Josh Wolfe of Lux Capital frequently uses the concept of directional arrows of progress, meaning that technologies are directionally predictable; this concept might be extended to other fields: for example, trading costs are an arrow, their direction was downward and RobinHood just accelerated this development by some years bringing costs to zero. Today I would like to play with this idea and see if I can predict where the p2p sector will go given its, and finance in general, recent past. In broad terms, I see two big arrows for p2p and I will them call top down and bottom up.
Top Down
This arrow represents the ‘direction’ in which retail investors receive access to investment opportunities that were previously available only to professional, big shop investors. P2P platform initially opened the consumer loan market to small investors; then came car, business and real estate loans. The universe of investment categories will expand and Heavy Finance is the latest example in this sense, with loans specific to the agricultural sector. Further developments might be trade finance for importers/exporters or loans for franchises. I also hope to see further geographical diversification, with platforms offering access to originators outside Europe.
Bottom Up
This arrow represents investment opportunities that were created for (and by) retail investors and later became, in a different form, assets classes for professionals. Crypto might be the biggest example here; and related to crypto, new platforms like Lendary started to form, bridging crypto with p2p lending. If the top down arrow is the good arrow for retail, the bottom up is the bad one. Think about Funding Circle, Rate Setter and Lending Club: they all started catering for small investors and ended the relationship to deal only with bigger pockets of cash.
A related development is loan originators that grew thanks to retail investors and later started to issue bonds, finding a more stable and less expensive source of funding. Private Equity and Hedge Funds are entering this field as well, sucking away more air from retail. The advantage for (legit) platforms and LO is that they can deal with only a limited number of investors that can move big amounts. In an ideal world you would want to invest along them, riding their due diligence and legal departments in case things turn sour for free. The unfortunate reality is that it will not take long, if things goes smoothly, for them to take all the cake for themselves.
I invested in Funding Circle way more money that I gave any other platform because an institution like the EIB was using it to support small firms in Europe. While my hope of investing in a low risk / high return vehicle was certainly crushed, getting 4% in an environment where professional Senior Loan Funds target returns of cash + 300/400bps is not that bad.
The Archer
Not sure if I nailed the definition here but both above developments depend on a crucial element: financial regulation. My analysis is based on a scenario where regulation stays ‘as-is’ but the dominance of one arrow over he other is heavily influenced on future changes in regulation.
Top-down opportunities are simply investments that were available only to accredited investors that some entrepreneur deem viable for retail as well; financial regulation is essentially a cost, those opportunities exist because they offer value in a diversified portfolio and an entrepreneur might find a way to generate profits that justify the added regulatory cost. The entrepreneur might also find a way to make investments less complex/more intuitive, suitable for a non-professional audience, or solve the technical hurdle of having to put together a big number of investors. The bottom-up arrow strengthens when entrepreneurs realise that financial regulation due to dealing with retail investors is too much of a burden and they can still run their business dealing only with accredited investors.
I am not a fan of financial regulation, to say the least. The theoretical concept that ordinary folks have to be protected against losses due to exposure to complex investments might hold in theory but it cannot be enforced in reality. For example, I cannot invest in any US based ETF but I can freely buy any shitcoin that is issued on a random crypto exchange. I can trade FX with 20x leverage but I cannot buy an ETF that uses derivatives to lower the investor risk. Twenty years ago I was so pumped about the ETF innovation mainly because it gave me the opportunity to finally invest in ‘mutual fund’ strategies that were restricted because of how mutual funds are distributed. European financial regulation completely stifled that innovation, I can invest in US stocks but not ETF…how can a single stock be less risky than a basket? Sometimes I would really like to understand the logic of the regulator.
There are instances where regulation could be good. For example, IF Bondora was regulated AND the regulation would demand a real audit of the holdings and commitments behind Go&Grow, investors would be in fact protected, or at least they would have better visibility on the risk they are incurring. We do not need more regulation, we need more SMART regulation. I will not hold my breath.
Institutionalisation
A big bank / financial institution will enter the p2p sector, most likely via an acquisition. If in the past traditional banks might have been reluctant to push apps/online activity for the fear to lose customer relationship, COVID-induced closure of physical branches might have forced bank management hands for good. Future loan origination activity will be more and more online, it is only a matter if banks will open their funding books to retail investors or only offer deposit-enhanced solution like Goldman Sachs MARCUS. The market for Covered Bonds (bonds backed by residential mortgages) and Asset Backed Securities (bonds backed by credit card loans) is well established and deep, Mintos is going in the same direction with its Notes, I do not see the reason why a bank could/would not do the same.
