How One Online Lending Platform Emerged From the Trust Crisis

Credium

Part 2 of an interview with Gilad Woltsovitch, founder of the online lending platform Backed, Inc.  Read part 1 here. What happened after 2013? The whole source of capital has shifted dramatically, and the reasoning is that in building a marketplace, you always have two sides to fill. Because of the environment of 2008, with […]

Credium

Part 2 of an interview with Gilad Woltsovitch, founder of the online lending platform Backed, Inc.  Read part 1 here.

What happened after 2013?

The whole source of capital has shifted dramatically, and the reasoning is that in building a marketplace, you always have two sides to fill.
Because of the environment of 2008, with no credit sources, there was endless flocking of borrowers to lending platforms and the supply side for credit was very hard to fill to catch up with the demand. Platforms have been fueled by VC funding, with a mindset of capturing market share and cared less about showing profits, and more about booking more and more loans.

What happened was that the lending platforms needed to market to enough retail investors to support the high demand. They needed to collect a lot of individual lenders in order to have a real diversified or decentralized source of financing for such a large amount of loans. In order to solve that, VCs started fueling platforms with their own balance sheet lending, saying “Ok, until you find enough resources to fund these loans, take some of our equity money and start giving out loans and carrying on your balance sheet as debt.”

When that started to scale up, they were allowing themselves to be a little more lenient in the risk models because they weren’t dealing with other people’s money, and they saw more and more coming in. They saw the valuations going so high, it was a little less painful to lend that money out.

That’s all they focused on. Giving up on those stringent controls of risk meant that they have higher defaults which showed up only 3 years later, in 2016. While the market share was going up so rapidly, the hedge funds and the banks saw a great opportunity and said, “okay, they need supply to fill up the high demand for loans,” so, along with the balance sheet model, the marketplace lending paradigm came into place, and p2p lending shifted almost entirely from connecting borrowers and lenders to connecting between loans and centralized sources of finance, either balance sheet, or selling it directly to institutional investors who started having much more demand on how to price the loans themselves, and access to the inventory.

Institutional money caused a bit of a problem because they forced the peer to peers to change?

Yes. When you’re a marketplace lender and you need to fund $100 million in loans, you need to have 10,000 individuals deposit $10,000, it’s a big challenge. But if you have a Wall Street hedge fund come up to you and say “I’ll give you $100 million,” then you allow them to dictate some of the business metrics.

They don’t only dictate the cost of capital, they also require you to hire lawyers, and to hire grading companies, and to hire other known mediaries(?), notaries to vet and proof stamp everything that you do so they will deem it appropriate for them. That’s more money that someone needs to pay. It’s a cost that needs to be taken on by someone in the lending equation.

That started jacking up the prices because lending capital itself was becoming more expensive as retail investors were expecting 5-6%, but hedge funds like to see double digits. All of these caused platforms to rush in to gain market share on very unstable sources of capital that are very much just following where the highest return will go.

This led to the centralization of capital sources and created additional risks. Concentration risk entered into it when you solve the supply side by letting hedge funds finance your loans, it puts some sort of ease on the platforms to continue to focus on the borrowing side, and taking this false assumption that the hedge funds will always be there.

It all hit the fan in 2016, and there was a huge trust issue between the lenders of the hedge funds and the platforms. They pulled out all their funds from most platforms.

It sounds like 2016 saw a huge vacuum open up in online lending?

Yes. A lot of small platforms did not survive. This centralized a lot of the power within the platforms that were able to do securitizations. Because the hedge funds pulled out, balance sheet lending is almost the surviving model of all the alternative lending models.

Platforms get a credit facility from institutional investors, whether it’s a hedge fund or a bank, this way those institutional investors are hedged against the risk. They give you the credit facility and you pay them back interest rates.

A balance sheet lender gives out loans at a higher rate than its cost of capital and lives on the margin.

You make it sound like individual investors and individual lenders are both getting held with the bag?

Exactly.

The originators themselves who are issuing those loans on behalf of the capital that they are paying for are suddenly stuck with a whole lot of debt on their balance sheets. The platform generates loans with an average of 4 years per loan. if you are issuing $1 billion in loans, you have an average of $4 billion on your balance sheet that you can’t offload. There is no secondary market for it. You cannot liquidate or leverage those assets in order to grow your business.
Platforms have become digital agents for the banks and institutional investors. They source out all of the borrowers. They do the pricing. They fund the loans. But there always constantly squeezed within a margin between the cost of capital and the rate they can lend out while still being competitive.

That is why the platforms who have access to cheap capital are the big survivors.

Do you have a better solution?

That’s exactly why we started Credium.

The industry transformed into something it was not set out to be. Now individual investors can only access this lucrative asset class by buying tranches in securitized SPVs by brokers who are selling off securities of platforms. By paying all these intermediaries in the middle, you end up receiving a much worse deal than you would if you directly lend, which was the original p2p vision.

