Innovation in the established bank-tech companies

bank marketplace lenders

Since the financial meltdown of 2008, regulators have cracked a whip on bank lending. So far, however, there are no such regulations on crowdlending platforms. To counter this, banks (Goldman Sachs is the prime example) have set up marketplace lending (MPL) platforms in silos, which are completely separate entities. As a result of the aforementioned financial […]

bank marketplace lenders

Since the financial meltdown of 2008, regulators have cracked a whip on bank lending. So far, however, there are no such regulations on crowdlending platforms. To counter this, banks (Goldman Sachs is the prime example) have set up marketplace lending (MPL) platforms in silos, which are completely separate entities.

As a result of the aforementioned financial crisis, banks vacated many business segments due to regulatory issues and a shortage of capital. Marketplace lenders have taken advantage of this and captured many of these areas. The financial software publisher Misys realized that banks need to recapture this space for long term feasibility and has launched a white label crowdlending platform for the banking sector.

The initiative was born out of Fusion Reactor, its own innovative engine where new ideas are brainstormed. The idea for the SaaS solution came from French engineer Jean-Cédric Jollant. From inception to launch took less than two years.

Company History

Misys was founded in 1979. Over the years, they has managed to carve its niche in the financial software industry with roots deeply engraved in lending and have developed products like Loan IQ, which has been present in the financial industry for over 25 years and used by most banks. Around 43% of all syndicated loans all across the globe are processed through Loan IQ.

Misys started as a computer systems supplier to insurance companies but has emerged as a financial services software provider through multiple mergers and acquisitions. Recently merged with payments technology firm D+H, Misys has a presence in 125 countries and has over 2,000 customers. Their team of experts are able to address industry requirements at both a global and local level.

Location and Manpower

Misys is headquartered in London, UK and has offices in the major financial hubs of the world (New York, Paris, the Philippines, and Plano, Texas). Its biggest technology office is in Bangalore, India. The company has 5,000 employees of which 2,000 are developers. Around 500 are based out of Paris Another 150 are in Plano. The rest are evenly spread in all other centers.

FusionBanking CrowdLending

A cloud-based lending platform available as an enterprise solution, Misys plans to run alongside its other array of products as an SaaS. Banks have been losing customers to marketplace lenders (MPLs) because they do not offer a large enough variety of products to compete. Banks either offer prime loans that range from 3%-6% or credit cards that range from 15%, hence leaving a huge gap between 6%-15% interest rate for MPLs. Considering there is a huge population in the near prime category, it is necessary to address this unattended potential customer base.

The Idea Behind FusionBanking CrowdLending

The majority of MPL lenders are not actual lenders but more like intermediaries. MPLs act as a bridge between existing bank customers, bank investors, and existing bank services. In actuality, all three sources are originating from the banks.

Even though MPL lenders don’t have lending capabilities, servicing, or recovery services, they still are managing to put a hole in the bank market. More importantly, banks are on the verge of losing relationships with customers and the revenue generated from those relationships.

Misys came up with FusionBanking CrowdLending to stop the hemorrhaging of clients and help banks service the digital-first millennial generation. Also, the company has combined LoanIQ and CME, an origination software, into a white label platform.

Progression

Since banks are the cheapest source of lending, customers will obviously go to them first. But banks have a high rate of rejection as per their lending guidelines, and those applications are wasted or go to online lenders. For example, Standard Chartered in Asia declines 80,000 SMBs per year on average. Therefore, rather than giving over the relationship to MPL lenders, using Misys’ solution, banks can put this business back on their own platforms.

Revenue Model

Misys charges 2% of whatever they process. Apart from that, the company does not charge hidden,  upfront, or license fees. They charge a one-time customization fee, and the 2% fee is lowered after they cover costs. The main motive is to make the platform profitable for banks as soon as possible and help banks retain 99% of the revenue from their relationships. The company plans to target smaller banks first to have a proof of concept for larger banks.

Conclusion

Until recently, traditional banks believed they had two options, either throw in the towel or enter into partnerships with MPLs. Goldman’s Marcus has changed the narrative. Now, banks believe they have the tools to compete. But, instead of building on their own or buying a platform (which is not sustainable for smaller banks), partnering with Misys makes sense.

Misys has opened an avenue for banks to monetize their relationships digitally Creating a bank-owned lending platform allows for all participants to remain in the bank’s ecosystem.

Author:

Written by Heena Dhir.

Report: Marketplace Lending Securitization Tracker Q1 2017

Report: Marketplace Lending Securitization Tracker  Q1 2017

Marketplace lending securitization remains a bright spot in the ABS market. Total issuance topped $3 Bn this quarter with cumulative issuance now totaling $18.0 Bn across 80 deals. The movement towards rated securitizations at larger transaction sizes continues. All deals were rated in this quarter, with record-sized consumer deals from SoFi, a large multi-seller deal […]

Report: Marketplace Lending Securitization Tracker  Q1 2017

Marketplace lending securitization remains a bright spot in the ABS market. Total issuance topped $3 Bn this quarter with cumulative issuance now totaling $18.0 Bn across 80 deals.

The movement towards rated securitizations at larger transaction sizes continues. All deals were rated in this quarter, with record-sized consumer deals from SoFi, a large multi-seller deal from Marlette, and the first prime paper deal from Lending Club. All deals this quarter had at least one rating.

New issuance spreads continued to tighten and flatten—a credit friendly environment for securitization. In 1Q2017, we saw spreads tighten in riskier tranches, indicating strong investor appetite for MPL ABS paper in the market.

Bank and non-bank platform partnerships continue to emerge.

Over 15 banks are purchasing loans from marketplace lenders.

Our year-end forecasts volumes for new issuance of $11.2 Bn remain on-track. New issuers and repeat issuers are increasing deal activity.

3rd party solutions are emerging to improve investor confidence.
Originators are relying on 3rd party solutions to address “stacking”, perform data verification, loan validation, and improve investor confidence.

We expect higher volatility from rising rates, regulatory uncertainty, and an exit from a period of unusually benign credit conditions. Platforms that can sustain low-cost stable capital access, build investor confidence via 3rd party tools, and embrace strong risk management frameworks will grow and acquire market share.

 

Authors

Wilfred Daye wilfred@peeriq.com

Jianguo Xiao jianguo@peeriq.com

Yishu Song yishu@peeriq.com

Investors should consider PeerIQ as only a single factor in making their investment decision. Please refer to the Disclosure Section, located at the end of this report, for information on disclaimers and disclosures.

 

Introduction

Benign Macro Conditions Amidst Rising Rates

On March 15th, the FOMC announced an increase in the Fed Funds rate with a new target of between 75 and 100 basis points. The decision comes at a time when the unemployment rate is at 4.7%, the US economy generated 2.1% GDP growth in 4Q2016, and robust year-over-year wage growth of 2.8%. Fed futures forecast two more rate hikes before end of year. Consumer confidence continues to climb to its highest levels since August 2001.

The “risk-on” environment has continued in the first quarter of 2017 as the global reach for yield intensifies. 10-year bond yields remain at 2.4%, while the equity markets have continued to rally with the S&P 500 up 5.8% YTD and other equity indices near record highs.

For 1Q2017, overall credit markets have exhibited low volatility and credit conditions remain relatively favorable. Implied volatility on 3-month CDX HY options reached another historical low of 34%. On-the-run CDX HY traded 16 basis points tighter than 2016 year-end close with a range bound between 307 to 355 basis points. Further, in the US CLO market, new-issue spreads continue to grind tighter and reach historical tights.

Strong Capital Markets Activity in Marketplace Lending ABS

The encouraging macro conditions continued to support the growth of the MPL ABS market after the holiday season. The first quarter of 2017 witnessed several record-sized MPL securitizations. Seven deals priced, totaling $3.0 Bn, comprised of consumer, student, and SME collateralized deals. New issuance volume doubled in 1Q2017 vis-à-vis 1Q2016; the cumulative issuance volume now stands at $18.0 Bn since the inception of MPL ABS market in 2013.

The industry continues to experience strong investor sentiment as evidenced by growing deal size and improved deal execution. SCLP2017-1 is not only SoFi’s largest deal, but is also the largest unsecured consumer ABS in MPL ABS history with a collateral pool of $650 Mn. Marlette Funding Trust 2017-1 is the largest deal to date for the MFT shelf, with a size of $333 Mn, pricing tighter than MFT 2016-1 across all tranches with a flattened credit curve. On the SME side, Kabbage’s $525 Mn deal, led by Guggenheim, was also oversubscribed.

Another milestone reached in this quarter was the Arcadia Receivables Credit Trust 2017-1, which was the first ABS deal backed by LendingClub Prime loans. This continues

LendingClub’s presence in the securitization market after last quarter’s initial deal from the LCIT LendingClub shelf.
In addition to securitization activity, several partnerships with non-bank lenders developed in this quarter. Deutsche Bank upsized its revolving credit facility with OnDeck to $214 Mn. Prosper announced a $5.0 Bn loan-buying deal with a consortium of structured credit investors.

On the equity side, SoFi reached a $500 Mn investment led by Silver Lake for another round of financing, and further extended its distribution channel to community banks by partnering with Promontory Financial. Upstart announced a $33 Mn financing led by Rakuten.

M&A prospects increased in the small business sector this quarter. EJF and Marathon have built sizeable positions in small business lender ONDK. Kabbage is reportedly raising capital to fund acquisitions as well.

The IPO markets are re-opening to non-bank lenders. Elevate Credit (ticker: ELVT) set a $12 to $14 price range and intends to raise up to $107.8 Mn this week.

