Will Crowdfunding Become The Next Mis-selling Scandal?

The returns look attractive but a FTSE 100 (INDEXFTSE:UKX) tracker could be better

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Crowdfunding — which includes peer-to-peer lending and equity crowdfunding — is the popular new kid on the financial block. £1.2bn was lent last year through online platforms such as Funding Circle, RateSetter and Zopa, which enable private individuals to lend directly to small businesses and individual borrowers.

Volumes are set to be boosted further, with market-leading equity platform Hargreaves Lansdown planning to establish a peer-to-peer lending product. The Government is throwing itself behind the sector: the new British Business Bank is pouring £40m into Funding Circle, from April peer-to-peer loans will be eligible for inclusion in ISAs, and changes to tax rules will allow losses to be offset against gains.

The business is presented as ‘cutting out the middle man’, bypassing the greedy banks with their expensive infrastructure and allowing lenders to receive most of the interest paid by borrowers.

It’s a narrative that chimes with the times, but that makes it easy to overlook the fact that the risks involved in peer-to-peer lending are very different from those taken by savers with High Street bank deposits:

  • There is no deposit guarantee (the first £85,000 of bank deposits are Government guaranteed);
  • You can’t necessarily withdraw your money when you want — it depends on the borrower repaying, or other lenders replacing you;
  • There is no bank capital to act as a buffer — though platforms generally build a provision for bad debts;
  • The diversification of risk is much lower than on a bank’s balance sheet.

The diversification illusion

Most platforms assist lenders to diversify their exposure to each borrower, so that each lender has exposure to a small part of many different borrowers’ loans. But this apparent diversification belies the frailty of the business model: they are similar loans that are likely to be highly correlated. Peer-to-peer lending has grown up in a relatively benign economic environment, and a highly benign interest-rate environment. A downturn in the economy could put a significant proportion of borrowers in trouble at the same time.

Moreover, as some of the two-, three- and five-year term loans come to maturity, borrowers might have difficulty refinancing when interest rates are higher. Lenders would face the choice of rolling over loans, or forcing the borrower to default. A liquidity problem becomes a solvency problem. Bankers are familiar with this phenomenon: peer-to-peer lenders have yet to experience it.

Last month the FSA rebuked peer-to-peer platforms for comparing their products to savings accounts, and more recently it criticised equity crowdfunders for misleading customers. But the hype runs deep. Last weekend’s Sunday Times presented a table comparing the 12% p.a. “top possible return after typical defaults and fees” for peer-to-peer lending with 3.3% p.a. for a 5-year savings account and a 3.6% p.a. prospective yield on equity income funds. Peer-to-peer platforms typically talk of an expected net return around 6% p.a.

Apples & pears

You don’t need to be a highly-sophisticated investor to see that’s comparing apples and pears. The authoritative Barclays’ Equity Gilt study calculates annualised UK equity returns over the past 50 years at 5.5% p.a. above inflation. The FTSE 100 has produced returns of 9.8% and 9.2% p.a. respectively over the past 3 and 5 years. An investor tucking money away for some time is still likely to do better putting money in a FTSE tracker than in peer-to-peer loans.

I’m sure there’s a place for crowdfunding in portfolios, especially for more sophisticated investors. But there is a danger that savers will be led into products that are riskier than they seem, not least propelled by the rhetoric of banker-bashing.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Tony Reading has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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