Ana-Maria Minescu

FINTECH Explained

Volume info:

ISBN

Copyright 2018 by Ana Maria Minescu

July 2018

ISBN  

Cover – Bogdan Manea / Kredo Image SRL

1 FOREWORD

A page in the journal of an anonymous millennial

Thursday, 5th of December, 2017

“I’m an early bird. Usually.

I’ve started my day by checking the messages on StockTwits and the newsfeed on eToro. Afterwards I placed some orders on eToro to buy some shares that seem to be trending. I also discovered a few more traders worth following on eToro – they’ve had a good run recently and they have an interesting investment philosophy. Tomorrow the US non-farm payrolls for the previous month are published – as I like to think of myself as a trader of volatility to some extent, I also wrote a small trading algorithm that I had in mind for some time on AlgoFast. As I like to diversify my portfolio, I’ve decided to invest a small amount in cryptoassets as well. I check what my portfolio did overnight. In my account on Binance, I sell some ADA, that had a great run recently and I buy some XRP. I buy some ETH on Bitstamp with euro and transfer it to myetherwallet to have it ready for that ICO that I’ve been following on Telegram and that launches today.

Time to go to the office. On my way I checked on my mobile my portfolio I have with Wealthfront. I recommended Wealthfront to my parents as well, but they prefer Betterment, because they already use it for their RetireGuide tool which they find very practical. Ah, talking about my parents: today I have to buy the present for them for their anniversary next week! But I know what to get and I’m buying it online; I’ll pay with PayPal, it’s all easy and quick. Luckily I’ve just received the money back from LendingClub. Ah, and talking about shopping… I ran out of my favourite night cream, I must not forget to order a new one tonight by pressing the Dash Button from Amazon Prime!

Lunch time! I meet my best friend for lunch and he tells me he gathered the financing needed to launch the pop-up bar project he had in mind via Kickstarter, a crowdfunding website. Not only did he receive the funding faster than he was waiting for, but there is so much interest that he is even considering increasing the scale of the project. Another friend joins us for coffee. She raised an impressive amount of money for a social cause via Crowdrise. We congratulate her for this. There is one thing even more important than making money: being charitable and helping the less fortunate ones.

In the evening, I go for dinner with another group of friends. I’m particularly glad to see one of them as he missed most of our recent dinners. He explains he’s been busy working on a project to issue common shares for a company on Linq, a blockchain-based trading platform of NASDAQ.

What a busy day! Money never sleeps, but for me it is time to go to rest…”

I will ask you now a slightly disturbing question: where is the bank in the story above? The money is obviously everywhere.

Indeed we live in times of change. Banks continue to be all about money. But money is less and less about banks. Nowadays people pay, send money, borrow, lend, invest and secure financing for projects increasingly without the involvement of banks.

2 TARGET READERS

This book is addressed to a broad audience and consequently is aiming to cover potential concerns from all of them:

Students will be the main beneficiaries of this book, because the book is giving structure to a topic which despite being already abundantly documented, is not necessarily available in text book format. The main benefits for students would be the detailed explanation of the main themes (such as P2P lending, alternative payments, blockchain, cryptocurrencies etc.) and the highlighting of the main stakeholders and geographies relevant for the fintechs. The future graduates who develop a passion for fintechs will thus know what exactly they could do and where they should go to achieve that.

However, the book is not a text book. Being a banking professional myself, I have tried to gather information which is of a commercial nature and which is detailed enough to be of great use for the professionals wanting to define, fine tune or execute the future strategy for the bank they work in. The main benefit for professionals consists of the analysis of sector trends and from the wide range of examples and case studies highlighted in the book.

Last but not least, the book is addressed to all readers who are passionate about innovation, technology and finance, and who are keen to stay up-to-date with the fast-paced developments that are occurring around us.

The book is hopefully answering many questions, but it aims to set the ground where additional further questions will be asked. By you, the readers.

3 INTRODUCTORY THOUGHTS

3.1 Why is the Fintech revolution happening?

  The main driver of the Fintech revolution is the change of consumers’ attitude and demands. The world we now live in is a hyperconnected world. We are almost constantly connected to the Internet through the smartphone, the tablet, the PC , the smart watch or the smart TV. The social media and the mobile apps are no longer an innovation, but the surrounding reality. Consequently, our demands have shifted towards features such as improved transparency, non-stop accessibility, automation and ease of use. The main agents of this change in demand are the Millenials{1}.

Moreover, the 2008 financial crisis has generated regulatory changes in the banking sector, which are aiming to make the banking sector safer and more secure, but which sometimes (as a side effect) represent a significant burden on the banks. Higher and higher capital requirements, disclosure requirements (e.g. MiFID) and systemic charges (bank levies) are only a few of the challenges that the traditional banks are facing. This context created opportunities for innovation from the financial start ups{2}.

Brett King in “Bank 3.0” identifies four phases of behavioural disruption{3}, meaning four phases of disruption occurring within retail financial services which can each be seen as a game changer:

- the arrival of the Internet, amplified by social media;

- the emergence of the smart phone;

- the shift to mobile payments on a larger scale;

- “banking being no longer somewhere you go, but something you do”

The social media age brought the concept of “crowd”, allowing customers to share experiences, feedback and recommendations. Consequently any brand (including bank brands) became more vulnerable in front of the more and more demanding customers. Bad experiences with a brand are quickly shared via the social channels, with a significant destructive potential for the brand. While before the emergence of social media, the banks were able to be selective in choosing their clients, the balance of power has now shifted massively in the favour of the customers, who can be very selective when choosing the bank they will work with, based on the large variety of knowledge and opinions shared via the social channels.

The emergence of the smart phone is important and can be classified as a distinct phase because the smart phone is the driver for mobile banking. A large number of banks are already offering their customers mobile banking apps, which allow you to access all the services available on the ATM (except for cash withdrawal) and even more: check the account balance, make a deposit, make a payment etc. Many banks are already making it possible to apply for a consumer loan via the mobile banking, without the need to go physically into the branch and talk to a relationship manager.

  The shift to mobile payments on a large scale refers to more than just making a payment via the mobile banking app. It refers to the “convergence of our mobile phone and our credit/debit card”{4}. Payments through SMS and NFC-based (Near Field Communication) mobile wallets are already being offered by a variety of providers (banks, telecoms, technology companies and independent companies). 

The importance of this phase stems from two major facts. On one hand, when adopted on a global scale (ie the adoption of a “technical standard for mobile money that could be adopted globally by network operators and device manufacturers”{5}), such mobile payments would kill almost completely the need for cash. Secondly, the loss of physicality could translate into the disappearance of the need to interact with a bank for daily banking operations, meaning that for some people (such as the unbanked ones), “the phone would become the day-to-day bank account of the near future”.

The fourth phase refers to “banking being no longer somewhere we go, but something we just do”.  As Bill Gates, Microsoft chairman, already predicted since 1994: “Banking is necessary, but banks are not.”

Certain banking services have already been provided for a long time by non-financial services companies, for example: credit cards offered by supermarkets to their customers (Tesco, Sainsbury’s, Waitrose and ASDA in the UK), credit lines offered by retailers to their customers. This trend is about to continue and to be amplified at a much larger scale and at a much more rapid pace, especially given the emergence of the Fintech startups as a parallel and combined development. 

3.2 Who are the main beneficiaries from the Fintech revolution?

The main beneficiaries are of course the consumers, who are just receiving better service: faster, cheaper, more transparent and non-stop accessible. In addition, there are several sectors and sub-sectors which are perfectly positioned to benefit from the latest developments: payments, crowdfunding, lending and wealth management.

3.3 The Fintech ecosystem – who are the players?

In a report analyzing some of the regions/hubs with the most significant FinTech activity (named ecosystems), Ernst & Young (2016){6} identifies 4 attributes necessary for the well-functioning of such ecosystems. These attributes are: talent, capital, policy and demand, and each of them is represented by various players, as detailed below.

Talent refers to the “availability of technical, financial services and entrepreneurial talent” and is displayed by players such as: providers of fintech services (financial institutions, non-financial institutions, start-ups) and providers of knowledge about fintech (the academia). Due to the complex nature of fintech activity (combining financial services with a strong technological component), the lines among the main categories of providers of fintech services and more and more blurred. Some start-ups have grown large enough and have even gone public, but others are finding it beneficial to enter into partnerships with established financial institutions. These institutions at their turn understand the pressure from the fintech fenomenon and in an attempt to maintain their market share, they either develop fintech capabilities internally or seek partnerships with startups. Last but not least, large established technology companies with strong customer bases try to leverage on their technological knowledge to start delivering financial services to customers (telecoms offering mobile payments services or online lending, ecommerce platforms providing consumer finance or mobile wallets etc).

