FinTech Lending - What's New?

When I was working in the financial sector during the 2000-2010 period I don’t recall the term FinTech was commonly used, perhaps it wasn’t even coined yet.

FinTech, the use of ("new") technology in finance, touches multiple areas, like:

• lending/borrowing

• (crowdfunded) equity finance

• payments

• (consumer) banking

• international remittance

• insurance (InsureTech)

The list is longer - and perhaps more diffuse because FinTech companies have often vertically integrated several of such financial domains.

In a series of entries we will talk about each of the above financial areas. In this entry we start by looking at lending. In the early FinTech context, lending was often in the form of microfinance and peer-to-peer (P2P) lending. The technology driver was simply the increasingly ubiquitous internet. Key buzzwords to remember here are the Long Tail and crowdfunding. This can be called the first wave of FinTech, FinTech 1.0 if you wish. The business driver would be reduced cost by cutting out middlemen fees like traditional banks would charge. The loans were unsecured with potential high yield if the loan would not default but also risk of completely losing your investment if a borrower would default.

Spreading the risk for lenders was one of the drivers behind the second wave of FinTech. FinTech 2.0 started around the second decade of this millennium and technology keywords here include AI, big data and blockchain and now also cryptocurrencies as accepted fiancial tokes running on blockchain. The business driver is not necessarily primarily lower cost, instead it would be more so a promise of higher yields, backed up by machine learning on massive datasets as well as efficiency and transparencies coming from the blockchain ecosystem

EARLY EXPLORERS OF P2P LENDING

Let's start by looking at some of the poster boys that rocked the traditional lending market in the first decade of 2000, e.g., Zopa (UK 2004), Prosper (USA 2005), and Kiva (USA, 2005). There are many more.

Kiva (kiva.org)

Kiva's business model was inspired by Nobel Peace Prize winner (2006) Dr. Mohammad Yunus and his Grameen Bank (established 1983) who provided very tiny loans to women in Bangladesh who otherwise would be refused such service by traditional banks or who could easily be financially abused by loan sharks. In addition to the fact that the small amounts were enough to make a huge difference in the lives of the borrowers who could start their businesses, the repayment rate turned out to be very high.

Example of a Kiva project presentation on the Kiva.org site.

Kiva connects lenders and borrowers via the internet. Lenders can choose which region, country, project and finally which business and person they lend out their small amounts. For these lenders the investment becomes more personal, with a human touch.

Working with an extensive network of field partners on the ground who disburse and collect the moneys, Kiva is one of the earliest online-to-offline (O2O) models.

Although in the last five years Kiva did introduce several new loan categories, compared to 2005, the business model has changed very little.

Zopa (zopa.com)

Whereas Kiva hasn't significantly changed its model since inception, Zopa did grow beyond an internet platform only matching (UK) investors and individual borrowers who mostly were looking for a car loan or loans for home improvement or debt consolidation - a very different target group from Kiva's entrepreneurs.

Zopa's revenue stream comes mostly from transaction fees. These include a fee for borrowers and an annual fee of 1% for lenders.

Zopa's Borrowing Power app is directly linked to the Zopa loan it unlocks: prospective borrowers can see immediately if they are eligible and at what rate.

In 2017 Zopa became fully regulated by the Financial Conduct Authority (FCA) and received approval to be an Individual Savings Account (ISA) manager, offering Innovative Finance ISA products since 2017. It has applied for a banking licence (online-only bank) and was given an interim banking licence in 2018. It seems Zopa moved away from being a straightforward lending marketplace towards a more vertically integrated financial services provider.

In the years of FinTech 2.0, Zopa also started to use AI and machine learning based on a non-linear credit risk assessment model (traditional credit agencies typically use linear modelling, with less possible forms, "outcomes") providing lenders new insight into repayment quality of borrowers with thin credit files.

Prosper Marketplace (prosper.com)

Prosper started in the USA very much like Zopa, with a similar target market of borrowers and lenders looking for car or wedding loans or loan to tidy up their personal finances.

Prosper's revenue comes from a fee on its customers' transactions. Borrowers pay an origination fee which height depends on the borrower's Prosper Rating. Investors pay an annual servicing fee.

The Prosper online interface for borrowers.

In the first decade of this millennium, the FinTech 1.0 era, lenders and borrowers on the Prosper site determined loan rates using a Dutch auction-like system where rates start high and descend until a bidder accepts.

This business model changed in 2010 after Prosper was registered at the Securities and Exchange Commission (SEC) in 2009 and started to use rates based on Prosper's loan pricing algorithm crunching the borrower's credit report and other financial information. Prosper verifies borrowers' identities and personal data before funding loans and, like Zopa, manages all stages of loan servicing.

