Today, borrowers see Peer to Peer (P2P) as a vital supply of capital in a climate of reduced bank lending, (The Business Models and Economics of Peer-to-Peer Lending” by Alistair Milne & Paul Parboteeah (No. 17 / May 2016) p. 4-5) while investors see P2P as a way to potentially earn an inflation-beating investment return when savings interest rates are at an all-time low*. P2P platforms connect the two, allowing investors to lend money directly to borrowers.

However, as with any investment product, there are risks involved in P2P investing, with the primary risk for investors being credit risk, i.e. whether borrowers repay. So how do some P2P platforms manage this risk from an investor’s perspective?

Provisions against losses

Some P2P platforms set aside capital they receive from either borrowers or investors to cover any losses, also known as a ‘provision fund’. If a borrower fails to repay their loan, or pay the interest due, these provisions are typically used to pay lenders the money they are owed, provided there is sufficient money available.

Diversification to reduce losses

If a borrower defaults, how can the impact on your investment be reduced? You can do this by spreading your capital across different investments, also known as diversification.

There are two main ways that platforms offer diversification.

Some platforms recommend customers manage diversification themselves. For example, one P2P platform suggests that lenders spread their investments across different borrowers so that no more than 1% of their total investment is lent to a single debtor. This way, lenders can dramatically reduce the likelihood of losing all their money, compared to if they were to invest in just a single loan.

Other platforms offer automatic diversification. They can do this by operating a provision fund. By investing through a platform that provisions for bad debt, investors could benefit from the full diversification of the entire borrower portfolio. This is because provisions are used to pay lenders all outstanding capital and interest in the event of a borrower default, provided there is sufficient money in the fund. Lenders can therefore only suffer capital losses if the provisions are entirely exhausted, and this could only occur if several different borrowers default within a short period. Therefore, although lenders make loans to individual borrowers, the risk of them suffering capital losses is spread across every borrower in the portfolio

Recovering losses

Borrowers may be required to provide security or guarantees when taking out a loan via P2P platforms. These are held on behalf of the lenders to help recover losses if the loan were to default, by providing the lender with rights over the defined assets.

Integrated data to reduce losses and improve forecasts

Some P2P platforms integrate with external data sources to help measure the credit risk of borrowers throughout the life of the customer relationship, rather than just at the start. This can help improve the accuracy of risk measurement and can allow platforms to more actively manage credit risk on behalf of their customers on an ongoing basis, therefore aiming to benefit the investors too.

*Key differences between P2P marketplaces and traditional savings accounts

The Financial Service Compensation Scheme (FSCS) guarantees bank deposits of up to £85,000 for small businesses with an annual turnover of less than £1 million. Investing cash in P2P markets does not carry this absolute protection, but some platforms offer different ways to reduce losses as outlined above.

No matter which P2P platform you invest through, there will always be an element of risk, and therefore these platforms generally offer higher returns than simply holding bank deposits. Therefore, understanding how platforms mitigate risk and protect investor returns should be core to your decision process.

Please note that Growth Street is an investment product and not a savings account. Your capital is at risk if you lend to businesses and lending is not covered by the Financial Services Compensation Scheme.

Growth Street Exchange Limited is an Appointed Representative of Resolution Compliance Limited, which is authorised and regulated by the Financial Conduct Authority (no. 574048).

Credit Image: @dooder - Freepik

Shalom is the Head of Marketing at Growth Street. After a successful career in investment banking at Barclays and RBS where she covered interest rate products in sales and structuring, she transitioned into Fintech, a space she believes will bring a much needed refocus on customer focused services to the banking sector.

Growth Street offers better business banking.  Growth Street operates an alternative finance platform for SMEs that offers borrowers better finance terms on business overdrafts and delivers a competitive risk-adjusted return for lenders, who can access an investment return of up to 6.5% AER. Capital at risk.