Diversification: Making P2P lending safer
When it comes to building an investment portfolio, we at Lending Works are proponents of diversification. There are many ways to diversify, be it across companies, industries, geographies and even asset classes as a whole. Stocks and shares offer the carrot of good returns; albeit carrying higher volatility/risk, while bonds provide a safer option, but with lower yields.
Peer-to-peer lending is now recognised as a favourable investment alternative too. Aside from the excellent returns, one of the biggest appeals of lending through peer-to-peer platforms is its lack of correlation with other asset classes.
Incorporating P2P into your portfolio
In the spirit of diversification, we would never advocate investing your entire portfolio into a solitary platform, or even solely into P2P in general. Just as stock-only investing has its pitfalls, so does piling all your money into Lending Works (or wholly into the sector itself). We are very confident in what we do; however, diversifying across investment sectors can protect against “black swan” events.
In the same breath though, P2P offers a middle ground in terms of risk and reward between stocks and bonds, and has become a ‘must have’ in the eyes of many investors and institutions. No longer is it an unknown quantity. Instead, it continues to build a proven track record of consistently lucrative and safe returns for its lenders.
Adding to investor confidence is the fact that peer-to-peer lending in the UK is now regulated by the FCA, while industry bodies such as the Peer-to-Peer Finance Association (P2PFA) – of which Lending Works is a member – ensure that robust systems and controls are in place to protect customers and the reputation of the industry.
Protecting your money
The one key factor to consider is that lenders in P2P are not covered by the Financial Services Compensation Scheme; which, in equivalent terms, guarantees individual savers at a bank up to £75,000 if the institution goes bust. Peer-to-peer platforms have contingencies in place to counter this though, including reserve funds to cover lenders for any arrears and/or defaults they incur on the money lent to borrowers. Indeed, Lending Works' Reserve Fund is an important part of its safety framework. However, we've taken protecting lenders' money a step further by developing a unique insurance mechanism against borrower defaults from fraud, cybercrime, accident, illness, loss of employment or death.
With the Lending Works Shield in place, it probably won’t surprise you that our lenders have received all capital and interest payments due to them since we began operating. Our cumulative defaults to date can be found here, while the upper end of our expected defaults for the year ahead is estimated to be around 1.54%. Our Reserve Fund alone, which is regularly topped up using part of the fee paid by each borrower, would be more than sufficient to cover these figures, while if the Reserve Fund runs out for any reason, the insurance provides an additional and reliable safety blanket.
Diversification as a safety measure in P2P
Investors will always take into account the worst-case scenario, so in the interests of transparency, we thought we’d explain what happens in the unlikely event of the above safety measures failing all at once in the face of borrower default.
Diversification is the fundamental principle we use in minimising any losses incurred by our lenders. Firstly, when a lender transfers money into their Lending Works Wallet and makes a lending offer, the funds are matched with multiple borrowers. If lenders use the Auto Lend function to re-lend their repayments, the repayments are then re-lent to new borrowers, thus meaning your capital is diversified across many, many different loans. This is what we refer to as ‘front-end’ diversification.
Further down the line of defence is the Lending Works Shield, which uses ‘mid-stage’ diversification to offer protection spread across all lenders. The Shield is underpinned by a meticulous underwriting process to ensure that only the most creditworthy borrowers are approved. In addition, we have the Reserve Fund and unique insurance, and this combination offers our lenders unrivalled threefold protection.
But even in an extreme situation of systemic economic problems where there is default on a large scale and the Reserve Fund is depleted, and/or the insurance doesn’t pay out, the burden of individual default losses would never fall on any single lender(s).
If the Shield were to fail, a Pooling Event may be declared. In such an instance, lenders would take a pro-rata loss against capital and interest repayments due to them, which is what we refer to as ‘back-end’ diversification. Approximately speaking, for a capital loss to occur to any lender, the default rate beyond the point of a Pooling Event being declared would need to be in excess of the weighted average rate of interest on the remaining loans held by lenders among every active lender on the Lending Works books.
This process ultimately ensures that any losses are shouldered fairly. Since lenders cannot choose individual loans to invest in, it’s only right that they shouldn’t be unfairly impacted by the loans allocated to them by the platform. It should also be pointed out that if this extreme situation led to the liquidation of Lending Works, the loan book remains active, and the independent Trustee, along with our back-up services provider, would continue to run day-to-day operations ensuring all outstanding monies due to lenders will be collected and paid to them for the remainder of the lending period.
Why we take the diversification approach to safety
We believe the Pooling Event to be the fairest way, given that our lenders do not have the choice of which borrowers they are allocated to. Instead, we use a system we call the ‘Fair Algorithm’, which fairly allocates loans to our lenders.
Some platforms take a different approach, whereby money from lenders is lent out in small chunks (as little as £10) to a multitude of borrowers. In essence, this is taking front-end diversification a step further than we do. The downside though is that rather than pooling any losses, the individual lenders will lose the entirety of these chunks for each default not covered by the respective reserve funds, meaning some lenders could end up losing out substantially while others are unaffected.
Transparent and safe
It is clear that the combination of front-end and back-end diversification will minimise any potential losses to lenders, but it must also be reiterated that the likelihood of a Pooling Event being declared is incredibly slim - even in the case of the economic climate taking a dramatic turn for the worse. In fact, throughout the recent financial crisis, default rates in prime consumer peer-to-peer lending platforms only reached between 2 and 5% in the UK – the sort of figures our robust safety measures are well equipped to deal with.
That said, these are eventualities that need to be considered, and by offering a transparent insight into the worst-case scenario, we trust we are giving all our lenders – current and prospective – the required facts so that they can make a completely informed decision.
Yet it is the best-case scenario which has consistently prevailed within ethical and successful platforms such as Lending Works, and is the core reason why our pedigree continues to be characterised by satisfied lenders who enjoy outstanding returns.
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