By Rupert Taylor on 16th May 2016
Much has been written about the recent travails of the US marketplace lending sector. The commentary has broadly reflected the vested interests of the various camps. To disruptors this is: ‘a step in the evolution process’. To the incumbent banks: ‘sure signs of flaws in the model’.
AltFi Data cannot disguise our own agenda. Our business is as an independent provider of data for benchmarking, pricing and analysis. As such, we are inclined to respond to every issue with cries of either ‘transparency’ or ‘disclosure’. We are seeking to provide data that can be used to inform investor decisions, to highlight the attractions of the asset class, and to hold both platforms and asset managers to account. To achieve this we have a vested interest in platform transparency. But we make no apology for this because we strongly believe that it is central to the emergence of a successful new ‘alternative’ asset class.
You will not, therefore, be surprised that we see disclosure as a major element of Lending Club’s recent troubles. Not correctly disclosing full details of what a client is purchasing is a colossal failing in any financial business. But in a disruptive new financial industry, which seeks to set itself apart in the field of transparency, it is unforgiveable. To us Lending Club's woes have demonstrated that Alternative Finance can no longer pay lip service to transparency. To understand why we must reflect on exactly why transparency is so central to the marketplace lending model.
Without transparency, online platforms that match borrowers and lenders, and take a fee for doing so, would present a very obvious representation of the agent/principal conflict. The platform is financially motivated largely by the origination and distribution of the loan. In fact, compared to the investor that ends up holding the loan, the platform has a relatively tiny ongoing economic exposure. To make matters worse, the platform has a significant hand in the pricing of the loan. This takes caveat emptor to an extreme. Under this scenario the lender, having zero alignment with the agent that sourced and priced the loan, has limited inclination to take and hold that risk at a price largely defined by the platform.
Prevailing thinking says that this conflict is solved by transparent disclosure. This disclosure serves a dual purpose. Firstly, loan level disclosure provides investors with the opportunity to perform due diligence on the loan, or more likely, loan groups. Secondly, platforms disclose their lending track record, i.e. the performance of all previous loans. This creates alignment by tying the fate of the loans to the fate of the platform. If the loans perform poorly, or turn out to have been mispriced, investors will cease to fund new origination, or at least will demand a fairer price in the form of a higher yield. In a worst case, they could desert altogether.
But there is a problem. The first of these disclosures faces significant problems in the real world. The practical usefulness of loan-by-loan analysis is limited. In the UK, the industry body - the P2PFA – recently made loan book disclosure a requirement of membership. Moreover, constituents of the Liberum AltFi Returns Index UK have been disclosing their loan books since February 2014, and Funding Circle has done so since its inception. In the USA Lending Club also discloses its loan book, with an impressive level of granularity, on a daily basis. Information on new Lending Club loans is lagged by three months to ensure that price sensitive information is not disclosed. But this is merely because, as a quoted company, it would not be appropriate if the market could second-guess revenues based on new loan origination.
So Lending Club successfully ticks that box. But how much scrutiny is actually brought to bear as a result of the disclosure of static loan books? It is likely that all but the most rudimentary analysis is far beyond the retail investor. Lending Club alone has originated over 1.5m loans. Meaningful analysis of these files requires significant computing power, coding ability and financial expertise. This is made even harder by a lack of consistency in the fields provided by different platforms and the variable quality of the underlying data. Even institutional investors would need to make a significant investment of time, technology and expertise to perform meaningful analysis.
In practice this means that the primary method of disclosure adopted by the industry so far is of only limited use. Loan book disclosure represents an excellent first step, but more is required to deliver enough transparency to create the alignment that the model requires. It is reassuring that some institutions are making the investment required to analyze these loan books, and are committing significant amounts of capital on the back of this research. Equally, independent sources of data analytics are slowly emerging to turn loan book information into digestible information and to bring this analysis to a wider audience. AltFi Data will be launching AltFi Data Analytics later this month. This tool will show standardised and comparable metrics for the 4 largest UK marketplace lending platforms. For the first time investors will be able to review net returns, gross lending rates, arrears, and defaults, on a comparable basis, across platforms, borrower type and security type. Indeed, the LARI index can now be broken out so that the net returns of each platform can be compared on a consistent basis. But it is worth noting that this tool has been two years in the making. Only now are loan books being represented by tools that allow meaningful analysis to be performed on a wide scale. Delivering transparency takes time and remains a long way from covering the entire market.