The borrowers end up paying more because there’s more middle men as the value chain got longer.

The silver lining in all of this is Blockchain. By 2016, it matured enough to truly decentralize this whole complex system of online lending which requires transfer of accurate trusted information between two parties who want to transact.

All this complexity can be solved by setting up a secondary market that will allow the 98% of platforms operating by holding debt on their balance sheet to go ahead and liquidate their debt.

How does it address the trust crisis of 2016?

With peer to peer you had to trust the server of the platform that the information their hosting there has always been that exact same information, and nobody changed it in between. That’s why you have all these intermediaries to audit and make sure that the information that’s being transferred between two sides of the marketplace is accurate, and transparent, and time stamped, and everything is kosher.

That answers the crisis of trust? What about the barrier of liquidity?

We are setting up a secondary market which will allow any platform to sell their borrower notes as long as it’s registered and regulated as a security.
The lenders have the upside of offloading their debt.

Traditional peer to peer lenders have access to liquidity by uploading their loans and having somebody else buy it, without having to be a specific member of their platform. It gives them the chance to offload a huge amount of debt off their balance sheet, and focus on growth.

On the buyer side, we are allowing anybody to have full transparency to the risk of the note, the pricing of the note, the servicing history of the note. Anybody who wants can have exact accurate information in a smart loan contract that is locked on the blockchain.

How will this benefit individual retail investors over peer to peer?

With peer to peer you have to trust the platform issuing the note. If you want to put $100,000 in Lending Club notes, you have to part ways with that $100,000 for up to 5 years because those notes are going to start paying back on a monthly fixed income return.

If you want to liquidate in the middle, you have to find another Lending Club user who is willing to buy off your inventory. Since there is no real liquidity in that secondary market because there is a very small, closed system, you will have to give a very big discount just to get your money back before the period is over.

It’s a huge advantage if you are buying a note and you can park your money there for a few months, and just sell it off. We are introducing a complete supply side for liquidity.

What happens to online lending if there is no Blockchain or secondary market? What are the consequences if these disruptions don’t happen?

Online lending will stagnate.

Your secondary market is being set up to resume the growth in online lending?

Exactly.

We think that institutional investors like insurance funds have a great opportunity to enter this market if they know that they would have a secondary market where they can trade this asset. We are creating a tradable asset with the mechanics to have a fair market value and price discovery.

Can this do anything to the cost of capital for lending platforms?

Yes. We are also introducing new buyers to the market. We have a whole universe of crypto-investors who currently have no ability to protect against volatility. The only option they have today is to transfer to a pegged digital currency, which holds a reserve of fiat cash and protects their deposit, but they get no interest on it.

There’s a few downsides to that. One downside is the fact that this is not a security. It’s not regulated and you don’t really know if this capital sitting as a reserve for those pegged tokens is used for leveraging or other things.

The second is that it doesn’t pay any interest. All you do is protect against volatility. You might as well have put the cash under your pillow.

Parking it in this pegged currency is a solution that today reached $500 million in market cap of crypto-currency parked just to protect against volatility. There is a concentration risk because there is a single body controlling all of that half a billion dollars. If there is any failure of trust. If there is any failure in management of those funds, the whole market cap is at risk.

By backing up your cryptocurrency savings with borrower notes, you get it backed by a regulated security that has an originator accountable for the risk scoring, underwriting, and everything regulatory agencies require. You have servicers that are accountable for making sure that the loan is current, collected, and up to date, and you have the Credium Foundation that is also accountable that both the originator and the servicer are compliant and functioning in order.

You have a pegged cryptocurrency that is backed by a regulated security accountable to parties to make sure that the funds are backed up, plus, it pays you a return. You get interest for locking up those funds in a fixed income savings instrument.

The other upside is that you have a secondary market so if you want to liquidate it you can sell those tokens to somebody else.

The third advantage is that you don’t have concentration risk. We are onboarding as many originators as possible. If one of them fails, only those invested in that specific originator will get hit, but the market will be resilient because there are so many other originators involved.

How much more of the market share can be acquired once you set up a secondary market?

With a secondary market, online lending can go from 10% to at least 50% of the market over the next 5 years. Blockchain technology will enable people to transact using tokenized securities. There are no intermediaries to trading them.

That’s your goal?

The Credium Foundation has two arms. It has a protocol development, developing standardized risk pricing, decentralized exchange of borrower notes, pegged currencies to back those notes, that’s the protocol.

Then there is Creduim Foundation which we are calling the Alternative Lenders Alliance to participate in building the marketplace inventory, designing the product themselves – the fixed income securities that they are issuing today but as digital tokens, and working with regulators to ensure that the regulatory framework matches the requirements.

