Louis Schwartz, chief executive of Loanpad, explains why the provision fund model isn’t always the most effective way to protect retail investors…
DEFAULT RATES ARE beginning to loom large for the peer-to-peer lending community, as platforms start to see large tranches of loans reach maturity. As a result, the ways that platforms protect their investors from capital losses have been under scrutiny, with two methods proving to be the most popular: provision funds or ‘skin in the game’. For Louis Schwartz, chief executive of recently-launched P2P platform Loanpad, ‘skin in the game’ could be a more viable option.
“Provision funds can provide a somewhat false sense of security, or at least an unknowable level of security,” he says. “They are often funded by reducing lender returns, so basically these funds are built with money that may otherwise have been paid to investors, and the overall value of the provision fund represents a very nominal amount when compared to the total size of the loanbook – often just one or two per cent.
“If the rate of defaults is higher than that, the provision fund would essentially get wiped out. And then you have to make the decision, what investors are going to be covered, and at what point in time are they going to be covered? And can the platform even continue without the provision fund?”
Schwartz, unsurprisingly, is an advocate for the ‘skin in the game’ model, and Loanpad has devised a system whereby all of its retail investors will see a sizable part of any loan being funded by lending partners.
These carefully-selected lending partners invest at least 25 per cent alongside retail lenders on every single loan on the Loanpad platform on a first-loss basis. Schwartz says that this 25 per cent acts like a provision on each specific loan, as opposed to a provision fund that is aggregated across all loans.
“Provision funds can hide the level of risk when everything’s good and everyone’s getting their returns as expected, until a time when the provision fund may no longer be able to keep up,” says Schwartz. “At that point, the underlying loans and their risk profile would become more noticeable and relevant to investors, as will the duration of the underlying loans and thereby liquidity.
“We feel that the ‘skin in the game’ model provides a more sustainable and transparent approach to risk management.” The other undeniable benefit of the ‘skin in the game’ model is that retail investors have the peace of mind that comes with investing alongside established large-scale investors who have already done in-depth due diligence on each loan. This adds another layer of quality control, says Schwartz, and should help reassure retail investors.
However, communicating this message presents a challenge. Schwartz believes that more needs to be done to educate investors, as there is a huge difference between the two methods of mitigating risk.
He adds: “In the current environment and with Brexit uncertainty, investors should assess what they are investing in carefully, to ensure they fully understand the features, risks and benefits of each platform and its risk management methods.”