One of the most exciting things about fintech is how it helps to satisfy economic demand for financial services in underserved populations. Two examples include access to mobile payment systems for the unbanked, and access to peer-to-peer (P2P) or "marketplace" loans for consumers and small business borrowers. Fintech also gives individuals and small businesses a new way to invest in the financial markets as a provider of credit.
A less compelling reason for the euphoria is the misplaced perception that such innovation somehow removes the risk associated with middlemen such as banks. Slick interfaces can reinforce the view that P2P platforms are transparent and disclose everything that users need to know to make quick and sound decisions. However, there is nothing inherent in the basic architecture of P2P that mitigates the impact of excessive risk taken by lenders or borrowers, whether incentivised by greed or bad government policies. The very algorithms that are currently programmed to weed out subprime borrowers can easily be rewritten to lower loan underwriting standards.
Intermediaries and risk
These risks, however, are not caused in themselves by intermediation. In fact, intermediaries are vital to the sustainability of any new business model. The current US regulatory environment requires the involvement of banks, even when the P2P platform is run by a non-incumbent that avoids most, but not all, banking and banking-related regulation. In a typical P2P loan, the "lender" is an investor who funds the underlying loan by purchasing debt securities ("platform notes") issued by the platform. The platform issues the securities in either a public offering (shelf-registered notes tailored to match specified loans) to the general public, or a private placement to accredited (mostly institutional) investors – these processes involve additional intermediaries who underwrite the offering and provide other essential services.
The notes are backed by the receivables of the underlying loan, which is originated by a real deposit-taking bank, which (in the "originate to distribute" P2P model) sells the loan to the platform. The notes are limited recourse – the platform pays the investor on the note only if the borrower makes the corresponding loan payment to the bank. The deal structure does not remove risk as much as it shifts the risk from the bank to the platform and from the platform to the investor. The investor cannot independently verify the information provided by the borrower because the platform does not identify the borrower. There is some give and take in the risk allocation – for example, subsidiarisation can mitigate the investor's exposure to platform bankruptcy risk.
Furthermore, P2P transactions cannot be disintermediated. The platform is itself an intermediary that makes a profit by matching dispersed counterparties. The network fosters the impression of choice, but it can only be successful if it gives counterparties the option to choose from a menu of "good" choices. For now, this is only possible if the platform consolidates rather than decentralizes risk pricing and other "black box" matching processes (for example, proprietary or outsourced credit rating functions) under the hood.
Secondary market crucial to viability of P2P
Intermediaries also play a crucial role in the development of a liquid P2P secondary market, which is necessary to help the market grow. For example, investors are more likely to lend if they know they can exit their positions on an exchange. Additionally, P2P loan receivables (and the corresponding note payments) are assets that can be securitised just like any other receivable. Lenders and borrowers will want a fully developed securitisation market that generates the funds needed to sustain the P2P business model. This is especially true in the unlikely scenario where regulators restrict the involvement of banks, which fund their loans by leveraging their bank deposits and access to cheap Federal Reserve loans. The volume of securitisations will likely surge as more data becomes available about the first waves of loans as they become due, and as the regulatory environment becomes more settled.
One much discussed legal issue is whether platform notes represent "asset-backed securities" in the first place under the post-crisis risk retention rules even if each note is linked to a specific loan, rather than a pool of receivables. One thing, however, is certain. The emergence of fintech does not herald the demise of intermediated credit markets.
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of The Economist Intelligence Unit Limited (EIU) or any other member of The Economist Group. The Economist Group (including the EIU) cannot accept any responsibility or liability for reliance by any person on this article or any of the information, opinions or conclusions set out in the article.