Whilst there are practical obstructions to performing widespread due diligence from loan book disclosure, the fact that this disclosure is so widespread, and that meaningful analysis is now beginning to be brought to bear, is representative of a developing culture of transparency. Over time the architecture will emerge that supports these disclosures and will increasingly facilitate more widespread analysis. But given the difficulties of analyzing loan book data, in the near term this disclosure should not be seen as a panacea. Whilst Lending Club discloses impressively granular daily loan book data, evidence is emerging that it has not yet developed this culture of transparency.
The problems at Lending Club seem to have been a combination of process, disclosure and conflict. A lender had requested a particular set of loan characteristics but these requirements appear to have been knowingly unfulfilled. Further investigation revealed that CEO and founder Renaud Laplanche had a significant conflict of interest by recommending that the company make an investment in a fund that he had not disclosed his own beneficial ownership of. Together these failures represent clear signs of an absence of this culture of transparency.
In fact it reveals a further problem – transparency is not an absolute. It is very hard to even define it in absolute terms. Lending Club holds itself out to be transparent. And on many measures it is. What more transparency could investors want than daily disclosure of a granular loan book? But identifying transparency is subtler than that, especially when loan book disclosure is actually of limited practical use to the vast majority of investors.
In reality there are degrees of transparency. The limited practical use of static loan books, together with Lending Clubs’ problems, also reveal that transparency needs to be cultural. As in so much of finance – the devil is in the detail. Investors will begin to recognize that satisfying a blunt criterion such as loan book disclosure may not prove that the platform is genuinely creating alignment with investors. This is why platform due diligence remains critical to investment decision making in marketplace lending. Because the asset class is made up of many tiny loans, and standardization has not yet been achieved, analysis of the process that the platform uses to select, price and allocate loans is far more important than analysis of each underlying loan. Even more important is an understanding of the platform’s culture. Does the platform really subscribe to the principle of transparency? Or are they just keeping pace with expectations in order to appear transparent?
Perhaps the most important clue that indicates the development of this ‘culture’ of transparency may prove to be the attitude of a platform to capital markets and the emergence of secondary market liquidity. Just as the presence of institutional capital should bring reassurance to the entire investor base, as it suggests that professional scrutiny is being brought to bear, a platform that embraces the secondary market is a platform that welcomes and accepts the extra scrutiny that this entails. Under the leadership of Laplanche, Lending Club did not seem to welcome this scrutiny.
As with any disruptive industry, marketplace lending is offering a better deal to consumers. Customers are the sure fire winner as disruption delivers a better value product – in this case in the form of better rates for both borrower and lender. Whilst technology is responsible for a significant part of the value creation that can now be shared between borrower, lender and company shareholders, ultimately a better value proposition that successfully disrupts the incumbents relies on reaching significant scale to achieve profitability. In the case of all of the industries where technology has facilitated a disruptive new model, the precedent is clear. Disruptors destroy the economics of the incumbents, deliver better value to the consumer, but only achieve profitability after huge market share gains. A functioning secondary market would create the virtuous circle that could deliver this scale. The assurance of liquidity would encourage investment and this in turn would deliver a lower cost of capital to ensure even better value for borrowers, which would in turn drive origination. One would imagine that creating a functioning secondary market to deliver an improved proposition to both borrowers and lenders and to almost guarantee further market share gains versus the incumbent banking sector would be at the top of the agenda for all platforms. Especially for Lending Club - the market leader in the world’s leading economy?
Or perhaps not. As title sponsor of LendIt USA – the largest alternative finance industry conference – Renaud Laplanche gave the opening presentation just over four weeks ago. In a 40 minute ‘keynote’ entitled ‘Marketplace Lending’s Next Phase of growth’ there was no mention of secondary markets. Not even a reference. Not even a vague, euphemistic allusion. Nothing.
