p2p lending risks – and what you can do about it

by Samuel
13 min read

Is peer-to-peer lending safe?

There are no returns without risks. And the higher the interests you earn, the higher the risks you are bearing. With interest rates beyond 12-14%, p2p lending is definitely a risky endeavor – compared to stocks (around 10% returns per year), or state bonds (with 5-6%).

With that being said in the beginning:

Although p2p lending is risky – as all forms of investing are to a certain degree –, you still should be encouraged to invest.

By not investing throughout your life, you will most likely lose returns and interest that are absolutely vital for your long-term financial well-being.

Yet many investors asks themselves the legitimate question whether p2p lending in particular is safe?

As you can imagine, there is no absolute answer to this question.

We would say, it is even impossible to answer that question! It is a bit like asking: is it safe to cross the street or taking an aeroplane? Statisticians will reply: it is unlikely that something happens, but a certain probability is there.

The same applies to investing. Probability and historical experience show that you can lose money. On the other hand, if you do not invest, you most likely miss out great returns. Ultimately, it depends on your particular case. You will never find out as long as you don’t try 😉

Rather than answering this question in absolute terms, you should see in relative terms what could make you lose money when investing into p2p loans or crowd estate.

Therefore, we focus on risks – and means to mitigate that risks.

What is risk? Risk ☢️ is defined as a situation or condition that exposes your invested money to the danger of losing it. Risk is real. As an investor, you may not see the money back if you neglect the realities of default or crash of market players.

With this article, we aim to sensitize you for the major dangers that are out there.

Risks under your control

Please, don’t take that one personally. 🙏🏼 Do you know what is the first and most fundamental risk for your investments? You, yourself! Like any other investor is for themselves.

It is your own responsibility to keep your house tidy. Your house, in the case of investing, is your portfolio. Let’s see what you can do.

Psychological risks

Have you ever caught yourself being thrilled by the high rewards being promised to you? That is understandable. But here comes the “but”:

Don’t be greedy!

Don’t get fooled by the high interest rates that p2p lending platforms promise to you. No one is paying you more than 12% of interest if there would be no considerable risks!

Instead, be precautious and form a strategy of best practices. Uphold your margin of safety.

In 5 steps to get invested into p2p loans we explain which mindset you should acquire when you want to stay focused. Especially, when you sail through the rough times.

Informational risks

Unlike our American investors, the whole p2p lending market in Europe, especially in Eastern Europe, is relatively young. We have simply not so much experience to draw upon. There is not too much to predict when a p2p platform goes into a wind-down.

So stay informed! In the current stage of the p2p lending market you cannot simply rely on putting all your assets into auto-invest, let it run on autopilot and get yourself off from it. It is recommended to keep track of the biggest platforms you are investing into.

Concentration risks

Diversification – there is hardly a more fundamental rule than this one. To avoid cluster risks in your portfolio, you need to diversify your investments. Within the realm of p2p lending, there is various parameters along which you can diversify. That is to say, diversify:

  • by investing on various platforms that are not correlated;
  • by loan originators;
  • by countries;
  • by spreading along the whole range of interest rates;
  • by asset classes (or loan types);
  • by buying tiny bits – called notes – rather than acquiring an entire loan of a single borrower.

Risk of lost interest

If you earn interest and repaid principal, you should let your capital accumulate. Do not let your funds lounge around uninvested. Because of self-inflicted cash drag, you will miss out the effect of compounded interest. Time is your best friend. Time not only makes your healthy investments grow. It also helps to heal the wounds of havoc in your portfolio.

Risk of selling too early

If you want to liquidate a p2p loan, many platforms offer you the possibility to sell that loan on the secondary market. Selling too early on the secondary market, however, is a major reason for losing a considerable amount of money. The process is called “crystallizing losses”.

When you push off a lone on the secondary market, you often have to pay fees. Those platform fees charge you fees between 0.2% and 2.5% when selling a loan too early.

Our advice is, stay firm with a passive and long-term investment strategy. At least try to not touch your investments for many years. However, exceptions may be made when there are exceptional risky developments on a platform going on.

