An investor is considering a new fixed-income product, peer to peer lending (P2P): customers are offered an interest rate for depositing money in an account and the P2P firm lends out its money as loans. The investor is not interested in any other peer to peer business models eg depositing money in exchange for shares etc. In order to answer these question you will need to conduct independent research, learning, understanding and analysis of P2P. You should also apply concepts that you have learnt in the module, and on finance courses in general, in answering these questions. Qu.1 The investor wants to model the investment of a P2P as a newly issued bond. The newly issued bond has the following specification: -Coupons of £50 paid annually, with first payment starting from 1 year from issue of the bond -bond maturity: 10 years -par value £1000 -discount rate: 6%. a) Calculate the value of this P2P investment. Show your calculation method. (10 marks) b) If the risk of default increases today, then what happens to the value of the investment today? Briefly explain your answer in terms of the bond pricing formula. (5 marks) Qu.2 Explain how the P2P lending business model works. Your answer should include the basic concepts of P2P operations that enable both the P2P firm and the lender to profit from the P2P business model. (25 marks) Qu.3 Discuss the risks involved in P2P lending, and how an investor or the P2P firm itself can manage these risks. In answering your question you should compare the P2P risks and risk management to those in bond investments or retail bank accounts (either from the perspective of the investor or the firm itself).
Fixed Income Analysis and Trading
Question 1.a: Calculating the Value of a P2P Investment
Peer to peer lending allows clients to either be investors or borrowers. It enables borrowers to get finances from an individual or groups that are willing to offer loans to the qualified applicants. Thus, one will not be borrowing from a financial institution. Various applications or websites exist to serve this purpose. They offer a platform where a potential investor can meet the borrower and carry out the lending business. The peer to peer lending may take the form of a bond. In the current scenario, the investor has chosen to model the investment as a newly issued bond. The specifications are Coupons of £50 paid annually, with first payment starting from 1 year from issue of the bond, bond maturity of 10 years, a par value £1000, and lastly a discount rate of 6%.
It is important to calculate the value of this P2P investment. However, specific factors need to be highlighted beforehand. First, to calculate value of a bond, the present value must first be calculated (Dimic and Orlov, 2017). Par value is the same as face value, but different from present value. Par value is the amount at which the security is issued, or at which it can be redeemed. For instance, if the par value is £1,000, then the bond can be redeemed at £1,000 at maturity. The present value refers to the amount expected, which has been determined at the date of valuation (Djatschenko, 2018). Thus, to calculate the bond value, the present value of all interests that will be made is added to the present value of the principal amount at maturity. The formula for these two calculations are as follows;
V coupons=∑[C/ (1+r) t]
V face value=F/ (1+r) T
C=future cash flows, that is, coupon payments
r=discount rate, that is, yield to maturity
F=face value of the bond
t=number of periods
T=time to maturity
The value of the bond in the current scenario can be calculated as follows;
t= 10 periods
- Present value of annual payments = 50 / (1.06)1 + 50 / (1.06)2 + 50 / (1.06)3 + 50 / (1.06)4 + 50 / (1.06)5 + 50 / (1.06)6 + 50 / (1.06)7 + 50/ (1.06)8 + 50 / (1.06)9 + 50 / (1.06)10 = 47.17+ 44.50+41.98+39.60+37.36+35.25+33.25+31.37+29.59+27.92= 368.00
- Present value of face value = 1000 / (1.06)10 = 558.41
Hence, value of bond= £ 368.00+£558.41= £926.41
Figure 1: Balance Accumulation of the P2P Investment
Figure 2: Payment Schedule of P2P Investment
Question 1.b: Risk of Default
If the risk for default increases today, the bond value becomes impacted significantly. Considering the bond pricing formula, the most important factors include the coupon payments, discount rate, par value and even time. Thus, when default occurs, the issuer will not be able to make the scheduled coupon payments as required, or even pay the principal on its bonds (Leland, 2019). This is often due to the surge in borrowing costs.
After filing for bankruptcy, the time it takes to recover is often unknown. For some, it may take a year, while for others it may take even 10 years (Leland, 2019). Thus, the time value for money is lost in the waiting process since the bondholder will not be receiving any payments. Bonds are often purchased since they offer income payments. Thus, when no coupon payments are being made, investors will remain stuck with the investments which are not bearing any interests (Schwert, 2017). The recovery value is unknown, as well as the recovery date. Hence, the bond being repaid may end up being much less than the par value which was offered. This means that the bondholder will still experience a significant loss. A defaulted bond is not profitable to the bondholder. That is because the value of the investment made today will decrease significantly due to the uncertainties involved.
