The Many Faces of the P2P Secondary Market
While online marketplace lending (MPL) has experienced nearly continuous growth in its investor and originator base over the past decade, the lack of liquidity and secondary market trading options remains one of the key hurdlesto broader adoption across investor segments. Fortunately, a growing number of players have entered the market to address multiple facets of the MPL market from syndication to ratings and analytics. This article highlights the operational and regulatory challenges participants are facing to set up a functional secondary market, lists the current market operators, and discusses the options available to investors in the space.
Ingredients for a Functioning Secondary Market
While regulations play a major role in how a market functions, a favorable regulatory environment is not necessary for a market to exist. There are three key ingredients needed for a functional secondary market:
- Price: An adopted valuation framework
- Two-way market: A sufficient number of buyers and sellers
- Standardization: Terms, rules, and standard market trading convention
A trusted price and valuation framework represent the most fundamental and important ingredient in a market even if participants arrive at different conclusions as to a fair price at a given point in time. A robust two-way market with many participants helps accomplish a trusted price by accessing the wisdom of crowds. In addition, a broad and deep two-way market gives investors flexibility to sell assets and gain liquidity when needed. At the same time, market liquidity (and crowd wisdom) can evaporate in an instant during sharp downturns like the recent global financial crisis, resulting in one-sided markets and heavily skewed pricing.
The last condition of standardization is not critical for primary markets but is necessary for a sustainable secondary market. Uniform rules and valuation methods ultimately allow for the commoditization of products such as ETFs and mutual funds. Standardization, including of documentation, also allows valuation authorities to provide pricing in lightly traded or non-traded markets. With more hedge funds entering the space, relying on the transacted prices of the thinly traded MPL secondary markets is not a viable solution. While many funds are able to foot the bill for pricing services such as Duff & Phelps, transparent valuation, particularly for single loans, for the general public remains illusory.
The Current State of Secondary Markets: Individual Loans and The U.S. Regulatory Experience
A discussion of the US MPL market would not be complete without a discussion of the current regulatory landscape. Currently, US law makes securities far easier to sell than loans, which under U.S. law are not securities. As a result, large market orginators such as Lending Club and Prosper issue notes that are technically securities referenced to loans underwritten by their partner bank (in this case Web Bank). This allows both platforms to make the loans available to both unaccredited and accredited investors. To date, debt crowdfunding rules have not been solidified, forcing P2P originators to operate within rules designed for larger, more mainstream loan segments like mortgages and corporate debt. In addition to the notes needing to be registered with the SEC, only a FINRA registered broker-dealer can list these deals. Hence, Lending Club and Prosper used the broker-dealer FolioFN to outsource their secondary market needs. In addition to these hurdles, Prosper shuttered its Folio offering in October 2016 due to lack of activity. Meanwhile, Lending Club’s secondary market offers a mix of loans similar in profile to, but in smaller volume than their primary market.
Aggregator platforms have also struggled with the structure of current regulations. Orchard Platform, founded in 2013, raised almost $60 million in venture capital with the goal of creating a fluid secondary market for whole loans for the US market. The company was successful in creating some of the strongest analytics in the space, but was unable to overcome some of the key regulatory hurdles. After an expected launch of October 2016, its secondary market offering, the Deals Platform, launched in September 2017 with nearly $500 million in deals with far fewer capabilities than planned. The company was not able to facilitate more than a handful of bilateral loan deals and several originators decided to bring their capital market functions in-house to source liquidity (see below). Ultimately, the product did not achieve the company’s desired traction and Orchard was later sold to the US originator Kabbage in April of this year.
The Current State of Secondary Markets: European Individual Loans
In contrast to the US experience, trading loans in the secondary market has proven far less onerous in Europe, particularly in the UK, where the laws have been streamlined with an ultimate benefit for the P2P industry. As a result, originators that follow the clearly stated capital requirements, disclosures, and loan-servicing rules from the regulator can make their loans available to the general public. This has also enabled faster adoption and setup of secondary markets. Several originators, including Albrate, Bondora, and Fellow Finance to name a few, currently operate successful secondary markets in Europe for their own loans today.
The streamlined regulations have also opened the door for aggregator platforms. Arguably the leader in the space is Mintos, a Latvia-based marketplace which operates a marketplace of over 35 originators. Mintos’s secondary market has grown exponentially, crossing €21 million traded since inception in 2015.
