal is to open up loans and lending to direct investment and, by putting institutions in between, it ultimately means the retail investor gets a smaller return. We are very keen that as much return as possible should flow back to retail investors. That’s at the heart of our model.”
The intermediary issue also influenced RateSetter’s decision to stay focused on retail. “You can think of things like investment funds where there is retail investment on one side and they are operating through a fund, a big institution or a bank to get a return,” adds Battersby. “Inevitably, that’s another mouth to feed in the transaction, you are introducing another intermediary, and that is something we are not instinctively attracted to.”
Landbay is a specialist P2P platform for buy-to-let mortgages which started life as a purely retail proposition but has recently started taking institutional money as well. It lent out almost £40m in 2017 and institutional money now makes up about three quarters of its funding.
Chief executive John Goodall says the success of the retail-focused business was what opened it up as an option in the eyes of institutional investors. “We started the business to provide retail investors with better and fairer options through direct lending, offering attractive and predictable returns,” he explains.
“Retail lenders have been fundamental to our success and allowed us to prove the business concept in the early days. Nearly four years on and we have had zero defaults and zero arrears in our history of lending. This performance has in turn definitely opened up conversations with institutions for us.”
The Innovative Finance ISA (IFISA) is predicted to be a game-changing development which will keep the UK’s P2P sector firmly anchored with retail investors.
The tax wrapper opens up the sector to the lucrative ISA market, offering individuals a tax-free allowance on income from their P2P investments, akin to a stocks and shares allowance. The products have been so popular that in some cases platforms have staggered rollouts to meet demand.
RateSetter launched its IFISA last month and Battersby expects it will be key to attracting more retail investment into P2P, especially given current low rates on cash ISAs and volatility in stocks and shares ISAs. “The IFISA could be a very important development to drive people to think about P2P as an investment, especially when you look at the ISA landscape currently,” he states. “I expect we will see a material increase in take-up on what we saw in 2016/17.”
Landbay’s Goodall describes the ability to put a tax-free wrapper around P2P investments as a “landmark moment” for the industry, and proof that P2P is now firmly in the mainstream. He predicts it will attract a new wave of retail investors to the sector in years to come.
So what will the P2P lending sector look like in a few years’ time? Will we see a US-style influx of institutional cash – now making up 80 per cent of P2P funding across the pond – and how much could this change the face of a sector built to serve the needs of individual borrowers and lenders? The platforms themselves pledge not to forget about their retail customers, even if it means they have to work harder.
“You can get involved with an institutional investor and substantially increase the amount of money that’s on a platform, that is a choice you can make,” says RateSetter’s Battersby. “You have to work harder for each retail customer and that’s fine with us as we think retail money can fuel sustainable growth.”
Landbay’s Goodall says his platform will always focus just as much on retail as institutional money, partly because it wants scalability, and to reduce over-reliance on any one source of capital.
Niblock says Orca Money would like to see the retail investor base grow with the industry in future, and he thinks ultimately the platforms will stay true to their roots.
“My view is that institutional involvement in the sector will grow, but the P2P platforms will retain a mixture of capital sources, making them more robust,” he asserts. “The true nature of P2P lending is lending directly from one individual to another party. This was the original model conceived by Zopa in 2005 and I don’t think the industry will abandon this.”
This article first appeared in the March issue of Peer2Peer Finance News, which is now available to read online.