Let us consider the principal risks facing today’s prospective P2P ISA investors.
The following apply specifically to typically peer-to-peer business lending platforms but could easily be extended to cover the two other main forms of peer-to-peer lending (property and individual loans).
As with all lending (peer-to-peer or otherwise), the largest and most obvious risk facing the lender is that of borrower default – in other words, the risk that the borrower will fail to make good their repayment obligations to you as lender.
In any lender/borrower situation, the lender’s capital is – to a greater or lesser extent – at risk; though it is possible to mitigate this risk in certain situations.
Traditionally, peer-to-peer lenders in the ‘personal loan’ space have provided unsecured, personal loans, with little or no recourse for recovery. The risk is somewhat mitigated by the fact that, often (though not always), the lender is able to spread his or her loan book across dozens, even hundreds of borrowers – meaning that any individual default would be limited to the extent of that lender’s exposure to that one individual.
Business-lending peer-to-peer platforms are a little more complicated from a risk perspective, particularly where lenders are providing capital to fund specific companies (thus removing the risk spread enjoyed by lenders on some of the individual loan platforms).
To counter this, many of the business lending platforms operate strict risk control methodologies. Some will only enter into asset-backed loans, i.e. lending only where the value of the loan is secured against an underlying asset within the borrower’s business. This security could take the form of property assets (land, buildings) or even equipment and machinery, where appropriate.
In such a situation, the lender’s risk is somewhat mitigated by the fact that, in the event of a borrower default, the lender will receive title to the secured asset, which in theory could then be sold on to recover any shortfall in the borrower’s repayments. The mechanics of this security are very similar to that of a homeowner mortgage.
In the event that these recovered funds are insufficient to recover the full amount of the loan – which may be the case if the loan was secured against an illiquid asset, which has to be sold in a hurry at below market value – the p2p platform may be able to launch further proceedings against the borrower, and they will usually make you aware of progress during this exercise.
Specifically for property-related p2p loans, there is an additional risk on the borrower’s shoulders – the underlying behaviour of the property market. A downturn in the UK property market could make it very difficult for the borrower to meet their repayment obligations if, for example, the rental yield of a property which had been purchased via a p2p loan dropped to the extent that it could no longer meet the interest obligations of that property purchase loan.
Despite booming in recent years the p2p lending sector is still relatively embryonic. It is not unthinkable to envisage a situation in which one or more of the actual p2p platforms enters financial difficulty – there could be a huge number of reasons that this might occur.
As a lender who has placed funds within a p2p platform (regardless of whether that platform and/or the loans held within in it are p2p ISA eligible), there would be a significant risk to one’s capital in the event that the platform were to stop trading. It is likely that, in the event of a platform ceasing to trade, a number of that platform’s borrowers might be motivated to withhold capital and interest repayments on their loans – largely because such borrowers would not want to pay funds into a platform where they do not know for sure that the funds would be used to pay down their loan balances.
Most of the established platforms have made some inroads to ensuring that in the event of platform insolvency the risks to the lender’s capital would be increased no more than is necessary. Such measures would typically include the use of segregated client (borrower/lender) money accounts, so that the borrower’s repayments (and cash owed back to the lender) are kept physically and legally separate from the operating cash held by the p2p platform itself. There will typically be a number of account trustees in place to ensure that cash cannot freely move between borrower, lender and platform unduly.
Interest Rate Risk
This form of risk has in many ways been below the radar for some years now and relates to the prevailing interest rates available on the open market at any given point during the term of the loan.
Supposing you as a p2p lender were to lend £10,000 via a p2p ISA for 5 years at 5%. Let us also suppose that, once committed, these funds cannot be withdrawn – at least not without incurring a severely detrimental interest penalty.
If prevailing interest rates outside of this agreement (say Cash ISAs, even regular bank savings accounts) were to see a rise in interest rates to say 6% during the course of this loan, the lender is going to be worse off to the extent that he/she cannot move the capital from the p2p platform (where it is earning a steady 5%) into the external 6% account.
Whilst not a specific risk to capital itself, it is worth considering that there is always going to be a cost-benefit trade-off.
There is also a risk that, should inflation rise above 5% during the course of the loan’s life, the value of your loan capital (in real terms) will deteriorate to the extent that inflation exceeds the annualised interest receivable on that loan balance – though in reality, it may be the case that this 5% represents the ‘next best option’ given your risk profile.
P2P Loans are not covered by the FSCS
This is a major risk factor which must be given good consideration prior to entering any p2p lending agreement. Peer-to-peer lending is not the same as leaving your money at the bank.
Unlike a regular bank savings account, peer to peer lending is not covered by the Financial Services Compensation Scheme. Your capital is therefore at risk.
Lenders are urged to take note: whilst most platforms are regulated by the Financial Conduct Authority, there is a distinct difference between the FCA (which regulates the sector) and the FSCS (which provides loss compensation).