If you want a sneak preview of the future of banking, the place to look is not London or New York, the world’s financial capitals. Instead, you should be paying attention to what’s going on in China and in Africa.
You see, the inadequacies of the developed world’s financial system only really became apparent to most people in the wake of the 2008 financial crisis. Suddenly everyone woke up to years of mis-selling scandals, and rampant overcharging by financial services providers.
Meanwhile, the slashing of interest rates by the Bank of England meant savers could no longer get inflation-beating returns simply by keeping their money in the bank.
But in less well-developed countries the banking system has long been inadequate to meet people’s demands. That’s led to alternatives springing up – ones that show the way for the future of finance in this country and elsewhere.
Take China. The country’s biggest money market fund is not run by a bank. It’s run by the Chinese equivalent of Amazon, or eBay – Alibaba. Last June, the e-commerce giant started offering to pay savers better interest rates on their cash than China’s state-controlled banks. It now has $40bn assets under management and 81 million savers, says The New York Times. Similar ‘internet banks’ are setting up to chase depositors’ savings too.
It’s little wonder that these are popular with Chinese savers, who have had to put up with ‘financial repression’ – where official interest rates are held below the rate of inflation – for far longer than their British counterparts.
Yes there are risks (this is ultimately an investment, not a savings account). But when the alternatives are seeing your money munched up by inflation, or investing in a casino-like stock market, or a volatile property market that booms or busts according to the whims of the government, you can see why China’s savers might feel comparatively safe in the hands of Alibaba’s charismatic and outspoken founder Jack Ma. The company also has a unit that lends to small businesses.
In Africa, the problem is not so much that banks offer an inadequate service, as that the infrastructure just isn’t there. In 2002, research (backed by Britain’s Department for International Development) found that people were transferring airtime credits on their mobile phones as a form of money transfer.
This eventually led to the creation of M-Pesa – a ‘branchless banking’ service allowing people to carry out basic banking operations, such as paying bills and transferring money, through their mobile phones.
After taking off in Kenya, M-Pesa was expanded into markets including Afghanistan and India. Vodafone is now bringing the service to Europe, starting in Romania.
Challenging traditional banking
Now, with the financial crisis destroying confidence in the banks, and global financial repression forcing savers to think a lot harder about where they put their money, people are starting to question the services that banks offer.
And increasingly, thanks to the power of the internet – which makes it easier for people to deal directly with one another, cutting out the layers of middlemen getting a cut of each transaction – they’re finding better ways to get the same services at a lower cost.
Changing money to go on holiday? You can get a poor exchange rate and pay big charges to a bank – or you can slash the cost by using a peer-to-peer (P2P) network, such as TransferWise.
This involves individuals in two different countries simply agreeing to swap money with one another at a far better rate than that on offer via the banks. Looking to borrow money? Try a P2P lender such as Ratesetter or Zopa – where willing individuals will line up to make loans to decent credit risks, and at a lower rate than your bank will offer.
About the only thing that traditional banks offer these days that you can’t get from non-banks is the security of the Financial Services Compensation Scheme (FSCS), which ensures deposits of up to £85,000. But even that selling point has been undermined by the aftermath of the financial crisis.
Savers have been told in no uncertain terms by money-printing central banks that if they want the return on their money to keep up with inflation, then they had better get used to taking some risk.
In a world where investing in blue-chip shares is regularly presented (however wrong-headedly) in the press as an alternative to saving in the bank, it’s no wonder that people are willing to view P2P lending as a viable option for their savings.
As the incumbents, you might think that the banks are in a good position to get ahead of the competition. But the banks have a handicap too. They are weighed down by legacy infrastructure – how many expensive bricks and mortar branches does Ratesetter have? Exactly. And they are weighed down by their tarnished reputations too – another unwelcome legacy.
In short, the financial industry is being turned upside down and disrupted in the same way that the publishing, broadcast and retail industries have already experienced, and are still enduring.
