A growing number of advisers are starting to consider and recommend peer-to-peer (P2P) lending as an investment solution for clients. Perhaps you are thinking of getting on the crest of the P2P lending wave, too. Maybe you have read some of the recent articles on how technology is changing this space and want to know more. Or, perhaps you’ve already done some research and just want to be sure you’re considering the right things before you offer P2P solutions to your clients.
In this article, imac legal & compliance looks at the things you should consider if contemplating this Fintech-enabled investment opportunity for your clients.
The basics: what is peer-to-peer lending
Matching borrowers with investors has been at the heart of financial markets since the advent of markets themselves – matching lenders with borrowers. So, there’s nothing new in the concept of P2P lending. But technological advances have brought about innovative new products and offerings, including new online ‘matching’ facilities. With these technology advances (Fintech), P2P lending can take much greater scale than before. Fintech also allow much greater tailored matching of lenders directly to borrowers – without the need for intermediaries such as banks.
But at its heart, a P2P lending arrangement (or ‘marketplace lending’ as ASIC terms it and would prefer we all referred to it as. Good luck with that, ASIC!) is an arrangement where an investor invests money to seek a return and that money is then lent to borrowers who can be either businesses or consumers.
How are P2P lending arrangements structured and what are the risks?
This is where much of the development has taken place of late. Technology has enabled P2P solutions that simply weren’t possible before. Typically, P2P products are now made available via an online platform, e.g. via a website, which facilitates loan requests.
But even though technology is one common feature, P2P products can and do vary considerably. First, from a regulatory perspective, the way the arrangements are structured will determine what type of financial product it is. E.g. some are structured as managed investment schemes, while others may issue derivatives or securities, or operate as a financial market. And, if it’s a managed investment scheme, it may be registered or unregistered, retail or wholesale.
It is important to understand these structures first as each has its own set of risks, pros and cons. Also, the disclosure obligations with each will be different. Naturally, if the P2P operator, by virtue of the design of their P2P solution, is operating a financial product (such as a managed investment scheme) they will need to be properly licensed under the financial services regime, not just credit. And you, as an adviser, will need to be authorised to advise and deal in the relevant financial products.
Who are the borrowers?
Some operators will provide lending solutions only to retail consumers (meaning the National Consumer Credit Protection Act regulates the conduct of the parties), while others may focus on business lending, short term loans only, small credit amounts, secured or unsecured lending, particular demographics, equipment financing, or wholesale lenders. Knowing the potential borrower pool helps to identify and understand the risks.
Is the platform itself any good?
The platform itself – how good is it? As P2P is a Fintech solution maybe it’s too easy to assume that the platform itself will just work and work well. But as you would know from your use of other investment platforms over years (such as IDPS), they can be excellent or infuriating or anything in between. It is important to do your due diligence to identify whether the platform provides the functionality you and your clients require and whether the administration that backs it up is reliable, accurate and timely.
How are client monies dealt with?
One of the things it is important to understand is what happens with client monies when not invested. Unlike traditional MIS investments where operators simply purchase more underlying investments (e.g. shares) when a new client brings new funds, P2P relies more intimately on supply and demand. What happens if the operator can’t attract enough borrowers for all investors’ funds? Will investors be entitled to any interest on monies in a cash account? Will they be able to withdraw funds without delay? And how safe is such money? i.e. is it held in trust and separated from the operator’s assets? Note that it is not unusual for P2P operators to claim a portion or all of the earnings of such cash monies.
Also, do investors get to select the loans they wish to invest in or do they instead get to select certain criteria only, such as a prescribed or desired interest rate and loan term? If investors don’t get to choose who their borrowers are, you need to have absolute faith in the operators (and anyone else promoting the loans) to ensure that there is a fair and equitable way of matching investors to borrowers so that your investor clients don’t, for example, get lumbered with ‘lesser quality’ loans/borrowers.
Naturally, some arrangements are riskier than others. E.g. if your investor clients are the only investors funding a loan for a particular borrower, this is a concentrated credit risk. Or, does the P2P lending product offer investors diversification across a large number of loans so that no one investor will ever be the sole lender funding a particular loan arrangement?
In any case, it is vital to have confidence in the P2P provider’s lending assessment procedures and criteria, as these will be some of the biggest determinants of the level of risk your clients are taking on. Some P2P operators will deal only with ‘good’ credit risk borrowers while others will have a broader dragnet.
Also, it is necessary to gain a good understanding of the P2P operator’s rules and procedures if or when a borrower defaults. Do you know if or when operators can sell the debts, leaving investors with little or no input or recourse?
Get to know the P2P operator
In fact, the more you know about the P2P operator and the people behind it the better. As not many can present a long track record in Australia, you will need to have confidence in the people running the platform. If they are not known to you personally, they should have demonstrable track records in credit and/or financial services as well as technology.
The other aspect of the technology itself is its efficacy in fighting fraud and cybersecurity risk. You need to ensure that your investors’ personal details as well as their investments are well protected.
Unsurprisingly, conflicts are also one of the bigger considerations for you. P2P operators may profit from both investors and borrowers. You should have a look at the way conflict risk is identified and managed. And be particularly careful of any operator that will itself be a borrower.
And last but not least, the fees and potential returns associated with each offering ought to be well and truly considered.
imac legal & compliance has developed a FREE checklist for advisory firms looking at offering P2P lending as an investment solution so you can be sure you’ve considered all the right things. SEE BELOW.
Ian McDermott is Principal Lawyer with imac legal & compliance pty ltd, a legal and compliance advisory firm helping small-to-medium financial services businesses.
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