Phil Young: Why I’m troubled by P2P lending


I am open minded, but peer-to-peer lending troubles me and there are a few myths and rumours which need debunking:

You do not have to advise on it to be independent

While peer-to-peer lending is FCA-regulated it is not a retail investment product, so you do not need to advise on it to remain independent.

Should you remove permission?

We do not really know where any of this will go in future. It could end up covered by the Financial Services Compensation Scheme. There is already an innovative finance Isa and talk of allowing it into pensions. So it is advisable for investment firms not to remove the permission as you will only have to pay to add it on later should you wish to advise in this area. Insurance-only firms not intending to get involved in peer-to-peer business should consider removing this new permission as keeping it will have an impact on financial resource requirements and regulatory fees.

Check your PI

Professional indemnity insurers are wary of this right now as it is a niche market with little track record as an advised investment. If you want to advise in this area check it is covered and what the excess will be.

What are insurers worried about?

Peer-to-peer is not an evil product per se, there is just a risk that a significant number of advisers will offer this as an alternative for cash, select the highest rate not the most stable platform, and prompt a wave of complaints when it does not go to plan.

What is often referred to as a “toxic” product is more a combination of factors leading to a high volume of complaints which taints the rest of the market.

It is not cash, but…

In my experience, the people looking at peer-to-peer as an investment are not selling down equities, they are investing from cash. These are people not wanting the “risk” of equity markets, but looking for a higher return than cash. As the headline attraction is the rate, it is hard not to anchor our understanding of peer-to-peer lending to cash.

“More risky than cash, but less risky than equities.” That is how it is marketed and reported on in the press. It appears less volatile, for the reasons stated below, and for many people volatility equates to risk. However, risk to capital could be considerable, and Lord Adair Turner has already warned of irresponsible lending in anticipation of huge losses among peer-to-peer lenders. FCA chief executive Andrew Bailey also expressed concerns around this new market.

The dangers of suck it and see

Using Ratesetter and Zopa looks and feels like investing in a fixed interest paying deposit account. The protection funds smooth out regular investment returns so you get the same return each month. Bad debt is chased down behind the scenes, giving the impression that there is no bad debt at all, unlike equity markets, where a daily price gives a very visible indicator of the ebb and flow of equity markets. A false sense of security which could lead to overconfidence and overexposure.

The future for this market, and its conflict of interest

My guess is the UK market can only go one of two ways:

  1. Investment returns will continue to drop as the drive towards greater professionalism, security and regulation will force costs up at the expense of sizzling headline returns. This will curb exponential growth but avoid any high profile disasters.
  2. It will grow exponentially as a low interest rate environment drives demand for better returns than cash. There could be a boom in new lenders, who have to take on riskier debt to satisfy demand. This means more bad debt, failures, and a decline in confidence.

Fundamentally, there can only be a finite number of people in the UK needing to borrow, who have a good enough credit rating to be trusted but not good enough for a bank to lend to. I do not know how big that market is, but this seems like a crucial question. Either the market must cap itself at a certain level, or accept more risk to keep growing.

There is an inherent conflict of interest in running a peer-to-peer platform that relies on satisfying both investors and borrowers, which can lead to a less sceptical approach than lending your own money.

How does it fit in with financial planning and investment theory?

How does it fit into an investment philosophy? Is peer-to-peer an asset class? How does it diversify a portfolio, and which other asset classes does it not correlate to? It is a bit too early to reliably assess how it performs under different, stressed market conditions.

Tax structures such as venture capital trusts and enterprise investment schemes do not fit neatly into a mainstream investment philosophy either, but can point to the tax advantages of such schemes as the main reason for taking on what might otherwise be an unacceptable level of risk. For now, I can see the attraction to direct investors, but I am not sure this is ready for the adviser market just yet.

Phil Young is managing director at Threesixty