Investment or casino bet: how safe is peer-to-peer?

Several innovative lenders are stuck in regulatory limbo, finds Adam Williams as he investigates a fast-growing sector

Disillusioned with low interest rates at high street banks, hundreds of thousands of hardpressed savers have turned to peer-to-peer (P2P) investment in recent years. Yet there are ongoing concerns over the level of risk and quality of some providers, prompting the City watchdog to implement new rules to ensure investors are not short-changed.

P2P lets individuals lend money to companies and others, earning interest from the borrower. It is often seen as a halfway house between cash savings and traditional investment, but the risks involved are more akin to the latter.

While cash savings of up to £85,000 are protected through the Financial Services Compensation Scheme, any money directly invested in P2P is at risk if the borrower on the other side fails to repay.

There is additional danger if the platform itself collapses and, given the fledgling industry has yet to weather a financial crisis of any kind, investors must also be aware of this “platform risk”.

Even though the Financial Conduct Authority (FCA) has regulated the sector since 2014, a number of providers have yet to be fully authorised despite their repeated attempts. As many as five active firms have so-called “interim permissions” and are able to take consumers’ cash, even if they have little chance of being fully authorised in their current state.

A Freedom of Information request submitted to the FCA by Telegraph Money showed that firms have repeatedly applied for authorisation but have withdrawn their applications when it became clear there was little prospect of success. Of the 388 applications for authorisation submitted since October 2016, 312 have been withdrawn but none rejected.

Rejecting the firms’ applications outright would force them to cease trading immediately and would put investors’ cash at risk, an outcome that the regulator would find difficult to justify, no matter how unsuitable the firms are.

However, the FCA is currently undertaking a major review into the entire P2P sector and is concerned about the way some firms conduct their business. Such are the risks involved, it wants everyday customers to be limited to investing 10pc of their cash in this way.

It fears that customers are being left in the dark about what they are really investing in, and how much risk that involves. One financial adviser likened investing through certain P2P companies to gambling in a casino.

Julia Groves of the Downing Crowd platform said high-quality firms were “crying out” for greater supervision of the industry to help weed out any bad practice.

Hidden risks

The P2P sector has ballooned in recent years and, while no cross-industry data exists, it is thought around 200,000 accounts have been opened.

Despite their short existence, many firms have overhauled their business models since launch. Originally, providers let investors choose exactly where their money would go, with customers choosing projects or investment opportunities that appealed to them. Today the vast majority of P2P companies “auto pick” for their customers, choosing which individuals to invest in on their behalf.

However, there are fears that this poses a conflict of interest for some firms, who are responsible for both pricing the risk of different loans, and then allocating investors’ cash between them.

Despite its appeal to many traditional savers, Blair Cann of M

Thurlow & Co, a financial adviser, said he would not recommend P2P to his clients, who typically have an average attitude to risk.

“You are investing in individuals who, in many instances, were unable to get a loan elsewhere,” he said. “Some providers may be less risky but we don’t like it on principle.

“If I had high-risk clients who were willing to go for P2P investing or go to the casino and bet the lot on red, then we may be active in the market.”

Lack of disclosure has repeatedly been highlighted as an issue by the regulator. Many P2P providers do not clearly display how risk is calculated, or the fees they charge borrowers. This can make it impossible for investors to make informed choices.

“A key concern is the significant gaps between the rate the borrower pays and the interest rate lenders earn on their money,” added Ms Groves. “Investors should choose a provider that clearly discloses fees and, better still, makes those fees contingent on performance.”

Ian Gatenby, 60, was attracted to P2P by the high returns on offer. The consulting engineer from Wem, Shropshire invested £50,000 with Octopus Investments but became worried that 8pc of borrowers were late repaying their loans.

“It worries me about how safe the loans are, given they are individuals you don’t get to see,” he said. “It is blind faith that the provider is doing its job properly.

“In future I’d find somewhere else to put my money.”

Octopus told Telegraph Money its systems were robust and said it invested its own money in every P2P loan.

The regulator is also concerned that investors may believe they are protected against losses when a platform has a “provision fund”. These small funds create a false sense of security for investors. Rather than protecting investors’ cash in the event of a widespread collapse, these funds would only be able to cover minor losses.

One of the biggest platforms, Zopa, decided to close its provision fund last year, citing changes in tax rules that made it easier for individuals to offset any losses.

To protect individuals, the regulator has proposed a limit on how much everyday investors can pour into P2P.

Those who are not experienced investors or high net worth individuals would be barred from investing more than 10pc of their wealth in this way.

Ms Groves said: “A quick ‘sophistication’ test is not hard to do when you first sign up to a crowdfunding site. For those who don’t pass, this just isn’t an appropriate investment.”

The FCA’s industry consultation will close later this month, with the regulator expected to publish its final rules in spring 2019.