Peer-to-peer lending reinvents banking as we know it. What began about a decade ago as a means to borrow money for those who couldn’t do it at the banks is now becoming a mainstream financial instrument. The volumes of loans are increasingly growing, showing incredible 300% growth over a single year as measured by April 2015. Although this growth is partially spiked by unprecedented venture capitalists’ interest in the market, the growth levels are expected to break the records for a long time to come.
Predictably, with so much venture capital, P2P lending was bound to interlace with the rest of financial world. Banks are looking to either integrate or partner with the platforms that offer such services and private capitalists are taking the opportunity very seriously. After a decade of loans given online, private investors are ready to consider these loans as a viable investment portfolio. For Wall St., this is a perfect time to step in – average yields on such investments are at 7%, compared to near-zero yields on government bonds and media attention never leaves the marker.
Derivatives are now being introduced to satisfy investors’ demand for P2P assets. Apart from high yields on P2P loans, there is another major difference of these derivatives from other loan-based securities – there is no single type of collateral that borrowers provide. Moreover, there is none in many cases. The loan volumes are relatively small and short-term; and the borrower has to return the money to a particular person. This concept created a self-controlling mechanism, whereby lenders pick borrowers, betting their own money and borrowers feel more responsible as compared to dealings with consumer banks.
There are difficulties, however, in creating a security that would mimic all the features of P2P loans, as well as their risks and high yields. That is why smaller firms are trying to master this idea and bigger banks are waiting to step in at a later stage. There are also fears as to whether securitization will not lead to another subprime crisis. But, should a derivative that adequately represents movement in P2P market be created, there will be little resemblance to the boom-era mortgage-backed assets. In fact, it will work in an opposite direction – by modifying risk assessment and providing borrowers with ‘just’ interest rates that come directly from the financial markets.
This puts traditional banking at risk. If P2P-loan-backed securities are to be massively traded, the interest rates for borrowers will be lower than they otherwise would get in a bank. This is simply because banks have much higher administrative expenditures and are subject to stricter regulations, effectively resulting in a higher fee as compared to a P2P platform that only needs to administer virtual users and facilitate transactions.
The interest rates for P2P borrowers might go lower even more. Investors are already eager to use P2P derivatives for hedging purposes. Most of the loans are short-term and returns are accurately predictable. Some of the investors will be willing to forego a small percentage of the yields for the increased liquidity that P2P-backed assets will provide.
The derivatives themselves are likely to take the form of credit-linked notes with total-return swaps, not the credit-default swaps that many attribute to the financial crisis of 2007. SLMX that is writing the documentation has partnered up with AK Capital LLC that will execute the trades and plans to bring the first derivatives to the market by the end of this year. The derivatives will be based on the loans given through LendingClub that was valued at $9 bln at last year’s IPO. Without doubt, others will follow the lead and Wall St. will soon see a new type of securities on the market. The question is how much will it influence the actual borrowers and how consumer banks will adapt.