Blockchain delivers regulators on a silver platter all the information they can ever hope for. A decentralized marketplace will enable regulators to have full transparency and immediate access to all information exchanged at all times.

So, you are saying that Blockchain can add at least another half a trillion dollars to the online lending industry in the next 5 years?

Yes.

Authors:

George Popescu
Allen Taylor

Rising Up From the Online Lending Crisis of 2016

Backed

A one on one with Gilad Woltsovitch, founder of the online lending platform Backed, Inc. His personal journey navigating the turbulent times of the last two years, how Backed emerged from of the online lending chaos of 2016, and how he discovered a Blockchain-based solution to establish a secondary market for credit assets that can […]

Backed

A one on one with Gilad Woltsovitch, founder of the online lending platform Backed, Inc. His personal journey navigating the turbulent times of the last two years, how Backed emerged from of the online lending chaos of 2016, and how he discovered a Blockchain-based solution to establish a secondary market for credit assets that can add at least another half a trillion dollars to the online lending industry over the next five years.

This interview consists of two parts. Part 1 is below. Part 2 will be published next Tuesday.

Tell us about the opportunity you see with the plateau online lending has hit and the maturity of Blockchain and Ethereum?

Alternative lending reached a point where it is a sizeable enough industry to remain a viable financing source for credit, we think there is a huge market to disrupt using Blockchain technology because right now this industry reached around $182 billion globally in online lending.

But the potential is much bigger.

The immediate addressable market is around $1.5 trillion globally. The only problem is that all of these assets are being generated in silos so every single company issuing borrower notes is doing its own underwriting, risk scoring, reconciliation, and issuance of notes all inside their own ecosystem.

Because there’s no secondary market, the industry has reached the point where it’s difficult to continue to grow because of these liquidity issues. In a short time, this new form of lending captured over 10% of the market. A new catalyst to move it forward is a real game changer.

How did you get interested in blockchain in the first place?

I read about Ethereum in a white paper. I got really interested in the technology and how it could bring disruption to the world of trust. It seemed like general purpose blockchain is the right way forward compared to the others who were trying to build on top of blockchain which wasn’t what blockchain was meant to be. That’s what got me interested in Ethereum. It is a very pragmatic and elegant solution to making a general purpose blockchain.

The ICO for Ethereum happened, I think, half a year later. I participated it in because I was emotionally invested in it already. I believed in the vision.

Vitalik reinforced the seriousness of this.

What role did you envision Ethereum and Blockchain at that point?

It’s interesting because we were just entering the FinTech space, after getting really excited about the revolution bitcoin brought about. At the time, we felt that the whole technology was too premature to go out and confidently raise funds from investors and be accountable for building a product on top of the protocols that were so young and so volatile. We thought it’s not a right time to build a blockchain business. Especially for us at the time because we are not cryptographic developers.

But, I knew from day one, and I told it to every single investor that joined Backed, Inc., that Blockchain technology should be the foundational kind of structure that we build on for our products.

So, in the back of my mind, even though Backed was started up as a very traditional alternative lender, I always knew that once the ecosystem matures enough, we will incorporate it into the business. That’s what led to the birth of Credium.

What was it that got you so interested in Blockchain technology?

The ability to transfer information transparently, and reduce the need for third party trusted intermediaries in between. It’s something that I began to understand when studying music. I studied the theory of electronic music, or, signals in general. There is a concept called the signal and system theory. When I look into a lot of networks in general, I always look at it from this kind of paradigm, thinking how is the correlation between the signal, as you transfer it throughout your network with minimal amount of loss. If you have signals floating through air, which is in music, you have minimal loss of information because the medium itself is just transferring the data. But once you need to digitize it, and start processing it, and reconciliating between two end points not necessarily speaking the same language, reducing it all to a failed information transference.

The bank hosts information about deposits. How many deposits does it have? How do those deposits behave usually? It needs to analyze through its systems how this information will help loan officers make decisions of how much leverage can it take, who can take the risk, and how does their profile look?

In a centralized system, you need a lot of intermediaries. They stamp the validation, the correctness, the kyc, the credit history, the amount of available funds, the risk model itself. Everything has to be vetted and audited, and when it’s transferred between entities within the same system, or even more complicated, between systems, you have more and more points of failure. Intermediaries cost money. In the end, the borrower pays more.

You see a problem when information has to go through too many hands, and the borrower pays for it?

Exactly. At the end of the day, everybody in the middle needs to get their piece of the pie. In the system of credit, the borrower is always in the lower position to incur all the markups and costs.

Do you see this as the problem that you set out to solve?

