Online lenders have been facing an uphill battle recently as investors question whether they are truly getting the loan transparency they need to confidently invest in this young industry. Investors, credit providers and ratings agencies are worried about loan data integrity as well as collateral and ownership rights behind the loans.
But this all sounds a bit familiar, doesn’t it? Comparisons have been made to the 2008 mortgage crisis where we saw another market falter due to a lack of proper operational risk controls and investor transparency across an industry. Remember investors trading hundreds of millions of dollars of loan information in spreadsheets, as depicted in “The Big Short”? It couldn’t possibly happen again, right? Will Margot Robbie be explaining in layman’s terms the transparency conundrum for investors in online lending in a blockbuster film 10 years from now?
Online lending faces arguably its biggest challenge but also its greatest opportunity today — putting the proper risk and transparency infrastructure in place to attract more permanent capital to drive the industry forward. But before we go down that road, it’s important to take a look at where we’ve come from and where we’re heading…
Phase One: Concept – The Early Days (2006-2010)
Online lending traces its roots back to Europe in 2005 when ZOPA pioneered the idea of peer-to-peer (P2P) lending in an effort to make lending and borrowing easier for individuals. Europe served as the early breeding ground, with Prosper launching the first official P2P platform in 2006.
From 2006 — 2008, other US platforms cropped up, offering quick loan processes and easier access to capital across a wide swathe of categories from student loans to personal loans and small business loans.
The concept of partner banks — like WebBank and Cross River – issuing loans on behalf of these platforms, quickly became an established model. These banks helped ensure the borrower regulations were met, including state licenses among others. Consumers are well protected and borrower fraud is tightly managed.
But in 2008, regulators took notice of this rapidly expanding market, and the SEC issued a statement requiring lending platforms to register and report loan financials to the Commission to protect investors. With this change, the SEC highlighted the need to treat fractional loans as securities that need to be reported. This action, coinciding with the economic downturn from 2008-2010, led to a rather quiet two-year period in the online lending space.
Phase Two: Institutional Entry – Enter the Big Dogs (2011-2015)
As with any new industry, it’s one thing to have a great idea, but it’s another to get buy-in from those who can help scale future growth financially.
In 2011, the landscape changed for online lenders with institutional investors, in search of yield in a near-zero interest rate environment, tossing their hats in the ring to enter this emerging industry. A $US5 million investment from an anonymous institutional investor into LendingClub marked the first infusion of institutional investor capital into the online lending space.
And that was only the beginning as institutional investment continued to flow into the market, primarily from specialist hedge funds, often with lines of credit from well-known large investment banks. At this point, the industry evolved its name from Peer to Peer to Marketplace Lending and ultimately Online Lending to reflect the fact that large institutions were now funding a large portion of the loans.
In 2013, automated investment tools were introduced, making it easier for investors to access the specific loans they were after more efficiently. Companies like LendingRobot’s launch that year marked the start of algorithmic trading within the online lending space, allowing investors to pre-define algorithmic terms and execute trades on portfolios as soon as they became available.
Also in 2013, securitization changed the face of online lending, providing lending platforms more scalable access to capital to fund the needs of new lenders. Securitization is a
process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security that can be sold to investors. Eaglewood Capital closed on a $US53 million unrated securitization deal for loans originated by LendingClub, making it the very first securitization deal in the space. This was the first of many securitizations to come in the next few years.
In January 2015, online lending saw the first rated securitization occur for a Moody’s rated $US327 million deal of packaged loans from Prosper — a securitization put together by BlackRock. With more securitizations over the next few years and more ratings agencies getting involved, this market reached a whole new level of investor interest, with over $US15bn of Securitizations3 by the end of 2016.
Analytics and secondary markets began to emerge in 2015, with companies like PeerIQ, dv01 and Monja providing analytics and reporting tools to help investors better track their online lending investments. Secondary markets for these loans kicked off this same year, with the launch of both Orchard and Ldger, aiming to provide additional liquidity options for investors in the space.
Later in 2015, the first partnership between a bank and lender was forged with JP Morgan and On Deck leading the charge. This partnership model allowed bigger banks, like JP Morgan, to leverage the speed and efficiency of online lending platforms to better serve the small business segment.
Phase Three: Maturity & Scale — The Future is Clear (and transparent!) (2016 – …)
And now we arrive at the present – a tipping point where the fate of the industry lies squarely in its ability to adopt effective risk control infrastructure for investors to bring certainty to this asset class and therefore attract new capital.
While the ecosystem has put in place trading, analytics and reporting infrastructure, recent events and regulatory interventions are now driving the industry to introduce investment risk architecture to bring greater trust to online lending transactions. A modern fintech lending model has been using a thirty-year-old due diligence methodology, comparing loan tapes with loan agreements, both provided by the seller. It goes without saying that this method is far from modern or efficient, with no independent validation of data integrity against trusted data sources.
As securitizations become more prevalent in the market, the lack of independent loan level validation for compliance due diligence is raising some eyebrows and keeping sophisticated investors from participation. Auditors used for due diligence that file (15G) SEC submissions, when included on deals, do not highlight any external validation of the accuracy or integrity of the underlying loan data provided by the issuer.
2016 saw the industry stumble in its representations to the investor community, with manipulation of loan data, changing definitions and double pledging of assets. Today, transparency is being redefined. Online lending has undoubtedly provided greater loan data and performance reporting than investors are used to. However, loan transparency from the seller without independent data certainty has been proven dangerous. As Cormac Leech, Principal at Victory Park Capital Advisors, said to Business Insider, “you can see the ingredients printed on the can, but don’t really know what is inside”. You have to take the seller’s word for it!
Over the past two years, more than half a dozen trade associations have cropped up, aiming to create best practices and to engage regulators. With this many different associations, it’s only a matter of time until we see consolidation of such associations, in line with lending platform consolidation. These associations will need to increasingly help focus on implementing industry-level risk controls for both borrowers and investors alike.
Industry risk control infrastructure and real transparency is a critical element in any maturing market — as we saw with the 2008 mortgage crisis. By instituting scalable, real-time and integrated risk control technology, the online lending industry can provide the confidence that investors and warehouse lenders are seeking. In addition, it will enable secondary markets and new investment vehicles to flourish.
A vital part of this infrastructure is for the industry to adopt a central loan information clearing house that focuses on ownership rights and asset certainty for each loan as well as serving as a collateral pledge registry to prevent the double pledging of assets. Increased asset certainty is helping to protect and attract capital from new larger, more risk averse investor segments. With the infrastructure changes we’re seeing emerge in the industry today, including the potential of Blockchain technology, this goal of new capital sources is closer to reality for online lenders than ever.
The silver lining to last year’s mudslinging around online lending is that we’re now – more than ever – aware of the need for proper industry level operational risk controls — and that is the ultimate key to unlocking the immense opportunity here. As the industry adopts improved risk infrastructure, new investment vehicles become possible, the secondary market can take off and the industry as a whole will attract more capital.
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