Aggregators
I think we will see more aggregators like EvoEstate and Brickfy, portals were the ‘sponsor’ vet each project and invest with the users. Another possible model is a sort of AngelList, where the lead investor has skin in the game and other investors can follow their steps (not limited to single projects but open to investments in platforms). There is an advantage versus the same model used in the stock market, see eToro for example, because here the risk/return profile leads to different incentives. Given stock market high volatility, I can create multiple profiles in eToro that make high return/high risk bets. Even if I do not know ex-ante which profile will succeed, some will and given the risk profile, they will jump at the top of eToro ranking. Investors will rush to invest with me and by the time they will be angry by my subsequent losses, I would collect enough fees from eToro to justify the game.
What this is NOT is the current model, where bloggers publish their (virtual?) portfolios and get remunerated by the referral links. In this case you are simply investing along a guy who is really good at marketing.
The issue with portals
Portals like Mintos or Iuvo, despite their internal ratings do not offer a real screening of the loan originators they host. They put their interest, collecting fees, in front of users interest. A possible solution would be the use of an external, third party rating system, like S&P and Moody’s. If the sector grows, I see the case for start-up or established firms to take on this. Kristaps at p2p.holding is doing an excellent job in this direction.
There will be further concentration, bigger (and hopefully better) portals will attract more funding and better LOs, while smaller portals will disappear…it is the networking rule, baby 😉
ETN (and not ETF?)
From a technical point of view, I am not sure you can create an ETF that track and index of p2p loans, unless these loans are already traded on a public exchange. The process of share creation/redemption requires that the authorised participant has access to the underlying securities, if loans are not traded on an exchange this can happen only when the authorised participant is also the ETF sponsor. Unfortunately I did some research but did not find any definitive answer. In any case, I think an ETF or ETN will arrive. There are some advantages in this structure but the fact that the sponsor has to be regulated is not one of them. If the underlying loans are originated by a fraudulent activity, there is no recourse to the ETF sponsor for investors; regulation will only guarantee that the sponsor is well capitalised. Investors will be able to access the p2p asset class without ‘exiting’ their broker account: no need to open new accounts, access different platforms, having to deal with another tax declaration and so on. Now that some brokers like IB offer portfolio analytics, you can also more easily see the p2p contribution to your asset allocation and rebalance when needed.
A Legit Go&Grow
Given the success of the product, it is clear the appetite is out there for this type of investment solution; the main issue with the Bondora version is the quality of their loan book, their accounting practices and daily liquidity illusion. Trying to offer a floating but capped return (the 6.75% with an asterisk) might be good marketing but makes the product even harder to arrange. Using current Money Market Funds regulation as guidelines, to clarify to investors how liquidity might be gated; and mimicking those fund manager strategies, you can create a product with reasonable liquidity and an interesting yield…or at least that’s how I will do it (actually, if you are interested in this project, please contact me).
Conclusion
If anything else this post proved to me that I lack imagination, I would be a terrible VC; when I started writing, I was expecting to find crazy ideas…and I just demonstrated that is only obvious when someone else does it. And you? How do you see this sector changing in the future?
Viventor Update
Viventor sent an update about the situation with Atlantis Financiers…and it does not make any sense.
- they are talking like if AF is an un-related party, when AF and Viventor are owed by the same entity. It is like I am late with a rent payment and tell the landlord that the issue is that my wife is not paying. Sure we are not the same person but it is quite silly I pretend I do not know in which situation she is and play dumb.
- they say they blocked AF from the primary market when AF is saying that they stopped issuing new loans; again, it is like saying you do not see any picture of me and Scarlett Johhansson because I decided not to date her.
- they removed AF from the secondary market…to do an actual favour to AF and not offer evidence that their loans are going for cents on the dollar. I do not see how you protect your users if you remove a way for them to cash out, even if it is at a loss (provided that everyone receive the same information at the same time).
- if AF has cash flow issues, you do not need the annual financial report to tell you that…again, just walk to the door next to yours and ring to your common owner.
- Why Viventor needs an agreement that benefits all parties? AF is ALREADY benefitting from the fact that so far there has being no penalty to their lateness, Viventor should look for a solution that benefit its investors.
- AF issued loans that are supposedly backed by invoices. This is not a financing activity used by the most COVID affected sectors, like restaurants and hospitality. Unless AF had a client portfolio extremely concentrated to some industries, is difficult to see how ALL the loan book is late. As for DoFinance, I think again they are using the cashflows from current loans to pay for their operations (salaries and rent)…which is a breach of their contract.
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