Demystifying Risks in Peer-to-Peer Lending: How Risk Can Be Your Ally
All peer-to-peer lending platforms carry some form of risk, but it is how a platform mitigates or minimizes these risks that differentiates it from competitors. If you are an investor, you would want to know how money is being lent on Peer-to-Peer (P2P) platform and the risks associated with lending money on the platform.
To understand P2P lending risks, it's useful to first understand the lending process which is similar to the one used in banks when a person (or company) applies for a loan. The big difference is that in typical P2P lending, the risk is put on the shoulders of the private investors instead of a bank or financial institution.
Here is the usual peer-to-peer lending process:
- Borrowers apply for loans by providing their personal and financial information (e.g. income level, historical defaults, business plan, etc.).
- The P2P lending platform vets borrowers, does profile checks, and estimates risk profiles in order to calculate the interest rate of the loan.
- If the borrower`s risk profile passes the platform`s criteria, then the loan is made available on its platform.
- Private investors then select loan projects they want to invest in and a specific amount they wish to invest.
- If the platform offers a Buyback Guarantee option, the platform`s Safety Fund will give back the money and usually also some or all of the interests to the investor.
- If the platform does not offer a Buyback Guarantee option, the investor loses his investment.
Investing on the Nibble Platform: How Risk Can Become Your Ally
Here we review the “hypothetical” risks when investing on the Nibble platform
Why are these risks considered to be hypothetical?
- None of the risks have been realized during the company's existence. It means that all investments were returned on time with a predetermined interest rate.
- Nibble values its reputation and offers the investment strategy with Buyback Guarantee for the obtained assets and interest as well as strategies with higher returns.
- Investors` money is used to purchase rights of claim on loans issued by IT Smart Finance holding companies (loan originator), i.e. we do not have any so-called “external hard controlled investments”. Before the final customer gets his loan, he goes through a multi-level verification process, which guarantees a higher return rate in the future
Here are the risks that may result during the investment process:
1. Prepayment Risk (Early Payment)
When the final borrower repays the loan early, which is usually done by repaying the principal and accrued interest up to the date of early repayment, the investors might not receive the exact amount of income they were expecting.
To minimize this risk, it is very important to diversify investment and use the automatic reinvestment function. This allows you to avoid loss of income from non-invested funds in your account.
2. Loan Default Risk
Since P2P lending is debt-based investment type, the most common risk is the possibility that the borrower will not make future scheduled payments (default completely) or make late payments. In traditional P2P lending, this puts your investment at risk since the returns depend fully on the repayments made by the borrower.
Nibble mitigates this risk by offering the investment strategy with Buyback Guarantee of assets and interest – which removes the possibility of loss from an individual investment because the loan would be bought back by the loan originator (Joymoney) at a predetermined price. If the loan repayment is delayed, the company that issued the loan guarantees to buy it back on the 61st day.
An investor may still be faced with the possibility of default by the loan originator if it is not able to honour its guarantee – which is the next risk we will discuss.
3. Loan Originator/ Credit Company Default Risk
The loan originator where investors` funds are invested are financially stable and reliable. They are professional lending entities with good track records — vetting borrowers and related risks with multiple parameters and criteria (e.g. borrower`s activity in social networks, information about past loans, and the payment of taxes/fines).
A loan originator`s risk model is its competitive advantage. “We operate using our own scoring technologies and those of third parties. This is a very complex verification algorithm that is constantly being improved. Our software allows us to quickly and efficiently integrate new verification methods into the borrower`s evaluation algorithm, which are based on social network data, payment aggregators and geolocations,” says Maxim Pashchenko, the founder of the crowdfunding platform Nibble.
“Our internal scoring is complemented by external scoring technologies like Scorista. This gives us the highest predictive power in the market and helps to make loan decisions in less than 1 minute, directly helping us solve the most important determinants at the time of granting a loan” further adds.
However, the worst case scenario would be when a loan originator is going bankrupt, unable to honour its guarantees, or cease its activities. Lenders might end up losing some or even all of the money they had invested in the loan originator`s loans.
In this case, a management company will be assigned to help the investor to recover its funds in accordance with the rights of claim against the borrower. In addition, there is always a reserve fund which serves as an additional “safety airbag” of the investor.
A good P2P lending platform would ensure its approved loan originators are reliable and financially stable with a good track record.
4. Limited liquidity risk
There are things that could just happen in life that suddenly increase the need for cash. When this happens, liquidity becomes very valuable to you as an investor.
“Now for an investor a profit in the long-term is not as important as the income from investments. Nowadays it is important to get income as soon as possible, because in the era of Black swan events, it is difficult to predict profits you will get, and obtaining investments here and now is the most important thing,” says Maxim Pashchenko.
Nibble allows investors to withdraw their money even before the expiration date of the investment period and terminate the contract earlier.
How is this Possible?
After you request an early termination of the investment contract, Nibble will start the process of searching an investor for your portfolio. In this case, a new investor invests in your portfolio and Nibble pays the amount of invested assets and returns by strategies — withholding a commission fee of 3% of the total amount to be paid.
In case that Nibble does not find an investor for your portfolio within 30 calendar days after receiving a request for termination of the investment agreement, the amount is paid from the reserve fund.
5. External risks (including changes in legislation and country risk)
Fintech is a dynamic industry and a country's regulations may change over time. The holding company IT Smart Finance has a team of qualified international lawyers who regularly monitor changes in the legislation of the countries of the holding companies` presence, which may theoretically affect the core business.
In case of significant changes that will limit the company's activity, the investor has the option of early termination of the agreement and withdrawal of funds.
Various Risks in Different Strategies for Investment
Different strategies have different risks associated with them. Therefore, Nibble offers 3 investment strategies Classic, Balanced and Special. Beside the difference in degree of risks, they also differ in how those risks are distributed between the platform and the customer and in the level of annual income by each strategy.
The Classic strategy has shorter investment terms, lasting from 1 to 6 months, and low entry barriers. Minimum amount to start investing is 10 euro. However, the investor also gets a lower return of 6.5% per annum. Investing with Classic strategy customers invest in unsecured consumer loans classified as AA, A, BB, for which the borrower's risk of going into a payment delay is very low. This strategy also has Buyback Guarantee, so profitability is fixed and guaranteed.
The Balanced strategy implies investments in consumer loans classified as BB, B and CC. The degree of risk of non-repayment of a loan under this strategy is minimal though NPL 30 and NPL 60 might occur. However, they are nearly always paid back. The default risk for this strategy is low, but the income is significantly higher than that of the strategy with fixed income. Its return rate is 12–15% per annum with investment terms lasting from 7 to 60 months while the minimum amount to start is 100 euro.
The last one is the Special strategy. These are investments in unsecured consumer loans classified as B, CC and C. The degree of loan default risk under this strategy is higher than that in the Balanced one. However, the income that might come up to 19% per annum will definitely compensate for possible losses within the sum of the investment portfolio. The investment period of 12 to 60 months is chosen due to the fact that this portfolio includes loans for which a payment delay may arise, and their collection may take a more extended period. However, the minimum amount to start is 500 euro.
Two last strategies have much higher profitability with longer investment terms, but do not have any Buyback Guarantees. In case of non-repayment by the borrower, the investor bears the risk of losing all or a part of his invested capital. But at the same time these strategies keep a favourable balance between risks and profitability which makes them still a profitable way to invest money.
Depending on your risk appetite, you as the investor are the one who sets your own standards in which type of strategies you want to invest in.