This is what drew me into the idea of blockchain. How can we share information that will help us transact transparently without the need of intermediaries? We wanted to start our own business that will help borrowers access credit. It was too early to take a head dive into blockchain back in 2014. The whole world of peer to peer lending was just emerging. We saw that as a great opportunity to focus on a niche market that wasn’t getting served by the big players who dominated the space.

What niche market?

We noticed that the whole experience of people who didn’t accumulate enough credit history in order to be scored sufficiently. The models that the growing industry has been using is taking the minimum risk possible by only rewarding the customers they can find. You were being penalized by the old models for not having enough debt, and then you are paying more for the debt that you do take, which makes it more difficult to pay off, or pay off on time, which makes it harder to get more debt, or pay it off at a reasonable cost.

I saw proliferation of many companies who tried to attack and bring novelty to the risk underwriting mechanism. Upstart is a notable example. It started looking into underwriting people based on their education.

You saw that there were populations that were being underserved, and that the models were not getting enough information, charging more money because they just weren’t assessing the risks efficiently?

The industry as a whole noticed that these arcane models needed to be updated. Every platform took their own approach on how to resolve this within the regulatory boundaries of risk scoring.

Backed was one of those novelty companies that was part of the Lending 3.0 revolution. Backed was the cosigning flow of the solution.

What niche did you see the most opportunity in during the online lending revolution of 2013?

I noticed that “thin filed millennials,” as I call them, were branded by the Consumer Financial Protection Bureau as “credit invisibles.” This population is basically mainly millennials or immigrants that do not necessarily have enough history in the system to get a sufficient score.

What opportunity did you see to serve their needs?

We looked into how they get through college, to their first job, and their first apartment. We noticed that they rely on their families much more than you would think traditionally.

After 2008, more and more millennials had to rely on their parents to either continue to subsidize their rent, or let them use their parents credit cards because their parents have a good credit score.

How did this fare?

We built up the system in 2015. We launched the pilot program, Backed, Inc, in 2016. We gave our first loans with capital from our equity investors. Our business is growing better than we anticipated.

Around 40% of the portfolio is backed by cosigners. Every borrower with us has seen his credit score increase by at least 10 points.

We reduce a lot of the risk for the cosigners themselves. We really believe in the model.

Has it ever happened that a cosigner had to make a payment to keep the loan from going bad?

We had a few incidents where a payment was missed, but it was paid back by the borrower – at the cosigner’s insistence. The leverage of the relationship between the borrower and cosigner was enough to keep the loan in good standing.

It sounds like this is a successful model. Did you get funded?

We scored a deal with one of the biggest hedge funds in New York. We had a signed term sheet for $20 million investment in our company.

So, the champagne was on the table and the check was ready to be signed?

Yes.

What happened?

We started hiring. While this was happening, a disaster happened in the industry that sent shock waves everywhere. It was the entire loss of trust between one of the lenders in the market, who had some issues of backdating their inventory.

Almost every single fund in the hedge fund industry pulled out, and we got a phone call basically saying that they are pulling out of the industry.

Was there any reason they pulled out that was about Backed?

It was clear that we were showing much better returns than expected. The Backed, Inc business model, the risk and underwriting side of the business I definitely think it’s a strong model. Its very niche specific so the challenges still remain on growth, and how big of a market it can achieve.

How is it doing from the Spring of 2016 to now, a year and a half later? Are more people taking out loans?

Definitely.

How has the industry reacted to the 2016 crisis?

It boils down to who has access to lending capital. Backed, in terms of the model is seeing organic growth. There’s more business to be done in our niche.
Until 2013, the model was pretty much peer to peer lending, and the platforms were just facilitating a marketplace between borrowers and lenders, basically allowing retail lenders to enjoy bank returns by diversifying their portfolio so they cut up every loan into securities, and investors with smaller amounts could diversify a whole portfolio of 100 loans without investing more than 10 or 15 thousand dollars, and earning returns just like the bank have on a pool of a hundred different loans.

So, instead of investing in 100 loans, you are investing in 100 fractions of different loan grades, and that was the whole peer to peer solution.

The problem that impeded our growth, just like any other niche platform, is the problem that the general model shifted heavily from 2013 onwards from peer to peer lending towards very centralized sources of capital, like institutional banks.

Authors:

George Popescu
Allen Taylor

 

 

 

 

 

 

Gilad Woltsovitch is the Co-Founder and CEO at Backed Inc., responsible for designing the company’s first-class platform, UX and UI. Before Backed, Gilad co-founded iAlbums, a semantic curation engine for media players in 2010 where he served as the company’s CEO from 2011-2014. In 2013, Gilad also served as the entrepreneur in residence for Cyhawk Ventures and joined the Ethereum project, establishing the Israeli Ethereum meet-up group. Gilad holds a Masters of Art Science and Bachelors in Sonology from the Royal Conservatory of The Netherlands in The Hague, University of Leiden.