Question 2: P2P Lending Business Model
The Peer-to-Peer (P2P) lending is a form of debt-based crowdfunding which is carried out by online platforms which connect borrowers and lenders by creating conventional loan processes, requirements, and even intermediaries (Nowak et al., 2017). This market has been experiencing significant growth since it offers the needed finances to specific borrowers such as individuals or even business start-ups among others. For investors, this P2P lending enables them to receive stable returns that come in the form of constant interest repayments. Hence, it is a great supplement to the traditional forms of assets such as bonds and stocks. P2P is perceived as an alternative investment, only that it offers low interest rates on the savings accounts.
Before one can invest in P2P lending, it is imperative that the business model of the platform that one wants to settle for is well understood. This will greatly impact the risk that the investor will face. Borrowers also need to have the same knowledge so that they can access loans with the most reasonable interest rates (Lavryk, 2016). The most common business models include the standard P2P lending and P2P lending with loan originators.
Standard P2P Lending Business Model
In the standard P2P lending business model, only one middle man exists between the investor and borrow. It features the platform or website that they will be using to meet and interact. This business model is ensures that the platform can be easily understood with regards to activities and even the incentives (Henriquez et al., 2019). The platform acts as the middleman who will mediate the transaction and ensure that the investor gets a borrower, who will repay the amount with interest. Hence, it is a straightforward kind of business model.
The lender invests any excess cash flow in terms of loans on the platform, and waits for the principal amount and interest after the scheduled time. The borrower applies for the loans and pays the principal and interest. The platform carries out the administrative and marketing activities which ensures that more borrowers and lenders are attracted, and that the repayments are made as scheduled (Praveen and Yuvasree, 2021). According to figure 1 below, the lenders are in the supply side (blue), and the borrowers are in the demand side (red). In the middle of the model, the platform exists. Its role as an intermediator in the supply and demand is evident. It manages the administration processes and even the loan contract. It follows through with any missed payments and ensures that borrowers repay on time. The defaulting payers are dealt with, and any legal issues are also handled by the platform.
If investors leave the platform in the event of bad returns, there will be no one to supply the funding needed. This will push the platform to go out of business. On the other hand, if borrowers are exposed to bad treatment that make them leave the platform, there will be no one to give the interest returns. Hence, this will also lead to the closure of the platform.
Figure 3: Standard P2P Lending
In the standard P2P lending business model, investor risk is on the borrower. If the borrowed amount is not repaid, the investor will lose the principal amount invested. Consequently, any platform which makes use of the standard P2P lending business model relies on its market position, and on a good reputation which promotes a profitable market for loan facilitation.
P2P Lending with Loan Originators
In this business model, two independent parties exist, which makes it hard for investors to understand the platform. Compared to the standard lending option, this business model features an extra layer in the form of a loan originator. Hence, the loan process becomes quite complicated. A loan originator features a non-bank financial organization which uses marketing to attract borrowers who are in search of funding. The two main roles of the loan originator is to convince the borrowers that their lending terms are fair, and that they can help the borrowers to close a deal (Conklin et al., 2018). However, it is important to understand that the loan originator is first and foremost a sales entity, then second a loan approval advisor.
This business model is illustrated in figure 2 below. The loan originator is included as a loan provider. They take care of the demand-side by offering loans that they obtain elsewhere to the platform. Hence, they enable the platforms to focus entirely on the attraction of investors.
Figure 4: P2P Lending with Loan Originators
Therefore, the main difference between these business models is that with loan originators, the loans are sourced outside of the platform (Nowak et al., 2017). Hence, larger loan volumes can be facilitated faster. The platforms are able to provide stable short-term cash flow as compared to the standard lending business model. However, the loan process and risk structures are also less transparent to the investors.
How P2P Lending Platforms and Lenders Profit
One major advantage of the P2P lending platform is transparency. Banks have many levels of hierarchy, too many paperwork, difficult to understand fees and schedules which can be quite stressful for investors to navigate (Lavryk, 2016). That is why many are preferring the P2P lending platforms. Majority of such platforms are simple, and straightforward. They feature a page that is dedicated to the fees charged and an explanation of how they make their earnings.
Although the fees are slightly different, they all make their earnings by charging fees for their administrative services. They offer an opportunity for investors to earn the best interest rates, and for borrowers to borrow funds without hectic processes (Nowak et al., 2017). In return, the platforms charge flat rate feed from borrowers or retain a specific margin in the interest percentage. There are a few platforms which also charge investors.
Investor interest in the P2P lending has grown significantly over the past years. That is because of the zero interest rate environment which makes it very difficult for them to earn enough interest on the fixed income assets (Shi et al., 2019). The P2P investment offers an alternative that has high returns among other advantages. Thus, the lenders profit through the interest rates earned whenever they invest their principal amount into the platform.
