Part 2 of an interview with Gilad Woltsovitch, founder of the online lending platform Backed, Inc. Read part 1 here.
What happened after 2013?
The whole source of capital has shifted dramatically, and the reasoning is that in building a marketplace, you always have two sides to fill.
Because of the environment of 2008, with no credit sources, there was endless flocking of borrowers to lending platforms and the supply side for credit was very hard to fill to catch up with the demand. Platforms have been fueled by VC funding, with a mindset of capturing market share and cared less about showing profits, and more about booking more and more loans.
What happened was that the lending platforms needed to market to enough retail investors to support the high demand. They needed to collect a lot of individual lenders in order to have a real diversified or decentralized source of financing for such a large amount of loans. In order to solve that, VCs started fueling platforms with their own balance sheet lending, saying “Ok, until you find enough resources to fund these loans, take some of our equity money and start giving out loans and carrying on your balance sheet as debt.”
When that started to scale up, they were allowing themselves to be a little more lenient in the risk models because they weren’t dealing with other people’s money, and they saw more and more coming in. They saw the valuations going so high, it was a little less painful to lend that money out.
That’s all they focused on. Giving up on those stringent controls of risk meant that they have higher defaults which showed up only 3 years later, in 2016. While the market share was going up so rapidly, the hedge funds and the banks saw a great opportunity and said, “okay, they need supply to fill up the high demand for loans,” so, along with the balance sheet model, the marketplace lending paradigm came into place, and p2p lending shifted almost entirely from connecting borrowers and lenders to connecting between loans and centralized sources of finance, either balance sheet, or selling it directly to institutional investors who started having much more demand on how to price the loans themselves, and access to the inventory.
Institutional money caused a bit of a problem because they forced the peer to peers to change?
Yes. When you’re a marketplace lender and you need to fund $100 million in loans, you need to have 10,000 individuals deposit $10,000, it’s a big challenge. But if you have a Wall Street hedge fund come up to you and say “I’ll give you $100 million,” then you allow them to dictate some of the business metrics.
They don’t only dictate the cost of capital, they also require you to hire lawyers, and to hire grading companies, and to hire other known mediaries(?), notaries to vet and proof stamp everything that you do so they will deem it appropriate for them. That’s more money that someone needs to pay. It’s a cost that needs to be taken on by someone in the lending equation.
That started jacking up the prices because lending capital itself was becoming more expensive as retail investors were expecting 5-6%, but hedge funds like to see double digits. All of these caused platforms to rush in to gain market share on very unstable sources of capital that are very much just following where the highest return will go.
This led to the centralization of capital sources and created additional risks. Concentration risk entered into it when you solve the supply side by letting hedge funds finance your loans, it puts some sort of ease on the platforms to continue to focus on the borrowing side, and taking this false assumption that the hedge funds will always be there.
It all hit the fan in 2016, and there was a huge trust issue between the lenders of the hedge funds and the platforms. They pulled out all their funds from most platforms.
It sounds like 2016 saw a huge vacuum open up in online lending?
Yes. A lot of small platforms did not survive. This centralized a lot of the power within the platforms that were able to do securitizations. Because the hedge funds pulled out, balance sheet lending is almost the surviving model of all the alternative lending models.
Platforms get a credit facility from institutional investors, whether it’s a hedge fund or a bank, this way those institutional investors are hedged against the risk. They give you the credit facility and you pay them back interest rates.
A balance sheet lender gives out loans at a higher rate than its cost of capital and lives on the margin.
You make it sound like individual investors and individual lenders are both getting held with the bag?
The originators themselves who are issuing those loans on behalf of the capital that they are paying for are suddenly stuck with a whole lot of debt on their balance sheets. The platform generates loans with an average of 4 years per loan. if you are issuing $1 billion in loans, you have an average of $4 billion on your balance sheet that you can’t offload. There is no secondary market for it. You cannot liquidate or leverage those assets in order to grow your business.
Platforms have become digital agents for the banks and institutional investors. They source out all of the borrowers. They do the pricing. They fund the loans. But there always constantly squeezed within a margin between the cost of capital and the rate they can lend out while still being competitive.
That is why the platforms who have access to cheap capital are the big survivors.
Do you have a better solution?
That’s exactly why we started Credium.
The industry transformed into something it was not set out to be. Now individual investors can only access this lucrative asset class by buying tranches in securitized SPVs by brokers who are selling off securities of platforms. By paying all these intermediaries in the middle, you end up receiving a much worse deal than you would if you directly lend, which was the original p2p vision.
The borrowers end up paying more because there’s more middle men as the value chain got longer.
The silver lining in all of this is Blockchain. By 2016, it matured enough to truly decentralize this whole complex system of online lending which requires transfer of accurate trusted information between two parties who want to transact.
