Peer-to-Peer Lending: Picture Perfect?
December 16, 2022
Lending is generally thought of as the domain of banks and other large financial institutions, but the business is changing. A new form of lending called peer-to-peer (p2p) enables individual investors to diversify their portfolios by microlending to loans across ratings and interest rates. According to Transparency Market Research, the global industry of peer-to-peer loans is expected to reach a value of over $1.1 trillion by 2030.
Prosper Marketplace is a platform that offered peer-to-peer loans as early as 2006. Initially offering variable-rate loans, the company faced regulatory and financial problems in the wake of the 2008-09 financial crisis and transitioned to fixed-rate loans. On the platform, investors can set criteria across categories of credit scores, loan ratings, interest rates, and more to create an automatic investment tool or individually pick loans. To allow diversification beyond one loan, only as little as $25 is required for each loan. The lending platform’s website reports an average annual return of 5.7% since 2009, which compares well to Vanguard’s Total Bond Market ETF (BND), which averaged 2.67% in the years since inception. Still, both underperformed the S&P 500 index over the long term.
The rise of peer-to-peer lending is not without consequences, however. Commercial banks face increasing competition with the elevation of the peer-to-peer lending market. Brian Wolfe and Woongsun Yoo published a research paper in 2017 noting the “…detrimental effect on loan volume and loan quality for small/rural commercial banks as a result of increasing peer-to-peer expansion….” If the market really hits $1.1 trillion in 2030, whether that growth comes at the hands of commercial banks or as a result of a broader rise in the lending market, remains to be seen.
Concerns also do not stop with commercial banks. Investors hoping to enhance their holdings must consider a variety of negatives that come with peer-to-peer loans. When parking assets in these loans, which in the case of Prosper, are in 2, 3, 4, or 5-year terms, liquidity is lost. Unlike stocks and bonds, which have large markets to buy and sell whenever one pleases, these loans are a commitment until the end of the term. Furthermore, these are unsecured loans, so bad economic times can spur default rates, destroying returns.
While the peer-to-peer lending industry is projected to grow significantly in the next seven years, and the loans offer investors potentially strong returns, there are also considerable drawbacks. The rise may come at the cost of commercial banks, and investors are left with few options in the ways of liquidity when compared with stocks and bonds.