A reason why P2P lending is earns more than banks for its customers is that the later institution is quite expensive to invest with. Once an investor deposits the money, the bank lends it out at a much higher rate than they promised the investor. Due to the service offered, and the risk taken by the institution, the bank keeps this extra interest even though it still has a rate promised to the customer (Lavryk, 2016). Therefore, it retains a bigger percentage, unlike the P2P where the bigger share is returned to the investor. It is better to lend money directly to the borrower rather than use the bank as an intermediary. Although the risk is a bit higher, the investor will also be able to enjoy higher returns.
Question 3: Risks Involved in P2P Lending
Although P2P lending is the new trend in the financial market, it has a series of risks that investors must consider. The investor is trusting that the money loaned will be repaid as desired. However, this may not always be the case as many things could easily go wrong as discussed below.
Loan Default and Late Debt Repayments
In P2P lending, investors loan out money to individuals or businesses who are seeking funding. In return, the investors benefit by earning the interest rates in addition to their principal amounts. Hence, in this P2P business model, the greatest risk is borrower risk. There is a risk that the borrower may default on this loan, thereby leading to a loss of the investment, as well as the loss of any potential interest which one may have accumulated (Polena and Regner, 2018). Fortunately, this risk may be managed without the need for additional expenses in terms of hiring a credit analyst.
A majority of this risk is related to the platform that an investor chooses to use, and how they help to safeguard the investments. For instance, some platforms offer loans that have been secured using collateral. Therefore, the investor can sell this collateral in case of default or ate repayment. Other platforms offer buyback and payment guarantees to the investors which enables them to recover their principal or even a part of it (Liu and Dong, 2020). Hence, despite the level of risk one is willing to take, it is often wise to understand the platforms that will be used by looking at how they mitigate and compensate for these risks.
Unsuccessful Loan Originator Risk
Most platforms in the European Union only act as aggregators and use loan originators. Hence, rather than lending money on the platform, the investor will lend it to the loan originator, who will then lend it to the borrower through the platform. The same process happens during debt repayment. The borrow pays the loan originator who will then pay it back to the lender through the platform that is being used (Lu and Zhang, 2018). Thus, there is an originator risk since the borrowing is done secondary to the platform. The important role of the platform in securing the principal amount investment is lost. This is an additional risk which may be avoided through the use of the standard P2P lending business model.
In the event that the loan originator goes out of business, the investor will experience a great loss of investment. Whether it is lending or borrowing money, one must be able to trust that the entity involved will not delay payments, or even go bankrupt. It is what separates good P2P platforms, from high-risk platforms. Good platforms need to engage with originators who are trustworthy, and whose credit records are promising (Liu and Dong, 2020). This can be proved by conducting an extensive due-diligence on the target loan originators. The P2P platforms need to know that they are collaborating with a loan provider who will not go out of business soon.
This risk of originators can be mitigated by considering the use of platforms which makes loan originators to also experience a form of loss, in case of defaults. The originator needs to have already established its own incentives with regards to the offering of good loans that will match the benefits to investors (Shi et al., 2019). Hence, to ensure that they may also experience a loss, the platform may require that the loan originator also invests a certain percentage, between 5% and 15% (Liu and Dong, 2020). Therefore, they will also have something at stake and will take the loan process very seriously.
If the loan originator goes out of business, the lenders may end up losing their principal amounts, or even a part of it. Thus, to manage this risk, it is important to diversify the investments but not using one platform, but many different platforms. Thus, if one originator fails, the others will still be functioning as expected. The vulnerability of the investor is reduced as a result.
The Risk of the P2P Platform going Bankrupt
P2P lending platforms are just like any other business out there trying to earn revenue. Although they may perform well and experience significant growth, the platforms may also perform poorly, leading to their closure. This is what is referred to as the platform risk. The P2P platform itself may go bankrupt, meaning that it will have to close down. When this happens, the platform is still responsible for collecting the remaining debts, and settling any outstanding amounts with its investors (Shi et al., 2019). Unfortunately, this may take a very long time especially if it files for bankruptcy. That is why some platforms consider the use of backup loan servicers.
These are companies which store a loan agreement while waiting for the borrower to repay. They maintain the payment accounts, as well as the pay-outs made to lenders so that in case the platform fails, the records will still be available. Since the platform is the primary loan servicer, these companies become the third-parties. It is an approach taken to ensure that a platform’s failure does not mean the borrower gets to keep the investment (Liu and Dong, 2020). Platform risk may also be reduced by doing a thorough audit of its financial health before getting involved with it. Those which do not publish their audits are questionable platforms. The best options are those whose accounts are readily available to the public.
As highlighted above, P2P lending platforms try hard to ensure that any investment made is kept safe. That is because it is a business which wants to maintain its good reputation and attract more investors. Borrower risk comes in two forms, late payment and default. Hence, the best P2P lending platforms are those which ensure that there are processes in place meant to help the investor to recover the debts as soon as danger signs are witnessed (Lu and Zhang, 2018). Thus, the moment a borrower starts struggling to repay, the platform steps in and ensures that the principal is recovered before the point of bankruptcy. The different approaches are often referred to as guarantees and protections. They are what make P2P lending much safer.
