One of the most important things in investing is knowing and understanding the risks involved. If you don’t know the risks you can’t evaluate if the return is good enough and how to you protect yourself against the risk. Warren Buffett’s number one rule of investing is don’t lose money. You can’t completely protect yourself from risk but you can minimize the impact but first you need to know what those risks are. In these article I focus on P2P lending but the same risks apply to many other investments too.
Marketplace or platform risk
You invest on p2p loans through credit intermediary or loan claims through a marketplace. In the case of credit intermediary the platform services the loan as well as does marketing to get borrowers. Many of those platforms make most of their income on the borrower side as fees. In the case of loan claims the platform mostly collects fees from the loan originator. Marketplace has to balance with how much fees it collects from investors and borrowers as well as with the quality of the loans or loan originators. If it fails to do that and doesn’t generate enough income to be profitable it will eventually run out of money.
UK has had many platform failures where the platform has gone to administration meaning a third party will service the loans and makes sure the platform is run down in orderly fashion. The administrator is not free and investors may end up not getting everything back. Also it may be that the platform was operated badly and loan collateral etc. is not as valuable as investors were lead to believe. This has also happened with real estate backed loans.
Platform may also be shutdown by the regulator due to many reason such as non compliance or misappropriation of funds etc. Swedish Trustbuddy was shutdown by the Swedish regulator. In UK there has also been shutdowns of platforms by FCA.
Third risk is that platform is out right fraud. There’s been very recently three Estonian platforms that turned out to be fraud. They were brought to bankruptcy by group of investors that self organized and funded themselves legal representation to petition court for bankruptcy. Now in these cases the platforms were not co-operating so they are much harder to recover anything. In these cases also criminal investigation is under way. This is absolutely the worst case that can happen.
You can lower the risk by sticking with platforms that provide audited financial statements and are more established. Also preferring regulated platforms and platforms that use regulated loan originators will lower the risk of scams but not eliminate it. Also being well established doesn’t always mean they are safe like Grupeer. Some platforms are owned and operated by their loan originator or their parent company like ViaInvest, Twino and Lendermarket. Since they are already under financial supervision due to their consumer lending business they are less likely to be frauds.
Credit institution risk
If you are lending through a marketplace like Mintos or PeerBerry the loans are not issued by the platform but rather a credit institution that is licensed to do lending in the countries they operate in. In this context the credit institution is called loan originator as they originate the loan and service the loan for its lifetime. You just buy a claim right to it in the most cases. Sometimes you don’t have a direct claim to the loan and in those cases if the loan originator goes bankrupt you are just a creditor to the loan originator without any collateral i.e. the borrowers loan.
Lending money is all about risk management and when that fails bankruptcy could follow when too many borrowers fail to pay. Many loan originators provide buyback guarantee for when the loan is late 30 or 60 days depending on the loan originator. In that case the loan originator carries the default risk of the loan. The guarantee is as good as the financial state of the loan originator. You can lower the risk buy choosing loan originators that are profitable and diversifying between them.
Credit default risk
When talking about loans there’s always the risk of default. There is a risk the borrower doesn’t pay their debt in the planned schedule or worst case not pay at all. Managing the risk is the core business of credit institutions. The risk is especially high in unsecured loans. In traditional p2p lending you have to rely on the platform to do a good job on the credit rating of the borrowers. Sadly the platforms interest is to issue as much loans as possible. Naturally you can minimize the risk by not taking the highest risk loans and studies have shown that mix of low to mid risk loans have better default adjusted yield. Also taking loan claims that have buyback guarantee will lower the risk but not eliminate and they you are taking a different risk. Best way to tackle credit default risk is diversification across multiple loans. The recommended minimum is 100 loans which means each loan risks 1% of the invested capital if they are equal size. Diversification is a must especially for unsecured loans.
You can invest using many currencies such as Russian Rubles, Pounds, Polish Zloty or even Kazakhstani Tenge in addition to Euro. Now if you mainly use Euro there is risk the other currency you have invested in depreciates against Euro and when you do the exchange back to Euro you might get less. Now it can also go the other way and you’ll actually make profit. I limit my exposure other currencies and mainly invest in Euro. Now there also hidden currency risk in Euro nominated loans that are issued for countries that operate on another currency. Now it’s the loan originator that bears that risk but it might realize also to you if the loan originator doesn’t hedge the currency risk. In the worst case the loan originator could get in financial trouble due to foreign exchange losses. So bear that in mind when investing.
Basic principal in investing in loans is that if it’s maturity is say 5 years you’ll get your principal and interest in that time unless the borrower runs into financial trouble and can’t pay in which case it may take considerable longer to get back your money. Many platforms help increase the liquidity by providing a secondary market where you can sell the loan or claim to a loan. If anything unexpected happens in the market the liquidity of the secondary market can also suffer like what happened with COVID-19. You could only sell loans if you provided a significant discount. You can also improve your liquidity by investing in short term loans but in exceptional situation those could be extended also and as result of COVID-19 many platforms introduced extensions.
Market or political risk
There is always the risk that something unexpected happens in the market that will affect in the risk of lending also. The whole COVID-19 situation really highlighted this risk as it caused mass panic to investor that in turn started off loading their investments and governments made temporary changes to lending regulation such as limited the interest rate or allowed extra moratorium or both. That lead to a chain reaction realizing other risks too such as currency and liquidity risk. Even during normal time there is always political risk as government can pass legislation that makes some lending products not viable anymore.
You can’t protect yourself from all the risks but knowing they exists and doing the right things to avoid them. Tell your tips and tricks to protect yourself against risks.