Academia – despite the overwhelming quantity of information available for free on the internet about fintechs, which anyone can use to become familiar with the new area, there is a need for formal education on fintech as well at all levels (undergraduate, postgraduate, executive education). In addition, there is a need for formal education in areas where students acquire the skills which are needed to work within a fintech firm, such as: data science, data analysis etc. A variety of courses started to be launched and some world renowned universities are being very proactive in preparing the young generations for the new world we are in. The following paragraph provides a few examples of such initiatives:

University of Oxford’s Said Business School is offering the Oxford Fintech Programme (of which I am a graduate as well) and the Oxford Blockchain Strategy Programme; Wharton University introduced a Fintech course available to undergraduate students; New York University has launched fintech courses at several levels: FinTech for Executives (a short course for executives), a FinTech specialization available to MBA students and a Foundations in FinTech elective course available to undergraduate students.

Capital is defined as “the availability of financial resources for start-ups and scale-ups”. According to Ernst &Young (2016), such financial resources can take the form of seed capital (GBP 0-5mn), growth capital (GBP 5-100mn) or listed capital (market listing). In terms of who are the providers, capital comes from Angel investors, Venture Capital (VC) investors and IPO investors.

Angel investors are wealthy individuals who “invest in early stage or start-up companies in exchange for an equity ownership interest”. At the initial stages, the angel investors will be keen to see the elevator pitch for the new business, a pitch deck (or executive summary), a prototype of the proposed product and information on who the early customers may be. They will also be willing to understand the details of the financial projections, the assumptions behind them, the total capital required and how long that is expected to last. Regarding the management team and founders, their profiles, background and motivation for the project are essential{7}. An entrepreneur can access angel investors through a variety of channels, such as angel investor networks, crowdfunding sites (eg: Kicksharter, Indiegogo) or dedicated websites such as AngelList{8}. Angel investing is a regulated activity. In the USA for example, angel investors need to meet the definition of accredited investors according to the Securities Exchange Commission (SEC){9}. Getting capital from angel investors is the preferred way for businesses which are already beyond the start up phase, but which are still so young that they need additional capital to develop the product or to define their marketing strategy.

While angel investors are wealthy people willing to invest in interesting and promising business ideas developed by others, venture capital comes from venture capital firms. Venture capital firms are made of professional investors, who can be ‘limited partners’ (those who invest money in the firm) or ‘general partners’ (those who manage the fund and work with the individual companies that the firm invests in). VC firms normally provide much larger amounts of money (Compared to angel investors). After the investment is made, the firm becomes actively involved in how the funded company is run. The aim of the VC firm is to exit from the investment after a period of several years, very often through an initial public offering (IPO){10}.

A strong presence of talent and capital in a financial center makes it become a so-called FinTech hub. Relevant examples of FinTech hubs are: UK (London), California, New York, Germany (Hamburg, Berlin), Singapore, Hong Kong, Sweden, Israel, Australia. 

  Policy refers to regulatory regimes (ie, support from regulators for new players), government programmes (aimed at encouraging competition and innovation) and taxation policy (ie, tax policies that are favorable across all stages of funding). According to the Ernst & Young (2016) study, the UK has the strongest FinTech policy environment due to large extent to the involvement and support of the Financial Conduct Authority (FCA). Other supportive countries from a policy perspective are Singapore and Australia, while the policy landscapes in the USA, Hong Kong and Germany “are viewed as more complex, conservative and opaque”{11}. Moreover, certain countries tend to specialize on specific sub-sectors of fintech, such as: cybersecurity in Israel, payments in Benelux, fund administration in Dublin, financial identity in Estonia, and cryptocurrencies in Malta and more recently in Switzerland.

Demand refers to consumer demand, corporate demand and demand coming from financial institutions (FI). According to the Ernst & Young (2016) study, as of 2016, the highest adopters of FinTech products were the US and Hong Kong consumers (according to the % of digitally active consumers that use FinTech, calculated for a selection of locations with FinTech activity), while the corporate demand (excluding demand from financial institutions) was strongest in UK, USA and Germany (according to the propensity of SMEs to adopt tech and digital solutions). In the case of demand from financial institutions, the study highlighted clearly London and New York as the clear leaders, reflecting the two cities’ status as the world’s largest financial centers{12}. 

3.4 The Fintech ecosystem – what are the tools?

As FinTech refers to that part of financial innovation which has a strong technological component, it makes sense to analyse which are the tools for innovation available to the various stakeholders.  Start-ups tend to use incubators, accelerators and venture capital resources, while the larger organisations tend to organize innovation labs and hackatons. Large organisations also afford in general larger spending on Research & Development.

Brigl et al (2014) explains not only what incubators, accelerators and venture capital resources are, but also what they have in common and in which ways they differ. While venture capital focuses in general on more mature start-ups, incubators and accelerators focus mainly on start-ups which are in their early development phases.

Incubators and accelerators are often assumed to have the same meaning. Indeed, both of them represent tools for start ups in their early stages and provide help to the start ups to grow their businesses (including office space)  and to improve their chances of attracting venture capital investments at a later stage. However, incubators focus mainly on innovation and development of the business model for a disruptive idea, while accelerators aim to “accelerate growth of an existing company” (Forrest (2014)){13}. This translates into how individual programs are structured, in the time frame envisaged and in the content and help made available to the participating start ups.

Following a very competitive application process (with selection rates below 2% in some cases), the start ups accepted into an accelerator benefit from a small seed investment and access to a network of mentors, alumni and investors, in exchange for a portion of the equity. During the course of several months, the accelerator gets the start ups “into the best possible shape and refines their pitch to investors” (Y Combinator{14}).

Examples of accelerators include: Y Combinator, Techstars{15}, Brandery{16}.

Incubators address themselves to companies which are at the very early stage of development (developing the innovative idea, making the business plan) and they can function in conjunction with government entities, venture capital firms and large corporations{17}. Office spaces are generally rented by the startup. Incubators include services such as: market research, internet access, access to education resources, co-working opportunities.

Examples of incubators include: Idealab{18}.

Venture Capital firms address themselves to startups in more mature stages of development. According to Zider (1998), “the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with the help of an investment banker”. The VC firm invests in a company during a time in the company’s life “when it begins to commercialize its innovation” and “until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity”{19}.

Examples of venture capital firms with interest in the fintech sector include: Anthemis Group, First Round Capital, TTV Capital and many others{20}.

The larger companies tend to use Innovation labs and hackathons as innovation tools in the area of fintech.

A study conducted by the Luxembourg Institute of Science and Technology (LIST) identified a series of traits which are definitory for Innovation labs: imposed innovation topic, large scale challenges, revolution rather than evolution, autonomous setup, diverse participation, collaborative, long term perspective, a diverse set of tools and going beyond ideation.

A large number of corporations (financial and non financial) have founded innovation labs. Examples include: UBS etc.

Hackatons are events organized by a large organization, where they gather a large group of software developers and entrepreneurs for a short period of time (24-48 hours) and puts them in front of a challenge for which they have to develop a solution or an app in the given time frame. Grijpink (2015) believes hackathons are becoming nowdays “a valuable tool for accelerating organizational change and fostering a quick march, costomercentric, can-do culture” in the context where speed and agility are increasingly important for all organizations regardless of their size{21}.

Most major banks are organizing hackatons on a regular basis, as documented by the press.

3.5 Who should feel threatened by the Fintech revolution?

Rarely are such big transformations occurring without generating negative consequences for at least some areas or groups of people. If we start analyzing the main changes (and benefits) brought by the FinTechs, we can start to identify the losing side(s) as well.

3.5.1 The workforce

The financial sector employs a significant number of people across all age groups. However, this number is already on a decreasing trend around the world.

More and more jobs with a repetitive content which require mainly routine skills are being transformed through the use of automation. This means that the number of such jobs is steadily decreasing. Even high-skill jobs performed by office employees are being eliminated or reduced in terms of content through the adoption of artificial intelligence or robotic process automation (RPA) methods. As an example, robotic process automation can be implemented in banks for activities such as: mortgage approval, expense reporting, regulatory compliance, fraud detection (ie robots detecting fraudulent transactions) and others. RPA is in fact a programmed software that is able to simulate simple human actions. It acts like a virtual workforce and it can be used for repetitive and rule-based tasks and in the situations where high volumes of data need to be processed. The simplification of work and the significant reduction of time needed to perform the activities envisaged imply a reduction in the workforce previously involved in those activities.