Strong Credit Facility Deal Flow

Besides securitization, credit facility warehousing is an alternative venue for lenders to source financing; however, the cost of credit facility depends the borrowers’ counterparty risk, asset class, credit performance, and pricing in the competing ABS market.

OnDeck continued to restructure its financing framework. It amended its asset-backed revolving credit facility with Deutsche Bank, extending the maturity date and increasing borrowing capacity. The Class A tranche of the facility has an advanced rate of 85%; and Class B 91%.

Further, Fundation secured an asset-backed credit facility to expand its business from MidCap Financial, a specialty finance firm. Renovate America completed a $100 million credit facility with Credit Suisse to expand its unsecured consumer home-improvement lending product.

Waterfall Asset management provided a £100 Mn credit facility to UK-based Lendable and $100 Mn facility to BorrowersFirst. Victory Park Capital provided a $100 Mn facility to LendUp.

Deal Performance Weakens, Structures Protecting Senior Notes

Elevated charge-offs have contributed to trigger breaches in ten active MPL ABS deals, eight unsecured consumer and one SME deal, representing $1.5 Bn of total issuance volume.

Data integrity continues to be in the mind of all participants in the marketplace lending ecosystem. In December 2016, Structured Finance Industry Group (SFIG) released the ”Green Paper” on data reporting standards. To further bolster SFIG’s effort, PeerIQ offered the industry Data Standards and Best Practices, which summarized the key learnings and best practices we have developed from years of experience as the leading data & analytics provider in the marketplace lending ecosystem.

Definitions and Inclusion Rules

Our Tracker includes all issuances connected to assets originated by marketplace lending platforms, which we define as including both:

(i) Online and other novel technologies to increase operational efficiency, risk accuracy, and borrower experience, and

(ii) Non-deposit funding for lending capital.

We recognize there is rapid innovation in lending channels, and welcome all comments and consideration on inclusion rules.

I. Quarterly Round-up

The first quarter of 2017 witnessed seven securitization deals, totaling $3.0 Bn in new issuance, the largest quarterly total that the MPL ABS market has seen, which brings total issuance to $18.1 Bn. This represents a 20% increase over 4Q2016, and 100% increase over 1Q2016.

Total securitization issuance to date now stands at $18.1 Bn, with 80 deals issued to date (48 Consumer, 22 Student, 1 Mortgage and 9 SME) since September 2013 (Exhibit 1).

Exhibit 1
Cumulative Marketplace Securitizations

Examining issuance by underlying collateral segment, we see large increases in consumer and student relative to the first quarter of 2016, up 76% and 54% respectively. SME remains the smallest segment, but Kabbage’s $525 Mn issuance is the largest SME deal since their previous one in 2014 (Exhibit 2).

Q1 2017:

• SoFi: SOFI 2017-A, SOFI 2017-B, SCLP 2017-1, SCLP 2017-2

• LendingClub: ARCT 2017-1

• Marlette: MFT 2017-1

• Kabbage: KABB 2017-1

This quarter, SoFi priced its largest consumer securitization, which is backed by a $650 Mn pool of consumer loans. SoFi continues to remain active in the student sector as well with two deals this quarter totaling over $1 Bn.

Prior to this quarter, the market had only seen deals backed by LendingClub Non-Prime loans; however, with the Arcadia Receivables Credit Trust 2017-1, we witnessed the pricing of the first deal backed by LendingClub Prime loans. The deal consists of loans with higher average loan balances and higher FICO scores, which resulted in tighter pricing than tranches backed by non-prime loans.

Rating agency participation has continued to be a key driver for strong deal execution. All deals issued in 1Q2017 were rated by at least one rating agency (Exhibit 3 & 4). Again, we expect that the almost all MPL ABS deals will be rated as issuers seek to broaden the base of eligible investors and access cheap funding.

 

Finally, deals continue to increase in average deal size over time, led primarily by SoFi’s large placements. The average securitization deal now stands at $425 Mn for 2017 (Exhibit 5).

 

II. MPL Securitization League Tables

Dealers intensified their participation in MPL deals this quarter with Goldman Sachs, Deutsche Banks, and Guggenheim scoring record-sized deals. Maintaining its top rank in the league table, Goldman Sachs led $625 Mn in total new issuance, an 18% growth from 4Q2016 (Exhibit 6). It executed deals with SoFi and Marlette to maintain its 23% market share in MPL ABS. Further, Guggenheim showed over 200% growth through their role as the sole dealer in Kabbage’s $525 Mn securitization. The top three dealers, Goldman Sachs, Morgan Stanley, and Deutsche Bank have contributed to over 55% of the total market share in MPL space.

As we noted in 4Q2016, deal interest and involvement remains high despite mixed headlines, regulatory uncertainty, and firm-specific considerations throughout 2016. This positive trend continued in 1Q2017 with nine of the top ten lead managers increasing their involvement in MPL issuances. In addition, the industry saw new participant, BAML, lead the two SoFi student deals this quarter.

Risk retention regulations, now in effect, increases the capital burden for issuers and may slow the pace of deal activity. Various risk retention solutions are emerging as we have summarized here.

Turning to the co-manager league table, SoFi remains the clear leader in the co-manager league, increasing their participation value to over $3.4 Bn through their co-manager position on their two student deals (Exhibit 7).

Deutsche Bank and Morgan Stanley’s co-manager participation in these SoFi deals significantly increased their involvement as well. This brings Morgan Stanley even closer to joining the top three participants, which now maintain approximately 65% of the total market share.

From originator league table (Exhibit 8), SoFi is a clear leader and takes over 51% of the market share. The second place Prosper only has 13% of the total pie. Further, SoFi has much large sandbox, including student refi, unsecured consumer and mortgage loans, whereas other originators focus on a single vertical.

We currently observe 143 rated MPL ABS bonds in the market. As of 1Q2017, DBRS leads Moody’s, Kroll, S&P and Fitch in the amount of rated bonds (Exhibit 9). DBRS rated $6.6 Bn Student MPL ABS, or approximately 45% of sub-segment, competing primarily against Moody’s within the student sector. Kroll dominates the Consumer MPL ABS category with 53% market share. The mortgage sub-segment currently has an even split amongst DBRS, Fitch and Kroll.

1Q2017 also saw an increase in ratings actions. For deals issued prior to 2017, there were several ratings updates. Deals from SOFI, EARN, AVNT, and CHAI shelves received ratings upgrades, serving as, yet, another positive sign from the agencies.

CAN 2014-1A was downgraded by both S&P and DBRS as the deal breached the minimum excess spread trigger.

 

III. New Issuance Spreads

New issuance spreads in 1Q2017 continued to tighten, reflecting a healthy risk appetite in the capital markets. We saw a continued preference for senior tranches over riskier subordinated bonds (Exhibit 10). However, in the consumer and student sectors, the term structures flattened from the previous quarter, reflecting stronger investor appetite for riskier tranches.

Kabbage executed a first SME securitization since Q216, backed by a revolving pool of receivables consisting of (i) business loans or (ii) merchant cash advances. The deal features a 36-month revolving period during which time principal collections may be reinvested to purchase additional receivables. The A tranche was priced 50 basis points tighter than deals in Q216; and the B tranche priced 270 basis points tighter. The D tranche priced at 1050 basis points, forming a steep credit curve.

IV. Deal Credit Support Profile

Deal credit performance has weakened, although structural protections continue to protect bondholders. Deteriorating collateral performance has contributed to trigger breaches in ten active MPL ABS deals, eight unsecured consumer and one SME deal, representing $1.5 Bn deal issuance. Despite weakening in credit performance, we have not seen a meaningful uptick in initial credit support for unsecured consumer loan MPL ABS, reflecting growing comfort in the current conservative rating approach by the agencies. The senior and mezzanine tranche initial credit support has been stable for SoFi, LCIT, and other shelves (Exhibit 11). Still, Avant deals have featured increasing credit support at issuance (solid lines are regression lines).

Due to the amortizing nature of the collateral pool, MPL ABS bonds typically exhibit shorter weighted-average life (WAL) and a faster deleveraging profile than other structured products, such as MBS bonds backed by 30-year mortgage collaterals. As deals season and perform as initially expected, the credit supports increases. We quantify the amount of deleveraging by measuring the differences in current and original credit support for the same bond. Exhibit 12 shows that the senior part of capital structure begins to deleverage first then mezzanine tranches (solid lines are regression lines). For instance, Prosper senior bondholders will enjoy a 40% improvement in credit support as the bond seasons.The declining credit support in Loan Depot and CircleBack deals reflectsworse-than expected collateral performance and the structural impact of breaching performance trigger

V. Credit Performance Trends

Consumer credit delinquencies and charge-offs continued to increase during the first quarter, across consumer credit verticals including installment, student, and auto loans. Prime credit card portfolios continue to exhibit low and stable levels of delinquency.

This quarter, we released a Performance Monitor to track the health of marketplace lending loans using bellwether public programs from LendingClub and Prosper. Charge-off rates for both originators continue to be elevated for loans in 2016 vintages. The increase in charge off rates agree with delinquent loan pipelines as loans transition from delinquency to charge-off states. Originators have taken actions including tightening underwriting criteria and raising rates.

Charge-offs remain elevated outside of marketplace lending as well. 60+ delinquency rates were up for private-label credit cards; FFELP and non-FFELP student loans experienced higher delinquency rates as well. In the auto sector delinquency rates on prime and subprime delinquencies may pass pre-crisis levels by end of year.