Risks caused by others

Credit default risks

When acquiring a loan, the borrower is obliged to pay back the money by law and contract. However, there is always a risk that the borrower is not able to pay the rates of a loan.

At times, it results in delayed payment. According to EstateGuru, the major reason for this is that borrowers may overestimate their ability to do all payments according to the schedule. That does not necessarily mean that the borrower will not pay back. It rather alters the cashflow of your investment.

On the other hand, sometimes borrowers have to pay a penalty for not paying in time. The overall returns can increase from the delay. Yet, penalties are a double-edged sword. If extra payments due to penalties strangle the borrower’s capacity to pay back, that may worsen the overall situation.

Sometimes borrowers may not be able to pay back the outstanding amount due whatsover. Reasons why borrower may not pay back the money are often terrible in nature: job loss, health problems, divorce, foreclosure; sometimes also money miss management is the reason for personal bankruptcy.

However, it is of some misunderstanding that p2p lending sites would only accept those borrowers who are subprime. No sane credit business can select its borrowers on the assumption that they are close to default. It is therefore in the best interest of all market players to carry out a rigid process of screening out borrowers who are of high risk.

Classical mitigation strategies are to demand securities and collateral from the borrowers. Collateral can be a private property, such as a house, capital in stocks, or personal and business guarantees.

Especially in the context of real estate investments, you should have a look for a metric called Loan-to-Value (LTV). The LTV ratio is used to assess the probability of a loan to default:

The Loan-to-Value (LTV) is a ratio of the borrowed sum divided by the value of collateral

An example: A borrower wants to get 100 000 € for his house that is worth 150 000. Then you calculate 100 000 / 150 000 = 66,66% LTV. As a basic rule, you can memorize: The lower the LTV, the safer the investment. In case the borrower does not pay back, the collateral could be liquidated. The investors would be compensated.

Thus the utmost escalation to mitigate the risk of default is debt collection. Or less shiny: money squeezing. It shout be part of the due diligence process, how a platform carries out debt collection.

Loan Originator risks

In the end of 2017, the loan originator Eurocent went broke on the mintos platform. Hundreds of thousands of euro lost. People were suffering. It’s terrible!

Loan originators have defaulted. Going bust of loan originators is historically proven and will happen again. When dealing with loan originators, our basic recommendation is therefore:

Treat investments in loan originators as an investment of a company stock.

You are buying loans from a single company. It is important to know about its financial performance and business background. Can the loan originator guarantee the cash flow? How are its financial reserves?

Clearly keep in mind: Loan originators are not banks, they are companies with limited liabilities. This is important when reflecting about so-called buyback guarantees through loan originators. A buyback guarantee is a security mechanism by which a loan originator claims to buy back a loan if the borrower does not meet its obligations of scheduled repayments.

The buyback guarantee applies only if a borrower defaults, not if a loan originator defaults!

To meet its guarantees, a loan originating company will make sure that the average risk of default is improbable. First of all, a loan originator will impose the increased costs for guarantees to the borrower, usually not on the investor. Also, if the loan originator needs to buyback a loan due to late payment, it does not necessarily mean that the loan will default. That means that the damage to the loan originator may be limited in statistical terms. Furthermore, even if a loan defaults, there is sometimes the possibility to get the money back through a recovery process.

In any case, the loan originator can only uphold the buyback guarantee as long as the company holds enough cash. In times of market chaos, you can hardly rely on the buyback guarantees. Because loan originators are private companies with limited liabilities.

Finally, buyback guarantees are upheld by loan originators, not by the lending platforms! You cannot rely on your platform to bail their loan originators out.

Further risks to originated loans is are unsecured loans, that lack credit default swap.

The key mitigation of loan originator risks lie with the p2p lending platforms. In the best interest of the investors, p2p platforms should carry out due diligence. Not only when onboarding the loan originator, but also constantly, but especially if late payments just beginn to happen.

Once the loan originator is onboarded and issuing loans, one requirement should be the so-called skin in the game. Loan originators themselves need to invest a certain percentage (e.g. 5-15%) into the loans that they are issuing.

Additionally, what you can do as an investor is not limiting your investments to a single loan originator (see diversification). Of course, if you hear of one of your loan originators getting off track, consider to pull out your money if possible.