This is a binding agreement that is signed between the lender and originator or platform. It indicates that when a borrower is late with payment, or misses the repayment entirely for a specified amount of time, the guarantee comes into effect (Shi et al., 2019). The loan originator or platform has the duty to buy back the loan from the lender. This can be fully or partially depending on the agreement.
Loan originators prefer this approach since they want their loans to be funded by the P2P lending platforms. Hence, to ensure that they earn the platform’s trust, they offer the buyback guarantee. The time varies depending on the platform. Also, how the lenders are repaid is unique. Some buyback terms ensure the investor is compensated for the principal and interests wholly. Others only compensate for a certain percentage of the principal (Liu and Dong, 2020). Thus, in the event of a default, the buyback compensates the investor. However, it is important to note that, when the loan originator goes bankrupt, the buyback guarantee is deemed invalid. The existing loans will either go to the backup servicer or even get lost if there is no one to follow up. This is how investors end up losing their money even when they go for companies with buyback guarantees.
Most conventional finance companies hold a reserve of cash meant to act as security against loan losses. Some P2P lending platforms also follow a similar approach, only that they are referred to as provision funds. These platforms have money ready to be paid out to lenders in case of delay or default. The funds cover a specified amount of the loan principal that has either been delayed or lost, thereby reducing the impact of the loss on the investor. Just as is the case with buyback guarantees, various degrees of protection are present with provision funds (Shi et al., 2019). It depends on the platform and loan originator. In some cases, the investor gets to choose which fee they want from a certain percentage. Hence, it is important to understand when these protections can take effect, and how much they are worth. This should be done in advance before any money is investment in the platform.
Delays in Money Lending
A P2P lending platform cannot force borrowers to take loans. Hence, once money is transferred to the platform, interest can only be earned once it had been borrowed. A risk exists in the sense that the borrower’s requirements may not match that of the lender (Lu and Zhang, 2018). Hence, it takes time to match a borrower and investor. It means that they will be waiting for some time without any interests until they can find a match. The returns will be less than expected since the lender may have calculated interest right from the start of the investment.
Considering the analysis conducted above, it is clear that investors should learn to diversify and properly understand their platforms. The investment should be distributed such that only small amounts are invested in specific platforms. It will ensure that the greatest security is achieved as the risk of platform failure is very minimal (Lu and Zhang, 2018). Therefore, in case it occurs, only a little amount will be lost or held over a long time. The investor will continue to enjoy the returns from the many other platforms it used. This approach also gives the investor a differentiated portfolio. Hence, it will be able to absorb any shocks that were not anticipated beforehand.
Before investing any amount, the investor should be patient enough to watch the P2P lending platform in action. Processes such as how cash is loaned, and the associated risks, must be well understood. Hence, by the time the investment is made, the lender will know what to expect, and measures will have been taken to manage these risks. The investor should take time to collect and review specific company information such as general volume, number of defaults, time it takes to recuperate, and the likely returns (Lu and Zhang, 2018). This research may be done individually, or the lender may approach the P2P lending platform and ask for data. Such information is key to the determination of the right platforms.
Investors should always loan out money based on their risk appetite. The borrower profile is an important consideration when looking for the right candidate for funding (Lu and Zhang, 2018). Some investors are not willing to take on too much risk, while others do not mind being big risk takers. Therefore, if the borrower pays on time and has no history of default, then the investor who has a low risk appetite can take on the challenge. However, some have a history of delay and even default, but they eventually make settlements with the lenders. Such are great candidates for investors who do not fear investing in a high risk borrower. That is because the return will be worth it if it actually works out as expected. However, it is often smarter to remain on the secure side and only loan out to those whose record history is positive. Once a danger side has been identified, it is difficult to predict whether the borrower will even repay the amount as required.
Choose the most Reliable Platform
Although a majority of the P2P platforms are straightforward in how they handle investments and their charges for services offered, it is still important to carry out a due diligence check. Thus, the platform need to feature the charges and characteristics that an investor is comfortable with (Lavryk, 2016). Be sure that the platform is valid, and that it has been functioning effectively for a long time. Otherwise, one risks losing the investment if the platform is unreliable.
After the first principal amount and interest has been cleared, it is better to reinvest the amount, rather than hold it. The cash is better off earning more interest in the platform, thereby creating more income. The investment will keep growing, ensuring that the investor’s return will be massive by the time he decides to quit the platform (Praveen and Yuvasree, 2021. Once the right platforms have been identified, the investor should be willing to invest more, even though the amount will still be diversified across other platforms.
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Henriquez, R., Cohen, I., Bittan, N., and Tulbassiyev, K. (2019). Blockchain and Business Model Innovation: Designing a P2P Mortgage Lending System. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3371850