The primary driver of increased losses for non-bank lenders more generally are

i) a mix-shift to riskier borrowers as measured by credit score,

ii) increased “stacking” behavior (whereby consumers take out multiple loans simultaneously), and

iii) re-leveraging of the consumer balance sheet due to greater availability of credit.

VI. Commentary and Outlook

For 2017, we expect higher volatility from rising rates, increased regulatory uncertainty, uneven policy execution, and an exit from a post-crisis period characterized by unusually benign credit performance.

Although the macro environment remains benign with exceptionally low volatility in capital markets, we expect the next several years to pose significant challenges for risk managers due to the re-normalization of credit performance, intensifying competition for borrowers, and changing payment hierarchy trends.

Re-Normalization of Credit Performance

The Great Recession of 2008 is now more than eight years behind us. We are in the late stage of the current credit cycle.

Consistent with Fair Credit Reporting Act waiting period requirements, derogatory credit items (“derogs”) associated with bankruptcy, foreclosure, and short sales will fall off borrower credit bureau reports in 2017. As a result, we expect an expansion of marketable population to include previously ineligible borrowers.

The re-normalization of credit performance will create significant analytical challenges for underwriting and investment analysis. For instance, models trained on post-crisis borrowers that defended their credit thru the cycle will tend to underestimate losses.

Further, lenders today face new constraints in how they manage their risk from consumer protection regulation such as the CARD Act of 2009, which among other rules, eliminated “universal default” as a mechanism for mitigating risk.

Advanced risk analytics and historical data, such as offerings empowered by PeerIQ analytics and TransUnion dataset, will crucial for risk assessment and management for originations and investors alike.

Changing Consumer Behaviors & Payment Priority

Prior to the Great Recession, mortgages were the first priority of payment on the consumer’s liability. This behavior changed with eir negative equity in home values and the emergence of strategic mortgage default. During the crisis, according to a TransUnion study, consumers holding a mortgage, auto, and bank card consumers tended to default first on their mortgage debt, then credit cards, and finally auto loans – a reversal of prior payment priority trends.

Auto loans emerged at the top of the consumer liability payment hierarchy due to their need in accessing employment and impact of repossession.

The consumer’s relationship with their financial institutions and are changing with the emergence of new technology including ride-sharing services, robo advisors, and online banking services.

Increased competition amongst financial institutions and technology that can render traditional arguments of payment priority obsolete requires heightened monitoring of payment priority trends, and continuous benchmarking of originators performance vs. their peer group.

Not surprisingly, platforms are finding ways to deepening their relationships with customers via community-based service offerings, broader product offerings, and differentiated service.

See for instance SoFi’s dating and job-matching service and new products in insurance and deposits. Lending Club’s announced an expansion into auto-lending. Real estate lender PeerStreet announced a partnership with robo advisor Betterment.

Trigger Breaches Event Stabilizes

In 1Q2017, SoFi SCLP 2015-1, a bespoke bilateral transaction between an investor and provider of financing, was the only additional transaction to breach a deal trigger.

Exhibit 12 summarizes the ten active deals that had breached triggers in MPL ABS sector (nine unsecured consumer and one SME) with $1.3 Bn of total issuance volume. Since the inception of MPL ABS market, we have observed 10% of deals breaching triggers historically.

In the context of ABS transactions, trigger breaches are manifestation of unexpected credit performance, poor credit modeling, or unguarded structuring practice. If an early amortization trigger is violated, excess spreads are diverted from equity investors to senior noteholders with the goal de-risking the senior noteholders as quickly as possible.

From the equity investor’s perspective, tighter triggers allow higher potential equity returns in the absence of any collateral losses. However, equity investors will experience higher return volatility if the collateral pool incurs credit losses. Conversely, less restrictive triggers allow more cushion for losses before the coverage tests are breached, and require greater subordination levels and, hence, more capital.

Trigger breaching events do not necessarily imply credit deterioration of the collateral pool. The art of trigger setting is a core structuring competency for an issuer, warehouse lender, or securitization deal team. A strong analytics toolset offered by firms like PeerIQ will help issuers and investors alike to guard against trigger breach scenarios.

In our 4Q2016 securitization tracker, we anticipated greater participation in the securitization space as one-off issuers seek to become repeat issuers to optimize deal cost and capital market distribution. We expected $11.2 Bn of total new issuance in 2017 for a base case scenario, representing 47% growth in ABS issuance from 2016 (Exhibit 13).

Further, rated securitization has moved from a coming-of-age milestone in the maturation of an originator to a key funding pillar. In 1Q2017, all new transactions were rated by at least one rating agency.

We expected further emergence of repeat issuer. In LendIt 2017, Prosper unveiled its new shelf Prosper Marketplace Issuance Trust (PMIT), expecting first deal in Q2. Further, LendingClub expects to retain $100 Mn of quarterly originations on balance sheet beginning in 2Q17. LendingClub also has its own branded shelf, and we speculate that these loans may potentially be securitized in multi-seller deals. This suggests a $400 Mn in new issuance from a LendingClub shelf.

Under our base case scenario, we expected $130 Mn from LendingClub shelf in 1Q2016 outlook, and we modeled $500 Mn in new issuance under a bullish scenario.

With $3.0 Bn of new issuance in 1Q2017 and recent announcements from new repeat issuers (potentially including Upstart and Prosper) and Avant returning to market, we are on track to realize our year-end projection of $11.2 Bn in new issuance.

Multi-seller trend continues

In 2016, PeerIQ predicted the rise of multi-seller deals as issuers seek to create a reliable path to liquidity for whole loan investors, drive standardization, spread deal costs, and reduce execution risk. The most recent Marlette transaction is notable in that 7 loan sellers vended loans into the deal. We expect a continuation of the multi-seller trend across several platforms.

Bank Partnerships

We argued in prior research that banks can improve their ROE position by funding or financing whole loans from marketplace lenders, and that most banks will choose to partner with marketplace lenders rather than compete.

We believe 2017 will feature a number of bank partnerships with non-banks, and increased competition from traditional banks.

In 1Q2017, Upstart announced their intention to deliver their SAAS technology to assist banks, credit unions, and retailers to originate loans. We expect to see more of this ‘capital light’ business model ahead (see Avant & Regions Bank, or OnDeck and JP Morgan for instance).

We expect traditional banks to cooperate with marketplace lenders to marry their low-cost funding profile with low-cost operations of marketplace lenders.

Higher Volatility from Regulatory Uncertainty

Concerns of heightened regulatory scrutiny last year have given way to a largely constructive outlook, although regulatory uncertainty remains high.

Platforms are sponsoring self-regulatory efforts via trade associations such as SFIG and the Marketplace Lending Association. The message is resonating. In an important milestone for 2016, US Treasury, Federal Reserve, SEC, and the Office of the Comptroller of the Currency (OCC), each publicly acknowledged that marketplace lending is expanding access to credit to traditionally under-served segments.

Markets expect a bias to action from the Trump administration, a more favorable regulatory outlook, and potential for relief on risk retention, bank capital & liquidity requirements, and a reduction in CFPB and SEC enforcement actions.

The President-elect Trump’s transition team, including the nominee for Treasury Secretary, has indicated the new administration wants to “strip back” parts of Dodd-Frank.

Overall, we expect the pace of regulatory relief will be slower than most market participants expect. While the new administration has made some general statements about Dodd-Frank, it’s too early to tell which changes may materialize.

Within MPL specifically, the SEC, the OCC, and state regulators have differing views on jurisdiction and approach to regulation. Moreover, given the cloture rules in the Senate which require 60 votes to overcome a filibuster.

We expect the most likely areas for bank regulatory relief lie within the capital and liquidity framework which has hampered ROE for large banks and community banks alike. Banks have already adapted to incremental consumer protection obligations and shed Volcker-related prop businesses.

Non-bank lenders, especially those adopting a partner funding bank model, will seek regulatory clarity to reduce true lender risk (see for instance Madden v. Midland, Bethune v. LendingClub, or CFPB v. Cash Call) and argue for pre-emption.

In March, OCC Head Thomas Curry, re-affirmed plans to grant special purpose national charters to qualifying FinTech firms. Curry cited “public interest,” a “patchwork of supervision,” and the “great potential to expand financial inclusion” as motivations for the charter.

The charter would offer pre-emption—the ability of chartered FinTechs to export rates across state lines—and avoid the need for disparate state-by-state licensing or originating via partner-funding banks. In constructing the guidelines, the OCC seeks to continue to foster financial inclusion via FinTech innovation, while maintaining public confidence in national banks and the banking system more generally.

The supervisory guidelines in the proposal require, among other provisions, a top-down culture of compliance, a risk assessment and management framework, and to-be-specified capital and liquidity rules. (See here for PeerIQ’s summary of the supervisory guidelines).

Qualifying FinTechs require significant investment in governance, risk management systems, and financial inclusion plans. Chartered FinTechs must adopt a top-down culture of compliance, meet strict supervisory guidelines (summarized here), have seasoned bank professionals on boards and management teams, and seek approval from bank regulators on major business plan changes. More generally, under the charter, FinTechs must culturally resemble the very banks they seek to disrupt. Applications for the charter will be made available to the public on the OCC website.

More fundamentally, the charter does not address the core funding and liquidity issues impacting the sector. The strict qualitative criteria suggest that the charter will be awarded sparingly, case-by-case.

