Altfi: take 2 – 2 peer or not 2 peer?

This article was originally published on Altfi: here.

PrimaDollar CEO Tim Nicolle reassesses alternative credit funding models in light of the FCA’s latest proposals.

In March 2017, I wrote an article for AltFi called “To peer or not to peer”.

As this original article states, when we set up PrimaDollar, we had to decide how to fund our business. We provide trade finance to emerging market exporters who have mid-cap or large-cap customers, typically in OECD countries. We could choose between:

• Having our own balance sheet, raising debt and funding receivables ourselves, and
• Setting up a peer-to-peer funding model where retail and institutional credit investors would fund receivables directly on a non-recourse basis.

For us, the answer to the question “to peer or not to peer?” was “not to peer”. So we funded ourselves via our own balance sheet, recently closing our first securitization. This financial technology gives us scalable access to low cost funding, and does not have any of the regulatory or reputational uncertainties of the peer-to-peer world.

Was it a mistake to go down this route? Recent market developments are shedding some light on this.

1. The FCA proposals, July 2018

The FCA has now published proposals to move from the current light regime to a restrictive and much tighter system of regulation.

At 156 pages, this is quite a document – but it is worth reading, especially chapter 4.

Since at least 2015, the FCA has accepted that is has a duty of care to the credit investor in a platform, just as it has a duty of care to the depositor in a bank. Now the implications of that position can be seen.

Amongst other things, the FCA seems likely to shut the door on the “originate-and-distribute” model of pure peer-to-peer if the end-investor is not a professional or an institution (paragraph 5.49). Unfortunately, this is likely the right answer, and aligns the treatment of peer to peer lending with the principles that apply to other markets (not just credit institutions like banks, but the principles underlying MiFID, new STS securitization regulations and UCITS).

There are good peer-to-peer platforms out there, but the sector is clearly being contaminated by a proportion of profiteers and less ethical operations. There are operators who charge borrowers a lot and pay investors a little, and platforms that are complex and not transparent. This breakdown between risk, reward and disclosure raises valid concerns if participants lack the expertise to appreciate what is really going on.

Given the wide variety of business models and complexity of the products – the FCA has a choice: either (a) require platforms to accept risks as a principal (like a bank), with an appropriate amount of capital to absorb these risks (so investors are protected by own funds and truly have “skin-in-the-game”); or (b) restrict the funding of platforms to those credit investors who are capable of making informed decisions. The consequences of regulators not acting quickly enough can be seen in China this week as credit investors take to the streets complaining about Chinese peer-to-peer platforms losing their money.

The regulator has its hands tied here. Regulation is necessarily a one-size fits all model, and the regulations need to be kept simple enough so that everyone knows where they stand. In our view, the restrictions proposed by the FCA will become a reality, notwithstanding the P2P industry viewpoints so well expressed in this article by Ryan Weeks.

2. Migrating away from the peer-to-peer model

Most, if not all, alternative credit providers that we know are now moving away from peer-to-peer.

We can see at least four business models clearly available, and these can be implemented in combination:

1. Service provicer: whereby the platform acts as an out-sourcer to underwrite and administer leads that are generated and funded by a large credit institution. Whilst it is not entirely clear, it does look like this could be the story behind the MarketInvoice tie up with Barclays, to administer clients on Barclays’ behalf, funded with Barclays’ money.
2. Institutional and professional peer-to-peer only: this model can work well, but generally only for higher yielding receivables, as these investor groups tend to want yield. The main issue is whether sufficient scale can be built given the narrowness of the market niches that offer the required economics.
3. Become a bank: so that lower cost retail money (deposits!) can still be used. This may be most appropriate for consumer platforms with lower risk models – Zopa is the well-known example in the UK heading in this direction.
4. Build a balance sheet: and borrow from the capital markets. This generally requires more equity capital than most platforms have available. This is the model that PrimaDollar has adopted from the start, operating as a principal.

The right answer can be a combination of the above strategies.

3. Challenges

But there are challenges. Many peer-to-peer business models are suffering from a number of issues:

• The addressable market space can be rather small, which means that growing to a sufficient size to become self-sustaining is difficult if not impossible, especially if funding costs rise when cheap retail money is taken away.
• The cost of sale involved in winning each new customer is too high relative to the lifetime value that the customer generates to the platform.
• More equity capital is needed to run balance sheet or bank business models, and this equity capital can be hard to raise.
• VCT or EIS tax restrictions in the UK can mean that a pivot is simply not possible without compromising investor tax advantages.

4. What about hybrid models?

Perhaps the answer is to mix peer-to-peer models with a pivot to include other business models.

Mixing peer-to-peer with balance sheet funding models: This hybrid model has some parts of the business funded by investors on a non-recourse basis, and other parts which are retained and funded with own-funds. This can allow lower yielding but higher quality receivables to be managed on the books, with higher yielding but higher risk receivables funded by professional peer-to-peer investors.

There is a conflict of interest here – as the platform has to decide which receivables to fund where. But the FCA business conduct rules provide a framework to manage the conflict of interest, and this is something that the FCA clearly contemplates allowing (paragraph 5.37).

Mixing peer-to-peer with an out-sourcing service: This hybrid model is where the platform operates in its own right on a peer to peer basis but also provides underwriting and administration as an out-source service to large credit institutions (funding the institution’s customers with the institution’s own money).

The economics of the out-sourcing service may not be as exciting as peer-to-peer, but banks have a lot of customers; banks are also quite good at funneling those customers into financial products that are, in the main, appropriate. If the alternative credit sector can underwrite and administer those products more efficiently than the banks can themselves, this all makes sense.

5. What about PrimaDollar?

Having the right funding model is a necessary condition for the success of our business – but it is not the most important point. More important is our ability to generate a sufficient volume of good quality receivables at a yield which makes economic sense.

As a global trade finance platform, we have a huge addressable market space and we operate in uncrowded markets where the cost of sale is relatively low. Our systems are set up to sift the large amount of enquiry that we get every week to locate those trades which best fit our models for risk and return. We are scaling quickly, but only time will tell.

6. Are peer-to-peer plaforms in trouble then?

The FCA regulations will increase the cost of business for platforms and some platforms will lose a significant amount of their lower cost funding as pure retail money is withdrawn.

But the key questions for any platform are: (a) does it have the credit fundamentals correct? and (b) does the business which the platform writes make economic sense?

If these two points are met, then the technical question as to the most appropriate funding model is probably something that can be adjusted over time, provided the management team has the skills to make the transitions involved.