How P-to-P Lending Evolved into Different Animals in U.S., U.K.

The U.S. has the dollar, while Britain has the pound. We have a president, and they have a queen.

Now add one more item to the list of differences between the two closely linked nations: the U.S. has marketplace lending, a fast-growing sector dominated by institutional investors, while the U.K. has largely stuck to the peer-to-peer loan model, in which retail investors supply the industry's capital.

Peer-to-peer lending was born a decade ago in London, and the concept soon crossed the pond. In the much larger U.S. market, the P-to-P industry grew more rapidly, but it also mutated into a way for large financial institutions, including banks and hedge funds, to invest in loans while allowing online platforms such as Lending Club to handle the messy details of underwriting.

Meanwhile in the U.K., the P-to-P industry has remained closer to its roots, as a vehicle for individuals to earn a more modest return on their savings.

[Coming this November: Marketplace Lending + Investing. Hear how participants in this fast-growth niche are using data and technology to propel lending into the 21st century.]

Observers in both countries attribute the diverging trajectories to a mix of regulatory and cultural factors. At the same time, they predict that institutional investors will become a bigger factor in the U.K., while U.S. retail investors will soon gain new ways to invest in marketplace loans. The ongoing shifts underscore the fast evolution of a nascent industry that is rife with experimentation.

"The two markets seem to have grown in different directions," said Jahan Sharifi, a lawyer at Richards Kibbe & Orbe LLP, which represents hedge fund investors.

But he added: "The markets could switch very rapidly."

U.K.'s Conservative Path

Peer-to-peer lending platforms in Britain have long marketed themselves to consumers as an alternative to depositing cash in the bank, as opposed to a riskier investment vehicle.

"The main idea is to give a low, stable return to retail investors," said Mike Baliman, who hosts a podcast about U.K. financial technology.

Zopa, the London-based firm that invented peer-to-peer lending in 2005, advertises annualized returns of 5.0%, which is at the low end of the yields advertised by U.S. marketplaces. "No bailouts required," Zopa's website states, in an appeal to savers who were turned off by banks' role in the financial crisis.

"I'd say the vast majority of Brits tend to want to put their money somewhere for a few years and let it build up," said Mat Gazeley, a Zopa spokesman.

A top competitor in the U.K., RateSetter, advertises pretax returns of up to 6.4% with little risk to the investor. "£649,873,514 lent and not a penny lost," the company's website states.

Both Zopa and RateSetter maintain reserves that are used to compensate consumers who invest in loans that go bad. Those pools of money function sort of like privately funded deposit insurance, and cause the U.K. loans to look more like a savings product than their American cousins do.

The lower returns on U.K. loans have made them less attractive to institutional investors.  At the same time, the British government has taken steps that have bolstered the retail market — for example, writing regulations that are specifically designed for peer-to-peer lending.

The U.K. government is also making it easier for consumers to invest their retirement savings in P-to-P loans. After Aug. 5, changes to the country's rules for individual savings accounts, which are similar to individual retirement accounts in the U.S., will mean that everyday folks can hold some or all of their savings in P-to-P lending platforms.

"In the U.K., it's simply easier to do retail capital formation," said Sam Hodges, managing director of Funding Circle USA, the San Francisco-based arm of a London-based peer-to-peer lender.

"The U.K. in terms of regulation … moves a little bit faster than the U.S.," said Scott Talbott, senior vice president of government relations at the Electronic Transactions Association in Washington, noting that Britain is a smaller market with a flatter regulatory structure.

To be sure, there are institutional investors getting into the U.K. market. For example, Britain's Metro Bank, which was founded by Vernon Hill, the former chief executive of Commerce Bancorp in New Jersey, recently announced a partnership that will allow it to lend through the Zopa platform.

But for the most part, U.K. banks have been slower to embrace the online lending platforms than their U.S. counterparts.