Emergence of 3rd Party Solutions to Promote Confidence

To gain investor confidence, marketplace lenders are now adjusting to the demand from warehouse lenders and whole loan investors for greater transparency and due diligence, including independent reviews, “hot” back-up servicing arrangements, verification, credit validation and heightened data integrity standards.

Further, the recent uptick in delinquency and losses in SME and other sub-segments, in general, leads to a persistent focus on fundamentals, loan modifications, and technology to benchmark performance and combat stacking, TransUnion, for instance, launched a Fraud Prevention Exchange to combat stacking via a tech-enabled consortium of leading non-bank lenders.

Issuers and investors will deepen their investments in 3rd party data and analytics for a variety of investment and distribution activities, such as analyzing deal waterfalls, evaluating deal collateral triggers, monitoring deal performance, coordinating multi-seller securitization deals, and improving investor confidence with loan-level data transparency.

The above trends highlight the need for 3rd party analytics, such as those offered by PeerIQ, to improve transparency, standardization, comparability, with the goal of improving investor confidence and the smooth functioning of ABS markets.

We remain optimistic on the lending ecosystem. The broad secular trends underpinning non-bank lending growth and the global demand for yield remain intact.

About the author: PeerIQ offers portfolio monitoring and loan surveillance, structured finance analytics, third-party reporting, pricing and valuation and advisory services across both whole loans and ABS products.

 

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How MPLs Can Fight The Regulatory Burden

MPL legal compliance regulation

CFPB, along with the state regulators, are cracking the whip on FinTech companies. California has advanced a lot of enforcement actions and investigatory measures. The Telephone Consumer Protection Act (TCPA) is one such regulation under which a lot of companies have come under scrutiny. Regulators have tightened the screws and the ripple effect has been […]

MPL legal compliance regulation

CFPB, along with the state regulators, are cracking the whip on FinTech companies. California has advanced a lot of enforcement actions and investigatory measures. The Telephone Consumer Protection Act (TCPA) is one such regulation under which a lot of companies have come under scrutiny.

Regulators have tightened the screws and the ripple effect has been felt by all players, big and small. To cope with the chaos, marketplace lenders (MPL) are hiring law firms to manage regulatory actions and ensure compliance. One such law firm is Ballard Spahr, one of the biggest law firms dealing with banking regulations.

What’s Going On With Marketplace Lending?

MPL have witnessed some crucial developments of great interest to Ballard Spahr.

  • The industry has witnessed a substantial upsurge in regulations. The respected financial newspaper American Banker has hit hard at the lack of regulation in marketplace lending. Most importantly, MPLs were themselves pointing fingers at each other. This has solidified the perception that the industry is not regulated.
  • The case of Madden v. Midland Funding, and the Lending Club fiasco, made matters worse. These events triggered an overreaction from regulators, and the market as a whole. This led to investors abandoning MPL-generated loans, which caused further operational disruptions.

TCPA restricts telephonic solicitations and the use of automated telephonic equipment. If someone is telemarketing without permission, there is a $500 per call statutory penalty. But companies have found a loophole by leveraging offshore call centers who impersonate hotel chains for extracting personal client information. This is then further sold as a lead to the lending industry. Pearson and his team ensure their clients are approved for telemarketing and are operating within the boundaries of the law.

How Ballard Spahr Helps MPLs Stay Compliant

Ballard Spahr’s list of clientele ranges from high profile commercial banks like Chase, Goldman, and BofA, PE and hedge funds, payday lenders, auto title lenders, and others who primarily focus on finance and debt collection.

Based in Philadelphia, Ballard Spahr has more than 500 lawyers across the United States specializing in litigation, business, finance, intellectual property, public finance, and real estate law. Scott Pearson heads the division concentrated on marketplace lending.

Pearson is widely regarded as an expert on the unique issues faced by this industry. He specializes in defending clients against the regulatory actions from Consumer Financial Protection Bureau (CFPB) and state authorities. Since the inception of CFPB, the regulatory compliance burden has increased manifold. Coupled with credit crisis of 2008, the workload for Pearson and his law firm has increased drastically. His clients not only seek his representation and legal advice, but they also want his firm to make sure their companies comply with CFPB regulations. Over the years, Pearson’s face off with regulatory authorities has helped him to understand what is required by regulators and on what points the prosecutors/class action lawyers are going to attack. This insight is extremely valuable for his clients.

What tilted Pearson’s interest in MPL were two major litigations in which he defended merchant cash advance (MCA). One was for Rewards Network and another was for AdvanceMe, which later became Capital Access Network (CAN). As a result of these two path-breaking cases, he gained a lot of insight into key compliance issues.

There’s also a lot of confusion surrounding the scope and definition MCA. According to Pearson, MCA is not a loan if structured properly, and if the originator complies with regulations, there’s no reason to face scrutiny. A prime example is AdvanceMe. It started as an MCA but now is a leading SME lender; Pearson and the General Council did all the consumer agreements for the company to provide an extra layer of security.

With so much happening, it’s hard for Pearson to predict how the MCA space will shape up in the future. He believes the current trend of companies entering and exiting the space will continue.

There’s a lot of demand for capital by the SME segment. But regulations and compliance issues have made some companies afraid to take the plunge. Therefore, being able to structure the product properly, and per the highest legal standards, is extremely important for survival. With the FinTech industry and the attendant regulations evolving, having a competent law firm is a necessity. Ballard Spahr have the expertise and the experience to be a valuable partner for MPLs.

Authors:

Written with Heena Dhir.

Allen Taylor

Risks and registry solutions for emerging risks in the marketplace lending industry

Risks and registry solutions for emerging risks in the marketplace lending industry

Executive Summary When the marketplace lending (“MPL”) industry saw its first securitization in 2014 during a time of rapid expansion of the number of MPL loans being closed and platforms arriving to facilitate them, it was common to hear how the MPL revolution had caused “disruption” in consumer lending. Much has changed since that time, […]

Risks and registry solutions for emerging risks in the marketplace lending industry

Executive Summary

When the marketplace lending (“MPL”) industry saw its first securitization in 2014 during a time of rapid expansion of the number of MPL loans being closed and platforms arriving to facilitate them, it was common to hear how the MPL revolution had caused “disruption” in consumer lending. Much has changed since that time, and 2016 has proven to be a particularly tumultuous year. Regulators have fired warning shots to the industry, highlighting a litany of potential risks inherent in third party lending arrangements, and warning against practices and arrangements that may insufficiently protect banks, investors and consumers. The oldest and most prominent MPL platforms suffered public setbacks. The institutional capital that had mobilized around the industry with innovative funding arrangements opted for a more cautious testing of the waters. This has been the year where the MPL industry itself has been “disrupted” by emerging regulatory concerns.

What has emerged is a growing realization of a systemic misalignment of incentives in the MPL value chain. Section 1 of this White Paper will discuss the recent regulatory developments that emerged in 2016 impacting MPL platforms, the banks who partner with them, the investors who acquire MPL loans, the warehouse lenders who provide necessary capital to fuel the growth of the market, and the ratings agencies tasked with rating MPL securitizations. Through promises of scrutiny in the examination process to litigation over “true lender” or interest rate portability claims in separate but analogous payday lending arrangements, regulators are touching upon the lack of sufficient protections in the MPL ecosystem. There are concerns about whether platform compensation is too linked to origination as opposed to loan performance, whether original creditors are sufficiently involved in the underlying originations, whether investors can rely on platform loan verification processes which lack independent confirmation, whether warehouse lenders are sufficiently protected from double-pledging if its underlying borrowing entity sets up a Ponzi scheme to keep its operations going, and whether the precedent in Madden v, Midland Funding, LLC will have ramifications for long-term interest rate portability and the enforceability of put-pack obligations.

Accordingly, the industry is concerned about whether this misalignment of incentives will lead to a collapse in a down market of increased defaults, as occurred in the mortgage banking industry almost a decade ago. Section 2 of this White Paper will summarize the core risks that appear as recurring themes across the different regulatory pronouncements. Risks are analyzed for each of the types of entities involved in typical MPL funding arrangements. Section 3 describes potential solutions to the growing list of perceived risks in this innovative and promising industry.

Regulatory developments disrupting MPL lending

Three years ago, critics of MPL lending would often accuse regulators of not paying enough attention to potential risks in the industry, and suggested that platform lending was largely unregulated. Platforms rightly responded with a description of all of the consumer protection requirements that applied to the origination, servicing and collection of MPL loans, but that answer addressed consumer litigation risk without adequately addressing questions on the role of consistent regulatory oversight in maintaining institutional stability. This past year, the OCC, FDIC, Treasury Department, CFPB and SEC all tightened their focus on the industry with public pronouncements that helped give shape to the future we can expect in federal regulation of platform lending. Courts have added additional wrinkles in scrutinizing the structure of MPL transactions for preemption purposes, while States have also begun their own analysis of possible new local licensing requirements.
OCC White Paper

In March, 2016, the Office of the Comptroller of the Currency (“OCC”) published a “white paper” on the FinTech industry and invited public comment. The OCC charters all national banks and federal savings associations and agencies of foreign banks. The stated mission of the OCC is to ensure that national banks and federal savings associations operate in a safe and sound manner, provide fair access to financial services, treat bank customers fairly, and comply with applicable laws and regulations.
In its Fintech white paper, the OCC expressed cautious optimism about the potential of FinTech to improve access to credit, but also expressed concerns about various potential risks. The OCC noted that strategic, credit, operational, and compliance risks remain top concerns associated with marketplace lending. Specifically, the OCC observed:

1. Strategic risk: The OCC determined that strategic risk for regulated banks remains relatively high as banks try to execute their strategic plans and face challenges with growing revenue.