With the continuous pressure on revenues following the financial crisis and a strong focus on cost cutting, the technological developments that allow banks to significantly reduce workforce are very welcome. In a conference in Frankfurt in September 2017, the former CEO of Deutsche Bank, John Cryan, suggested that half of the employees of the bank he was running could be replaced by robots, following implementation of machine learning and mechanisation. He explained that “in our banks we have people behaving like robots doing mechanical things, tomorrow we’re going to have robots behaving like people”{22},{23},{24}. Another recent example is National Australia Bank (NAB), which announced in November 2017 that it would cut 12% of its workforce (or approx. 4.000 employees) over a period of three years as a result of planned implementation of artificial intelligence (to replace customer support staff) and digital systems (to reduce in-branch jobs){25}. At a more general level, Vikram Pandit (a former CEO of Citigroup) declared in September 2017 that he expected 30% of banking jobs may disappear over the following five years as a result of technology{26}.

3.5.2 Owners of commercial real estate

The traditional banks have been performing their activities mainly through their network of branches. They have already started to expand their virtual banking services and they are onboarding more and more clients via these new channels. However, they still have a large network of branches in place which are very expensive to maintain and due to the ongoing pressure on margins they will be forced to close them. Many banks have already embarked in ample branch-closing initiatives (as of 2017) and many such initiatives are in progress or are being (re-)launched.

As of 2017 there were approx. 189,000 branches of credit institutions in the European Union (vs. more than 237,000 in 2008){27} and as of 2016 about 93,000 such branches in the USA{28}.  The imminent closing of a significant part of these branches may create pressure in the real estate sector (commercial properties sub-sector){29}.

3.5.3 Universities

Certain university degrees and certifications would need to change dramatically in order not to become obsolete

The recent developments in technology have been changing all areas of finance. For somebody who works in finance (even if as an employee of a traditional financial institution) it is no longer enough to understand only the traditional side of finance. The competition and the influence from fintechs are far too significant to ignore. Nevertheless, most of the finance courses at university level are still very much leaving out the technological innovations related to finance. This would need to change in the sense of including the fintech developments in the curriculum as well.

In addition, certain technological developments are challenging not only the content of the traditional university courses, but even the way in which they function. The emergence of artificial intelligence and automation make the offering of online distance learning possible on a very large scale. According to Smithsonian.com, “unless universities move quickly to transform themselves into educational institutions for a technology-assisted future, they risk becoming obsolete”. In India, the lack of student demand has already caused the closing of 800 engineering colleges out of approx. 10.000 existing ones. The risk of low student demand due to the increasing popularity of online courses is expected to become significant for the US universities as well in the coming decades{30}.

On the other hand, more and more universities have been launching short courses in fintech, in an attempt to offer their students the relevant skills for the current rapidly evolving environment. University of Oxford’s Said Business School, Wharton University and New York University are just a few of them (see previous section for details on the courses they offer on fintech as of the date of writing this book).

3.5.4 Banks

Further pressure on margins for the banks and on their market share

Being very cost efficient, the fintechs are able to offer their products and services with very low commissions. Consequently, if they want to still be competitive, the incumbents have to adjust down their commissions as well, which results in a significant pressure on their margins. According to Citigroup, Retail (as a business segment) is particularly at risk (especially regarding payments and unsecured lending), while corporate and wholesale banking are currently only under limited pressure{31}.  Unfortunately Retail accounts at the moment for a large share of the banks’ profits (ranging from 43% in Europe to 19% in Japan{32}), implying that such a threat is significant. However, certain services provided by the fintech are new, not already provided by banks, meaning that the banks have to a certain extent also missed out opportunities{33}.

3.6 Topics addressed in the book

The fundamental transformations mentioned in the previous pages would not be possible without the tremendous developments that have occurred recently in technology: NFC, big data analysis, cloud computing, blockchain, virtual reality, artificial intelligence etc.  The additional value that the Fintech companies are bringing comes exactly from the technologies which they are based on. Technology makes it possible to improve overall the banking services by simplifying the processes behind them, more precisely by driving the costs lower, by shortening the response time (for example in the case of a loan application) or by redefining a service from scratch (e.g. payment through SMS).

While the area of fintech is incredibly vast and touches on a variety of concepts, the current book aims to focus only on the following topics, that are generally considered of central importance:

- Alternative lending

- Alternative payments

- Wealthtech

- Blockchain

- Cryptocurrencies

4 ALTERNATIVE LENDING

Generally called Peer-to-Peer (P2P) lending, alternative lending can be found under other names as well (online lending, marketplace lending etc). As the name suggests, P2P lending platforms connect savers with money to lend with individuals or small businesses that need to borrow, creating thus a market place.  In its initial form, alternative lending eliminates financial institutions from the lending process, simply making it easier for an individual to lend money to another, charge interest and wait for the repayment of the loan. The loan experience through an alternative lending platform is generally entirely digital (including application, origination, underwriting, servicing) and the approval is very often received by the applicant almost in real time, which makes it significantly more efficient (in terms of costs and time) than the traditional loan experience through a bank, which can even take weeks for approval sometimes. However, meanwhile the financial institutions have seized the opportunity and the threat posed by alternative lending and many of them have launched in such projects themselves or partnered with dedicated startups in order to be able to provide similar services.

Although they are often used interchangeably, the various names used for defining alternative lending DO have some subtle differences among them. The most widely used (and the initial term) was peer-to-peer lending. This term referred to an online platform which would simply connect borrowers and lenders. However, as the sector evolved with the involvement of institutional players and the emergence of balance sheet lending provided by online platforms, the term P2P lending was not comprehensive enough anymore. Thus the term marketplace lending (MPL) has started to be used.  Online lending is another term which is general enough to cover the different evolving characteristics of the sector, but maybe not specific enough.  Last but not least, alternative lending is general enough to exclude the lending performed through traditional banking methods and channels, but possibly too general, as it lacks the reference to the technological nature of the sector. Since there is no standardization in the relevant literature, in the current chapter I will be using all four terms interchangeably. 

One of the first areas to be explored by fintechs, alternative lending has been around since 2005, when the UK-based P2P lender Zopa was founded, followed in 2006 by the launching of Prosper Marketplace and Lending Club in the USA and Paipaidai in China in 2007. One decade later, in 2017, among the 25 fintech unicorns identified by CB Insights globally, many of them were alternative lenders{34}: Affirm, Kabbage, SoFi, Credit Karma, Funding Circle, GreenSky, Lufax, Avant, Prosper.

Meanwhile, other important milestones have been reached. Several alternative lenders have gone public, with the all-time high of equity funding for the alternative lending sector reached in 2015 (USD 6.3bn collective equity funding). In addition, consolidation became an important trend in the sector, with a peak in the number of acquisitions, mergers and shutdowns reached in 2017{35}.

However, as the industry matures, skepticism has also increased in relation to the business model of alternative lenders, which still remains to be tested in times of downturns, increased regulatory requirements, increasing operational challenges related to scalability (internal controls, risk management, loan servicing) and increasing concerns around cybersecurity{36} and rising interest rates.  Any of these factors could put pressure on the borrowers and lead to an increase in defaults.

While at its inception, Zopa was promoting the concept of “alternative finance” as something revolutionary (“finance by the people, to the people”), according to FT (2016), a decade later, the P2P was transformed from alternative finance into “another lending channel for banks, hedge funds, pension funds and others”, or in other words it is becoming more and more “a part of mainstream finance”.  On one hand, one may consider that the involvement of traditional financial institutions in the alternative lending sector may squeeze out individual investors. On the other hand, growing and achieving scale would not be possible without the institutional money{37}. Consequently, the involvement of the financial institutions in the area of alternative lending should be seen just as a natural step in the evolution of the sector. According to Forbes (2018), in 2016, a significant part of the alternative lending business was funded by institutional investors such as banks, pension funds and asset managers (45% of P2P consumer lending and 29% of P2P business lending){38}.

On a different note, one should note as well the difference between P2P lending and microfinance. Both services refer to the intermediation of online loans among peers. However, microfinance refers to loans of very small sizes (under USD 1,000) and are usually run by non-profit organizations. One such example is Kiva.

This chapter will focus on P2P lending rather than on microfinance.

4.1 Driving factors

4.1.1 The emergence of the peer-to-peer economy

It is natural to assume that the development of the peer-to-peer lending activity has been partly correlated with and influenced by the development of the peer-to-peer economy in general. The peer-to-peer economy (or sharing economy) refers to all the activities through which the owners of various assets or capital agree to share it directly with potential users against a fee, without the involvement of an intermediary. Some of the best known examples include Uber (car sharing) and AirBnB (flat sharing). Uber is such a famous example within the sharing economy category, that sharing economy itself is sometimes called uberization.