Lending platform risks

What do Kuetzal, Envestio, Lendy, Collateral UK, Monethera, Zeltum, Agrikaab, Orca, Boldyield and maybe soon Grupeer have in common? They are gone! In the worst cases, they have been even scammers!

Kuetzal, for example, seems to have conspired with scammers in the so-called alborg petrol case. Kuetzal supposedly brokered a loan of 850 000€ to the fake “Russian” oil company Alborg Petrol. They were luring investors into that loan by neglecting the fraudulent circumstances. Lawsuits are going on.

Fraudulent and criminal behavior has damaged dramatically the reputation of the p2p lending industry. Another example: The fast invest case: Its CEO is involved in dubios activities – so is the platform.

One level below fraud, is the problem of conflict of interest. That is: When investment platforms and loan originators or other players in the market work together against the best interests of the investors. Kristaps Mors shows with the example of mintos, how the interests of the owners are entangled with its loan originators. p2p lending platforms may abuse their market power to board off risks to the investors.

While fraud and crime hits definitely all-time lows, bankruptcy of investment platform is a more “profane” reason why investors can suffer terrible losses. Like loan originators, the platforms are usually also companies of limited liabilities.

If a platform goes out of business, an insolvency administrator should be appointed to settle the claims. Either they will continue the business after significant losses, or – more likely – will shut down the company.

Further problems associated to platforms are:

The central mitigation consists once again of due diligence (we will talk about this in another article).

Systematic risks

In every market, there will be ups and downs. The lending market is of no exceptions. Supply and demand rise and fall, investors preferences will change. And bear in mind, a certain degree of loans will default. There is few you can do about it. To a certain degree, if the overall performance of your portfolio is positive, there is nothing to worry about neither.

But what if there is greater problems? What if there is structural issues that go beyond your personal risks, yet even beyond institutional risks? Then we talk about systematic risks. Let’s have a look.

Political and Legal risks

There is no pan European Regulation at the moment in place. Though, the European Union is working on a common crowdlending regulation.

Nevertheless, investors are mostly bound to the legislation of the member state where the p2p platform is located at. In continental Europe, the only country having partly a national legislation on p2p lending is the United Kingdom.

Latvia is the home of many popular p2p lending platforms, such as mintos, twino, ViaInvest or Viventor. This is not accidentally. The legal framework encourages p2p lending. Or better to say: The absence of regulation encourages entrepreneurs to set up their p2p lending platform in Latvia due to the lack of regulation. On the contrary, the Estonian platforms, such as Bondora, Estate Guru or EvoEstate are stronger regulated.

Due to the above stated incidents of fraud and crime, peer-to-peer lending definitely requires a stronger legal framework to protect the interests of investors and borrowers alike. Some platforms, at least publicly, work in this direction by demanding more regulation, or even auto-imposing best practices from foreseeable regulations.

Currency risks

Currency fluctuations can affect you, if you invest in a currency other than the leading currency of a investment platform. Especially big market places, like mintos, provide investors with the opportunity to invest in loans of foreign currencies. If the exchange rate of that currency devaluates compared to your home currency, but the loan sum stays the same, you are going to lose money in relative terms.

Global market risks

If there is a severe economic crisis, unemployed will rise. Consequently, consumers will have less money in their pockets. People may not be able to pay back their loans. When this happens, one can bet that most of the calculations of the p2p industry can be thrown into the bin. As well as their dunning letters and recovery processes. A systematic collapse has happened in the past. And it can and will happen in the future. Some examples:

  • Recession and massive lay offs during the great depression 1929
  • The financial crisis 2008
  • The ongoing Corona virus pandemic 2020

Mitigation is here most likely out of your control. Deposit protection funds of your country, shifting the asset class, or macroeconomic policies could help you as an investor through the crisis.

Summary

There is many things that can go wrong in your investment journey. There are things that you can control, and things that you can’t control. In the end, if things get nasty and losses are inescapable, the concern will be raised about who will be financially liable for the loss. And rest assured, as an investor, you will be the first target. It is therefore in the best interest of the investor to know the risks.

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