The Beginning of P2P Derivatives?

By Georgina McCreadie on 6th May 2015

P2P/Marketplace Lending

We have written at length on institutional investors becoming involved in the peer-to-peer space and now it has almost been accepted that institutions have seen the value in this new asset class. The question is now how will the asset class adapt and how will the institutional investors mould it to maximise returns. And using derivatives seems to be one of the ways that investors are going to do this. 

The Beginning of P2P Derivatives?

In an article last week Bloomberg declared that P2P lending has gone “mainstream” and “no one is scoffing at peer-to-peer lending anymore – least of all, Wall Street”.

In this low yield environment peer-to-peer loans offer great returns compared to most fixed income assets. On average investors will receive about a 9% return (in the UK it is about 5%), much higher than the 0.25% on a 1 year treasury note for example, and this is continuing to drive institutional investors to the peer-to-peer market. 

Bloomberg reported that Michael Edman, a veteran of Morgan Stanley, is creating derivatives that will give investors a new way to bet on, or against, peer-to-peer loan performance. Edman runs New York-based Synthetic Lending Marketplace, SLMX, and it is expected that the form of SLMX’s derivatives are likely to take the form of credit-linked notes with total returns swaps, rather than credit default swaps. 

Edman explained:

“It’s a high-coupon asset that’s had very good returns for the short period of time it’s been around. I don’t have reason to believe that’s going to change dramatically anytime soon, but there are bad loans out there.”

He believes that the ability to short the loans could curb some of the enthusiasm for the asset class before any of the debt sours. Edman has much experience in the CDO space, having bet successfully against the unregulated mortgages before the 2008 crash. 

It has also been suggested that another firm, PeerIQ, is looking at entering the derivatives market. 

The problem with investing in individual P2P loans is that the investor takes on a huge amount of default risk, and this will vary over time. Loan defaults have been manageable so far in what has been a relatively benign credit and economic environment. But volatility may grow in the future and there is inherent unpredictability around default rates in this new asset class. Hedging this risk can be done with derivatives but the question remains over how these derivatives will look.  

One of the main issues in the P2P investment space is product standardization, as the platforms will have different lending criteria and different loans on the platform. It could prove difficult to provide a hedge when the underlying products are so different. Then there is the derivatives themselves – they are likely to be, at least initially, Over-The-Counter derivatives with specialized documentation which could reduce liquidity and fungibility for first mover users of the product. Transparency by the platforms (and a commitment to continue with that same level of transparency) and, almost more importantly, those who are structuring the derivatives is also key. 

The comparison has been made with the subprime mortgage market pre-crash. Investors are getting into a product where the value of the underlying asset may not be entirely clear. Platforms may also be tempted to lower borrowing standards to help ensure their investments remain a high yield investment and that they stay competitive compared to other investments.

Frank Rotman, a partner at QED Investors, an Alexandria, Virginia-based venture-capital firm that has invested in Prosper Marketplace Inc., Social Finance Inc. and 13 other P2P lending platforms, commented:

“It feels like the year 2000 again. Everyone is chasing ’it,’ but they don’t know what ’it’ is, and that is kind of scary.”

Sam Griffiths, MD and Co-Founder of AltFi Data, added:

“Having been involved in the credit derivative market right from its early stages, I can understand how derivatives on P2P could play a useful role and be additive to the development of the industry. However, the lessons from the past need to be remembered and observed.”

Another cautionary voice is Ron Suber, President of Prosper, who said in his closing keynote and the recent LendIt conference that the introduction of P2P derivatives “could be the end if it’s done wrong.”

The right mix of transparency and product standardisation will need to be found to allow an investors to hedge individual loan default risk. 

It is clear not all investors have faith in the P2P model. It has been reported that less than a year after going public Lending Club is the sixth most bet against stock on the New York Stock Exchange. Derivatives hold a large opportunity for the P2P industry as they will allow many more investors to become involved in the asset class, but as a potentially unregulated product there may be problems in the future with the pressure it may put on the platforms to perform. 

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