17 Understanding peer-to-peer products
To complete the review of investment products, let’s look at one that has only been around for a few years – but which has rapidly become popular – peer-to-peer lending. But it is also an area yet to be tested by a severe economic recession, and as we were putting this course together, the financial effects of the Covid-19 pandemic were only just starting to hit. So before investing in peer-to-peer, be very careful.
This market has grown because beleaguered savers who have seen returns on their accounts fall to miserly levels in recent years, and to levels below the rate of price inflation, are being increasingly tempted by peer-to-peer (P2P) lending. However, it must be stressed that these are investments that come with risks and are not savings products – in fact, some firms have been reprimanded by the FCA for making them look like savings products.
This growing market involves investors pooling their funds with other investors to lend to individuals and businesses. The P2P providers undertake the credit checks on those borrowing from the schemes, and they take a cut as their profit. There are no banks or other financial intermediaries. The returns offered by investing in a P2P pool are attractive relative to those on ordinary savings accounts – assuming borrowers pay the money back.
The attractions of this alternative investment have seen this form of lending growing, with £3 billion being lent in the UK in 2018, according to the Peer2Peer Finance Association. The Peer2Peer Finance Association was absorbed by Innovate Finance in 2020.
Note that peer-to-peer lending is different from another product you might hear about – ‘crowdfunding’. Peer-to-peer lending provides loans, whereas crowdfunding provides equity finance to companies. In effect, crowdfunders are buying shares in the companies they are lending to.
Beware the significant risks of P2P lending
Although P2P is regulated by the Financial Conduct Authority (FCA), it does have risks that investors need to be aware of. Risks certainly exist – why else would the returns markedly exceed those on no-risk investments such as National Savings & Investments (NS&I) products? The key risk is of defaults by those who have borrowed from P2P funds – although those managing the funds mitigate this by spreading the funds invested across a number of borrowers. Even if the money lent is fully recovered from a defaulting borrower, there is likely to be a long wait to receive back the funds you invested.
Another key factor to bear in mind is that P2P investments are not currently covered by the Financial Services Compensation Scheme (FSCS), meaning investors could lose all their money if a P2P provider went bust.
One final tip before investing in P2P: check the FCA website to make sure the company is registered with the regulator.
Activity 9 Testing the robustness of the P2P market
Some analysts claim that the attractiveness of the P2P market can only be tested if the economy experiences a sharp economic slowdown. What is the reason for this opinion?
The key risk to investors in P2P products is borrowers defaulting on repayments. In benign economic conditions with the economy growing and interest rates low, the rate of defaults may be very low, perhaps giving a false impression of the riskiness of this way of investing. The acid test would be to see how the default rate changes if the economy is in difficulties – e.g. a major recession. Only then will investors have a fuller picture of the risks they are taking for receiving interest earnings well above the prevailing level on conventional savings products. At time of writing, we don’t yet know the full economic effect of the Covid-19 pandemic – this will be the acid test about whether P2P investments are robust, and we await the results with some trepidation.