One London-based startup, investUp, recently decided to abandon its plan to partner with banks and re-sell their loans to the crowd.  Executives at the firm said that U.K. banks are too risk-averse to sign on to the idea, and are waiting to see whether P-to-P lenders will survive the next recession.

U.S. Push for Higher Yield

A pivotal point in the evolution of the U.S. market came in 2008, when both Lending Club and its largest rival, Prosper Marketplace, were temporarily forced, for regulatory reasons, to curtail their operations. 

At the time, both P-to-P firms realized that the U.S. government was going to classify their investor notes as securities, and so they would need to register with the Securities and Exchange Commission.

Eventually, Lending Club and Prosper began filing daily prospectuses with the SEC, which allowed them to sell to retail investors. But that process is costly, and newer competitors have chosen not to follow suit.

"It's capital-intensive. It's people-intensive. It's a lot of work," said Ron Suber, Prosper's president.

Accredited individual investors, who generally have a high income, a net worth of at least $1 million, or both, can invest in the loans offered on various rival platforms. But middle-class investors in the U.S. do not currently have a lot of P-to-P options, unlike their counterparts in Britain.

Meanwhile, Lending Club, Prosper and other U.S. platforms have turned to institutional money in order to fuel their rapid growth. Prosper originated $205 million in loans in December, which was up from $60 million a year earlier.

"Today Prosper is about one-third retail and two-thirds institutional," Suber noted. "I would just say that the institutional demand has at this point been greater than the retail demand."

Lending Club declined to provide a breakdown of its loan volume by investor type. But the San Francisco-based firm originated more than $4 billion in loans last year, with about 60% of those loans going to riskier borrowers and yielding returns of 8.5% or higher.

Industry observers pointed to several factors that have hastened the rise of institutional investors in the U.S. That list includes the fact that there is simply much more institutional wealth to be invested in this country than there is in Britain, and the emergence of new technology and support firms that have made it easier for U.S. institutional investors toplace large sums in online platforms.

At the moment, there still appears to be room for growth among hedge funds and other investment firms. A recent survey of more than 300 U.S. institutional investors found that 29% of the respondents currently have investments in the sector, while 85% of respondents expressed an interest in making such an investment.

The survey's results were published in a report by Richards Kibbe & Orbe and a student-led project at the University of Pennsylvania's Wharton School of Business. "We think that the high level of interest in making some form of marketplace lending investment indicates potential for continuing strong growth," the report stated.

Shifting Winds

Still, observers warned that in both countries, the mix of between individual and institutional investors could change quickly.

In the U.S., online marketplaces are trying not to alienate retail investors, who sometimes complain that large institutional investors snap up the most attractive loans before individuals have a chance to evaluate them.

"I think the pendulum will swing back, and you will see even more retail participation," Prosper Marketplace's Suber said.

The American platforms might be wise to prepare for a scenario in which hedge funds, which can be fickle investors, quickly exit the sector. Rising interest rates could make other asset classes more attractive. Higher credit losses, if they materialize, also could spark an exodus.

At the same time, a new way for individual Americans to invest in marketplace loans is now on the horizon. During the third quarter of this year, two P-to-P funds for retail investors will open, according to Suber.

Those funds should give individual investors in the U.S. access to a broad swath of marketplace loans from different online platforms. "That will allow individual investors to invest," said Peter Renton, the publisher of Lend Academy, a website that covers marketplace lending.

Renton argued that the process of evaluating individual loans, which is how the P-to-P industry got started, is time-consuming and not something that appeals to a broad range of people.

"People aren't interested in managing their own money. People want someone else who's experienced to do it for them," he said.

The recent trends in the U.K. are in the opposite direction. British loan platforms have recently become more interested in attracting institutional money as a means of fueling faster growth.

Some British companies saw the success of Lending Club's initial public offering — the U.S. firm has a market capitalization of nearly $7 billion — and may be hoping to emulate it.

"What's taken off recently is a realization that an IPO is possible for the first few," said Baliman, who hosts the London Fintech Podcast. "The main name of the game right now is growth, asset growth."