About a decade ago, peer to peer lending came on the scene. It was designed as a way for people to borrow money not just from banks or other lending institutions, but from individual investors. Anyone could go onto a platform like Lending Club or Prosper, and fund any of the loans on its platform. They could fund entire loans, or invest in fractions.
This new technology promised to cut out the middle man and enable the everyday depositor to make a bank’s return on their money instead of it sitting in a savings account generating 1%.
Peer to peer promised new methods of assigning risk by utilizing technology to gain more information on borrowers. New data points gave underserved markets like millennials another chance to access new capital.
By streamlining the process, fewer expenses to originate these loans would result in better margins for originators, smaller barriers to entry, more competition, and ultimately more innovation. With more transparency, individual investors would have all the information they needed to buy loans that would be paid back.
Everybody was supposed to win.
But it didn’t work out that way. What went wrong?
In their zeal to revolutionize lending, the peer to peers fell short. They were unable to execute working solutions to overcome the following challenges:
Too many middlemen.
Online lenders were able to streamline some of the steps and automate others, reducing costs. They still need lawyers. They still need credit rating services. They still need accountants, auditors, brokers, salespeople, and more middlemen to make their platform work.
Even though onboarding and underwriting are now more efficient, there are still huge expenses in acquisition, cost of capital, and servicing. The added value in the new lending model only brought down costs marginally, and not significantly.
Failure to Diversify.
A new breed of lender was hatched when platforms empowered ordinary customers to lend their savings out at 7-20% rather than parking in a standard checking account. This brought a diversity of investors and interests to this new form of lending.
It fizzled out too soon. To raise $100 million, a lending platform would have to encourage 10,000 customers to transfer $10,000 from their personal accounts to their platform. That requires an army of salespeople, all earning commissions. A bank, or large financial institution could fund $100 million in loans with a single order.
Which is exactly what they did.
They began to wield disproportionate power over the lending platforms. Peer to peer was supposed to offer everyone the same opportunity. The banks were able to muscle their way into control by scaling up the platform companies in a way no retail investor could. The banks began to demand to see the loans before everyone else. They were able to cherry pick the most attractive loans, leaving the pits for everyone else.
As lending platforms grew, hedge funds rushed in to provide lending capital. They saw the opportunity while interest rates for low. They could raise money at low rates, while personal loans still demanded higher interest, creating high margins. This created a single flow of capital to the online lenders, thus creating a concentration risk where all the money was coming from one place.
Hedge funds don’t originate personal loans, so they funded online originators to get into this market. This drove peer to peer away from lending to the people, and more towards lending for the hedge funds. The biggest sign was when lending platforms stopped offering fractional loans, which was a great opportunity for smaller investors.
Market Share over Monetization
Most lending platforms started with venture capital funding. The marriage between finance and technology, is complex. The traditional strategy of early stage tech companies is to prioritize gaining market share over profitability. With financial institutions, the bottom line is always, the bottom line: profitability comes first, then scale up.
Peer to peer lenders applied the tech model to a financial industry. As a result, standards for accepting new borrowers were relaxed, loaning money to less qualified people. By the first quarter of 2016, default rates skyrocketed. This resulted in a higher risk premium on everyone. The hedge funds pulled back all at once.
Supply kept on coming in, but they were unable to unload it to enough investors once the hedge funds pulled out. They had to pivot to securitization. The small investor gradually got edge out of the buy side.
Lack of Transparency
In giving retail investors the chance to loan money to people, they were supposed to have access to all the details involved in pricing the loan. As costs to maintain this lending model continued to rise, online lenders were only giving out enough information on potential borrowers to satisfy regulators. Too much uncertainty increased the level of risk for potential lenders within the platform.
Despite the innovations in user experience, underwriting, and measuring risk, online lenders are still struggling to fulfill their vision to revolutionize lending by increasing inclusion and reducing costs. Since mid-2016, the barriers of entry have risen dramatically for originators, as well as smaller investors. With less diversity in the market, liquidity remains a barrier to growth. The inability of both platforms and investors to offload loans from their balance sheet has caused a stagnation in the industry.
The winner takes all momentum has reasserted itself, and the big players have retained their title.
Gilad Woltsovitch is the Co-Founder and CEO at Backed Inc., responsible for designing the company’s first-class platform, UX and UI. Before Backed, Gilad co-founded iAlbums, a semantic curation engine for media players in 2010 where he served as the company’s CEO from 2011-2014. In 2013, Gilad also served as the entrepreneur in residence for Cyhawk Ventures and joined the Ethereum project, establishing the Israeli Ethereum meet-up group. Gilad holds a Masters of Art Science and Bachelors in Sonology from the Royal Conservatory of The Netherlands in The Hague, University of Leiden.