In relation to the sharing economy, FT(2014) explains, “finding new ways to monetize used or existing assets has the obvious and immediate effects of raising their value and the wealth of their owners, while simultaneously reducing the value of comparable stuff owned by incumbent companies […] who find themselves burdened by the newly competitive environment. […] And all without any new stuff actually having to be made”{39}. The driving factors behind the growth of sharing economy, highlighted by FT (2014), citing Arun Sundararajan (NYU) are:

- the consumerization of digital technologies, meaning that in the past few decades, radical innovation has been driven more by the needs of consumers than by the needs of companies or government, which is in contrast to the previous times. The direct consequences of this phenomenon have been easy access to the new digital technologies and familiarity with them for the consumers, which can then enable the use of peer-to-peer platforms for various exchanges.

- the emergence of digital institutions – this refers to “digital technology-based platforms that facilitate exchange in the same way that economic institutions historically have done”. Examples include platforms which perform digital identity verification or credit scoring systems, which subsequently “facilitate trusted economic exchange in hundreds of different peer-to-peer marketplaces”.

- urbanization and globalization – the space constraints that urban residents are faced with makes them favour the sharing economy approach. In other words, they often prefer to pay for access to an asset or a resource instead of owning it.

- ecological and resource considerations – these refer mainly to the fact that sharing economy most often implies a more efficient use of resources as well, which increase its attractiveness for the larger and larger number of people concerned with such issues.

4.1.2 Macroeconomic environment

The macroeconomic environment has been in many ways accommodating for the development of alternative lending. First of all, following the financial crisis in 2007, many banks reduced lending volumes, with the most significantly affected segment being the SMEs.  The alternative lending platforms seized the opportunity occurred from the needs of such clients and took advantage of it. Although currently the banks’ appetite for lending is back and their interest to get involved themselves in alternative lending is high, the sector is well-established and mature enough to resist, which means that the most likely further development would be in the direction of partnerships among traditional banks and alternative lenders.

Secondly, the years of low interest rate environment that followed the financial crisis have lead professional investors in the search of investment opportunities with higher potential yields, and online lending (through securitization, but not only) positioned itself as such an opportunity.

Last but not least, the financial crisis brought with it a decline in employment and consequently a decline in income and purchasing power. Many potential customers either did not qualify for loans from banks, or they were not willing to pay the high interest rates charged by them. The online lenders came to fill in this gap.

4.1.3 Customer-driven focus on user experience

According to a study performed by Deloitte (2016) on the UK market, it can be clearly demonstrated that one of the factors with a positive influence on the growth of the P2P lending sector is the P2P lenders’ ability to offer “an attractive customer experience at acceptable lending rates”. More specifically, what attracted customers to such platforms were factors such as: fast and easy application process, fast decision making, competitive rates, little documentation requirements and convenience of the online platform{40}. Although performed only on the UK market, one may assume that the finding is likely applicable to other markets as well.

4.1.4 Developments in technology and data analysis

The developments in technology and data analysis have helped the development of online lenders in multiple ways and at multiple levels. The increased connectivity of people to the internet and the increase in online activities in general have been generating huge amounts of data. On one hand, such data (eg browsing history) can be used by the online lenders to target potential new clients by advertising their services to them. On other hand, such data can become inputs in the lenders’ credit assessment models. Moreover, the improved analytics are helping the lenders make better sense of the big data that has become available.

4.2 Types of alternative lenders

Alternative lenders are issuing in general loans to underserved borrowers, such as consumers seeking to consolidate debt at more favourable interest rates, SMEs whose business size, loan amounts or existence are considered by banks too low to be profitable or trustworthy, mispriced students with low probabilities of default, and other individuals and SMEs which due to their risk profile are classified outside the banks’ target market{41}. Consequently, from the types of borrowers that they can serve, the alternative lenders can be classified as follows:

Lenders to Individuals: such lenders are focused mainly on the needs of private individuals and on the products which are specific to them, such as consumer loans (eg: Lending Club, Prosper, Avant) or mortgage loans (eg: SoFi). A sub-category of this group includes the Lenders to Students (eg: Earnest). Other large players in this general category include:  Zopa, RateSetter

Lenders to Small businesses: such lenders focus mainly on products relevant for the SMEs, such as providing liquidity for purchasing inventory or increasing the workforce (eg: OnDeck, Kabbage, Funding Circle). In comparison to traditional banking products, these lenders managed to reduce the threshold for accessing the loans on all levels: lower loan amounts, lower financial requirements and shorter approval process.

From a business model perspective, the P2P lenders can be classified as follows{42}:

Balance sheet lenders are those P2P lenders that use their own balance sheet and take credit risk themselves: Kabbage

Market place lenders are those P2P lenders that facilitate connections between lenders and borrowers without taking on credit risk on their own balance sheets: Lending Club

Hybrid model lenders are those P2P lenders that may lend either directly to some of the borrowers or in a mixed fashion with part of the loan funded by the firm and the remaining part funded through the platform: OnDeck.

One other type of player in the alternative lending sector is represented by the lending-as-service-providers (LaaS), which “offer risk assessment and underwriting on-demand to stores or brands that want to offer loans, while outsourcing the processes to do it”{43}.

4.3 How does Peer-to-Peer (P2P) lending work?

Most P2P lenders function on an online investment platform that is enabling on one hand borrowers to attract lenders and on the other hand investors to purchase loans. They develop their own risk models for loan approvals and pricing. They also process loan repayments from borrowers, ensuring the repayment to the lenders who invested in the loan.

The P2P is acting like an online intermediary, as it is not common that investors and borrowers are already connected outside the platform. Sometimes the lenders can choose which loans they want to buy (i.e., to invest in), while sometimes the investment is allocated automatically to the pool of loans. All transactions are taking place online.

The P2P lender is charging a fee for the service, which is how it creates revenues. The attractiveness for the borrowers comes from the better interest rates applicable on the loan (vs. traditional lenders), or sometimes from the availability of the loan itself (in the case of non-bankable borrowers). As to investors, they are attracted by the higher rates of return on investment vs. investment alternatives with similarly (low) risk profile. This win-win strategy is possible due to the cutting out of the banking middle man, which allows more favourable rates for all protagonists: the business model is simply more efficient, as the P2P lenders do not have the costly big branches and overheads that traditional banks have.

However, as a downside one should keep in mind that the investors do not get the same level of protection as in the case of savings accounts or deposits; buying P2P loans is from a risk point of view closer to investing than it is to saving.

In a much simplified way, the P2P lending process works as follows:

Step 1: Registration

Customers sign up to the platform either as borrowers or as investors/lenders.

Step 2: Application and approval

A borrower submits an application for a loan. The application is usually completed in two steps: a preliminary soft credit check (based on an initial set of pieces of information from the clients) which results into an estimated loan amount and an estimated rate, and the credit check itself (performed for clients who decide to continue the application after the indicative conditions received after the soft credit check). The duration of the approval process varies, but it is in any case shorter than in the case of traditional banks. The whole process can take 24 hours or less for SMEs and some individuals, but it may take up to 48 hours for students, while in certain situations it may take as little as 5-10 minutes, depending on the documentation that needs to be provided by the applicant{44}.

Step 3: Funding{45}

In the case of marketplace lenders, if approved, the loan will be displayed on the platform so that the investors can fund it. In general, investors do not fund entire loans, but rather invest only in a small portion of many different loans. This approach ensures risk diversification and spreading. During the time that the loan is online available for subscription (usually a few weeks), investors have the opportunity to request additional details in order to decide whether to invest in the loan or not. In case the loan gets fully subscribed before the end of the subscription period, it is then removed early from the platform. The user is also able to delete it from the platform, in case he no longer needs to take it. Moreover, it may also happen that only part of the loan is subscribed, in which case a smaller loan than the one initially applied for is being issued.

From an investor’s perspective, there are also multiple alternatives available. Many platforms offer automated investment plans, which can allocate your investment among a selection of loans, based on the criteria defined by the investor (risk, maturity etc). Alternatively, investors may also choose the loans individually, despite it is much more time consuming than the automated plan.

In the case of balance sheet lenders, the funding process is much simpler and shorter, as the lenders make their own funds available to the borrowers and do not depend on investors.

Step 4: Disbursal of funds

In this step, the money becomes accessible to the customer.

