Skin in the game in peer-to-peer lending is a term used to describe the situation where P2P loan originators are risking losing their own money together with lenders buying their approved loans. The amount of skin in the game is usually between 5 % and 15 %. This translates into the amount the loan originator will lose if the credit approval was bad and the loan is defaulted without any recovery.
This exercise comforts the lenders that the loan originator takes the credit approval serious. Since the loan originator’s main job is to sell loans, there is a risk that they will facilitate a lot of loans with bad credit scores to borrowers simply to earn the commission when the loans are sold to the P2P lenders.
Why Skin in the Game is Important
The main reason why skin in the game is only used in relation to p2p loan originators and not traditional lending-based crowdfunding platforms lies in how the acquisition of borrowers happens. In peer-to-peer lending, there are two different business models: 1. The three-party business model consisting of lenders, a P2P platform and borrowers; 2. The four-party business model consisting of lenders, loan originators, a P2P platform and borrowers.
In the four-party online lending business model, the borrowers come from outside the platform and that itself makes the whole process less transparent and riskier. This additional risk would be a deal breaker for most investors if it wasn’t for the creative finance product called Buyback Guarantee and skin in the game.
The reason that lending money to borrowers acquired by a non-bank financial institution that earn a commission on the trade is considered very risky is because the more a loan originator transfers risk to others, the more they earn. This phenomenon is best described by what Nassim Nicholas Taleb calls The Rubin Trade in his book SKIN IN THE GAME (2018, p. 13):
Robert Rubin, a former Secretary of the United States Treasury, one of those who sign their names on the banknote you used to pay for coffee, collected more than $120 million in compensation from Citibank in the decade preceding the banking crash of 2008. When the bank literally insolvent, was rescued by the taxpayer, he didn’t write any check – he invoked uncertainty as an excuse. Heads he wins, tails he shouts “Black Swan”.