High risks for high returns
Of course, this isn’t a new story any more. Barely a day goes by without a press release hitting the MoneyWeek inbox proclaiming some new angle on P2P or ‘crowdfunding’. And critics of P2P and alternative finance in general argue that the sector suffers from many of the same problems that have led to the downfall of the banking sector.
As Dan McCrum noted on FT Alphaville at the end of last year, these companies just act as middlemen – “they have no ‘skin in the game’” – which is one reason the subprime mortgage crisis blew up (the companies writing the loans were selling them on – via securitisation – to investors, so had no incentive to ensure that credit quality was good).
And as John Kay notes, also in the Financial Times, there are bound to be scandals and fraud in the future – at which point the regulators will be forced to jump in and crack down on the sector to the point where the survivors will, in effect, be indistinguishable from banks.
We’d take these objections with a pinch of salt. This is classic media-cycle stuff. You get the hype (P2P will destroy the banks!) and then you get the backlash (P2P is a load of hype!) and the truth is somewhere in the middle.
Here’s what’s most likely to happen: the more excited that people get about P2P and alternative finance, the more companies will launch to take advantage. As competition in the market grows, some will lower credit standards in order to offer higher returns. The same desperate hunt for yield that has driven both rates and credit quality down across every other financial instrument will do the same to P2P.
Then, one day in the future, there will be a recession. At that point, default rates for the spivvier players in the market will rocket, a bunch of companies will blow up very publicly, and everyone will declare that it’s all over for the sector. But the stronger players will weather the storm, lick their wounds, and end up being all the better for it.
You only have to look at what happened with the increasing popularity of junk bonds in the 1980s. This demand was born out of a similar era of desperation for above-inflation yield. When the market blew up in the late 1980s, and ‘junk bond king’ Michael Milken ended up in jail, everyone thought it was all over.
But nowadays junk bonds remain a huge and – despite the name – perfectly respectable part of the market, provided you understand the risks.
The golden rule
This is the key point. If you intend to use P2P platforms, bear in mind the golden rules you would apply to any other form of investment. Firstly, these are not bank accounts. Yes, some companies offer protection funds.
And most have very low historic default rates. But the protection funds are only as good as the companies backing them – they are not comparable to the FSCS. And default rates are in the main so low because most (though not all) of these companies were set up in the wake of the financial crisis, so they haven’t really been tested yet.
So, if you need 100% rock-solid capital protection, this stuff isn’t for you. But if you need 100% capital protection, you shouldn’t be investing at all.
Secondly, the higher the potential returns, the greater the risk. If someone is offering you a double-digit return in this era of 0.5% interest rates, that means there is a substantial risk to your capital.
If you don’t understand where that risk is coming from, and the person promising you this return is unwilling or unable to explain it to you, then you shouldn’t invest – it’s as simple as that.
There are two main ways to profit from the ‘alternative finance’ revolution. One is to use the providers to save money on traditional banking services, or to invest your money. We look at two of the more interesting options below.
The other way, of course, is to invest directly in the companies that are disrupting the banks. We look at some of the best options at the end.
Two adventurous P2P platforms
There are literally dozens of P2P platforms out there, from well-known sector giants such as Ratesetter and Zopa, which compete with the banks for the savings and loans market, to invoice management platforms that offer higher returns, but involve taking on more risk, investing more money, and doing more of your own due diligence.
We’ll be looking at all of these in more detail in future issues, but for now, here are two platforms we’re particularly interested in. Both are on the more adventurous side of the spectrum, so just be aware of that if you plan to invest.
LendInvest (www.lendinvest.com) offers P2P lending secured against residential or commercial property – crowdfunding for mortgages, basically.
The team came from Montello Capital Partners, a short-term mortgage-lending specialist. It completed the world’s largest-ever P2P loan in January this year – a £4.2m loan to a developer looking to turn office buildings in Croydon into flats.
