P2P Lenders be Aware: The Two P2P Lending Business Models

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Have you noticed there are significantly different online lending models in the so-called P2P Lending market? This short article will take you through the differences in the two ways of lending money to strangers online and provide you with a useful guide explaining what it means for you as a lender.

Traditional Lending-based Crowdfunding (Three Party Platforms)

The traditional understanding of crowdfunding is that you are giving/investing/lending money to the funder with only one middleman to facilitate the process. In traditional P2P Lending, the platform administrates the transactions, debt collection and marketing towards both lenders and borrowers in return of a fee. This means that there are three participants in the business model: 1. the borrower, 2. the platform and 3. the lender. The process is simple and easy to understand – as a lender your main risk is that the borrower do not pay back the money. Also, you have a transparent idea of who you are lending money to, how the process is structured and the situation of the borrower in terms of transparency. The traditional lending-based crowdfunding with three participants is illustrated below:

Three Party Platforms - Pros & Cons

Pros

  • Higher quality of loans
  • High transparency
  • Simple and straightforward
  • Always direct investment structure

Cons

  • Low volume of available lows
  • Debt collection takes the time it takes (in extreme cases it might take years)
  • Cashflow is more inconsistent (a borrower default impacts total repayment right away)

A New Business Model for P2P Lending is Arising (Four Party Platforms)

In 2009, the platform Twino started using a different approach to lending-based crowdfunding, involving a fourth part in the process: the non-bank financial institutions called loan originators. Twino figured that not having to find the borrowers themselves would give them an advantage over traditional lenders as this enabled them to focus the marketing only on attracting lenders. In that way, a new business model with loans available for investing from outside the platform itself was born in the market of online lending. This business model entails a total of four participants and two middlemen (the platform AND the loan originator) between the lenders and the borrowers. The Four Party Business Model is illustrated below:

Since the amount of companies selling the idea of loans to borrowers all over the world is endless, combining the traditional non-bank world of borrowing money with the new modern internet-based world of lending money allowed Twino to facilitate larger amounts of money faster than their competitors.

Four Party Platforms - Pros & Cons

Pros

  • High volume of loans
  • More stable short-term cashflow
  • Borrower debt collection is quick (as a lender with buyback guarantee)

Cons

  • Lower quality of loans
  • Less transparant
  • More complex risk
  • Mix of indirect & direct investment structure
  • Possibility of losing everything in the case of loan originator bankruptcy

Rapid Growth and Concerned Investors

With Twino’s success, other platforms using the same business model arose (such as Mintos, now one of Europe’s biggest online lending platforms). However, as the market started getting bigger, concerns regarding this new type of business model came to surface. As the loan originators are sales entities first and credit approval companies second, these concerns translate into questions such as:

  • As a lender, how can I be sure that the repayments of the borrowers will reach me?
  • What keeps the loan originators from facilitating large amounts of doubtful loans to earn their commission?
  • How can the risks of lending be contained when transparency in the borrowers and the facilitators is so low?

To counter the worries of potential lenders, many of the platforms operating with the Four Party Business Model, started introducing requirements to the loan originators.

The two most common requirements and ways the platforms try to mitigate the risk is either by having loan originators invest a small amount in the loans together with the lenders (Skin in the Game) or by creating a contract saying they must buy back the loans, if payments are missed for a certain number of days (Buyback Guarantee). This has helped attract much more lenders, even though the risk is just transferred to the loan originator company whom it might take years to default if borrowers can’t pay and the originator keeps getting more and more funding – and thereby stretching the risk over years, instead of gradually seeing the actual borrower defaults. However, these two maneuvers do not counter the risk of a loan originator company paying huge commissions to its employees and shareholders, goes bankrupt and starts all over again.

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