2. Credit risk: The OCC found that credit risk in the ecosystem is increasing because of impressive loan growth in recent years. The OCC noted an increase in concentrations and risk layering, as banks aspire for yield in an increasingly competitive market.

3. Operational risk: The Comptroller expressed concerns about increasing cyber threats, the overreliance on third-party service providers, and resiliency planning.

4. Compliance risk: The White Paper noted that banks face challenges meeting regulatory requirements, noting the challenges of managing Bank Secrecy Act risks as well as new regulations governing mortgage disclosures and the Military Lending Act.

The OCC announced it was creating a working group to study developments related to marketplace lending, and urged industry participants to protect consumers and grow the industry in a safe and sound manner.  The OCC is also considering the possibility of a limited charter for MPL platforms in order to address criticisms that the platforms otherwise are not directly regulated like other types of lending institutions.

FDIC Draft Guidance

A large bulk of marketplace lending to consumer borrowers is conducted through state-chartered banks which answer to the Federal Deposit Insurance Corporation (“FDIC”). The FDIC is able to regulate state-chartered, nonmember banks because those banks rely on their federal supervision in order to export their home state maximum interest rate under the Federal Deposit Insurance Act.  The FDIC has scrutinized marketplace lending arrangements in three of its publications in the span of nine months, expressing systemic concerns for the safety and soundness of its supervised banks.  In FIL-50-2016, the most recent proposed guidance in July 2016, the FDIC requested comment on draft guidance regarding third-party lending. The guidance provides safety and soundness and consumer compliance measures that FDIC-supervised institutions should follow when lending through a relationship with a third party, the agency explained, supplementing the FDIC’s existing Guidance for Managing Third-Party Risk, issued in 2008.

Defining third-party lending as “an arrangement that relies on a third party to perform a significant aspect of the lending process,” the proposed guidance references categories such as institutions originating loans for third parties, originating loans through third parties or jointly with third parties, and originating loans using platforms developed by third parties.

The FDIC noted that managing and controlling the risks of third-party relationships would be challenging, especially when origination volumes are substantial or numerous third-party relationships are in place. The FDIC advised that institutions should establish a third-party lending risk management program and compliance management system commensurate with “the significance, complexity, risk profile, transaction volume, and number of third-party lending relationships” to cope with these risks.

As set forth in the guidance, the FDIC indicated that a bank’s risk management program and compliance management system should comprise four elements: risk assessment, due diligence and oversight, contract structuring and review, and oversight.

The FDIC has identified the following risks:

  1. “Strategic Risk” – risks caused by poor business decisions;
  2. “Operational Risk” – risks associated with inadequate internal processes, employees and systems;
  3. “Transactional Risk” – risks caused by problems with the delivery of products or services;
  4. “Model Risk” – risks resulting from overreliance on and misunderstanding of platform qualitative models;
  5. “Pipeline and Liquidity Risk” – risks resulting from transactions that are not consummated or funded as planned;
  6. “Credit Risk” – risk that a third party is not able to meet the contractual requirements;
  7. “Compliance Risk” – violations of rules, laws, internal policies and procedures, or the institution’s business standards;
  8. “Bank Secrecy Act/Anti-Money Laundering (BSA/AML Risk” — risks associated with undue reliance on the third party to conduct any aspect of BSA/AML compliance.)

The FDIC announced that examiners will assess MPL lending arrangements based upon credit underwriting and administration, loss recognition practices, the applicability of subprime lending guidance, capital adequacy, liquidity and funding, profitability and budgeting, accounting and allowance for loan and lease losses maintenance, compliance with consumer protection laws, programs for safeguarding customer information when held by third-party platforms, and oversight over the third party’s BSA/AML requirements. With regard to contract structuring, the FDIC advised that contracts with platforms should allow the bank to have full access to information and data necessary to perform its risk and compliance management responsibilities, including access to loan performance data, internal and external audits, and funding information.

The proposed guidance would establish increased supervisory attention for institutions that engage in “significant” lending activities through third parties, defined to cover banks where such lending has a material impact on revenues, expenses or capital; involves large lending volumes in relation to the bank’s balance sheet; involves multiple third parties; or presents material risk of consumer harm. In such situations, the FDIC proposed a 12-month examination cycle, concurrent risk management and consumer protection examinations, off-site monitoring, and the possibility of the agency’s review of the third parties involved.

Treasury White Paper

On July 20, 2015, the US Department of the Treasury (“Treasury”) issued a Request for Information entitled “Public Input on Expanding Access to Credit through Online Marketplace Lending” (the “Treasury RFI”). Treasury was seeking information on a host of issues, including the role of electronic data sources and data-based processes in marketplace lending; business models and product offerings; access to credit for underserved markets; customer acquisition processes; accuracy of credit risk and underwriting models; platform relationships with traditional lending institutions; platform use of third-party service providers; what role government can play to help foster growth of the MPL market; risk-retention and alignment with investor interests; potential risks to consumers; investor considerations; and development and growth of a secondary market for MPL loans.
Treasury received almost 100 formal comments from marketplace lenders and other FinTech companies, lending institutions, consumer groups, among other interested parties. Treasury is not technically a regulator, so the issuance of the RFI and the resulting White Paper presented more of a policy discussion than a set of proposed mandates.
On May 10, 2016, Treasury issued its White Paper entitled, “Opportunities and Challenges in Online Marketplace Lending.” Treasury identified several core observations from the RFI responses, including: (1) the use of data and data modeling represents both potential benefits and potential risks, including fair lending risks and gaps in consumer protection; (2) the MPL industry has the potential to expand access to credit, although the majority of consumer loans are being originated for debt consolidation purposes; (3) the MPL industry is growing, but has not yet experienced a full credit cycle; (4) there is a perceived need for greater transparency for market participants, including with respect to pricing terms for borrowers and standardized loan-level data for investors, and the possible role of a registry for titling interests in MPL loans; (5) the secondary market is still developing and will require transparency; and (6) many commenters are looking to regulators to provide additional clarity around the roles and requirements for the various participants in the market, including with respect to consumer and small business protection, cybersecurity and fraud, bank partnerships and the true lender doctrine, Bank Secrecy Act and anti-money laundering (“BSA/AML”) requirements, and risk retention.
Treasury then outlined a series of policy recommendations offered by the public, which included:

1. Provide an Exemplary Consumer Experience and Back-End Operations. MPLs must have a comprehensive servicing and collection strategy in place, including back-up servicing options, in the event of a down market and a resulting increase in delinquencies. Treasury also recommended that the industry adopt standards to improve each borrower’s experience throughout the entire loan process, even in the event of delinquency or default.

2. Increase Transparency for Investors and Consumers. To enable transparency, the MPL industry could create a publicly-available, centralized registry for tracking data on loans that includes data on the issuance of notes and securitizations and data on loan-level performance. Treasury suggested that improved transparency would help to develop a wider investor base and a more active secondary market. To improve investor transparency, Treasury suggested that the industry adopt standardized representations, warranties, and enforcement mechanisms. Additional recommendations centered around standardized loan data reporting standards, transparency on the performance of securitized loans, and consistent market-driven pricing methodology standards.

3. Greater Access to Credit Through Partnerships. Treasury recognized the potential for online marketplace lending to expand access to credit in underserved markets. According to Treasury, however, marketplace lenders currently serve primarily prime or near-prime borrowers. Treasury recommended that marketplace lenders better serve underserved markets through referral, co-branded, or white label partnerships with Community Development Financial Institutions (“CDFI”). But while recommending partnerships between financial institutions and marketplace lenders, Treasury also encouraged prudential regulators to evaluate these partnerships and their associated risks carefully.

4. Improved Access to Government-Held Data. Treasury encouraged wider use of smart disclosures (i.e., release of information in standard machine-readable formats). In addition, Treasury recommended that the CFPB and the FTC include the use of smart disclosures in their guidance and standards on consumer disclosures.

5. Establishment of a Standing Working Group. Treasury recommended the creation of a standing working group on marketplace lending that includes Treasury, the CFPB, FDIC, FRB, FTC, OCC, SBA, SEC, and a representative of a state bank supervisor. So while Treasury itself would not directly be regulating the industry, it would be working closely with those entities with enforcement authority.

Consumer Financial Protection Bureau

When the General Accounting Office (“GAO”) first started studying the MPL industry in 2011, it was widely discussed that the newly-created Consumer Financial Protection Bureau (“CFPB”) would ultimately become the industry’s leading regulator. In 2016, the CFPB has made announcements suggesting that it is moving aggressively towards assuming that role. On March 7, the CFPB formally announced that it would be taking complaints through its online portal from consumers regarding experiences with MPL lenders in origination or collection.

In addition to its announcement about its complaint process, the CFPB issued an accompanying bulletin, entitled “Understanding online marketplace lending.” The bulletin advises consumers to consider certain issues before taking a loan, warns consumers about refinancing certain kinds of debt, advises consumers to check their credit reports, and lists various issues consumers should think about when loan shopping (including the length of the loan term, interest rates, fees and penalties).
The CFPB’s purpose in making the announcement is seen by many as a signal to the MPL industry that it would be more aggressive in monitoring platform lending in 2017. Indeed, nothing else was particularly new in the announcement. The Bureau conceded that its recommendations to consumers in seeking a loan were equally applicable for any type of loan, and not just MPL loans. Moreover, consumers already could complain to the CFPB about marketplace loans using the CFPB’s existing loan categories. The Bureau’s advice to consumers reads more like a warning, indicating: “keep in mind that marketplace lending is a young industry and does not have the same history of government supervision and oversight as banks or credit unions. However, marketplace lenders are required to follow the same state and federal laws as other lenders.”

