Personal loan markets are a bit imbalanced. The costs to originate loans are inflated by the need for lawyers, auditors, credit ratings agencies, brokers, and more. With so many middlemen, smaller originators are being squeezed by high expenses.
Can anything be done about it?
Optimally, the loans originated by peer to peer would be sold off to retail investors. But the shift away from selling fractional loans pushed out the retail investors, leaving the hedge funds. In 2016, the hedge funds pulled out, stranding billions in loans on the originators’ balance sheets.
The only way to make it go away, is to package all of those loans into a Special Purpose Vehicle (SPV). These loans are sold as securities to institutional investors like hedge funds, pension funds, and insurance companies. In order for institutional investors to be allowed to invest, the securities must pass a rigorous legal process. The loans must be rated. The papers audited.
It all costs money.
In order for the big online lenders to pass on the debt to institutional investors, they have to incur large expenses from middle men, squeezing their margins. For the institutional investor, the ROI on these SPVs justify the increase in price. For the originators, who have few if any alternative options, it’s a cost of staying in business.
But these expenses create barriers to entry to all but the biggest online lenders.
The smaller online lenders are left out. They don’t have the means to originate enough loans to get the attention of the institutional investors. They cannot securitize so their debt stays on their books, often paralyzing their ability to originate more. Their growth is confined to their rate of return.
Why Peer to Peer Lending Didn’t Deliver
Peer to peer lending was supposed to shake things up. When online lending came on the scene, the regulators didn’t know what to make of it. They didn’t have a clue as to which laws applied. As a result, online lenders didn’t pay anyone to make sure their assets met any regulations.
Once the regulators found a way to govern, the party was over. Online lenders had to pay more for regulatory fees and rates went up. When peer to peer got started, interest rates were at their post-2008 lows. They remained at 0% for a long time. As they began to rise, the cost of capital did also.
Peer to peer lending is all about moving cash. It’s about loaning out money, and then selling the loans to investors. To keep any cash on hand went against their business model. They are not depository institutions, and cannot borrow at the Fed Funds rate, which is currently at 1.25%.
A Solution for Smaller Investors
What if an originator didn’t securitize a bundle of loans? What if an online lender went on its platform and tried to sell its loans? It could take some time. There are markets for smaller originators who don’t sell to institutional investors, but liquidity is a major issue.
The secondary markets that do exist are only to meet basic regulatory requirements. They are closed to participants outside the originating platform. If you buy a note from Lending Club and you want to sell it, you can only sell it to someone on the Lending Club platform.
Loans purchased on a peer to peer lending platform will most likely be held to maturity. If an investor wishes to sell it, it can take a long time. One investor said that he waited 18 months to sell the loans he bought on a peer to peer lending platform at the price that he wanted.
The problem is liquidity. Peer to peer loans are “trapped” within their own platform. There is no secondary market where all of the loans originated by over 200 lending platforms can come together to provide liquidity for one another.
But what if there was?
A secondary market for loans issued by small originators could enable these companies to get the loans off their balance sheet as fast as the bigger players. A marketplace of these loans can create the liquidity badly needed by both originators and investors. If loans on 200 platforms suddenly converged into one marketplace, liquidity could cease to be an issue.
A secondary market can pave the way for smaller originators to flourish. The originators will have a place to sell their loans. Investors have a place to trade them. The liquidity and stability would create opportunities for a wider array of investors, such as the crypto community, to offer new sources of lending capital, ushering in the next phase of growth for the industry.
The New Marriage
Online lending has been fueled by hedge funds, who crave high returns on low volatility. As defaults grew, the hedge funds saw too much risk relative to their investment and walked away. In short, after a short marriage the groom wanted a divorce.
The new suitor may be the crypto investing community. Holders of digital coin are invested in highly volatile assets. The same secondary markets that are too much for hedge funds can provide a safe haven to park crypto assets into something pegged to the US dollar without leaving the crypto markets.
The underlying assets they invest in on this market will be backed by a highly diversified portfolio of loans eliminating the single point of failure offered by todays “stable” coin.
This new marriage has the chance to finally make good on the original promise of peer to peer lending.
Gilad Woltsovitch is the Co-Founder and CEO at Backed Inc., responsible for designing the company’s first-class platform, UX and UI. Before Backed, Gilad co-founded iAlbums, a semantic curation engine for media players in 2010 where he served as the company’s CEO from 2011-2014. In 2013, Gilad also served as the entrepreneur in residence for Cyhawk Ventures and joined the Ethereum project, establishing the Israeli Ethereum meet-up group. Gilad holds a Masters of Art Science and Bachelors in Sonology from the Royal Conservatory of The Netherlands in The Hague, University of Leiden.