How P2P lenders should counter “black box” accusations

The UK’s peer-to-peer lenders are shifting towards passive investment strategies. Funding Circle, the leading online marketplace for small business loans, called a halt to manual loan selection at the end of August. Henceforth it will funnel customers into one of two passive investment accounts, with a view to generating more consistent returns for all of its investors.

The change has earned the platform a number of disgruntled investors. One investor, commenting on an AltFi article, called it “the last straw”. “I'll be withdrawing all my funds from FC and placing them on more attractive P2P platforms,” he wrote.

Enthusiast investors have been gaming peer-to-peer lending platforms for years, exploiting their expertise in credit to earn premium returns. One strategy for doing this involves selling in and out of loans at choice moments in the return cycle.

The peer-to-peer lending industry can stomach a few less expert investors. The industry is for the most part constrained by borrower demand, not by a lack of lending capital. Zopa, for example, hasn’t on-boarded a new investor for six months – such is the investment demand among its existing customer base. On balance, levelling the playing field for all investors will be to the industry’s long-term benefit.  

Unless – and this is a big unless – peer-to-peer lenders come to be depicted as black boxes. Up to now, the industry has enjoyed a reputation as uniquely transparent within financial services, with many platforms making their full loanbooks available for perusal online. Of course, transparency varies platform-to-platform, but the practices of the very largest platforms has until now upheld the notion that good disclosure can align the interests of originators and investors in P2P.

A balanced article in The Times this morning chronicled the industry’s steady transition from manual to passive investment. Here’s an excerpt:

“The industry’s leading players all appear to agree that users’ interests are best served by a “black box” approach to arranging loans, which provides simplicity and paves the way for platforms to offer tax-efficient Isa products.”

The article goes on to question the extent to which investors understand the risks of their investments, given that many are now unable to pick who and what to lend to. It rightly questions how much can be gleaned from “unwieldy” online loan portfolios by the average investor.

James Hurley, who wrote the article, spoke to AltFi Data’s Rupert Taylor about the need for standardisation. He correctly notes that varying interpretations of what constitutes a loan default makes it even more difficult for individual investors to discern the quality of a platform’s lending.

Taylor says that standardisation of measurement and metrics would “ensure investors understand exactly how their capital is being lent”.

But here’s the problem: somebody has to do the standardising. In UK, that somebody is Taylor and his team at AltFi Data; they take cash-flow data from the UK’s four biggest platforms and produce comparable outputs, which allow industry observers to scrutinise performance in a very granular fashion.

Voila? Not quite. Access to the insights produced by AltFi Data costs a pretty-penny – considerably more than could be justified by the average investor.

How do we get around this? Individual investors might well be encouraged simply to learn that institutional eyes are closely monitoring the major P2P platforms’ lending. But surely there’s a more direct method of allowing them access to these insights?

At AltFi, we’ve previously argued for some kind of widget: powered by AltFi Data’s analytics tools, embedded on the statistics pages of the platforms it works with. These widgets would display a uniform set of headline performance metrics, such as net returns and cumulative loss rates, over given time frames. Many of the platforms already have statistics pages, but like the available online loanbooks, they suffer from a chronic lack of standardisation, and from a lack of third-party verification. A series of widgets could solve both issues.

The peer-to-peer platforms could then refocus their energies on publishing expected return metrics. The shift to passive investment strategies in P2P is driven by a desire to deliver more consistent outcomes for investors. A similar shift is taking place among investment advisors, according to recent research from Equifax Touchstone. Being able to measure a peer-to-peer platform’s expected returns against reality would equate to meaningful transparency – not just for a select few institutional investors, but for all investors. The proposed AltFi Data widgets would allow for this.

Another metric that would allow investors to get a better handle on risk is “probability of return”. The fact that more and more P2P investors are now funnelled into autobid accounts has led some observers to conclude that P2P is a “pooled” investment instrument, but it isn’t. Direct contracts still tie lender to borrower, meaning that performance isn’t uniform. Even very well diversified investors could find themselves falling foul of a spree of defaults, bringing their performance both below expectation and below the platform average.

P2P lenders are currently attempting to circumvent this issue with smarter autobid tools that prioritise the allocation of funds for investors whose returns are underperforming.

But the publication of a “probability of return” metric would enrich lenders’ understanding of risk at the point-of-investment. It’s an argument long-championed by London Fintech Podcast host Mike Baliman. What the concept boils down to is this: what percentage of investors have historically underperformed, matched, or outperformed the platform-wide return, and by what margins? Investors need to know this, because they need to know the likelihood that they'll end up in the unluckier portion of a platform’s investor base.

The peer-to-peer lending industry is to be commended for its attempts at transparency. But as one industry insider once told me: “nobody thanks you for transparency; they just want more”.

More may well be needed to counter the prevailing mood in the mainstream media.