Securities and Exchange Commission

The Securities and Exchange Commission (“SEC”) has been the most involved regulator of the MPL industry since the arrival of LendingClub and Prosper, focusing primarily on the protection of investors and filing requirements associated with the registration of platform notes as “securities” pursuant to its 2008 enforcement proceeding. There have been new developments, including the final regulations on credit risk retention becoming applicable in December 2016. The risk retention requirements were designed to address criticisms of the misaligned incentives associated with the “originate to distribute model” of asset securitization. The risk retention requirements require a securitization sponsor to retain not less than five (5) percent of the credit risk for any asset that the securitizer transfers or sells to a third party through the issuance of an asset-backed security. In addition, the new regulations prohibit a securitizer from directly or indirectly hedging the credit risk that it is required to retain. The goal is to incentivize securitizers to improve the structure of securitizations and align the interest of securitizers with those of investors.

The core question going forward in MPL securitizations involves which entity is the “sponsor” for the purposes of risk retention. A “sponsor” under the risk retention requirements is defined as “a person who organizes and initiates a securitization by selling or transferring assets, either directly or indirectly, . . . to the issuing entity.” Where a balance sheet lender securitizes loans that it originates and holds on its balance sheet, it will be deemed the “sponsor,” but where the loan seller is not the originator, but rather a type of loan aggregator, it could be argued that the funding bank or the platform could be deemed the “sponsor” depending on the circumstances, although commentators believe that the aggregator is the most likely party to be deemed the sponsor for risk retention purposes under that scenario.

In a promising development for MPL investing, RiverNorth Marketplace Lending Corporation filed an N-2 with the SEC in June. The N-2 is the filing made by an Investment Company with the SEC in order to launch a “Closed End Fund” pursuant to the Investment Company Act of 1940. It is the first filing for a CEF in the United States that has an investment strategy focused on investing in marketplace loans. It is designed to attract the permanent capital that MPL platforms have been seeking, albeit in the form of high net worth individual investors. This CEF would allow individual investors to use professional management to gain access to diversified pools of marketplace loans without having to join each and every platform to hand pick loans for investment. But while the SEC is presumed to have encouraged this development in MPL financing, it is well known that the SEC is investigating the largest platforms for potential violations.

Related Judicial Developments: “Valid When Made” and “True Lender” Analysis

Although the MPL industry has not been the subject of any noteworthy cases, platforms and investors alike have watched closely as courts have made controversial rulings that may have ominous ramifications for the business model of many MPL platforms.

Is “Valid When Made” Still Valid?

The first of these cases is a decision by the United States Court of Appeals for the Second Circuit in the case of Madden v. Midland Funding, LLC . The Madden case involved a New York borrower whose credit card account became delinquent, and was ultimately sold to a debt buyer for collection. The borrower brought a class action suit in federal court against the debt buyer alleging that the 27% interest rate provided for in the credit card agreement and charged by the debt buyer violated New York’s usury statute.

The debt buyer argued that the interest rate was not subject to New York usury law due to federal preemption principles. Section 85 of the National Bank Act permits national banks to make loans at the rates and fees permitted in the state where the bank is located, and to export

those rates and fees in loans to borrowers residing in other states, even if those rates and fees would otherwise be illegal in the borrower’s state of residence. State chartered banks have similar rights to export rates and fees under a related federal statute . The trial court agreed that the usury law was preempted and the claim was dismissed, but the Second Circuit ultimately reversed that decision. The Second Circuit reasoned that preemption would apply if a national bank were collecting the debt, it does not apply if the usurious rate is being charged by a third party, non-bank purchaser of the debt. The Court stated that NBA preemption applies to a nonbank entity only when the entity has acted on behalf of a national bank. Since the debt buyer was an assignee rather than an entity acting on the bank’s behalf, preemption would not apply. The Court expressed its desire to prevent nonbanks from doing an “end run” around state usury laws.

The Madden decision has been roundly denounced by the financial services industry. The decision ignored the “valid when made” doctrine that has been relied on by other appellate courts undertaking the same preemption analysis . The “valid when made” doctrine holds that an agreement is not usurious if its terms were not usurious at the loan’s inception, and that the validity of the loan travels to an assignee of the underlying promissory note. The debt buyer petitioned the Supreme Court to review the case. The Supreme Court requested the views of the Solicitor General on whether it should hear the case. The Solicitor General filed an amicus brief, that was joined by the Comptroller of the Currency, arguing that the Second Circuit’s decision was incorrect and that the “valid when made” doctrine required preemption. However, the Solicitor General did not recommend that the Supreme Court take the case, noting that the parties had neglected to litigate core components of the preemption analysis and therefore a direct conflict did not exist with other appellate court decisions on the issue. On June 27, the Supreme Court denied the petition for review.

The case has been remanded and is ongoing. There is a remaining state law issue, as the credit card agreement had a choice of law provision, and it may be that the original interest rate will be permitted if the trial court of the application of Delaware law. The case may get reviewed again on this issue or related issues when a final judgment is entered. In the interim, the decision is binding in the Second Circuit states (New York, Connecticut and Vermont), but not elsewhere. There is also the added potential that the decision may apply to a borrower who moves to a Second Circuit state. In addition, debt buyers of defaulted debt generally will not be able to enforce the same interest rate as the creditor who originated the debt. It is likely also the case that other assignees of the loan are denied the same interest rate authority, including securitization vehicles, hedge funds, other purchasers of whole loans, including those who purchase loans originated by banks pursuant to private-label arrangements and other bank relationships common to the MPL industry.

Who is the “True Lender”?

Another theory relevant to the applicability of usury statutes is the “true lender” theory being increasingly applied in payday loan scenarios in which the marketers of payday loans are accused of using solely as a ruse for evading state consumer protection and usury statutes. The litigation centers on whether the pay day loan marketer is the “true lender” and that the bank lender should no longer be considered for preemption purposes.

Payday lender CashCall, Inc. has borne the brunt of this theory. In 2014, CashCall lost a case brought by the West Virginia Attorney General, in which the West Virginia Supreme Court ultimately upheld the decision to void the affected loans, enjoin CashCall from making additional loans in the State, applying millions in fines and punitive damages .

Just this summer, the Consumer Financial Protection Bureau (“CFPB”) successfully advanced the same theory against CashCall in a California federal district court . In granting summary judgment to the CFPB, the Court ruled that CashCall engaged in deceptive practices by servicing and collecting on loans in certain states where the interest rate on the loans exceeded the state usury limit and/or where CashCall was not a licensed lender. The decision represents an extension of the CFPB’s aggressive theory that collecting on loans that state law renders void and/or uncollectable constitutes a violation of federal law.

The court ruled that CashCall was the true lender on the loans that were issued by Western Sky Financial because “the entire monetary burden and risk of the loan program was placed on CashCall, such that CashCall . . . . had the predominant economic interest.” The court reached this conclusion based on the facts that, although the originator was the nominal lender on the loans, CashCall funded a reserve account to fund two days’ worth of loans, and also purchased all of the loans originated by Western Sky after a three-day holding period and before any consumer payments were made on the loans. In addition, CashCall had agreed to indemnify the lender for any liability arising from the loans. The court applied a “totality of the circumstances” test to determine which party to the transaction had the “predominant economic interest” in the transaction. This approach to determining “true lender” status could have implications for MPL arrangements in which platform lenders rely on bank partners to make and fund loans that are subsequently purchased and serviced by the platform.

There are varying standards applied in “true lender” cases. Some courts apply the “totality of the circumstances” analysis applied in the California CashCall decision. Other courts focus exclusively on which creditor is named in the loan agreement. Many courts rely on which entity is responsible for three functions: (i) the determination to extend credit; (ii) the extension of credit itself; and (iii) the disbursement of funds resulting from the extension of credit. Finally, some courts have taken the more fact-intensive approach adopted here, evaluating the totality of circumstances to determine who has the predominant economic interest.

How Have Madden and the True Lender Cases Changed the MPL Industry?

In February 2016, LendingClub finalized changes to its loan origination program with WebBank. The changes are presumably designed to address factors that have been determinative in the Madden and true lender analyses. For example, the borrower agreement now explicitly specifies that WebBank maintains the account relationship with the borrower for the life of the loan. Moreover, LendingClub’s compensation from a loan is no longer structured as a fixed origination fee based on the loan’s principal, but rather is tied to the loan’s performance. These changes enable WebBank to assert an ongoing interest in each loan it originates through the LendingClub platform.

State Licensing Requirements

State regulators have also been scrutinizing the MPL industry, particularly with regard to licensing issues in California and New York. The California Department of Business Oversight (“DBO”) has suggested concerns with the online marketplace lending business model. On May 9, the DBO sent letters to 14 marketplace lending firms with detailed questions as a follow-up to the responses the DBO received from its initial request in December 2015. The letters represent the second phase in the DBO’s inquiry into the industry’s practices.

The letters focus on five main areas of concern: (i) fair lending; (ii) referral fees paid to brokers or other entities; (iii) loan underwriting (particularly those loans underwritten using alternative credit scoring models); (iv) partnerships with originating banks; and (v) investor protections for purchased and securitized loans.
The DBO inquiry could, among other things, explore whether these entities are appropriately licensed under current state regulations, or whether a separate charter or body of regulations may be warranted for these companies. In addition, it is possible that the inquiry could lead to enforcement actions by the DBO itself or in conjunction with the CFPB.

