Risks of P2P Lending: The 3 most important risks you should consider
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In advertising, P2P lending is often referred to as a short-term substitute for overnight money. In some cases, it is even called an "alternative to a savings account ". That is a completely misleading analogy and creates false expectations among investors. Within the European Union, bank deposits of up to EUR 100,000 are protected by deposit insurance.
The asset class of P2P lending does not provide its investors with comparable security. Otherwise, it would be impossible to justify how investors can achieve returns of up to 15% p.a. with P2P loans in some cases.
If you are considering investing in P2P loans, you should be aware of the 3 most important risks. We will introduce them to you in this article.
Credit default risk
Credit default risk is the risk that a loan may default in full or in part. A default is defined as the inability of a borrower to meet their obligations.
The risk of default and credit transactions are inseparable. There will always be borrowers who cannot meet their obligations.
In the case of P2P lending, delayed payments and a subsequent default on the loan are also common occurrences. Depending on the platform and ratings, an average of between 5% - 15% of brokered loans default.
The credit default risk may reduce your return when investing in P2P loans. Excessive loan defaults can even lead to negative returns.
How do banks deal with the risk of credit default?
On average, banks always assume that a proportion of loans will default in the lending business. This is referred to as expected credit loss. The expected loss is managed by the banks through ratings (grade for creditworthiness), among other things.
The lower a borrower's credit score, the higher the expected credit loss.
The increased risk is compensated by banks charging higher interest rates to borrowers. Some banks even go as far as not lending to borrowers who do not have a minimum credit score in the first place. Credit scores range from 300 - 850 and are made up of 3 separate numbers reported by Equifax, Experian and Transunion.
More dramatic for banks is unexpected credit loss. This refers to losses from loans that are higher than average. If a bank is hit by multiple and large-scale unexpected credit losses, the bank is threatened with bankruptcy.
While banks actively try to counter the risk of unexpected credit losses, they are unable to completely eliminate it, as evidenced by the financial crisis in 2008.
The platform risk describes the risk of a platform going bankrupt. Should a P2P platform on which you have invested in, become insolvent, this may lead to a total loss of your investments on the platform in the worst case.
Considering that the main task of most platforms is the brokerage of P2P loans, one might quickly ask how such a catastrophic situation could have occurred in the first place.
Pyramid (Ponzi) scheme with dubious P2P platforms
The platform risk can be observed in dubious P2P platforms, which aim to build a Ponzi-Schema. There is no real business activity within this fraudulent system.
Put simply, a P2P platform pyramid scheme operates as follows: Investors contribute new money to the platform to invest in P2P loans. However, the capital is not invested in P2P loans. Concealed from the public eye, the platform operators drain funds into private accounts to make themselves rich. The alleged interest and repayments that investors receive in turn come from the money of new investors.
This system suddenly collapses when multiple investors want to withdraw their money at the same time. This situation reveals that a lot of money is missing and not all investors can be paid out. Unfortunately, by then it is already too late and many investors are left dealing with their losses.
Bankruptcy of the P2P platforms envestio and Kuetzal
The platforms envestio and Kuetzal had to file for bankruptcy in 2020. Both platforms were known to have attracted new investors with conspicuously high returns. In some cases, returns of over 20% were promised.
As time passed, investors discovered loans from companies that did not even exist on these platforms. In some cases, this went as far as inventing "mystery companies".
At present, there is still a dispute about whether the platforms were Ponzi schemes ("scams"). The fact that both platforms imploded exactly when a particularly large number of investors withdrew their funds at the beginning of the Corona crisis is another very strong indication that both platforms were Ponzi schemes.
Counterparty risk (loan originator goes bankrupt)
The counterparty risk is relevant for P2P platforms that act as a marketplace. This means platforms that do not broker loans themselves, but rather loans from loan originators. Counterparty risk describes the risk that a loan originator may file for bankruptcy.
If a loan originator goes bankrupt, all loans brokered through that loan originator may default at once and render them worthless.
Bankruptcy of Eurocent on Mintos
The bankruptcy of the loan originator Eurocent on the P2P platform Mintos demonstrated that bankruptcy of a loan originator is a real risk.
After Eurocent was unable to repay its corporate bond due on June 08, 2017, the bankruptcy of the loan originator was unavoidable. Placement of new loans was suspended on Mintos on June 26, 2017.
Buyback guarantees suddenly lost their value and investors started to suffer losses. In the following months, Mintos made an effort to be transparent and reported relatively frequently on the latest developments. However, as time went on, the reporting also decreased steadily.
In this case, it is assumed that the corporate bond and other creditors will be paid out of the bankruptcy estate first - ahead of Mintos investors. The investors on Mintos must assume a total loss of their invested capital.
Conclusion and summary
In this article we talked about the three most important risks of the P2P lending asset class.
At this point it is important to emphasize that P2P lending as an asset class also offers great opportunities, allowing for sustainable returns of up to 12% per annum. Other investors have already been successfully investing in P2P loans for years.
Successful investors understand the risks of their investments and actively manage risks to generate sustainable returns.
Having read this article, you should now be aware of the fact that loans, platforms and loan providers may default. That is why, for example, it would not make sense for you to invest your capital in only one P2P loan, on only one platform, from only one loan provider.
Quite the opposite, you should distribute your money over several platforms, over as many loan providers and loans as possible. This approach is also called diversification and is designed to reduce the expected risks as much as possible.
If you want to successfully invest in P2P loans, we recommend checking out our P2P Lending Guide.