What Oxera has to say on the P2P market and risk assessment

Recently Oxera, the economic consulting firm, published a report on the economics of P2P lending with a focus on the UK market. It is a comprehensive overview of the P2P dynamics and incentives. In our view the section on risk management is of key importance at the current development stage of the market.

The P2P market, since the first platform was created around 10 years ago, has reached a critical mass for institutional investors to get involved in the asset class. As of now there are several funds in the UK specifically focused on investing in marketplace lending.

The attractive characteristics of P2P lending to institutional investors are clear: 1) the high yields compared to other parts of the credit market; 2) the low correlation to short term market moves; but there is also a third more subtle point: the market is not crowded yet.

Money invested in fixed income is all competing for the same scarce set of “classic” assets: Investment grade credit, government bonds and the safer part of the high yield market are squeezed directly or indirectly by central banks buying programmes.

Investors moved to other asset classes to find returns with a similar risk profile to the classic fixed income market, these markets are now getting crowded too: Infrastructure projects, treated as quasi-fixed income investments, are in great demand by pension and insurance funds across the globe. Many credit funds have set up new private debt teams to lend directly to mid-market companies.

The P2P lending space is an obvious extension to the recent flows of funds in the fixed income space trying to diversify away from the classic bond market. Given the advantages of P2P outlined above and the fact that it is getting more complicated to invest in other classic fixed income markets, what is holding back most institutional investor to fully embrace the P2P lending?

Risk assessment is the answer. The Oxera report extensively covers the subject of how platforms ensure that risk is properly assessed for investors.

Their findings are that P2P platforms are incentivised to properly manage and assess risk and the credit risk assessments are in line with those used by traditional lenders. Oxera highlights 2 reasons why P2P platforms are incentivised to have proper risk assessment processes in place: 1) platforms charge ongoing services fees, if a loan defaults they lose that fee which reduce revenues; 2) there is a feedback loop from increasing defaults on loans originated on the platform and the platform losing reputation and hence future revenues.

P2P is a new asset class and many asset managers want to see how the asset class performs through a full economic cycle or in stressed conditions before entering the market. Despite it can be argued that other parts of the fixed income market (see corporate bonds) are priced for perfection, those instruments are better understood and asset managers have decades of data and full support from management teams and end investors to deploy capital in the bond market.

Oxera report, which was prepared for P2P Finance Association, is another step to help better understand the P2P market and the incentives at play. The market has to grow more mature, all participants will play a role: institutional investors will push for more stringent risk assessment methods, the regulator will oversee the risk underwriting practices, weak originators will disappear or will consolidate with stronger ones and data and analytics providers will make sure data is readily available and disseminated for participants to make informed choices.

The P2P market has a big potential of becoming a new investable asset class different from many others currently available, with all the diversification benefits that follow. In the process to fully develop the P2P market, all participants have to play their role to make sure that there will be as few accidents as possible. We at Alterest are one of those participants, with a key role of providing easy access to data and information about the P2P market with an aim of bringing transparency and simplified access to this asset class.

Link to the full Oxera report: http://www.oxera.com/Latest-Thinking/Publications/Reports/2016/economics-of-peer-to-peer-lending.aspx