A somewhat similar inquiry was initiated by the New York Department of Financial Services (“DFS”). New York’s inquiry reportedly focused specifically on the activities of LendingClub. While it is unclear whether the DFS inquiry is the beginning of broader industry-wide investigation in New York, it may be the prelude to a more comprehensive review of the industry. Some recent reports suggest that the DFS is planning similar inquiries into other industry participants, focusing in part on whether marketplace lenders should be licensed in New York. The DFS inquiry reportedly focuses specifically on the interest rates, fees, duration and volume of loans made to New Yorkers, as well as LendingClub’s policies for complying with fair lending and consumer protection laws. Similar to the DBO inquiry, the DFS inquiry seeks to understand the contours of this business and the effects, if any, it might have on New Yorkers.

Summary of risks for industry players

Based upon the aforementioned regulatory developments and other factors inherent to the industry, the risks to the common players in platform lending funding arrangements can best be summarized as follows:

Risks for Original Creditors

Regulatory Risk: Original creditors are facing increasing regulatory guidelines for bank third-party relationships. A bank faces the risk of sanctions if the bank does not exercise adequate oversight over its platform partners.

Reputational Risk: Original creditors also face the risk of adverse publicity if a bank partners with a platform that engages in abusive sales or collection practices. The bank faces similar risks if the platforms fail to service the loans properly. This risk is often associated with potential abuse of consumers. But it also extends to the risk that platforms have double sold loans, or have failed to maintain adequate custody of loan documents – servicing failures that ultimately lead to losses for investors.

Litigation Risk: If investors lose money because of platform failure, they will look to the originating bank as a deep pocket to cover their losses. Jilted investors are likely to allege that the bank acted as a joint venture with the platform, and therefore assumed responsibility for inadequate disclosures or other forms of negligence arising in the origination, transfer or servicing of marketplace lending loans.

Risk Retention: In the securitization context, banks face the risk that the Securities and Exchange Commission will regard the bank as the “sponsor” of the securitization because it sold the loans to the platform which in turn sold them to the securitizer with the expectation that the securitization would occur.

The rules are only getting more onerous for MPL securitizations after December 24, 2016, when the credit risk retention requirements of Section 15G (and associated Rule 15G) of the Securities Act becomes applicable. Under Rule 15G, a securitizer (the party organizing the securitization and selling assets to the sponsor) is required to retain five percent of the credit risk associated with the securitization. The rule prohibits the securitizer from selling, transferring or hedging any economic interest in the credit risk, or financing it on a non-recourse basis.

Risks for Marketplace Platforms

Regulatory Risk: Marketplace lenders are in danger of facing the “true lender” claims that have targeted the payday loan industry. A successful true lender claim, or any failure to comply with applicable consumer protection statutes or state licensing regulations could render the underlying loans unenforceable in certain states. The increased posturing of the CFPB in this space is an ominous sign for consumer protection claims again platforms in 2017. State regulators in New York and California have also become more assertive in seeking information from the industry, and could result in regulatory burdens that will increase costs or require changes to existing business practices.

Risk Retention: The SEC could potentially take the position that a platform functions as a “sponsor” of a securitization, even though it sells the loans to purchasers who actually securitize them. The argument is that the platform sold the loans in anticipation of securitization and provided related administrative services that facilitated the securitization. In this scenario, the platform will be subject to the five percent risk retention requirement, or will be obligated to ensure that another “sponsor” satisfies the retention requirement.

Reputational Risk: Adverse regulatory actions based on allegations of abusive or deceptive sales or collections practices will substantially damage a platform’s reputation. Similar reputational damage may result if the platform (i) fails to protect the confidentiality of borrower information and allows a data breach, and/or (ii) fails to maintain appropriate custody of loan documents (for those investors who do not themselves take possession), or similarly fails to maintain appropriate records of loan sales and collections, resulting in the improper allocation of collections to the appropriate investors.

Funding Risk: If investors lose confidence in a platform, or in marketplace lending generally, the platform may no longer have access to third-party funding on the terms or in the amounts that it requires for continued operations, let alone any expansion of those operations. The industry is still in an experimental phase, and the misconduct of one platform may have a ripple effect on other platforms, as investor losses caused by one platform may affect the availability of funding for the industry as a whole.

Data Breaches: Platforms should assume that they will be subject to a cyber-attack and therefore need to maintain adequate safeguards to protect customer data and proprietary information against unauthorized access.

Borrower Fraud: Just as was the case in the subprime mortgage crisis, borrower fraud is a substantial risk. Platforms need to take precautions by verifying borrower-submitted information on loan portfolios, and must apply procedures designed to identify fraudulent applications. Platforms are often required to repurchase loans in the event of fraud or first payment default, pursuant to the representations and warranties made to the investors.

The protection of investors has been a central concern of regulators since the inception of the MPL industry. These concerns were magnified by the massive losses experienced by institutional investors in the mortgage banking industry during the Great Recession. A series of themes can be found in the various regulatory announcements in the last year, which highlight the following practical risks to investors:

Insolvency Risk: Investors purchasing pass-through notes issued directly by the platform may suffer losses or payment delays if the associated platform becomes insolvent. If they have not been granted a security interest in the underlying loans, or if any such security interest is defective, the risk of loss may be substantially increased. Investors purchasing pass-through notes issued by a special purpose entity (“SPE”) face similar risks although to a lesser extent. Investors (including loan purchasers as well as note investors) also face insolvency risk deriving from the pooling of investor funds and loan collections in a “purchaser online account” maintained by the platform.

Fraud/Mismanagement: Investors could suffer complete or partial loss of collections if the platform (a) sells the same loan to more than one investor, or (b) fails to maintain appropriate records enabling it to properly allocate collections. There is the potential for this sort of risk to be masked by a Ponzi scheme arrangement for a period of time before the platform can no longer cover payments on existing loans with new originations or continued double sales.

Regulatory Risk: Investors face the risk that purchased loans may become unenforceable because of the platform’s breach of federal or state consumer protection laws, or state usury caps or licensing requirements. Particular risks include misplaced reliance on bank preemption to establish exemptions from usury or licensing requirements, or decisions by the CFPB determining that specific loan terms or collection practices are abusive.

Servicing Risk: Investors may incur losses if the platform does not properly service the loan. Greater losses are likely if the investor does not have appropriate rights to terminate the servicer. An additional risk is if a backup servicer has not been appointed, or is incapable of quickly assuming the servicing duties upon termination of the platform. A related risk is if the platform fails to render appropriate assistance in connection with a securitization contemplated by the investor when it acquired the loans.

Loss of Collateral: In programs that make secured loans (such as small business loans), the investor is exposed to risk if the platform fails to perfect its security interest or is incapable of effectively realizing the value of the collateral following borrower default.

Foreign Investors: Foreign investors are often a source of initial capital for start-up marketplace lenders, but foreign investors are generally subject to a 30% withholding tax on gross payments of interest made on any direct investments in marketplace loans in the United States, or a tax on net income if the investor is deemed to be in the business of making loans in the United States. To avoid these and other tax risks, arrangements need to be made to season or house the loans for a specified period before they are sold to the investor.

Verification Risk: Investors face a risk of loss if acquired loans have not been properly documented by the platform. If the loan data does not match the underlying loan documents and the investor has not retained a competent verification or validation service to confirm the documents before the loans are purchased.

Custodial Risk: If the investor does not take possession of the loan documents, or does not have placed into an electronic vault for its benefit, the investor will face the risk that access to such documents will be impaired if they are retained by a platform that becomes insolvent. The collectability of those loans is highly dependent on access to the underlying loan documentation.

Documentation Risk: Investors are highly dependent on platforms to properly originate loans. If a platform’s standard loan application and associated loan documents is flawed under state or federal law, the loans may be unenforceable. For example, the loans may breach the Truth in Lending Act, or the platform’s power of attorney arrangement by which the borrower authorizes the platform to execute loans on the borrower’s behalf may be defective.

Repurchase Risks: It is commonplace for an investor to obtain a commitment from the platform to repurchase ineligible loans. But the value of that commitment may be substantially impaired if (i) the commitment is subject to significant limitations on availability, or (ii) the platform does not have the financial capacity to repurchase a significant amount of nonconforming loans.

Risks for Warehouse Lenders

Warehouse lenders are essentially indirect investors in loans – they are making advances to investors and MPLs that will be secured by the purchased loans. As such, the risks to Warehouse Lenders are highly derivative of the entities that are their borrowers. To the extent that the borrowing entity that is acting as direct purchaser/investor from the platform experiences risk of loss or unenforceability or inadequate servicing, the warehouse lender is exposed to the same risk. However, a warehouse lender does have unique risks, such as the following:

Borrowing Entity Risk: The warehouse lender faces risks associated not only with the quality of the loans, but also with the quality of the borrowing entity to whom it has advanced the warehouse line. The borrowing entity may intentionally or inadvertently pledge the same loans to multiple lenders. Alternatively, the borrowing entity may fail to maintain adequate custody of the purchased loans, which would undermine the ability for the warehouse lender to collect on the loans in the event of default.

Structuring Risks: If the borrower is not a Special Purpose Entity (“SPE”), the warehouse lender may have exposure to the borrowing entity’s insolvency risk. If the borrower is an SPE, the lender will likely want a parent company to provide a guaranty or other form of indemnification in order to ensure that it has adequate protection in respect of any losses that may occur in connection with the facility.

