The UK’s financial watchdog is probing the crowdfunding sector for the second time in two years. The rationale behind this is that this sector is displaying signs similar to those that were displayed by market players in the lead-up to the financial crisis.
Putting this in perspective, the global crowdfunding market is expected to reach between $90-96bn by 2025, which is approximately 1.8 times the size of the global venture capital industry today, according to a 2013 study commissioned by The World Bank.
Lending Club, the largest US operator, was tainted by an employee fraud. Its CEO had to step down after being caught in a conflict of interest. Prosper, another large peer-to-peer lending platform, has also been in the spotlight after it was found to have lent money to gunmen and suspected terrorists.
Crowdfunding and its offshoot, peer-to-peer lending, come with inherent risks as any other financial product. These risks have to be uniformly communicated and understood by market participants before a market floor can be established. This is one of the premises of a well-functioning financial market.
Harbingers of trouble
These recent developments in the industry indicate that risks in the crowdfunding sector haven’t been understood, and are harbingers of the trouble ahead. If the goal is to become better investors, let’s start by understanding these risks for what they are.
Pooling of credit risk
This means that all investors as a group become vulnerable to defaults by borrowers, to whom they did not wish to be exposed. Most readers will remember risk pooling as one of the defining characteristics of the financial crisis of 2008.
Investors lend money for projects without performing due diligence on the merits and feasibility of the product or idea. Oftentimes, growth projections presented by the loan requestor or the exchange platform are not validated. Because the information available is asymmetric in nature, and the understanding of risks isn’t uniform, most investors remain poorly informed. This results in a false sense of security about the risks versus the rewards.
Limited role of the platform provider
The platforms that offer peer-to-peer loans typically do not assume any risk on their books. Their business model is to charge fees for any transaction, and possibly a percentage of the upside. Currently, regulations do not require the platform provider to conduct any due diligence on loans, or to assume the loans on their books. This amounts to securitisation of loans without taking on any of the risk. This can incentivise bad behaviour similar to what we saw during the financial crisis of 2008.
Guarantee-less reserve funds
Peer-to-peer lenders tout the existence of reserve funds in the event of a borrower default, but these reserve funds have no guarantee. Since this is a nascent industry, regulations are trailing the actual developments in the industry, which puts the onus of due diligence on lenders and investors.
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