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Why P2P lending opportunity may not scale for a long time

Posted on Posted in Finance, Startups

What is Peer-to-Peer Lending?

Peer-to-peer lending (also known as person-to-person lending; abbreviated frequently as P2P lending) is lending and borrowing which occurs directly between individuals or “peers” without the intermediation of a traditional financial institution like a bank. The counterparty risk in the transaction is directly between the peers.

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A P2P platform is basically an online market place which allows borrowers to attract lenders, and allow these lenders to identify reliable investment opportunities that meet their criteria.

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Person-to-person lending is for a for-profit activity managed by match making platforms.  These platforms may utilise credit models (applied on borrowers) for loan approvals, pricing of the loans and matching borrowers with lenders (using social media or other mechanisms).

In February 2005, Zopa became the first peer-to-peer lender to launch on the UK market. ZOPA stands for “zone of possible agreement”, a term used in negotiations. It has arranged loans worth some £1.42 billion since then, and remains the largest peer-to-peer lender, with more than 63,000 lenders and over 150,000 borrowers on the books.

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Peer-to-peer lenders have been growing fast as they seek to disrupt the traditional world of banking by connecting borrowers directly with lenders.

Key factors for rise in P2P lending platforms are,

  1. Fills the void left by Banks

The tighter restrictions on traditional lenders through higher capital requirements have reduced their likelihood to issue uncollateralized credit, for personal loans or other loans. Peer-to-peer lending is an alternative to traditional lending that’s gaining traction around the world, including India.

  1. High Interest Rate Spreads

The Interest Rate Spread (lending rate minus the deposit rate) is as low as 2.9% in the UK, compared to an average of 7% in India, making borrowing money in India comparatively much more expensive.

  1. Lower Cost of Capital/High Returns

In an era of low returns for investors and scarce capital for those who need it, peer lending provides a low cost alternative, usually at lower rates than through traditional funding.  Peer lending alternatives provide an affordable and attainable option for raising capital.

  1. Cost Efficient

Peer lending platforms have little need for physical infrastructure. This, coupled with the use of algorithms to determine the creditworthiness of applicants, allows for the platform to operate with a relatively low cost.

  1. Convenient

Online platforms are more accessible to users, who may find it easier to manage. Unlike traditional investments, which may be available only at certain times of day, these online portfolios are accessible at any time, giving the platform more flexibility to update its operations and adapt quickly to an evolving business model

 

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Challenges in P2P scale up, especially in India

As they develop, however, they’re bumping against a host of obstacles. We feel it will take a long time to take off. And when P2P lending becomes sizeable, it shall get higher regulation, leading to higher costs and competition by traditional financial institutions.

  1. International Players have Failed to Make it “BIG” yet

Once one of the hottest companies in the hottest sectors of the financial market, Lending Club was a FinTech unicorn that promised to disrupt the way millions of people borrowed and invested. Now its stock is plunging, the company is struggling to save its reputation, and Lending Club’s users are left to wonder whether peer-to-peer lending was such a good idea in the first place, with reports revealing that their losses would make “the worst bankers look like absolute geniuses”. Realistic players like ZOPA did grow very slowly, but never became huge.

  1. Huge Unbanked Population – harder to bring in P2P world

41% of India’s credit seeking urban household goes to non-institutional sources for loans. 57.8% of these non-institutional sources charge interest rates greater than 20%. Of these, 30.2% charge greater than 30% interest.

Whilst it may sound like a great opportunity, but the failure rate of repayment of such loans is fairly high and unpredictable. Jury is out on how technology can resolve this problem online.

It’s harder to bring this unbanked population on a P2P platform; as their ability and intent to repay is hard to measure.

  1. Cash Economy won’t Move to Banked Transactions Anytime Soon

Cash economy in India generally the black money which is kept away from banks and tax authorities. It’s unlikely that money can be invested in a P2P platform as it shall raise questions on the source of this money.

  1. Rajan’s recent departure from RBI poses Macro Risk

Ex RBI Governor was a supporter of P2P lending platforms, in principle. Despite publishing a recommendatory consultation paper on P2P lending, his exit may put an abrupt halt to this and other favorable banking and economic reforms in the pipeline. Regulation may eventually come in, pushing P2P to become regulated financial firms like banks.

  1. Multiple Aadhar cards, Multiple Identities

The UIDAI has detected countless cases where one person has been issued two Aadhaar numbers, with identical fingerprints and iris scans seeming to have passed the so-called ‘robust’ de-duplication test of UIDAI. The UIDAI had said, “We will look at the point where the FPIR (i.e. the possibility that a person is mistaken to be a different person) is 0.0025%”. This means that for a population of over 120 crore, there would be 18 lakh crore false positives!

  1. Ease of Doing Business in India: Not so Easy

In a country that is ranked 135th on ‘Ease of Doing Business’ according to the World Bank, the average time taken to build a sustainable business is too long. The situation is different in established markets with favorable ecosystems; it’s much harder to make start-ups work in India.

  1. Borrower Behavior & Trust Building

There is no dearth of stories about defaulters using every means possible to cheat the legal system, enough to make even the most optimistic P2P player hesitant. India’s 29 state-owned banks have written off a total of Rs 1.14 lakh crore between 2012-13 and 2014-15. Another symptom of bad credit behavior is the over four million cases of bounced cheques pending in the courts.

In such a situation, the risks are higher and a few defaults can lead to a blow up of the P2P industry. 

In conclusion, we stay cautiously optimistic that P2P lending may slowly take off in India, but we suspect it will take a very long time (at least 7-8 years) to make this a multi billion dollar market.

 

 

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