P2P | Course Paper

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Peer–to–Peer Lending:

Structures, Risks and Regulation1

Kevin Davis2 & Jacob Murphy3

June 2016

Abstract

In this paper we provide a concise overview of the key characteristics of P2P lending

platforms. We examine risks involved and consider alternative regulatory approaches

to P2P lending. We argue that the P2P model is an example of how modern

technology enables the integration of the functions of a market operator and a

provider of individual managed accounts (investor directed portfolio services) for end

users (as well as provision of other economic functions). This, we argue, removes the

basis for a legislative/regulatory distinction between market operators and market

participants/financial service providers which underpins current Australian regulation.

A new approach to regulation of markets is warranted which reflects this and which

would lead to P2P operators being regulated under that more general framework

rather than, as is currently the case, managed investment schemes.

1 Prepared for the 21st Melbourne Money and Finance Conference, Brighton,

Victoria, July 2016

2 Department of Finance, University of Melbourne and Australian Centre for

Financial Studies (Monash University). Kevin.davis@unimelb.edu.au

3 Department of Finance, University of Melbourne This paper is partly based on

work undertaken for an Honours thesis in the Department of Finance, University

of Melbourne and subsequently under a Kinsman Fellowship.

1. Introduction

Peer–to–Peer (P2P) lending involves the matching of borrowers and investors

via a web–based platform and the operator managing, as an agent for investors, the

resulting repayment obligations of borrowers. P2P lending is a fast growing industry

globally with the number of operators as well as the number of loans being issued

increasing substantially over the last 10 years. The USA and the UK have the most

established P2P lending markets. UK based Zopa is recognized as the first P2P

operator launched in 2005 while USA based Lending Club is the world’s largest P2P

operator and as of 31 March 2016 had issued over $18.7 billion worth of loans since

launching in 2007. The Australian P2P lending industry has been slower to develop

but now includes P2P operators such as SocietyOne, RateSetter, MoneyPlace,

ThinCats and True Pillars.

P2P lending is, in a number of respects, little different from other platform-

based markets which enable buyers and sellers of heterogeneous goods and services

to trade, with prices determined ultimately by demand and supply, but in the short run

by auction processes or fixed price offers. Examples include accommodation services

(AirBnB or Hotels.com), transport (Uber), new and second hand goods (EBay,

Gumtree, GraysWine Online), all of which have been made feasible by modern digital

technology.4

4 Einav et al (2015) analyse these types of peer to peer markets and discuss

issues involved in their regulation. They note that in fast growing and evolving

industries, regulations which appear sensible at an early stage may soon become

unsuitable. On the other hand, in platform businesses where there may be

significant network and scale economy effects, early stage regulation may be

appropriate to influence emergence of a desirable industry structure and

conduct.

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But there are some important differences. First, P2P operators provide their

own quality assessment of the product (loan) being offered – which is a form of

financial advice.5 Second, P2P operators manage (over several years) the subsequent

physical delivery to the purchaser (investor) of the obligations (interest and principal

repayments) of the vendor (borrower) – creating a principal–agent relationship.6

Third, P2P operators provide purchasers with account management (financial)

services (Investor Directed Portfolio Services – IDPS7) enabling purchasing (and

possibly subsequent resale) and custody of products (loan assets), and receipt (and

possible reinvestment in new products, storage, or withdrawal) of cash receipts from

products owned.

Development of regulation of P2P platforms in Australia has recognised all of

these features (ASIC, 2016) but has arguably focused on the last (account

management and investment facilitation) which is a feature of both managed

investment schemes (MIS) and IDPS (such as operated by stockbrokers). In the

absence of suitable legislation which reflects all of the features outlined above,

regulation of P2P operators has defaulted to compliance with MIS regulatory

requirements.

We argue that this is not ideal and that P2P platforms (and associated services)

are an example of a more general integration of provision of a number of economic

functions made possible by “Fintech”.8 This warrants reassessment of the current

5 Quality assessment of vendors or products (or purchasers) on other platform

markets is typically via participant ratings.

6 Another principal–agent relationship is created when (some) platforms allocate

investors into funding of specific loans meeting specified criteria (such as risk

grade or maturity).

7 Definition of IDPS and relevant regulation can be found in ASIC (2015)

8 Thus, whereas much discussion of financial innovation relates to potential for

“unbundling” of economic functions (such as in the case of securitisation

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legislative framework which is based on treating those functions as being provided

separately by separate entities – as was the case under older technology. Specifically,

we argue that P2P platforms combine together the functions of a market (exchange)

operator and a provider of financial services (individual account and trading

facilitation) such as exemplified by stockbrokers (market participants). Of particular

importance, Fintech can enable direct access to the market by end–users (without the

need for broker – market participant involvement) and integrated provision of those

functions listed above. This removes the case for a regulatory structure based on a

distinction between market operators and financial service providers (market

participants) which is a special case of non-integrated provision resulting from old

technology.

ASIC (2013) notes that its Regulatory Guide 172 regarding market operator

licences will be reviewed in total in “due course”. We suggest that this needs to be

undertaken in the context of the now (or emerging) feasible integration of market

operation and associated services (such as IDPS or IPO bookbuilds for new security

issuers) due to Fintech, and recognise that separate specialised treatment of market

operators is no longer appropriate (but may be a special case of a more general

approach). As part of that more general review, P2P regulation could be shifted from

the MIS category (which itself may be a subset of the more general approach) to the

new “omnibus” regulatory model.

We first outline the key features of P2P lending, then consider risk

characteristics which give rise to regulatory concerns before examining the options

for regulation.

enabling separation of origination and funding of loans), we note that it may also

provide new opportunities for “bundling”.

2. Key Characteristics of P2P Lending

The focus of P2P operators has predominantly been the personal and small business

loan markets. However as this financial innovation develops it is expanding into an

increasing number of different loan markets such as trade credit and mortgages. P2P

lending is often thought of as connecting retail investors and borrowers but has

evolved such that often the majority of investor funds come from institutional

investors. This has led to the term “marketplace lending” also being used to describe

P2P lending.

The attraction for borrowers is the potential to access credit when they may have

otherwise been declined from traditional financing methods and/or the possibility of

receiving more attractive interest rates on loans. While traditional intermediaries can

use risk based pricing and “new” forms of credit–relevant information (such as social

media), their limited use of these has been one factor providing opportunity for