The minimum investment size is £10,000, and the average annual return – according to the website – is 8.9%. Sample loans on the site currently include a 70% loan-to-value mortgage on student accommodation in Camden offering a 7% annualised return.
TrustBuddy (Trustbuddy.com), which is also listed (see below) is essentially a Swedish P2P version of payday lender Wonga.com. As with most other P2P companies, any money you lend is split across several borrowers. All loans are for a term of 30 days. If the borrower repays the money within 14 calendar days, they pay no interest. But after that, they start to be charged interest.
So far, default rates amount to 1%-2% of the total capital lent out, and the expected annual return is 12%, according to the website.
Clearly, as we pointed out in the main story, you don’t get a 12% interest rate without taking risks. But if you want exposure to the undoubted profits to be made in payday lending, TrustBuddy is an interesting way to go about it – and given the high valuation of its shares, lending through the company might be the better bet.
Five alternative finance firms to buy now
The first thing to say is that alternative finance is going to hit the traditional banks’ business models hard over the longer run. In the short term, this won’t affect share prices – there are too many other factors influencing bank shares just now, and the threat from P2P and other forms of competition isn’t high on most investors’ horizons.
So if you’re holding bank shares for other reasons (because you think the government will keep prices propped up, say), then there’s no reason to dump them on the back of this story. But in the medium term, it’ll start to bite. And long term it could leave most big banks unrecognisable.
One way to invest in ‘disruptive’ finance companies is to buy shares in Aim-listed GLI Finance (Aim: GLIF). This investment trust owns stakes in several P2P lending platforms, including invoice financing company Platform Black and business lender FundingKnight. The trust currently trades at a premium to its net asset value of just over 11%.
While we’d rather buy it at a discount, it’s one of the few direct ways to invest in this sector. And the benefit of investing through GLIF is that you are effectively outsourcing your due diligence to a team that is experienced at vetting P2P companies. Given the rush of companies into the sector, that’s no bad thing.
If you’d rather invest directly in a peer-to-peer platform, then one of the few options open is Stockholm-listed TrustBuddy (Stockholm: TBDY). In essence, TrustBuddy is a P2P payday lender – promising high returns for short-term loans to higher-risk borrowers. The trouble is, it trades on a vertiginous forward price/earnings (p/e) ratio of more than 100.
Chinese e-commerce giant Alibaba is expected to list very shortly in the US. But one way to get in before then is to buy US-listed tech stock Yahoo! (Nasdaq: YHOO). Yahoo! owns a 24% stake in Alibaba, and it plans to sell at least half at the Alibaba initial public offering (IPO).
As Forbes reports, several analysts argue that at the current valuation, anyone who invests in Yahoo! is practically getting the core company for free, once you take account of its cash holdings, stake in Alibaba, and also its stake in Yahoo! Japan.
‘Alternative’ finance isn’t just about new-fangled disruptive technology. In some cases, it’s simply about being a better bank. ‘Challenger’ banks, such as Metro Bank, have found niches thatthe old high-street banks have served poorly. One such bank is Handelsbanken (Stockholm: SHBA).
It yields 3.5% and trades on a forward p/e of 14. Its main selling point is a genuine focus on customer relationships, and it has grown rapidly across the UK. Another option, says regular MoneyWeek contributor David Stevenson of the www.altfinancenews.com website, is Aim-listed Tungsten (Aim: TUNG), founded by Edmund and Danny Truell.
The company helps multinationals by making it cheaper and easier to manage their invoices, and offers the suppliers of these multinationals the benefit of getting paid more quickly, in return for discounting the invoice.
Finally, there are two listings to watch out for later in the year. One is the launch of a closed-end fund investing in P2P platforms from P2P Capital Solutions, which is backed by hedge fund group Marshall Wace. There’s also Lending Club – the US equivalent of Ratesetter or Zopa – which is set to list in America in the third quarter.