All this complexity can be solved by setting up a secondary market that will allow the 98% of platforms operating by holding debt on their balance sheet to go ahead and liquidate their debt.
How does it address the trust crisis of 2016?
With peer to peer you had to trust the server of the platform that the information their hosting there has always been that exact same information, and nobody changed it in between. That’s why you have all these intermediaries to audit and make sure that the information that’s being transferred between two sides of the marketplace is accurate, and transparent, and time stamped, and everything is kosher.
That answers the crisis of trust? What about the barrier of liquidity?
We are setting up a secondary market which will allow any platform to sell their borrower notes as long as it’s registered and regulated as a security.
The lenders have the upside of offloading their debt.
Traditional peer to peer lenders have access to liquidity by uploading their loans and having somebody else buy it, without having to be a specific member of their platform. It gives them the chance to offload a huge amount of debt off their balance sheet, and focus on growth.
On the buyer side, we are allowing anybody to have full transparency to the risk of the note, the pricing of the note, the servicing history of the note. Anybody who wants can have exact accurate information in a smart loan contract that is locked on the blockchain.
How will this benefit individual retail investors over peer to peer?
With peer to peer you have to trust the platform issuing the note. If you want to put $100,000 in Lending Club notes, you have to part ways with that $100,000 for up to 5 years because those notes are going to start paying back on a monthly fixed income return.
If you want to liquidate in the middle, you have to find another Lending Club user who is willing to buy off your inventory. Since there is no real liquidity in that secondary market because there is a very small, closed system, you will have to give a very big discount just to get your money back before the period is over.
It’s a huge advantage if you are buying a note and you can park your money there for a few months, and just sell it off. We are introducing a complete supply side for liquidity.
What happens to online lending if there is no Blockchain or secondary market? What are the consequences if these disruptions don’t happen?
Online lending will stagnate.
Your secondary market is being set up to resume the growth in online lending?
We think that institutional investors like insurance funds have a great opportunity to enter this market if they know that they would have a secondary market where they can trade this asset. We are creating a tradable asset with the mechanics to have a fair market value and price discovery.
Can this do anything to the cost of capital for lending platforms?
Yes. We are also introducing new buyers to the market. We have a whole universe of crypto-investors who currently have no ability to protect against volatility. The only option they have today is to transfer to a pegged digital currency, which holds a reserve of fiat cash and protects their deposit, but they get no interest on it.
There’s a few downsides to that. One downside is the fact that this is not a security. It’s not regulated and you don’t really know if this capital sitting as a reserve for those pegged tokens is used for leveraging or other things.
The second is that it doesn’t pay any interest. All you do is protect against volatility. You might as well have put the cash under your pillow.
Parking it in this pegged currency is a solution that today reached $500 million in market cap of crypto-currency parked just to protect against volatility. There is a concentration risk because there is a single body controlling all of that half a billion dollars. If there is any failure of trust. If there is any failure in management of those funds, the whole market cap is at risk.
By backing up your cryptocurrency savings with borrower notes, you get it backed by a regulated security that has an originator accountable for the risk scoring, underwriting, and everything regulatory agencies require. You have servicers that are accountable for making sure that the loan is current, collected, and up to date, and you have the Credium Foundation that is also accountable that both the originator and the servicer are compliant and functioning in order.
You have a pegged cryptocurrency that is backed by a regulated security accountable to parties to make sure that the funds are backed up, plus, it pays you a return. You get interest for locking up those funds in a fixed income savings instrument.
The other upside is that you have a secondary market so if you want to liquidate it you can sell those tokens to somebody else.
The third advantage is that you don’t have concentration risk. We are onboarding as many originators as possible. If one of them fails, only those invested in that specific originator will get hit, but the market will be resilient because there are so many other originators involved.
How much more of the market share can be acquired once you set up a secondary market?
With a secondary market, online lending can go from 10% to at least 50% of the market over the next 5 years. Blockchain technology will enable people to transact using tokenized securities. There are no intermediaries to trading them.
That’s your goal?
The Credium Foundation has two arms. It has a protocol development, developing standardized risk pricing, decentralized exchange of borrower notes, pegged currencies to back those notes, that’s the protocol.
Then there is Creduim Foundation which we are calling the Alternative Lenders Alliance to participate in building the marketplace inventory, designing the product themselves – the fixed income securities that they are issuing today but as digital tokens, and working with regulators to ensure that the regulatory framework matches the requirements.
Blockchain delivers regulators on a silver platter all the information they can ever hope for. A decentralized marketplace will enable regulators to have full transparency and immediate access to all information exchanged at all times.
So, you are saying that Blockchain can add at least another half a trillion dollars to the online lending industry in the next 5 years?