The peer-to-peer lending industry in the UK is going through a period of rapid growth. As it becomes a more mainstream source of borrowing for consumers and SMEs, market participants have been examining the possibility of securitising portfolios of peer-to-peer loans as a means of driving further growth. Peer-to-peer lending was originally seen as a way of one individual or company lending to another without the involvement of a bank or other financial institution. As the sector has evolved, a large proportion of the lenders on these platforms are now hedge funds, asset managers, banks and other institutions. As a result, this type of lending is increasingly (and perhaps more accurately) referred to as “marketplace lending”.
Marketplace lenders typically use centralised electronic platforms to automate loan origination and servicing, which means that they generally have a lower cost base than traditional lenders. This has enabled them to pass on cost savings to customers and take market share from the banks. As the marketplace lending industry grows, participants are looking at ways to increase the availability of capital, and diversify their funding options.
US LEADING THE WAY
The first securitisation of marketplace loans was closed in October 2013. This deal was put together by Eaglewood Capital Management in the US, who sourced loans from LendingClub and securitised them in an unrated deal. This was followed in 2015 by the launch of the first rated transactions, including the Consumer Credit Origination Loan Trust 2015-1 transaction arranged by BlackRock Financial Management, which pooled loans originated by Prosper Funding. The issuance of rated notes further opened up the sector in the US, enabling investors such as insurers and pension funds to gain exposure to assets that would otherwise be outside the scope of their investment remit.
The rating agencies have noted significant levels of interest in this sector, primarily for transactions such as the BlackRock deal, which involve third party investors acquiring loans from a platform with a view to securitising them, but also for origination platforms seeking to securitise their loans directly. Some consider it to be just a matter of time until these types of transaction cross the Atlantic. Jonathan Kramer, director of sales at Zopa, was quoted in CityAM late last year as saying “Securitisation is coming to Europe, and that’s a good and healthy thing.”
THE BENEFITS FOR MARKETPLACE LENDERS
Securitisation allows institutions that otherwise would not have a mandate to invest in marketplace loans to gain exposure to this asset class. Financial institutions have been buying loans themselves, extending warehouse credit to buyers or, in some cases, partnering with platforms directly, such as Citigroup’s tie up with Prosper in the US. These institutions often cannot or will not make these types of loans themselves, but want to gain exposure to this market and the yields it offers. Gaining access to additional liquidity and raising funds in a way that represents an efficient cost of capital also allows marketplace lending platforms to offer better products and rates to their customers, which further drives the growth of the business.
It is worth noting that the marketplace lending industry encapsulates a broad spectrum of assets and models. Many differences exist in the focus, type of lenders, borrowers and policy in terms of loan size as well as credit criteria and operational setup. Not all of them will lend themselves to securitisation – we have already seen that certain platforms have attracted more investment from institutional investors than others. The level of diligence undertaken by these institutions gives comfort to other investors as to the model used by these platforms, and can serve as a legitimisation of the platform. The marketplace lenders hope that this effect would be even more pronounced for any platform that embarks on a securitisation of its loans, because the process of executing a securitisation transaction would involve the marketplace lender opening itself up to high levels of scrutiny by the arranging banks and credit rating agencies.
CREDIT ISSUES ARISING FROM MARKETPLACE LENDING
One concern that is often raised in relation to marketplace lending is that many platforms are still evolving, and that we have not yet seen how they perform through a significant downturn in the credit cycle. Some may argue that traditional SME or consumer loan portfolios provide an appropriate indication of historical performance of this asset class. However, the rating agencies have taken a fairly conservative view on this, and see limits in comparing different asset classes in past economic scenarios to determine future performance, citing the fact that performance data for meaningful origination volumes may only exist for two to three years. If the term of the loans is three to five years, this is not a sufficient timeframe to define a robust performance benchmark. They argue that data from non-marketplace lenders does not provide a direct comparison because of the differences in origination channels and possible borrower behaviour.
