The Ebb and Flow of Marketplace Lending
and what LendIt USA 2017 suggests about the future of FinTech
“He has his lusty Spring, when fancy clear
Takes in all beauty with an easy span..
..He has his Winter too of pale misfeature,
Or else he would forego his mortal nature..
..He has his Summer, when luxuriously
Spring’s honied cud of youthful thought he loves”
You would think I am crazy for quoting Keats while I talk about Marketplace Lending. But I couldn’t help notice how accurately these lines describe the phases that marketplace lending has gone through in recent times.
I attended the LendIt 2017 conference in New York in March with Wharton FinTech. As I entered the beautiful conference venue amidst an energetic crowd, I didn’t know what to expect. So much has been happening in the FinTech space off late that it’s hard to keep track.
But over the two days, I learned from key-note speakers, candid panelists, and curious attendees from different walks of FinTech. As my understanding grew and things became less murky, I left the conference enthusiastic about the future of FinTech and the promise it holds.
It would be unfair to talk about the future of FinTech without taking a look at the trail that got us here. The first half of this post provides an overview of marketplace lending and its transformation over the last few years. And the second half peeks into the potential future.
The evolution of marketplace lending thus far…
Two developments took place in the lending space post the 2008–09 crises. One, regulations were imposed on banks requiring them to reduce exposure to loans. Two, interest rates fell close to zero. As a result, securities such as government bonds, bank deposits, and high quality corporate debt no longer provided attractive returns to investors. Marketplace lenders (MPLs) came in to fill this gap by creating a platform for investors that provided access to higher returns on investment. The infographic below provides a simple illustration of how these platforms differ from the traditional banks.
MPLs brought with them several technological improvements.
First, new underwriting models increased access to credit. Users that were not considered ‘credit worthy’ based on traditional scoring metrics such as FICO could now be included in the borrower pool. A by-product of better underwriting was the reduced cost of credit as lenders learned to model risk better.
Second, technological improvements and automation in the space improved the customer experience by replacing traditional lending with a quick and efficient underwriting process.
Finally, competition in the space increased transparency. Some of the world’s largest global investment firms started investing in lending assets by buying them directly from the originator. This cut the thick margin-absorbing middle layer of banks.
So, what do we have next — a happy future?
The journey so far for marketplace lending has been bumpy. The initial success of these platforms was greeted with optimistic exuberance. In the relatively stable market of 2013–15, institutional investors poured significant capital into marketplace funded consumer loans. The investments did very well, surpassing returns provided by several other assets. This growing popularity was marketplace lending’s Lusty Spring.
While returns continued to be positive and above market benchmarks, the percentage of loans with delinquent payments started to increase and overall returns relative to the boom years fell towards the end of 2015 — notice the reduction in YTD returns. This pushed the space into a Gloomy Winter.
The middle of 2016 saw several cases around poor corporate governance and the lack of appropriate risk disclosures to investors. This was followed by the U.S. Department of the Treasury’s statements around potentially stricter regulations in the space, further reducing investor confidence.
The gloomy winter was washed away because of improvements in marketplace lending by the end of 2016. On the supply side, these included improved risk models, better governance, and increased competition. On the demand side, this included an increase in the number of borrowers on the demand side. The industry saw a rise in returns for marketplace funded loans and an increased trust in MPL platforms. Things came full circle with marketplace lending heading towards a bright Summer ahead.
… and the promise for the future
With participation from 350+ industry leaders and 5,000+ attendees, the LendIt conference this year provided insights into what the future of marketplace lending may look like.
Scott Sanborn, CEO of Lending Club kick-started the conference with a thought-provoking analogy. According to him, the lending space today is “the dormant powerhouse that Amazon was in 2000s”. Back then, with numerous challenges in the online space, industry experts laughed at the prospects of Amazon as a potential threat to retailers. The same can be said about online lending versus banks today.
Over the course of two days, LendIt covered several aspects of FinTech Innovation. Amidst specialized sessions, fireside chats, networking expos, keynotes and company demos — a few key themes emerged. These are summarized in the exhibit below.
Two themes particularly stood out.
Marketplace lending platforms in the US are burdened by regulatory challenges in a regime that has failed to keep pace with technological innovation. The state-by-state licensing is a huge burden for MPLs. For some firms, this means registering in each jurisdiction and having to comply with diverging standards for activities such as due diligence and securitization. These firms are eagerly waiting for a national FinTech charter that would have one clear set of rules and ideally uniform regulators.
On the other hand, the UK has seen some very progressive regulatory changes in support of the FinTech space in the past few years including (but not limited to) initiatives such as the regulatory sandbox that allows firms to test new products and services without incurring the normal regulatory consequences. Perhaps the US should take a leaf from UK’s book of regulatory changes to spur FinTech innovation.
The end of the unspoken war between FinTech firms and traditional banks seems to be in sight. As the banking industry continues to transform and FinTech firms come up with newer technologies for lending, underwriting, and authentication, the two sides have begun to see the benefit of playing nice. While banks gain from the innovation and technological capabilities that FinTech startups have under their arm, the startups gain from the established trust, extensive infrastructure, experience with risk and regulations and easy access to capital. Some partnerships that have emerged in the recent past are JP Morgan Chase’s deals with OnDeck Capital, and Bank of America’s partnerships with Cardlytics.
The future of such partnerships means greater automation, consolidation and enhanced customer service. One such way in which the partnership may develop includes the emergence of “Lending as a Service”. Under such a model, banks would utilize lending platforms for servicing and origination. Upstart’s new white-labeled “software as a service” product “Powered by Upstart” is an example of this — a product that services the entire consumer lending lifecycle. Another outcome of the bank-FinTech partnership may be ‘vendor relationships’ where banks leverage, securitize, and serve as trustees for online lenders.
The ebbs and flows of marketplace lending have been exciting to follow in the recent years. At this juncture, the real question to ask is — will the space face similar weather currents in the near future or is it heading towards a stable sunshine?