To paraphrase Crowdfund Insider’s “The Ultimate Crowdfunding Guide,” with peer-to-peer (P2P) financing, the risk an investor accepts is default. Every P2P financing platform has its own policy on default, and all investors need to take the time to understand these policies in order to protect themselves.
Because every P2P platform has its own default policy, and because the P2P financing business model is relatively young, we must be cautious when making generalizations about default rates across all platforms. Specific to Funding Societies, we fully aim to keep default rates close to banks – not exceeding 4 to 5% of financing amount to secure healthy returns for investors, even accounting for the cost of default.
The industry’s youth may cause investors with a low-risk tolerance to view P2P financing as an unpredictable instrument. Generally, there is a consensus among investors that P2P financing constitutes a higher-risk, but higher-reward investment.
Is this belief true and valid? Let’s take a look at the global trend of default rates in P2P financing platforms.
Let’s begin with default rates in USA platforms. In this fascinating article, the author analyzed historical trends of default in two well-known USA platforms, then drew conclusions about the default rate of the P2P industry.
(Note that the article was published in 2014, so some might find it dated. However, the analysis within is worth a read)
The writer pointed out that from 2007 to 2008, the USA economy was doing very poorly and that both Lending Club and Prosper were operating under their earliest and most imperfect credit models, which means the default rates of 2007 and 2008 can be waved off. Since 2010, both platforms have averaged a 5% default rate and are likely to continue having solid repayment rates in the future.
The article ends with a positive conclusion about the P2P financing industry. The author wrote: “I see refined underwriting algorithms and mailed borrower marketing, encouraged investor capital and purpose-built technology all repositioning itself over and over for the past eight years until they are arrive at the stable place they hold today. I see analysis and sweat and reanalysis in these charts, and in the end I see it culminating into one of the most simple and creative investments our country has ever seen.”
His statement underscores that under the right circumstances, which includes an innovative team and rigorous credit policies, P2P financing platforms thrive and provide attractive returns while lowering default rates. The key is in selecting a trustworthy platform to invest in.
Moving on, let’s focus on a well-known and respected P2P financing platform from the UK: Funding Circle. In their statistics page, Funding Circle claims that its average annual default rate stands at 2%. The rate has also remained solid over the years (calculated from 2012-2017), showing that platform maturity and good credit underwriting will stabilize default rates.
What about our own platform, Funding Societies? Here is our own statistics page. Historically, our default rate across the region has lowered overtime, which reflects the analysis of P2P financing platforms in the USA: continuous platform improvement and rigorous credit policies will lower default rates.
Another worthwhile read about the risks in P2P financing is the study released by the UK Peer-to-Peer Finance Association (P2PFA). Some of the study’s pertinent points include:
- The P2P industry has created more choice in the financing and investment market.
- P2P financing platforms conduct credit risk assessment using the financial industry’s best practices.
- P2P financing does not create systemic risk. Platforms are well-placed to weather a downturn in the credit cycle – defaults would need to increase at least threefold to reduce average interest rates for investors to below zero.
So let’s go back to the question we asked earlier: is P2P financing a higher-risk investment? Not necessarily.
However, the P2PFA study presented two caveats: that there is a good regulatory framework for the P2P industry and that investors are educated. For the first point, Malaysia is the first country in ASEAN to regulate P2P financing and Funding Societies has always been proactive and compliant towards regulations. We are recognized and regulated by Securities Commission (SC) of Malaysia.
For the second point, there will always be risks in investing, including risk of default in P2P financing, there are ways to mitigate such risks. How do you diminish P2P investment risks? You diversify your investment and reinvest your returns.
Diversification means distributing your funds across as many investment opportunities as possible to prevent loss in case of default. The more diversified you are, the more protected your investment. Even defaults hardly disturb your rate of return. If you choose not to diversify, you stand to lose most of your investments should a default occur.
Meanwhile, reinvestment refers to the act of funneling your investment gains into new investment opportunities to maximize your returns. Without reinvestment, you only receive the expected rate of returns. But with reinvestment, you can maximize (sometimes doubling, even tripling) your returns while minimizing your investment risks in case of default.
For more information on diversification and reinvestment, see here.
When investors fully understand the risks of P2P financing and take proper precautions to protect their funds, the advantages of investing in P2P financing clearly outweighs the risks. In fact, it’s very likely that most investors who keep diversifying and reinvesting their investment will continue to earn positive returns.
This article was first posted on the blog of our sister company Funding Societies (Singapore). Click here for the original article.
This article was written by Funding Societies, the first P2P financing platform to launch in Malaysia. We provide working capital financing for small and medium-sized enterprises (SMEs), along with attractive investment opportunities to the broader public. To learn more about us, click on our website here.