4.4 The lending model. Pricing and risks

Traditional financial institutions (banks) facilitate lending activities by leveraging on the savings that their customers are placing with them. More precisely, the customers of such institutions place their savings with them, receiving interest on the savings in return. The banks are subject to minimum reserve requirements and deposit guarantee schemes which insure these savings in most countries (for example the Deposit Guarantee Schemes – at country level and at EU level in the countries of the EU). Using the savings from the customers, the banks can originate loans to borrowers and they earn interest in return. The availability of loans and the rates which these loans bear are a function of the borrowers’ risk profiles, assessed via credit rating models. The interest earned by the bank on loans is higher than the interest paid on savings and deposits, but only a small proportion of the difference translates into profit for the banks, due to the high overheads. Most often, only borrowers with a low risk profile end up being serviced by the traditional banks, leaving the high risk customers at large underserved. Moreover, the loan approval process inside a bank requires multiple levels of approval and tends to be still relatively beaurocratic, which translates into long response times.

In contrast to the traditional financial institutions, the alternative lenders are using alternative lending models which fill in the gaps with regard to unsatisfied customer demands. While specific models differ from one lender to another, most of the alternative lenders do have certain characteristics in common: directly linking borrowers and lenders, utilization of advanced credit approval methods and more efficient processes.  Thus, the alternative lending platforms match directly the loan requests from borrowers with the bids from the lenders (in the case of marketplace lenders). As opposed to banks, lending platforms are earning their money from origination fees and other commissions.

Due to these models which give lenders the flexibility to choose the desired level of risk, the alternative lenders can cover also the demands from the high risk borrowers. The relatively simple model leads also to a reduction in transaction costs in comparison to the traditional lenders.

Regarding the robustness of their credit models, Giles Andrews (CEO of Zopa) explained:

“…we did see ... (in 2005) that consumers were over-indebted. Part of it (ie the model) is simply better modeling, better use of data, and some use of alternative data. We still use most of the traditional credit industry data, and we still find that by and large to be the most predictive, so we are using similar data to banks. But I think we buy more of it, and we use it more intelligently. […] The other part of it is that with a peer-to-peer model, the fact that people borrow money from other people seems to make them behave better in that relative circle of influence. There’s some evidence that customers prioritize our debts, in some cases, over others because there are other humans at the end of the loans.”

Most alternative lenders are using innovative credit scoring models. Such models start from the traditional set of data that banks are using in their credit scoring assessments, however they input nontraditional data points as well, such as: a business’ rating on an online platform (Yelp), the business owner’s social network on Linkedin (in the case of SME loans) or the level of wealth in a particular area{46}.  Other types of data being considered in the credit score assessment may include: the length of time the borrower has used the same email address, the size of the borrower’s network on Twitter, Facebook or other social media sites, sales volumes from credit cards, local and government public records{47}. The number of data points considered for the scoring model varies greatly across the sector, depending on the type of loan and on the type of client served. Research shows that in general the models used for consumer loans consider 50 data points, but at the same time OnDeck leverages more than 2.000 data points when they assess the creditworthiness of their SME clients{48}.

Moreover, there is a lot of innovation in the type of data points chosen. In the case of student loans, the students’ degrees and the universities they attend can be considered. However, there are many data points which would be easily available to the alternative lenders (such as race, age, national origin, gender) but which cannot be used for reasons of discriminatory practices{49}.

Some of the P2P lending platforms have created their own credit score measures: in the USA, Prosper has created the Prosper Score, while Lending Club has created the score called Model Rank; both lenders confirm that their scores are derived from a combination of the answers from a borrower’s application, from the FICO score{50} (or answers from another credit reporting agency) and “other” factors.

As an example, the Prosper score is based on the following key variables, as detailed on the website of Prosper{51}:

• Number of inquiries on the credit bureau

• Number of delinquent accounts on the credit bureau

• Credit card utilization on the credit bureau

• Number of recently opened trades on the credit bureau

• Debt to income ratio

• Loan payment performance on prior Prosper loans

4.5 Investors’ considerations on the new asset class

The alternative lending process is in fact creating a new asset class (or sub-asset class). There is no consensus yet across the investment community with regard to its classification, with opinions split between fixed income and alternative investments categories. Due to the fact that the product itself IS a loan, some argue that the alternative lending portion of someone’s portfolio should be classified under his/her fixed income allocation. However, due to its speculative (ie, high yield investment) and illiquid nature, some argue that it should fall under alternative investments{52}.

In terms of investing, there are two major ways to get involved: direct investment (ie, directly funding loans on the alternative lending platforms) or investing in securitized products with alternative loans underlyings. According to EY (2016), “securitized products provide increased liquidity, but at the trade-off of reduced yield and transparency”. 

Diversification within this new asset class itself can be achieved either via diversification of the investment among alternative lending platforms, or via diversification among types of loans (ie, for SME, for consumers, for individuals etc). Both of them increase significantly the complexity of the investment process, when the selection and the diversification are performed individually. As an alternative, one could make use of retail tools such as LendingRobot or NSR Invest, which developed secondary credit models able to do an advanced filtering through a vast number of loans and their related information. Such a service can be accessed for fees between 0.45 – 0.60%{53}.

Securitized products have alternative loans as underlying, which are repackaged. They  currently represent an increasing market within the larger asset-backed securities (ABS) market. As of Q1 2017, all deals in the USA had received at least one credit rating from a rating agency and over 15 banks were purchasing loans from marketplace lenders (eg: Goldman Sachs, Morgan Stanley, Deutsche Bank, Citi, Credit Suisse, JP Morgan, Barclays etc). The top originators involved in partnerships with the banks for the securitized products include: SoFi, Lending Club and Kabbage. The cumulative issuance of securitized products as of Q1 2017 had reached USD 18 bn (from 80 deals), following an increasing trend in issuance over several quarters{54}. However, this approach (already adopted as early as 2013, with a USD 53mn deal structured by New York based Eaglewood Capital, using P2P loans from Lending Club) is not free from criticism, with securitization being one of the most controversial techniques employed by investment banks{55}. 

The development of securitization in relation to alternative lending in the USA has to a large extent been determined by the large increase in the sector and by the “promise of higher returns”, which has been appealing to institutional investors during times of historically low returns on other financial assets{56}. According to Deloitte Center for Financial Services, the evolution of securitization in the marketplace lending sector is an indicator that the sector is becoming mature, that it “is fast becoming a more permanent aspect of the financial services industry”, and that “securitization has become a viable source for further funding for marketplace lending and a catalyst for its maturing and standardizing”{57}. Moreover, the market has also seen the emergence of a new category of players, which can perform loan surveillance of securitized loans originated through online lenders. Such a player is PeerIQ.

Despite the spectacular growth of securitization activity in the marketplace lending area in the USA, the secondary market is still in its infancy. According to Deloitte, in the USA what is lacking are regulatory guidelines and broker-dealer licenses for the online lenders, which are required for facilitating secondary market trading for P2P loans.

4.6 Main players, main countries

The markets with the most significant presence of alternative lending activities are as of beginning of 2018: USA, China and a selection of countries in Europe (especially UK). 

According to Forbes (2018), there is a “clear link between fast growth and an accommodating regulatory regime”, as the fastest growing countries in alternative finance activities are those countries where the regulators have tried the most to provide supportive policies to the sector{58}.

4.6.1 USA

According to Deloitte, the most common business model adopted by the US players is the so-called ‘notary’ model, which assumes the involvement of a partner bank as well in the process, with the role of originator for the loan. The loan is afterwards purchased by the platform, which issues a note to lenders, instead of a contract. The lenders can be retail, but they are mainly institutions (hedge funds, private equity firms, banks). Retail investors are allowed to lend only via platforms that have registered their notes as securities with the SEC. Moreover, retail investors in the USA also have restrictions regarding investment in business loans. One other particularity of the US online lending market is the strong presence of securitization, which is adding liquidity to the market. Moreover, USA is the first country to have ratings allocated to its securitizations (the first time a rating was assigned to such a securitized deal was in 2015){59}. 

As of Q3 2016, the total loan volume that had been originated in the USA by P2P lenders from the inception of the sector in 2007 was approx. USD  40 bn. A lot of these volumes had already matured, as the average maturity of the online loans was at that time 3-4 years{60}.

4.6.2 Europe

In Europe, the alternative finance market is clearly dominated by the UK (which is also home to the first P2P lender, Zopa). According to The Cambridge Centre for Alternative Finance, as of end of 2016, the European market for alternative lending was worth €7.7bn, out of which €5.6bn represented the UK alone{61}. The next largest European markets in the sector are France, Germany and the Netherlands. Other countries with alternative lending activity in Europe include: Finland, Spain, Italy and Georgia.

4.6.3 UK

The UK is the home market of the first P2P lender, Zopa. After its start in 2005, the P2P lending sector has grown rapidly and has diversified continuously. As of end of 2017, there were already at least 50 online lenders in the country. The types of loans that can be granted by the online lenders are now very diverse, including: consumer lending, business lending, real estate lending, invoice financing and other types of loans. In addition, other types of companies appeared in the online lending market that do not offer lending, but connected services: borrower comparison, credit check, compliance services, aggregators, data and research services.

