Should you use your Isa for peer-to-peer lending?

04 March, 2016

The UK’s £3.2bn peer-to-peer lending industry has come a long way since 2005 when the first platform connecting savers and borrowers was launched. Today, hundreds of platforms lend under the P2P mantle — and from next month, you can hold this within an Isa.

Whether investors should take the plunge in April and open a new Innovative Finance Isa is a vexed question. Although P2P has surged in popularity due to the attractive returns on offer, critics warn of the greater risks involved.

P2P has blossomed as prolonged low interest rates have held down returns on more traditional forms of saving and investing, at the same time as banks have become more risk-averse about lending. In its purest form, peer-to-peer lending involves matching those who are prepared to lend their savings to interest-paying borrowers. The connection is made via online platforms which facilitate loans without taking them on to their own balance sheets. Some platforms lend to small businesses, some only to individuals, and others lend to both. Like many other financial technology innovations, P2P is premised on cutting out the middleman — in this case, high street banks.

So far, this has been good news for investors. Unlike banks, peer-to-peer platforms are not subject to capital requirements and do not run branches, so they can often offer competitive rates to both borrowers and lenders. The asset class currently yields an average return of 5.15 per cent a year to lenders, according to the Liberum AltFi Returns Index.

Now it is set to hit the mainstream — from April 6 this year, P2P loans can be held in the new Innovative Finance Isa, shielding the interest repaid by borrowers from tax. Savers can deposit up to £15,240 a year into their new Isa, or transfer money in from existing Isas. But before getting started, investors need to understand how these products work and be aware of the risks involved, which are much greater than conventional cash Isas.

P2P Isas are investment products and therefore not covered by the UK’s financial services compensation scheme. While default rates on loans are currently low, this could obviously change if the UK economy takes a turn for the worse. In February, the industry attracted the ire of former Financial Services Authority chief Lord Adair Turner, who predicted that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the worst bankers look like lending geniuses”.

Choosing a platform The new Isas can be opened directly with peer-to-peer platforms. There are many different providers to choose from, but investors need to choose carefully — for now, you can only open an Isa with one of them, rather than splitting your cash across platforms. When choosing an Isa provider, investors should consider who they want to lend to and how — there is a lot of divergence here. The UK’s “big three” P2P lending platforms are Zopa, RateSetter and Funding Circle. Zopa lends only to retail borrowers, while Funding Circle lends only to small businesses. RateSetter lends to a mixture of retail borrowers, small businesses, and property developers, meaning any loan you buy has a mix of risk profiles. None of the companies allow you to select the exact loans you buy — though Funding Circle will allow you to select types of business loan according to your risk appetite. Crucially, if it does all go wrong, you will not be covered by the financial services compensation scheme.

To address concerns about risks, the big three have banded together with some of their smaller rivals — ThinCats, LendInvest, LandBay, MarketInvoice, and LendingWorks — to form a trade association, the Peer-to-Peer Finance Association, headed up by former regulator Christine Farnish. All of these platforms abide by the rules of the P2PFA, which include a number of measures designed to increase transparency. They all publish bad debt rates and five years of credit performance, returns performance, and full loan books — including data about borrowers and lenders. But this is not the only information investors need to wise up about.

Cherry picking

In order for investors to spread their P2P Isa investment across multiple platforms, a third party asset manager (such as Bestinvest or Hargreaves Lansdown) would need to become an Isa manager, and this has not yet happened. That is not to say that institutional money managers have not taken an interest in P2P platforms. One of the key differences between the platforms is the level of institutional lending they do. London-listed investment trusts have raised more than £500m to invest in P2P loans, while challenger bank Metro has signed a deal to lend through Zopa. A recent report by Cambridge university and Nesta, the innovation charity, estimated that institutions now account for about a quarter of peer-to-peer lending activity.

In the past this has raised concerns about “cherry-picking” — a practice that has evolved in the US P2P industry where institutional investors buy the most desirable, low-risk loans and crowd out the retail investors, who are left with riskier loans. The P2PFA has since introduced a rule banning this practice in the UK. Both Zopa and Funding Circle say they prioritise retail investors over institutional. The platforms channel institutional money, but randomly select which loans are assigned to retail investors and which to institutions. Anil Stocker, chief executive of Market Invoice, says that the presence of institutional investors should give comfort to investors, because they are in a position independently and professionally to check the credit quality of the loans they buy. So, he argues, if they decide to invest this is a good sign.water trampoline australia for sale

Future risks

A nascent industry, the biggest criticism of P2P lending is that it has yet to experience a financial downturn. Analysts of peer-to-peer lending platforms are quick to point out that their loan books have not yet come under any significant pressure. “To the extent we can tell, the risk rating operations of the P2P lenders seem credible, but we won’t know until the next recession what these loan books look like because we have not had a significant down market,” says Stian Westlake from innovation charity Nesta.

James Meekings, UK managing director of Funding Circle, argues that the criticism has been overdone.
“No, we haven’t been through a downturn, but what we have done is put all the loans we have at Funding Circle through a 2008 scenario to see what happens,” he says.

The stress test found annualised returns for investors would remain above 5.5 per cent even if UK GDP dropped by 4 per cent, interest rates rose above 4 per cent and inflation surpassed 6 per cent.

“So I think it’s a bit unfair when people say we haven’t been through a downturn,” says Mr Meekings. “Also the next [downturn] is not going to be the same — and when will it be? All these questions are questions that are relevant to the banks as well as to us.”

All the major platforms boast that they carry out robust credit checks on their borrowers. “I would be staggered if any bank or building society […] did more than P2P platforms when it comes to credit underwriting processes,” says Christian Faes, chief executive of LendInvest.

“Bear in mind it all starts with people, and employing the best people to build credit models and systems and do the underwriting for you — and the vast majority of those people have been headhunted from banks.” Peter Behrens, RateSetter’s chief compliance officer, argues that P2P platforms are “less automated” than banks in their credit checking processes.

“What we do is go out and talk to businesses. We get all sorts of financial information from them,” he says. “We visit a lot more than most banks would consider it worthwhile visiting.”

A final word of warning — despite the Treasury’s fanfare, the uncertain regulatory status of P2P lenders might mean that not all of them will be ready to launch their Isa products in April. At the time of writing, most currently hold interim permissions from the Financial Conduct Authority, rather than full FCA permissions, and there is no guarantee they will all be granted FCA-regulated status in time to launch their Isa products in April. Keep reading FT Money to stay informed about which platforms have gained approval as you prepare to make your investment choices.