Documentation Risk: As the borrowing entity, rather than the warehouse lender, will execute the loan purchase agreement and various other agreements with the platform, it needs to ensure that its rights in relation to the program are adequately protected in those documents. For example, the warehouse lender will want protections that require the borrowing entity to obtain the warehouse lender’s consent before agreeing to amendments of the loan purchase agreement, and will further want to control matters such as termination of a servicer.

Collateral Deterioration: If the new loans pledged as collateral deteriorate in quality, the loans may become ineligible under the warehouse lending arrangement, and the borrowing base may be eroded. The warehouse lender may suffer related losses if the borrower is not required, or does not conform to an existing requirement, to end the revolving period, immediately provide the principal payments to the warehouse lender, and generally enhance the quality of the collateral going forward.

Risks for Rating Agencies

Rating agencies were heavily criticized by regulators and politicians even prior to the Great Recession and the passage of the Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”). Much of the scrutiny centered on perceived conflicts of interest in the “issuer pays” model, which led to the passage of the Credit Rating Agency Reform Act in 2006, empowering the Securities and Exchange Commission (“SEC”) to regulate conflicts of interest and record keeping, and setting guidelines for which credit rating agencies qualify as National Recognized Statistical Rating Organizations (“NRSROs”). Concerns lingered in the following years about the type of and disclosure of independent reporting relied on by NRSROs in rating securitizations. In 2014, the SEC adopted final rules applicable to NRSROs, including new Rule 15Ga-2 and new Rule 17g-10. The new rules implement certain requirements relating to the disclosure of third-party due diligence services employed in connection with the issuance of rated asset-backed securities. Consistent with these historical concerns in the last decade, securitization process for MPL loans provides unique risks for NRSROs, such as:

Reputational Risk: A rating agency may suffer significant damage to its reputation if it’s rating of a marketplace loan securitization proves incorrect, particularly if the rating is too favorable. The performance information available for marketplace loans is still relatively limited. The lack of adequate loan and platform-specific information to support the ratings analysis remains a potential risk hampering efforts to increase the number of MPL securitizations. In addition, ratings agencies are obligated to consider all of the risks facing potential investors in MPL loans. Investors are increasingly aware of the regulatory uncertainties that affect marketplace lending, and a rating agency will need to show in its ratings analysis that it understands and has thoroughly considered these risks.

Fraud Risk: A rating agency is entitled to presume the absence of fraud in assigning its rating. But platform level fraud that results in investor losses will nonetheless undercut investor confidence in the MPL sector and in the ratings process.

GDR solutions

No single, third party service can address every potential risk to each party in the MPL ecosystem, but GDR provides services that address core industry concerns necessary for attracting and protecting institutional capital. Specifically, GDR provides independent validation of loan-level information to enable greater asset certainty for investors, and GDR offers the industry’s only collateral pledge registry service to ensure a reliable process for confirming collateral in warehouse lending arrangements.

RealValidation Services

GDR offer’s investors the first “real” validation service to ensure asset certainty. GDR’s validation service enables investors to have borrower and loan attributes independently verified without exposing the investor to the responsibilities and risks of managing the personally identifiable information (PII) associated with the loans. GDR receives this information from the MPL and validates it through trusted third party data sources to ensure that the loans and associated borrowers are real, that the platform accurately conveyed a borrower’s credit risk information to the investor, that the data in the loan file is consistent, and that the borrower is not currently listed as bankrupt, deceased, or on a watch list that would trigger AML/KYC obligations. GDR provides this service for investors at the initial purchase of loans, prior to a securitization of loans. GDR also does on-going monitoring to ensure trade lines are reported, and to do important compliance checks like AML/KYC. In addition, GDR offers a registry for MPL loans to record and track chain of ownership and servicing interests for the purpose of facilitating downstream transfers and facilitate a showing of standing for collection purposes.

What Regulatory Risks Does It Address?
As discussed above, a common risk faced across the ecosystem is the risk of negligent or fraudulent origination. Improper validation of accounts carries with it potential exposure for loans that cannot be collected. There is also the strong possibility for reputational risk, as the origination and transfer of erroneous loans could destroy the reputation of platform lenders, and of those who invest or rate these loans. GDR confirms that the loans exist, that the borrowers exist, that the funds have been disbursed, that the borrower’s reported credit score was accurately relayed by the platform, and that the borrower is not listed publicly as deceased, bankrupt or on a watch list triggering AML/KYC reporting requirements. It further protects against reputation, legal and financial risks associated with trade line reporting and ongoing compliance monitoring of borrowers.

GDR ePledge Registry

GDR has created a collateral tracking service for the marketplace lending ecosystem established to prevent the double pledging of MPL loans as collateral. When implemented, GDR can become

the source file for a platform lender to track loan level assignments and releases of collateral. Leverage providers have expressed interest in this type of registry of collateral since it can greatly reduce risks related to inadvertent misassignment or double-assignments of loans.

What Regulatory Risks Does It Address?

GDR’s ePledge collateral tracking registry addresses the risks related to asset certainty in warehouse lending arrangements. Warehouse lenders are protected from the potential of fraud or negligence committed by platforms, or by the investor granted a warehouse line. By recording and tracking collateral pledges, GDR also solves risks to the larger ecosystem relating to investments in the loans, including reputational and fraud risks faced by ratings agencies. GDR ensures pledges are not duplicated across lenders by validating loan and borrower information with the MPL and external data sources, while the warehouse lender ensures that the information it is receiving from the borrowing institution is valid.

GDR Chain of Title Registry and Servicing Rights Registry

GDR’s Chain of Title Registry supports secondary market sales and downstream debt collection. GDR’s Registry merges the ingenuity of FinTech with time-honored safe and sound principles for validating the titling and documentary support of loans in the secondary market. Markets for assets have traditionally been facilitated by the adoption of centralized registries to track the title and supporting documentation associated with the asset. This solution is essential for a new industry offering swift automation of new loans that ideally will travel freely in a marketplace that is both liquid and sound for investors.

As the market evolves and firms pursue different types of loans and different risk profiles, the ability to ensure compliance will be tested. The credit underwriting models, funding structures and the use of mostly outsourced collection services have not yet experienced challenging market conditions, such as a sharp rise in regional or national unemployment. As seen in other markets, a significant downturn in economic conditions can create challenges for debt owners when account information moves between parties. This has proven to be true historically when markets have been subject to liquidations and takeovers. In these circumstances, it can be difficult to substantiate a collector’s or debt owner’s right to collect the debt. Consumers can lose ready-access to account information, and incomplete, untimely or incorrect data can lead to harmful consumer practices in collection of past due accounts. For marketplace firms, the unique ownership and legal structures between investors and servicers creates an additional need to ensure that account information remains updated and intact as accounts flow between various parties in the marketplace.

What Regulatory Risks Does It Address?

Registries have traditionally served to formalize the process of creating an asset and to confirm it chain of ownership. The GDR Registry resolves risks attributable to the ownership of and collection rights to the underlying loans, and creates a stable process for the origination and transfer of MPL Loans. GDR also tracks servicing rights in its registry to establish conclusively for all parties the collection rights and responsibilities throughout the life of the loan. The registry process is designed to help those dealing with issues at the back end of the life cycle of a loan, those in the collections process who require a definitive means of establishing authority to collect and who are subject to consumer protection statutes such as the Fair Debt Collection Practices Act or its state equivalents.

GDR’s asset certainty products are designed to address many of the current and emerging regulatory risks by delivering greater transparency and certainty to the MPL ecosystem.  MPLs will benefit from increased confidence in industry assets and investor and warehouse lenders will benefit from enhanced due diligence and reduced risk.

Conclusion

In 2016, the regulators have identified a host of risks that they consider to be endemic to marketplace lending.  While the industry has not yet seen a flood of new, binding regulations, that flood will come if the industry does not implement structural changes to alleviate the misalignment of interests in the origination, transfer, securitization, and collection of MPL Loans.  GDR offers the solutions for asset certainty and formalized recording that will protect the interests of the MPL ecosystem, and quell the concerns of regulators who are still getting comfortable with online lending.  With GDR’s solutions, the MPL industry would be positioned to overcome this period of regulatory disruption and evolve into a fixture in the world of consumer lending.

Author: Benjamin M. Kahrl
General Counsel
Global Debt Registry

Bibliography

The author acknowledges with thanks the input he received from discussions with Peter Manbeck of Chapman and Cutler LLP, as well as the overview received from the following publications:

Angela M. Herrboldt, Marketplace Lending, Supervisory Insights, Winter 2015, available at

Peter Manbeck and Marc Franson, “The Regulation of Marketplace Lending: A Summary of the Principal Issues (2016 Update),” April 2016, available at

Anthony R.G. Nolan, Joseph A. Valenti and Christopher H. Bell, “Certain Compliance Risks in Marketplace/Peer-to-Peer/Online Lending,” February 9, 2016, available at -risks-in-marketplacepeer-to-peeronline-lending-02-09-2016

Anthony R.G. Nolan and Edward T. Dartley, “Securities Law Considerations in Online Marketplace Lending,” February 3, 2016, available at

Anthony R.G. Nolan and Edward T. Dartley, “Ten Key Things to Know Before Catching the Securitization Wave,” January 14, 2016, available at

FIL-49-2015 (November 6, 2015), available at

FIL-50-2016 (July 29, 2016), available at

“Supporting Responsible Innovation in the Federal Banking System:  An OCC Perspective,” March 31, 2016, available at

“Opportunities and Challenges in Online Marketplace Lending,” May 10, 2016, available at

 

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