As of 2017, the online lending market was still dominated by the top 3 players: Funding Circle, Zopa, Rate Setter, with approx. market stares of 31%, 24% and 15%. From on investor side, there is evidence that the share of investments from institutional investors in the total online lending market has been on an increasing trend, reaching approx. 30% of total investments in 2017{62}.

As a sign of evolution of the market, the online lender Zopa has applied at the end of 2016 for a banking license, aiming to diversify its funding. After getting the banking license, Zopa will be keen to start offering deposits to customers, who would then be protected by the deposit guarantee schemes. This would mark a first attempt from a P2P lender to become a bank{63}.

In addition, securitization of products, although not as developed as in the USA, is also present in the British market. The first securitizations with online loans underlying were performed by Funding Circle{64} and Zopa{65} in 2016.

4.6.4 China

According to Online Lending House{66} quoted by the FT(2017), as of mid 2017, China had already more than 2.100 alternative lending platforms in a market worth USD 120 bn, which is lower than the maximum of 2.600 platforms reached in 2015{67}. One of the main reasons why P2P lenders have been so successful in China is the fact that Chinese state-owned banks have been hesitant in the past to give loans to individuals or small businesses. Consequently, the P2P lenders found a market immediately{68}. In addition, according to Forbes (2017), also balance sheet lending (as a sub-category of alternative lending) has a strong presence in China, especially due to tech giants such as Alibaba and Tencent, which offer unsecured consumer loans through their online banks. 

However, after a series of frauds and scandals, the Chinese authorities are determined to regulate the alternative lending market more strictly, which is expected to push out of the market some of the existing players which are not likely to be able to become compliant with the new rules. The new rules prepared by the Chinese regulator would forbid online lenders to guarantee the principal or the interest on the loans they facilitate. Moreover, they would introduce a cap on the size of loans that can be contracted (Rmb 1 mn for individuals and Rmb 5 mn for companies){69}. The new rules are expected to come into force starting with June 2018. 

Examples of alternative lenders in China include:

- P2P Lending, Business & Consumer: ZhaoCaiBao (Alibaba), Lufax

- Balance sheet lending: Paymax (China).

4.6.5 India

According to Forbes (2017), India’s alternative lending market, with only 30% P2P lenders in existence despite a very high percentage of the population (almost 40%) being unbanked, seems to be in a much earlier stage. One reason could be the smaller number of “newly minted millionaires looking for places to invest” in India vs. China. However, as a dramatic growth is expected in the sector, the Reserve Bank of India has already started regulating the P2P market{70}.

Examples of alternative lenders in India include:

- P2P Lending, Business & Consumer: i-lend, LenDenClub, LendBox, Faircent

- Balance Sheet Lending: EarlySalary (general consumer loans), ZestMoney (Point of Sale loans), Buddy (student loans).

4.6.6 South East Asia

The alternative lending market in South East Asia is still relatively small, but according to Forbes (2017), it has huge potential for development, due mainly to a well represented SME sector in the regional fast growing economy, but which las limited access to financial credit. The SE Asian countries are progressing fast in terms of regulation for P2P lending as well, with their governments taking action and sending the message that they are ready for P2P lending and thay are interested in increasing such business in the area. Malaysia and Thailand are only two such examples{71}. 

Examples of alternative lenders in South East Asia  include:

- Singapore: Funding Societies, Capital Match, MoolahSense (all P2P Lending for Business)

- Malaysia: Crowdo (P2P lending to consumers)

- Philippines: Simplex (P2P lending to consumers)

- Indonesia: Taralite (P2P lending to consumers, balance sheet lending to online merchants).

4.7 Response from the traditional players

As Giles Andrews (CEO of Zopa, UK) was explaining in an interview taken for the book “Breaking Banks”, the P2P leanders are not aiming to completely replace banks, but rather to “do a slice of banking more efficiently and better”, meaning that “within the savings and loan industry, we can take a dramatic piece of banking away”.   

The alternative lending platforms are indeed bringing a lot of pressure on the traditional financial institutions in the lending area, creating an urgency for the latter to become more transparent, more user friendly and faster in responding to the customer requests.

In a study performed on the UK P2P lending market in 2016, Deloitte identified four options{72} that banks have for responding to the P2P lending phenomenon:

- White label, meaning a bank-branded platform, where the platform is operated by a third party lender and the bank provides only the brand name. This approach may be suitable for banks with a strong customer franchise but limited capacity for organic growth.

- Capability insource, meaning a bank-branded, on balance sheet lending service. An example is JP Morgan Chase, which is providing loans to its SME customers via OnDeck’s platform. This approach may be suitable to banks which already have a very strong presence in the market and available funds, but which are disadvantaged by legacy processes or IT systems. Alternatively, the approach may also be suitable for smaller banks, as an enabler.

- Deploy funds, meaning investing customer deposits via an online lending platform. An example in this category is Metro Bank in the UK, which deploys customer deposits through Zopa. The approach is suitable for banks with a low loan-to-deposit ratio.

- Refer borrowers, which means referring the less profitable customers or those outside the bank’s risk limits to an online lender. Such examples are RBS and Santander UK, which refer SME customers to Funding Circle. The approach is suitable for those banks which have a very large number of loan applications and are unable to serve all of them.

In more general terms, the World Economic Forum (2015) study{73} has identified 3 potential scenarios for the impact that the alternative lenders would have on traditional banks, depending on various assumptions:

1. Disintermediation of traditional intermediaries

In case the customer knowledge and trust in alternative lenders increases from both borrowers and lenders and the regulatory environment remains favourable to the alternative lenders, then it may happen that the P2P lenders evolve to become “the primary origination point for consumer lending”. Meanwhile, the traditional banks lose ground in front of them, due to legacy processes and capital requirements, failing to adapt quickly enough to the new paradigm. Traditional banks would not only be losing loans market share, but also suffer a negative impact on their capital ratios, as deposits would be eroding in favour of alternatives to savings offered by the new competition{74}.

2. Complementing of traditional intermediaries

In case the trust in alternative lenders does not increase sufficiently and the banks continue to have a limited appetite for taking high risk loans on their balance sheets, it may happen that traditional institutions and alternative lenders continue to meet demands from different classes of investors and borrowers (banks to cater to the customers with low risk profile, alternative lenders to cater to the customers with higher risk profiles), while also developing partnerships between traditional players and alternative ones.  In such a scenario, traditional banks would be better able to meet their customers’ demands, including from higher risk customers, as the banks would have the option to refer those demands to the alternative lenders they cooperate with{75}.

3. Driving change within traditional intermediaries

In case the pressure from the alternative lenders to the traditional banks increases significantly, it may happen that traditional institutions develop in a direction which allows them to adopt some key features of an alternative lending business model in order to improve the value proposition to the clients, while they also manage to create financial products able to cater to the needs of both high risk borrowers and risk-seeking lenders. The customer experience would significantly improve in such a case, and the traditional banks would also benefit from improved profitability{76}.

Several years later, elements from all three scenarios summarized above have already materialized, and the banks vs. online lenders story is one that is already going beyond convergence. In March 2016, Deloitte Center for Financial Services was stating that in the context of the US market, the banks and the marketplace lenders (MPL) were not only already converging, but “there would likely be much more bank – MPL convergence to come in the way of partnerships, joint ventures, mergers and acquisitions, and lending as a service (LaaS) (in both branded and white labeling capacity), making disintermediation a moot point”. Already one year after the publication of the aforementioned report, in 2017, Deloitte Center was seeing “a picture that is much bigger in scope than just MPL-bank convergence”{77}.

4.8 Trends in alternative lending

According to CB Insights, fintechs in general have entered since 2017 a new stage of development, where they move beyond a one-product model to a multi-product model, by building new services, buying other players or partnering with other firms{78}. This trend applies to alternative lenders as well, as proven by the following examples:

- Wealthfront (a wealthtech startup from USA – see dedicated chapter for further details) is expanding into alternative lending space through its new service for portfolio lines of credit, which it has started to offer in April 2017.

- Credit Karma (a provider of credit scores) expanded into tax services in 2017, by offering a free tax software to its users, which can be used for filing tax returns in the USA.

- Funding Circle (a direct lending platform for loans to small and medium businesses, founded in the UK) has announced a partnership with a US bank (Kansas INTRUST Bank) to increase its presence in the USA.

