Why ‘Peer-to-Peer’ Startups Haven’t Revolutionized Lending

Finance has proven to be stubbornly resilient to technology innovation. Online trading, despite its ubiquity, never delivered on its promise of democratizing stock investing. Bitcoin remains far from a threat to centrally managed currencies. Incumbent banks, if anything, have grown more powerful since the Internet emerged.

The latest innovation to fall short of its early promise is peer-to-peer lending. Conceived as marketplaces that linked people looking to borrow with others who had cash to lend, P2P lenders claimed to offer lower rates and, thanks to new algorithms that separated good borrowers from bad, reduced risk to lenders. Once again, old-school banks seemed to face a threat from an innovative business model.

From a pack of P2P loan startups, Lending Club and Prosper emerged as early leaders. Lending Club went public in late 2014. It was quickly followed by OnDeck, a startup that linked small businesses with institutional lenders, using a the same low-rate, low-risk business model as the P2P marketplaces. All relied on online platforms to reduce costs as well as data analytics to assess creditworthiness, a model that has come to be known as “marketplace lending.”

A year and a half later, all three companies appear to be on the ropes. Lending Club is trading at a little more than half its IPO price of $15 a share, and 73% below the peak price of $29 a share. Prosper was said to be planning an IPO in early 2015, then raised $165 million in an April 2015 private round. It has yet to enter the IPO queue. OnDeck, meanwhile, is down 64% from its IPO price and 75% from its peak price.

The share prices of these companies have slumped in spite of an early explosion in marketplace lending. Last week, a report by California’s Department of Business Oversight reckoned Lending Club, Prosper, OnDeck and ten other marketplace lenders originated an aggregated $15.9 billion worth of loans in 2014, a 700% increase from 2010.

In 2016, that growth is starting to hit some headwinds. State regulators are beginning to scrutinize the new generation of lenders, which explains why the California agency asked them for data on their loans. “We want to make sure our regulatory structure adequately protects the interests of our consumers and small businesses,” said a department official when the report was released last week.

Increased regulation by states like California is one reason investors have grown wary of online lenders. The Supreme Court is hearing a case that could subject P2P lenders, along with others that have a national charter, to interest-rate caps set by individual states. A ruling could curtail their high-interest loans to riskier borrowers. What’s more, the Consumer Financial Protection Bureau has started accepting consumer complaints about P2P lenders.

A bigger concern is the risk of rising loan delinquencies, which come when economies slow and interest rates rise. Economists foresee both happening in coming years. The California report noted that 30-day delinquency rates among marketplace lenders last year ranged between 0.03% and 18%.

Delinquencies are on the rise this year, making the peers that finance peer-to-peer loans that much more antsy. Unlike many traditional lenders that base loan rates on market interest rates, most P2P lenders determine the rates they charge borrowers. In January, Lending Club pushed up the rates it charges on its higher-risk loans by 67 basis points, or 0.67%. A month later, Prosper lifted the rates on its higher-risk loans by as much as 180 basis points.

That sense of caution is spreading. Last year, Wall Street firms began pooling P2P loans into securitized packages, a practice familiar to anyone who saw The Big Short. The champions of new finance were turning to old finance for help. In doing so, as the Financial Times has noted, “many of the purported benefits of online lending have quickly disappeared.”

This approach has encountered its own problems. A plan to securitize Lending Club loans through a U.S. unit of Spain’s Santander Bank fell through last fall. Prosper did securitize many of its loans through Citibank, but Moody’s warned in February it may downgrade several of these loan packages because of “a faster buildup of delinquencies . . . than expected.” In short, not enough of Prosper’s loans were being paid off in time.

Marketplace lenders are responding to the new challenges. Last week, several formed a trade association to advocate their interests. Still, the recent spate of bad news supports the bearish view on these startups – that they are only a specialized, overhyped niche and not a new paradigm in consumer and small-business lending.

The truth lies somewhere between the bulls and the bears. While the long-term potential of marketplace lending remains, it’s going to take longer than many hoped to reach that future. The nascent market is starting to encounter more of the regulations that traditional lenders face just as a cooling economy threatens to push up interest rates. Both will test the durability of the innovations P2P lenders have long promised.

In many ways, these are growing pains familiar to startups in many emerging industries. Like nanotechnology and 3D printing, startups in P2P lending are facing the backlash from early, outsized expectations. They will need more time to inch closer to their ultimate potential. Just how big and profitable that niche will be may take years to figure out.