Similar to the asset class in general, selling loans in the secondary market is not without risk. In early 2016, only about 15% of Minto’s loans traded at discount in the secondary market with an even mix of those trading at par or a premium. This ratio started shifting late 2017 and now over half trade at a discount. There is also originator and issue specific risk. Investors last year holding Hipocredit loans, which were trading at a premium, lost money when the company exercised its option to buy their loans back at par. It is worth noting this call option was different than the buyback option offered by a handful of other originators on the Mintos platform where the originator guarantees purchase of loans that are 60 days past due at par.
The Current State of Secondary Markets: Pooled Loans and Securitizations
While many early funds and investors could leverage in-house quantitative models and the API (Application Programming Interface) offered by larger P2P platforms to buy individual loans, the growth of institutional investors in the space has drastically increased the demand for pooled loan offerings over the past five years. After its founding in 2007, most investors on Lending Club came from the retail sector, but by mid-2015, almost 85% of capital was institutional. To meet size requirements, many institutions entered into forward-flow agreements to buy a set amount of loans in the primary market directly from the platform before origination. However, liquidity in the secondary market was still limited, as forward flows result in single loan exposures only.
With US institutions aggressively increasing their allocations to MPL loans, securitization has offered the fastest and most scalable method for bringing MPL loans to market, especially in the US. Despite the backlash from pooled credit products like mortgage backed securities (MBS) and collateralized debt obligations (CDO) following the global financial crisis, the asset-backed securities (ABS) market has become the dominant form of packaging of MPL loans, reaching $33.4 billion outstanding worldwide in the first quarter of this year. New issuance in Q1 alone reached $4.3 billion, and has grown exponentially from 2013 when total origination was less than $100 million3. Leveraging the ABS markets was a natural progression for online MPL loans as non-online lenders in auto, credit card, and student loans have long leveraged the securitization to access the capital markets.
Similar to the existing ABS market, a number of supporting services have appeared to increase the transparency and price discovery in the space. Ratings agencies currently play a crucial role in increasing investor appetite, particularly with many institutional investors being unable to invest in unrated securities. Since the 2Q17, all new MPL securitizations were rated, led by DBRS and Kroll with Moody’s and S&P not far behind. The growth of MPL securitizations has also driven the need to examine the underlying pool of loans so that investors can access the underlying creditworthiness of loans, even down to the individual level. Two of the market leaders, PeerIQ and dv01, have created solutions to automate and normalize the data feeds from different originators to allow investors to evaluate an MPL securitization on an individual loan and aggregate level.
Another benefit from the rise of MPL securitizations is that they offer individual loan owners another liquidity channel by selling into new securitizations. Large US online lenders like Lending Club and Upstart, have in-house capital market divisions that make this option available to select investors. While demand from recent MPL securitizations have allowed investors to sell their loans into these pools at a premium, investors must still be aware that such premiums may not be available in future deals.
The crowdfunding model, newer and more robust data sets, advanced computation, and predictive models have made investments like real estate and credit card loans in the primary market far more accessible to the general investor public. As regulation and technology evolve together, particularly in the US, there is a potential that the secondary market could follow the larger fixed income segments like treasuries or corporate debt by trading in highly liquid and commoditized products like ETFs. These products satisfy the requirements of having an adopted pricing framework, a thriving two-way market, and standardized terms.
That said, there is still a long path to commoditization for MPL loans. Products that are not standardized or simply not well understood tend to trade in niche markets with limited liquidity. One lesson, among many, from the global financial crisis was that pricing credit risk in general can become heavily distorted by liquidity conditions. This distortion is exacerbated in thinly traded markets like CDOs as investors often rush to the exit even in mild market downturns. Credit products are more difficult to standardize than stocks as they have multiple dimensions that complicate standardization. For instance, uneven liquidity on different parts of a credit instrument’s term structure can lead to liquidity traps, but also opportunities, in the secondary market. As the wave of tech-enabled originators, securitization, analytics providers, regulators, and ratings agencies continues into the MPL space, the resulting increased transparency will potentially open the door for further standardization and more robust secondary market trading options.
1. Johnson, R. (2017) Marketplace Lending Finds a Place in Institutional Portfolios, Greenwich Associates
2. Milne, A., and Parboteeah, P (2016) The Business Models and Economics of Peer-to-Peer Lending, European Credit Institute
3. Dole, A., and Walsh, K. (2018) Marketplace Lending Securitization Tracker Q1 2018, PeerIQ