In addition, the alternative lenders have also diversified the services related to their initial core activity, lending. More precisely, some have started lending to other companies which themselves do lending, while others started to do maturity transformation (for example the British P2P lender Ratesetter). Maturity transformation means borrowing short and lending long and is a strategy that traditional banks use. However, the concept of maturity transformation is not compatible with the concept of P2P lending, because the definition of P2P is that any investor owns a fraction of a specific loan until the maturity of that loan, implying no flexibility with regard to the maturity of the loan. As FT(2016) concludes, the fintechs in the area of alternative lending grew incredibly different among themselves and they started to become “ill-suited to the label ‘peer-to-peer’”{79}.

Ratesetter has also decided to run a provision fund aimed at protecting investors from losses. Such an approach represents a huge departure from the P2P lending model and it is in fact much closer to traditional banking practices. Ratesetter’s provision fund was nevertheless subject to a lot of comments and debates due to the way it is structured: when the fund is exhausted, investor funds are pooled and payments to the investors are calculated on a pro-rata basis as the loans are run down{80}. 

One other example of departure from the original definition of P2P comes from Funding Circle, a British P2P lender. As of end of 2016, Funding Circle decided to set the rates for the loans itself. This represented a departure from the initial model where the rate was being determined based on demand and supply of credit through the so-called ‘wisdom of the crowd’ approach. The main reason for the change of approach was that many loans were not being completed{81}.

Moreover, traditional banks are increasingly interested in all areas pioneered by fintechs, including alternative lending. Many of the largest financial institutions have acquired or invested in alternative lending platforms.

For example Goldman Sachs launched Marcus{82} by Goldman Sachs. Marcus is a digital consumer lending platform that “offers no-fee, fixed-rate personal loans, high-yield online savings accounts and certificates of deposit to help people achieve financial well-being”. Marcus offers its loans (which can range between USD 3.500 and USD 40.000) as an alternative to credit card debt. The platform was launched in October 2016 initially in the USA, but as of September 2017, Goldman Sachs announced its plan to launch it into the UK as well{83}. As of February 2018, the platform had over 350.000 customers, and according to Goldman’s CEO, it has the potential to service millions of customers{84}.  Moreover, in November 2017, it had already reached USD 2bn in originations{85}. In addition, Goldman Sachs also invested in NAV and FinanceIt.

Other similar examples of involvement in the P2P lending area from large banks include JPMorgan ‘s investment in Prosper and Morgan Stanley’s investment in LU.com.

The increased interest in alternative lending from traditional institutions is making the market more and more competitive. As argued by FT (2018), the “wholesale disintermediation of traditional banks by P2P now looks unlikely”{86}. Moreover, moves by some P2P platforms to apply for banking licenses (eg: Zopa) suggest there tends to be rather a convergence between the activities of banks and those of fintechs in the area of alternative lending, than a replacement.

As the sector matures, more and more alternative lending platforms are considering IPOs. Among the platforms rumoured or expected to seek an IPO during 2018 there are, according to FT (2018): UK-based Funding Circle, Atlanta-based GreenSky or Lufax (based in Hong Kong). However, the context is not entirely bullish, with two previous US P2P listings that did not go well (OnDeck and Lending Club, US P2P lenders that went public, both witnessed a decrease in their share price of more than 75% compared to the IPO price){87}.   

4.9 When things go bad

The situation has not always been ideal for the alternative lenders, and especially after 2016, the sustainability of their model (especially related to US P2P lenders) has started to be questioned following a sequence of bad news emerging in relation to them{88}. As Chirag Shah, founder and CEO of Nucleus Commercial Finance (a UK-based P2P platform) declared in an interview with Business Insider: “The easiest thing in the world right now is getting the money out. The difficult thing is getting it back. Everyone’s done the easy part of building the loan books. Now let’s see who can get the money back”{89}.

The section below highlights some of the troubling news with negative impact on the alternative lending sector in recent years:

- A series of UK P2P lenders have witnessed increases in their default rates in 2017 in the context of rising inflation during the year and significant increase in the unsecured consumer borrowing (which reached GBP 202 bn in July 2017, the highest level since 2008). Consequently, GLI Finance (an investment company with investments in the fintech sector) had to write down the value of its investments in 8 alternative lending platforms in September 2017, reflecting “concerns over the collectability of some platform loans”{90}. One of the platforms in question is Lendy Finance, a Portsmouth-based property lender whose rapidly increasing loan book was considered as of September 2017 to have 25% of its loans in default{91}.

- In February 2018, Zopa, the largest UK P2P lender with GBP 3 bn of lending, warned investors about increases in the default rate on its recent loans to levels above the levels reached during the financial crisis. The percentage of default loans in total loans has been on an increasing trend since 2016 as a result of Zopa’s change of strategy (in 2016 Zopa started to consider for loans the higher-risk borrowers with the aim of increasing the returns for the investors with a higher risk appetite). This rate increased from 2.88% (for Zopa’s 2015 loan book) to 4.86% for its 2017 loan book. As a comparison, the rate was 3.58% in 2008 at the peak of the financial crisis{92}. According to the FT(2018), “peer-to-peer platforms are under pressure to make their rates appealing to investors but also to keep them affordable and appealing for borrowers, who could turn to other sources of finance”.

- Early in 2018, Collateral (a UK based P2P platform launched in 2016, offering pawnbroker-style and property-backed loans) went into administration after it was discovered that it did not have the relevant authorisations from the Financial Conduct Authority, the UK regulator. The lack of authorizations imply the lack of protection that the customers of such a platform would otherwise benefit from{93}.

- During the first half of 2016, the reputation of Prosper (the second largest alternative lender in the US market) has been hit after it was revealed that it had lent money to one of the San Bernardino gunmen and suspected terrorists. Since then, the lender has not yet managed to fully recover{94}.

- In mid-May 2016, Lending Club (the largest US P2P lender) lost half of the value of its shares, when an employee fraud was revealed and the CEO resigned as a result of a debate over conflict of interests. In December 2017, the shares of Lending Club were down about 80% from the IPO price in December 2014 due to the previously-mentioned scandal from 18 months ago, but also because of decreasing forecasts for operating profit and forecasts for 2018 operating margin below analysts’ estimates{95}.

- Another fraud which made the headlines was the case of Ezubao, one of China’s largest P2P platforms. Founded in 2014, the platform had intermediated USD 7.6bn worth of loans with the involvement of almost 1 million investors in the year following its founding. In early 2016, it emerged that the platform was a Ponzi scheme{96}.

Frauds and defaults have been indeed some of the main concerns related to the alternative lending sector ever since inception. As confirmed in a study by Cambridge Center for Alternative Finance quoted by Forbes (2018), professionals predict that the two most significant risks to the future growth of P2P lending would be “the potential collapse of a well-known platform following malpractice, and a major case of fraud involving one or more high-profile transactions”{97}. Consequently, such pieces of news should continue to be followed closely by anyone with an interest into the sector.

Moreover, there are as well certain still unanswered questions in relation to alternative lending. For example Kroll Bond Rating Agency is wondering about the hierarchy of debt: “Where do online loans come in the hierarchy of debt? If you are a person with a mortgage, a car loan, a credit card and a loan that you got online via an aggregation site, which do you stop paying first? It seems likely that your relationship with a website is probably less important to you than your relationship with your credit card or mortgage provider”{98}.

The alternative lending sector has attracted criticism even from public figures sometimes. One of the most notable critics was Lord Adair Turner, a former chairman of the UK financial regulator (Financial Services Authority) during the credit crunch, who in an interview with the BBC in February 2016 expressed concerns that the P2P loans could become the source of “big losses” in the years to come, losses which would “make the worst bankers look like absolute lending geniuses”.  He explained his view through the fact that despite the high-risk nature of the borrowers, their ability to repay is not properly assessed.{99} Meanwhile he has revised his view towards a more optimistic state, declaring in an interview with the Financial Times in October 2016 that "I don't think the use of technology by peer-to-peer lenders or challenger banks will do anything fundamentally new..but they might be able to do credit underwriting as well as established banks and also aspire to offer better customer services."{100}

Some of the critiques targeted to the alternative lenders are of a rather philosophical nature. Many alternative lenders promote the concept of financial inclusion. However, critics explain that financial inclusion comes at the cost of intrusion into someone’s life, spending behavior, or lifestyle. The online lenders have a strong ability to collect personal data about and from their borrowers (in some cases superior to traditional banks), while at the same time they have no restrictions (yet) regarding sharing such data to third parties for cross-selling and advertising purposes{101}. In opposition to them, secret keeping is probably part of the traditional banks’ DNA; the characteristics of a good bank are in general a good quality loan book and a good reputation for being discreet. Consequently, traditional banks make money from interest, fees and commissions, but fintechs can make money also from monetizing the data they collect. According to Nguyen Trieu{102}, a fintech professional:

“Traditional finance is based on the century-old model of making money from interest and fees. But technology has allowed data-led business to make money from the information itself – without the need to charge for fees. Today, these two worlds are separate: finance is still based on interest income and fees and does not monetize information about clients’ behaviours.”

