Marketplace lending should not be easily dismissed

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P2P-lending has been one of the hottest topics in fintech for a while, and everyone (including myself) got on the bandwagon when it came to exploring the implications of P2P-lending when interest in the topic peaked around Lending Clubs IPO. Through 2015, the headlines has become fewer, but the segment still shows significant growth, with companies like Funding Circle showing 200% year-on-year growth.

While Lending Club received a close to $9 billion market cap valuation following the IPO as well as the unicorn status Prosper, SoFi and Funding Circle, chinese marketplace lending platform Lufax is valued at a staggering $10 billion. The number of billion dollar valuations in marketplace lending give an indication of the perceived potential in the segment.

For those who still perceive P2P-lending as an online platform for gray market loans that will collapse as soon as investors start losing their investments, here is how Lending Club actually works:

  1. A lender applies for a loan at Lending Club
  2. A bank (WebBank in Utah) actually issues the loan
  3. Lending Club acquires this loan from the bank and keeps it in their balance sheet
  4. Lending Club issues an unsecured structured note with a reference to the given loan
  5. Lending Club sells this security to an investor
  6. The lender pays interest and principal directly to Lending Club, which takes a cut, and pays the remaining interest and principal to the investor

This means that the lender never owes any money directly to the investor, but Lending Club handles all debt towards investors.  It is also worth while noting that this model allows Lending Club and Prosper to operate at a default rate of 5%.

The law firm Richards Kibbe & Orbe estimates that 80 percent of the investments in the U.S. P2P market originate from private equity and hedge funds, where the latter uses P2P loans as a way to invest directly in the debt market without commercial banks as intermediaries. This shows that the primary value proposition for marketplace lending is as an alternative asset class for investors. For lenders, marketplace lending is an alluring option for startups and SMEs that experience a funding gap since they do not meet traditional credit scoring requirements at incumbent banks.

The big question is: Could marketplace lending venture beyond unsecured loans and reinvent banking by challenging the cost of capital related to the banks ability to create credit? As of today, banks have a competitive advantage due to the abilityto create money through the banking license, but regulations sometimes tend to backfire, and in that case marketplace lending could be perceived as “a rare bird in the lands and very much like a black swan.”

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