Will the rate rise kill off peer-to-peer returns?

Investors benefited in the early years, but increased savings rates may harm this fledgling sector, reports Amelia Murray

Peer-to-peer (P2P) lending has grown dramatically since the financial crisis. In 2005 when Zopa, the first lending “platform” was launched, loans totalled just £1.5m. But last year total lending was £3.2bn with Zopa, Funding Circle (which counts the British government as an investor) and RateSetter controlling two-thirds of the market.

Yet growth has slowed this year, according to 4thWay, the P2P analyst, and the industry has suffered a flurry of negative headlines. Falling returns, a greater focus on defaults and signs of a crackdown from the City watchdog appear to spell a reverse of fortunes. Now that the Bank of England has increased rates, many will think P2P is not worth the risk.

P2P, which sees lenders matched to individual or corporate borrowers, thrived after the 2007-8 financial crisis when banks tightened credit checks. Savers were getting poor returns on their deposits and saw P2P as an alternative to interestyielding bank accounts. But what’s happened since? Rates offered by P2P firms have dropped: investors can earn 3.7pc with Zopa Core and 4.5pc with Zopa Plus, compared with rates of between 5pc and 6pc, after bad debts and fees, for the first five years after the company’s launch. The firm said no rate cuts were planned but that it continued to “monitor pricing for low-risk borrowers” and would react if it saw significant changes.

Risks are also rising. When Zopa launched it only offered loans to 0.5pc of applicants, said Neil Faulkner of 4thWay. Now its approval ratings are in line with traditional banks, which give loans to 20pc of applicants.

Since April 2014, peer-to-peer sites have been regulated by the Financial Conduct Authority (FCA), the City watchdog. Firms must present information clearly, be transparent and have “resolution plans” in place.

From April this year, P2P firms have been told they must have capital buffers of at least £50,000 to ensure they can withstand financial pressure.

But not all firms have been given FCA authorisation yet. Ratesetter, which launched in 2010, was only granted full authorisation in October this year. Without authorisation firms cannot launch Isas, a crucial step in reaching ordinary investors.

Despite this tightening of rules around P2P firms, lenders’ money isn’t protected by the Financial Services Compensation Scheme (FSCS) as it would be in a savings account.

Some peer-to-peer platforms have reserve funds to cover bad loans but there’s still no guarantee you’ll get your money back if there are problems. Zopa has recently begun “retiring” its “safeguard fund” and returned to its original model. This means new investors, and old ones after December 2017, will not be covered by the fund.

Mr Faulkner said while investors might take comfort from the existence of provision funds, they also have the effect of dampening the interest rates. they receive. He said: “Average returns are lower when there’s a pot of money to cover default loans.”

In July, RateSetter said that it would cover millions of pounds of bad loans. The problem started in 2014 when the platform began offering loans to five other lending businesses, which in turn lent the funds to their own customers.

RateSetter lent £36m to Vehicle Trading Group, a motor finance firm, which then lent £12m to AdPod, an advertising business. The firm got into difficulty and RateSetter had to intervene. It took over AdPod and will cover the outstanding balance of just over £8m from its own pocket rather than from its provision fund to protect customers. In February this year the FCA warned P2P firms to steer clear of “wholesale lending” such as this.

RateSetter was also forced to withdraw as a member of the Peer to Peer Finance Association, the industry’s trade body, after breaching strict transparency rules during the summer. This leaves just seven members including Zopa, Funding Circle and Folk2Folk.

In April 2016 a new Isa was launched for peer-to-peer investments. Consumers were told they could earn up to 8pc tax-free with an “Innovative Finance Isa” but the first was not made available until the following February.

Lending Works was the first major peer-to-peer lender to offer the Isa. Investors were offered 4pc for a three-year loan and 4.7pc for five years. Other providers have had to wait months for authorisation as the FCA trawls through their loan books.

And even those firms with Innovative Finance Isas are not necessarily making them available to all customers.

HMRC said only 2,000 of the Isas were subscribed to in 2016-17 with just £17m invested. The same year 8.5 million cash Isas and 2.6 million stocks and shares Isas were opened.

Professional financial advisers have long been sceptical of investing in P2P loans. They fear the volumes of tiny loans means they can’t effectively monitor risks.

Mark Meldon, managing director of financial planning firm Meldon & Co, said he expects P2P will just “wither and die”. He said the majority of advisers would never recommend their clients invest in the sector because it’s “all a bit misty and murky” and there are better investment options available.

“P2P is a child of the internet and was born in an ultra-low interest environment rate,” he said. “If rates rise it will start to lose its appeal.’’

But Mr Faulkner said such fears over transparency were overblown. He admitted the industry was “far from perfect” and that some platforms had made “large mistakes”. He said: “RateSetter didn’t have the oversight and made loans which were too big. But it’s admitted what went wrong and is taking the hit,” he said.

He pointed to slowing growth as a positive sign the industry was maturing. “If loans kept tripling, lenders would wonder where all the borrowers were coming from and if they were reliable,” he said.

“Rates are still far higher than what you can get from banks. While that’s the case the industry isn’t going anywhere.”

‘P2P was born in an ultra-low rate world. When rates rise it will start to lose its appeal’