In the same post, Nguyen Trieu gives Google as an example of technological company whose business model leverages on customer data for income generation. According to his estimates, 95% of the revenues of Google are from advertising, meaning that this huge portion of revenue is coming from exploitation of data collected by Goggle, which is afterwards processed and sold as information in the form of targeted ads. But while Google is trying to guess the spending power of its users, the online lenders (and fintechs in general) already have the financial information about their users, in a structured form and ready to be used. This is the reason for the claim that the biggest threat posed by fintech to traditional finance is the monetization of financial data, which “is a business in itself”.

On a different note, increasingly there are parallels made between the P2P lending model and the one of the subprime lending. Such an example is the detailed analysis included in a credit report from Moody’s about the US online lenders. The paragraphs below are relevant excerpts from the previously mentioned paper, quoted by the FT (2016){103}:

“Online lenders bear close resemblance to previous, securitization-funded monolines.

Starting in the late 1980s and continuing up to the financial crisis, there was a large increase in lending volume from rapidly growing monoline finance companies in a range of markets including residential mortgages, auto loans, equipment leasing and credit cards . These monolines relied heavily on the securitization markets for funding and were the “Fintechs” of the pre-crisis era . Their business models were similarly built on unstable foundations, and this resulted in them occupying niche markets, being absorbed into more stable institutions, or failing, rather than fundamentally transforming the lending landscape.

Monolines, like online lenders today, successfully identified a value proposition to both borrowers and investors that traditional banks and finance companies did not. Similar to the online lenders, the monoline lenders provided borrowers with simpler application processes and shorter approval times, as well as relied on new financing technologies (securitization in the case of the monolines) that presented the prospect of competitive returns and an alternative investment vehicle to investors. These advantages allowed upstarts to differentiate themselves from incumbents.

Also similar to the online lenders, the monolines had high valuations based on growth expectations. […]

Monolines relied heavily on confidence-sensitive securitization and warehouse funding. […]

Reduced funding required the monolines to make significant reductions in originations which, in turn, resulted in a large drop in nonrecurring gain-on-sale revenue. The monolines tried to re-size their expense base; however, revenues dropped much faster than their ability to right-size.

The monolines’ high leverage and low levels of tangible equity gave them little flexibility to weather a crisis in confidence. Given their unsteady foundations, the market stress led to a significant contraction in the monoline finance market. […]

The combination of wholesale, confidence-sensitive funding reliance and high percentages of non-recurring revenue that is dependent upon this funding makes these firms particularly vulnerable since revenues can decline far more rapidly than their expense bases.”

UK P2P lenders have been criticized as well for perceived similarities between their business models and the subprime credit models. The off-balance sheet participation is often given as an example of how similar the subprime mortgage brokers and alternative lenders are. For example Funding Circle (which does not hold loans on its balance sheet, something that none of the P2P lenders do) has a listed fund that buys only loans that it originates.  This is equivalent to an off-balance sheet participation, which is the mechanism through which subprime mortgage brokers used to introduce bad loans into the American financial system{104}. 

Last but not least, increasing concerns are generated by the fact that the mix of funding for the P2P lenders has changed over time in favour of institutional investors and securitization. While at the beginning the lenders used to be almost 100% retail lenders (therefore private individuals), over time the institutional investors have got involved more and more. According to Altfi (a data provider), the US P2P lending platforms received last year only 20% of their money from retail investors, while 50% were coming from buy-and-hold institutional investors and 30% coming from securitizations.

The original P2P model was straightforward, matching retail investors and retail borrowers. However, “platforms struggled to find enough cash from small investors to cope with rampant demand for credit. So they turned to institutional investors — and increasingly to banks that would repackage loan portfolios in the form of securitisations.”{105}

4.10 Current regulation for P2P lending

Although from an investor’s point of view, from the outside it may seem that lending money on a P2P lending platform is very similar to depositing money in a bank, which would subsequently lend it further to its own clients, in reality the two choices for placing one’s money are completely different. The money deposited in banks is protected (up to a certain cap) through various deposit guarantee schemes. However, the money placed on a P2P lending platform is not covered by the same regulations and as a result it does not benefit from the same guarantees. This was the main reason why many investors (and not only) have requested (and then welcomed) more regulation in the alternative lending sector.

Moreover, some of the large alternative lenders themselves have requested regulators to define guidelines for the new sector and to “set out common standards for declaring bad debts, and strict guidelines over how loans are marketed to consumers” in order to protect consumers in general and to maintain the reputation of the sector. For example in the UK, the Peer-to-Peer Finance Association (P2PFA) consisting of the main 8 lending platforms have requested in 2016 rules which would “protect not exclude” retail investors{106}.

As of end of 2017, the UK (through its regulator of the financial markets, the Financial Conduct Authority – FCA) seemed to be at the forefront of the P2P lending sector, while the specific regulation from other countries still has to adapt further.

More precisely, in the UK the FCA has started overseeing the sector in April 2014. The FCA has introduced rules for protecting the P2P investors, such as need to protect client money, requirements to meet minimum capital standards and setting up of resolution plans aiming to ensure that loan repayments would continue to be collected for investors in the case of a platform collapse{107}. In order to operate as a P2P platform, a firm has to be authorized by the FCA for P2P lending activity, a step which “added credibility and trust in what remains a relatively young marketplace”.

An encouraging but moderate view has been expressed by the Bank of England as well in its November 2017 Financial Stability Report{108}, where it stated “P2P lending could improve financial stability by providing an alternative source of finance for consumers and small businesses.  However, it may also give rise to risks, for example by lowering lending standards, or through procyclicality if rising default rates in a downturn made investors more reluctant to provide credit”. Being aware of related risks remains a key priority in their view, highlighting that “In its interim feedback report on this work, the FCA raised concerns around information quality, inconsistent disclosures and insufficient wind-down procedures for some firms.  In addition, the FCA has set out expectations of firms operating loan-based crowdfunding platforms which facilitate loans to lending businesses, as this activity may constitute ‘accepting deposits’”. This follows earlier concerns expressed by Governor Mark Carney regarding the risks posed by the online lenders and his recommendation for tighter regulation{109}.

In the USA there is no regulation specifically dedicated to P2P lending activity, but P2P lending platforms are subject to various other regulations, such as: consumer banking related regulation (for what concerns the consumer credit component of their activity) and SEC regulations (for what concerns the funding part). The consumer credit products in particular are subject to a very complex and extensive list of regulations both at federal and state levels, implying the need for equally complex compliance infrastructure for whoever provides loans falling under the incidence of those regulations. For this reason, it is very common in the USA that non-bank lenders partner with banks, one of the reasons being the wish of non-bank lenders to leverage on the banks’ compliance infrastructure{110}.

In China, after a series of frauds and scandals, the authorities have started taking more decisive actions to regulate more strictly the online lending sector. The first set of rules prepared by the Chinese regulator at the beginning of 2017 would forbid online lenders to guarantee the principal or the interest on the loans they facilitate. Moreover, they would introduce a cap on the size of loans that can be contracted (Rmb 1 mn for individuals and Rmb 5 mn for companies){111}. The new rules are expected to come into force starting with June 2018. 

According to Bloomberg (Nov 2017), in addition to the previously mentioned measures, there are new ones that China plans to implement and that are notable for three reasons: (i) temporary suspension of granting of new licenses to online micro-loan platforms, suggesting the regulator is taking time to analyse to online lending practices; (ii) banks are not allowed to buy loans underwritten by online platforms due to the high risks of such loans; (iii) securitization is forbidden, because it is seen to amplify risk.The reasons for the increased attention from the Chinese regulators towards the online lending sector are the concern generated by the extremely rapid growth of the sector, coupled with the concern that people may over-borrow and consequently fuel a bubble in the real estate market{112}.

5 ALTERNATIVE PAYMENTS

Payments represent one of the most widely used financial services across the world. It is impossible to live in our times without ever making payments. Payments truly are an inseparable component of our lives and they have been increasingly so ever since the first forms of money appeared. The means of payments however have evolved over time and they have diversified in order to accommodate the use of new forms of existence of  money such as digital money and e-money (ie fiat money in a digital form of existence) or mobile money (ie “financial services which can be accessed through a mobile phone”{113}). However, regardless of its type, any payment represents the means through which money fulfills one of its main 3 functions, namely the function of “medium of exchange”.

5.1 Influencing factors

Evolution of what is regarded as traditional payments has been influenced by the evolution of technology, by the emergence of the