The speed of evolution may also give rise to operational risk. In the US, loan volumes have not been able to keep up with demand and some are concerned that increases in the number of loans extended might mean that origination will outpace the development of the underlying infrastructure. Sound operational frameworks are critical to the success of marketplace loans, as a securitisation asset class as the fundamental requirement of uninterrupted cash flows hinges on this aspect of the lender’s business.
Another element of operational risk relates to servicing. Marketplace lenders are typically smaller and have considerably shorter track records than servicers of the traditional asset classes. However, this risk can be mitigated by putting in place an effective back-up servicing arrangement. It is likely that any securitisation of marketplace loans would require a backup servicing arrangement, which includes a warm backup servicer from the outset with appropriate trigger events for ratcheting up to a hot backup servicer should defaults occur.
It is hoped that many of the risks that are specific to marketplace lending can be mitigated by the large amounts of data that marketplace lenders provide to investors, as this differentiates them from their traditional counterparts. Many lenders post their loan books online, so investors are able to analyse the quality and performance of their debt on a loan by loan basis. Any indication of a rise in bad debts would be immediately apparent. In the UK three leading lenders – Zopa, RateSetter and Funding Circle – have made their loan book details available to the public through analyst AltFi Data. This enables borrowers, lenders and other interested parties to see exactly where the money is going, as well as the risk levels and potential returns.
In spite of the vast amounts of data that is made available, a further obstacle to securitisation may be a perceived lack of transparency. Some platforms base origination decisions on algorithms, others on analysis of historical data. Algorithms that determine a borrower’s creditworthiness are proprietary, and there is a limit to how much information platforms are willing to divulge, which means there may be question marks over various aspects – such as the use of social media data for scoring purposes. Where lenders only provide general details on the underwriting criteria that have been considered without disclosing the precise process followed to reach a credit decision, investors may seek more representations and warranties with respect to the underlying loans than would have been the case in a traditional consumer loan securitisation. The more transparent origination and servicing methods are, the easier it will be to securitise the loans.
Concerns have been expressed about marketplace lending platforms not having “skin in the game”, because their own balance sheet is not being used to originate loans. The fact that the platform’s balance sheet is not being used to originate loans is indeed one of the distinguishing features of this asset class, but this does not necessarily mean that they do not have anything at stake. The platforms would argue that this is mitigated by transparency. If origination standards were to drop, this would be immediately obvious through the online platform, and investor demand would drop. Any structures will also need to address the regulatory requirements for risk retention.
There is a perception that to date, the marketplace lending sector has had less regulatory scrutiny than other parts of the finance industry. This leads to a concern that securitisation may lead to an increased focus, and new rules being imposed by the regulatory authorities. However, it is hoped that the existence of a specific regulatory regime for marketplace lending in the UK would at least help to mitigate this in the UK. platforms to dramatically increase available capital, and as more platforms develop the critical mass and operational history required to support this kind of transaction, it appears to be a matter of time before a securitisation of UK marketplace loans is successfully executed. However. whether wider economic headwinds and market developments mean this happens in 2016 remains to be seen.
OUTLOOK FOR UK DEALS
The development of the wider ABS market in the UK over the next twelve months is likely to be a critical factor in determining whether we see the successful launch of the first UK marketplace loan securitisation deal. A substantial volume of loans has been and continues to be divested by the large UK financial institutions, and assuming that a proportion of these portfolios will be refinanced by way of securitisation, the potential supply of Sterling denominated ABS paper in 2016 may make it difficult for this new asset class to achieve the pricing levels that would make the transaction viable – particularly in light of the conservative approach that appears likely to be taken by the credit rating agencies. If there is capacity to enter into currency swaps this may be less of an issue, but either way, the price discovery process is likely to be a challenge for the early transactions.
As the marketplace lending platforms continue to originate more loans and gain market share, it is inevitable that they will seek to further diversify their sources of funding. Securitisation of marketplace loans is one way for marketplace lending platforms to dramatically increase available capital, and as more platforms develop the critical mass and operational history required to support this kind of transaction, it appears to be a matter of time before a securitisation of UK marketplace loans is successfully executed. However. whether wider economic headwinds and market developments mean this happens in 2016 remains to be seen.