The perils of P2P lending

P2P lending sold itself as a simpler alternative to traditional banks, but it’s grown increasingly complex. Now the FCA is worried that with complexity comes risk.

Peer-to-peer (P2P) lending has grown rapidly since the first platform, Zopa, opened in 2005. Since then, the industry has made over £8.7bn in loans, with the three biggest platforms Zopa, Ratesetter and Funding Circle lending over £1bn each, according to AltFi Data.

The idea behind P2P lending is that borrowers and lenders come together without the need for traditional banks. Businesses and individuals who cannot easily get mainstream funding are lent money by savers who earn much higher interest rates than they can get by putting their money in a savings account. However, since its inception, the industry has grown increasingly complicated; a sector that sold itself on simplicity and transparency is becoming more and more complex and the providers are becoming more like traditional lenders. Indeed, Zopa is now applying for a banking licence, so it can offer fully protected deposits along side its P2P products.

So the Financial Conduct Authority (FCA) is consulting on new rules to be introduced in 2017. The City watchdog is concerned that the businesses of some P2P lenders includes "aspects that are the same or similar to those in the investment management and banking sectors". The P2P sector is moving away from a simple "one to one" product to a model of "many to many", meaning that P2P lenders look increasingly like collective investment schemes but without the same level of regulation. The FCA worries that risks are not "adequately disclosed" and are not "sufficiently understood" by investors.

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So what are those risks? Investors should be aware that P2P lending is not covered by the Financial Services Compensation Scheme (FSCS). And while some platforms provide their own protection funds (see column, right) they do not offer the same level of protection if things go wrong. Indeed, the FCA believes such provision funds may "obscure the underlying risk" and "lead investors to believe that platforms are providing "an implicit guarantee of the loans they facilitate". In addition, plans for "wind down" for some platforms procedures to follow if the platform goes bust are "inadequate to successfully run-off loan books to maturity", it contends.

So if you are intending to invest in P2P, it's important to be aware of these risks and limitations. As the FCA says, it cannot be described as a "savings" product and should not be regarded as a type of deposit. "The risks, particularly to capital, are different."

How safe is your money?

If you put your money into a bank account or invest in certain investments through an authorised firm, you are protected by the Financial Services Compensation Scheme (FSCS). This protects deposits of up to £75,000 and investments of up to £50,000 if the firm holding your money going bust although it does not pay compensation for investment losses, such as a fall in the stockmarket. Losses on P2P lending platforms are not covered by the FSCS regardless of whether they are due to the borrower you lend to not repaying the loan, or the platform going bust.

However, some platforms run their own schemes to cover potential losses if borrowers default on the loans. Zopa's "Safeguard Fund" currently stands at £12.6m, 1.2 times what they expect the fund to pay out. Ratesetter's "Provision Fund" holds £22.3m, with a similar 119% "coverage ratio", against losses expected at £18.8m. These will only cover losses up to a certain level. Ratesetter's current default rate is 1.8%. If that rises to 3.7%, its provision fund will be depleted, and investors will start to lose interest. If it rises to 9%, investors will receive no interest at all. Any higher, and they lose capital. Figures are similar for Zopa a default rate of 3% and above, and investors lose interest. Over 10.5%, and they lose capital. Each fund operates differently, so it's important to understand what will happen in more extreme situations, since the schemes could have the effect of "collectivising risk", says Kadhim Shubber in the Financial Times. For example, Ratesetter reserves the right "to take interest and capital away from investors and put it into the provision fund to make sure there are enough funds to account for loans going bad". The upshot is that investors need to pay attention to the platform's entire book of loans when thinking about a worst-case scenario.

However, the performance of the loan book can be obscured. There have been cases where firms have "intervened directly in the market to avoid losses crystallising" meaning that they use their money to pay off a debt the borrower had defaulted on, but not informing investors that the loan was in arrears, Jason Pope of the FCA tells the Financial Times. This all hints at a wider uncertainty. P2P lending is a young industry and most firms were created after the last financial crisis. It's only when the economy turns down that we'll see how well its policies for managing losses, such as provision funds, can cope with rising defaults.

Pebble: crowdfunding's biggest failure yet

Rewards-based crowdfunding differs from loan-based crowdfunding in that, when you hand over your money, you dont expect to get cash back. Instead, you receive a "reward" based on the value of the contribution you make to projects that compete for funding on platforms such as Kickstarter and Indiegogo. One of the standout successes for crowdfunding was the Pebble smartwatch. After failing to secure funding from venture capitalists, it raised over $10m on Kickstarter from 66,000 backers in 2012, becoming one of the tech world's darlings.

After selling a million watches, founder Eric Migicovsky "laughed off" competition from the Apple Watch in 2015. At the height of the brief smartwatch boom, Pebble was courted by Japanese watchmaker Citizen, which is reported by Tech Crunch to have offered $740m for the firm. Earlier this year, chipmaker Intel offered a far lower $70m. But now it has become one of crowdfunding's biggest failures. After struggling through the year, the company has gone bust, with its intellectual property and key personnel bought for $40m by Fitbit, the maker of wearable fitness technology. No more Pebble watches will be made and existing owners will no longer get regular software updates. Those who pledged money for its latest project on Kickstarter will not be refunded until March 2017.

Ben Judge

Ben studied modern languages at London University's Queen Mary College. After dabbling unhappily in local government finance for a while, he went to work for The Scotsman newspaper in Edinburgh. The launch of the paper's website,, in the early years of the dotcom craze, saw Ben move online to manage the Business and Motors channels before becoming deputy editor with responsibility for all aspects of online production for The Scotsman, Scotland on Sunday and the Edinburgh Evening News websites, along with the papers' Edinburgh Festivals website.

Ben joined MoneyWeek as website editor in 2008, just as the Great Financial Crisis was brewing. He has written extensively for the website and magazine, with a particular emphasis on alternative finance and fintech, including blockchain and bitcoin. As an early adopter of bitcoin, Ben bought when the price was under $200, but went on to spend it all on foolish fripperies.