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Three Key Risks of Peer-to-Peer Lending

Are you still able to stomach these risks and invest in P2P loans?

The Peer-to-Peer (P2P) lending sector has gained quite a fair bit of attention as financial services have taken greater heights in its innovation phase in Singapore. The P2P platforms, gaining most of the limelight, are Funding Societies, CapitalMatch and MoolahSense as they have collectively raised more than $10 million in 2015.

The returns provided by P2P outshine general investments and depository instruments such as index investing and fixed deposits.

However, what are the key risks involved in P2P lending and what proportion of our investment assets should consist of such instruments?

3 Key Risks In P2P Lending

(1) Risk of Default

P2P platforms link people with excess money (investors) to businesses that requires extra money in order to grow (borrowers). By doing so, investors would receive return, in the form of interest payments.

In simple terms, we should think of it as us lending money to a friend in need. It would be possible that this friend of ours will make timely repayments back to us, or that the person may not be able to repay the money they borrowed.

P2P lending is done in a more professional manner with contracts drafted, signed and with limiting factors included in the agreement. Nonetheless, the fundamentals are similar.

Although the rate of default is currently quite low, with only a few bad P2P loans at risk of defaulting , we should be more vigilant because this is a new financial space just blossomed in the last 1-2 years.

How we should assess the risk of default on the broader perspective, without dwelling into professional jargons, is to assume that all of these loans would have risk levels above the types of business loans done in Singapore.

The reason is simple, if banks in Singapore are not willing to lend to these businesses, it is largely due to (a) lack of historical information – business only operating for <1 year, (b) businesses that banks are unfamiliar with, (c) high risk businesses – trading firms, (d) businesses that are deemed non-viable and (e) businesses marginally failed to meet the extremely strict criteria set by our banks.

If we are able to stomach such risk, then we should we consider investing into P2P loans.

(2) P2P Platform Operation Standards and Vision

What we mostly read about P2P and its risk is largely associated with the risk of default by the businesses that we are investing (through lending).

What is equally important is the P2P platform, which plays the most important role in managing the risk of default since they are the ones assessing the businesses and deciding whether or not these businesses should be put through to their platform for funding.

We have to understand two key things (a) how the P2P platforms assess the businesses and (b) long term vision of the P2P platforms.

As for (a), understanding the P2P platforms’ methodology in assessing businesses is important because we want to understand how the P2P platform is looking at the business before deciding whether or not to provide the loan. Furthermore, it allows market participants to feedback so that they can improve as well.

For (b), the long-term vision of a P2P platform is also important information. Like all businesses, if a P2P platform intends to stay in the industry and be a market leader, they have to ensure that they are always competitive and are the best at what they do. The simplest way of being the market leader and excelling in this business is to reduce default rates to as near 0% as possible.

(3) Lack of Transparency

If there is one thing that keeps us up at night when it comes to P2P lending, it is the lack of transparency in the underlying businesses where the loan originates as well as the methodology in assessing businesses.

Lack of transparency in underlying business

When some P2P platform raises money for the businesses, they would put only the industry of which the business (e.g. wholesaler, design and build, etc.) is in. The name of the business is not provided.

For investors who invest a larger amount, it would make sense for them to do some background check to get a sense of the viability. However, without the sufficient disclosure, it would be impossible to do so.

Some P2P platforms do disclose the names of the businesses they lend to, but we believe this should be the norm, rather than the exception.

Lack of transparency in methodology

We do not doubt the ability of P2P platforms to assess the businesses via their methodology. That is because they have incentive to ensure that their methodoloy is as foolproof as possible. However, without any “request for comment” from professionals in the industry, it’s hard for the market to know how these methodology works. It also means that investors have to place 100% trust in the platform.

What is the proportion of assets that should be allocated to such instruments?

The 3 key risks mentioned should not turn you away from investing as the returns provided are significant, ranging from as low as 10% to over 20% per annum.

As mentioned, if we are able to stomach the risks, P2P lending is a great way to diversify our investment portfolio.

Nonetheless, we would not advocate allocating a large percentage of your total investment assets into P2P just yet. At least not until the P2P platforms start to reduce the lack of transparency issues mentioned above.

Read Also: How Peer To Peer Lending Can Help SMEs

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