On top of increased scrutiny, secondary markets will also result in a loss of control for the platforms. At present platforms control the primary market pricing in these new ‘alternative’ loan assets. Gross lending rates adjust according to investor demand, but at the behest of the platform. Lending Club itself has increased lending rates three times in the past five months. This process began when the Fed began raising rates and Lending Club matched this with a 25bp rise in rates across all risk bands. It has since continued to raise lending rates - by an average of 32bps in January and by a further 23bps in April. A liquid and functioning secondary market would provide its own pricing signal. Whilst one could always make a case for older vintages trading at a different rate to new loans, it is nonetheless likely that a dynamic secondary market would soon become the major determinant of primary market pricing. And this would amount to a significant loss of control for the platforms. Just as transparency may not yet have truly coloured the culture at Lending Club, it would seem that the urge to retain as much control as possible, even at the expense of growth, certainly has. It would seem that the twin realities of increased scrutiny, and loss of control, have not thus far been accepted by Lending Club.
The path to a liquid and functioning secondary market is unlikely to be smooth. Investors are buying assets which have been originated by a completely new source and which offer a limited track record. Furthermore, as discussed provision of detailed, comparable data remains in its infancy. In this regard Prosper deserves huge commendation for the progress that has been made at interacting with capital markets and delivering successful secondary market transactions. This process has not been seamless. Ryan Weeks has written previously of the tensions that have developed. But Prosper, joined by the likes of SoFi, have delivered the first pioneering steps that are essential if the asset class is to deliver on its huge potential. These platforms demonstrate the culture of transparency required to allow the required scrutiny. A picture is emerging that would suggest that public loan book disclosure on its own may not in fact be the best indicator that investor scrutiny is genuinely being brought to bear. A better indicator may be evidence of institutional activity. If a loan book is not disclosed publicly, but is being provided to an institution with the tools required to perform genuine due diligence, this could in fact serve as better evidence that the loan book stands up to scrutiny.
Ron Suber – President of Prosper – made a sharply contrasting keynote at Lendit USA, just a few hours after Laplanche had spoken. In a presentation entitled ‘The Evolution of an Asset Class’ he explained:
“We need to be in every single fixed income asset class. We will do this through product expansion, and liquidity, and secondary markets and listed vehicles. All those things have to come together, for us to make that big leap.”
In fact his talk was littered with references to capital markets that he described as “a key component” of the industry’s ultimate success. He went so far as to explain that the industry has to “stay transparent and open in order to thrive”.
The contrasting content of these presentations is an excellent illustration of the notion of a culture of transparency. The scrutiny that institutional investors bring to bear requires the highest levels of disclosure. Platforms that embrace the challenge require a culture of transparency. Only armed with this will they rise to the challenge of delivering the information and data required to ensure that appropriate due diligence can be conducted – both on the assets and the originating platform itself.
Delivering genuine transparency also relies on the appropriate industry architecture. The recent establishment of the The Marketplace Lending Association, which will serve as a US industry body in a similar manner to the UK P2PFA, is an excellent development but it is notable that it has only just been formed. This culture of transparency cannot thrive in a vacuum. On top of willing platforms it requires: effective and enlightened regulation; an effective industry body; and data analytics providers that are free from conflict to allow unbiased representation of credible data.
If transparency is allowed to thrive then capital markets will fuel a further wave of growth. This growth will benefit consumers in the form of better rates, and the industry in the form of the scale required to deliver profitability. But to access this growth the industry needs to ‘walk the talk’ on transparency. And that requires more than just lip service. Loan book disclosure on its own is not enough. Until the data contained within these loan books can be usefully analysed, investor due diligence will be as much about identifying the existence of an appropriate platform culture. Certain clues can assist in identifying this culture. Platforms that welcome institutional participation, or even better, are actively encouraging the further scrutiny brought by the secondary market, demonstrate the culture of openness required to allow scrutiny. These platforms demonstrate a culture in which control over pricing is ceded for the greater benefit of delivering the liquidity that will fuel growth. They demonstrate a culture built on full and fair disclosure, which avoids conflicts of interest, and would not consider knowingly allocating investors with assets that they had expressly asked to avoid. Recent events would suggest that, thus far, that culture appears to have been absent from Lending Club. The industry on both sides of the Atlantic must take heed. Loan book disclosure is not enough without the tools to usefully analyse the data. The industry must recognise this and work to build the architecture that allows this culture to thrive.