Also like Zopa, Prosper branched out into additional financial services like tax-free or tax-deferred investment via self-directed IRA accounts.

Compared to Kiva the lenders are completely disconnected from the borrower as a person and instead, to manage risk to the maximum, lenders' funds are distributed in small amounts over a large amount of different borrowers.

And this can be done very well with AI.

FINTECH WAVE 2 NEW ENTRANTS

Despite several casualties among the early explorers of P2P lending, the above discussed three FinTech 1.0 companies show their resilience, they are doing well and have diversified their portfolio. They have introduced AI and machine learning to better predict default rates and as such are able to better price their services.

From around 2010 we can see that several FinTech 2.0 parties emerge alongside the early explorers. They can look like:

1. Competitors: compete as matchmakers with FinTech 1.0 companies on an entirely different technology platform, blockchain

2. Technology providers: they provide AI APIs to traditional and FinTech 1.0 companies for them to improved their credit scoring

3. Brokers: they build intelligence on FinTech 1.0 data and at a fee will invest on behalf of the lender over the most attractive borrowers to gain the highest potential

1. The FinTech 2.0 Competitor

With blockchain technology new P2P lending platforms could enable transactions independent of trust relations between lenders and borrowers. This is a potential threat to existing P2P lending platforms as well as other lenders like traditional banks who in one way or the other still play this role.

In this entry we will not discuss blockchain in depth. It suffices to know here that the key advantage of using blockchain technology in P2P lending is that it can remove intermediaries from the lending process, both FinTech 1.0 and traditional parties. Blockchain creates trust and decentralization and lays the foundation for a consensus mechanism that can eliminate the need of a trusted third party.

From a legal point of view, blockchain can thus be defined as a technology to validate transactions, whereas from a business perspective it can be defined as a peer-to-peer network for transferring value." Blockchain Beyond Cryptocurrencies (chapter 10)

Pushing the boundaries and leveraging blockchain technology at its core, some P2P lenders like BlockFi (2017), work the P2P lending market with cryptocurrencies and offer "wealth management" and as such have integrated the finance vertical deeper with credit card services, trading, deposit accounts.

BlockFi offers financial services in USA beyond P2P Lending, based on blockchain cryptocurrency

BlockFi and similar companies like Lendoit (2017) make use of a Smart Contract on blockchain technology. After a loan is posted on the market and filled by one or multiple lenders the smart contract executes and deposits the money to the borrower’s wallet. When the first payment is due, the smart contract automatically notifies the borrower and recognizes if the borrower successfully pays back the loan. This is a significant reduction in intermediaries.

2. The FinTech 2.0 Technology Providers

A good example of a company that helps FinTech 1.0 as well as traditional parties with their AI driven solution is Aire (2014). Aire has developed an API that integrates into a platform and through virtual interviews and machine learning can create personalized credit scores, not only based on financial parameters but also e.g., on forward looking factors like career and lifestyle.

In 2017 Zopa and Toyota Financial Services signed up for a partnership with Aire. According to the Aire web site they could help deliver up to a 14% uplift in credit acceptance without increasing risk appetite.

3. The FinTech 2.0 Brokers

Companies like LendingRobot (2014) lend out investor's money on behalf of the investor, based on the chosen investment strategy (and risk appetite). This happens automatically and fast. The latter was particularly an important driver for the creators of the service who, while managing their own investment on LendingClub, found that the most popular loans were gone a few seconds after publication. LendingRobot is an SEC Registered Investment Advisor since 2014.

LendingRobot invests and re-invests on your behalf

If you are a LendingClub or Prosper account holder you can make use of the LendingRobot API to configure your automated investing. One drawback of P2P lending is the lack of liquidity: you have to hold to your notes for the duration of the term. LendingRobot, however, does put thousands of notes for sale on a secondary market via a secondary market partner. Notes are on ongoing basis repriced which is an advantage to an investor who can sell loans and notes no longer wanted but can also buy existing loans and notes under more advantageous circumstances.

As notes pay off, your investment position declines and to stay fully invested is difficult to do it manually. LendingRobot offers continuous reinvesting of loan proceeds, maximizing the money in your portfolio for reinvestment and earning interest on a continuous basis.

In Europe we see some P2P lending platforms that do not depend on an external P2P landing market place like LendingRobot does. Companies like Mintos (2015), the largest P2P lending platform in Europe, and Twino (2015) offer auto-investment, also have a secondary market and even have buy back guarantee on some loans.

Mintos: choose your investment based on over a dozen parameters

IN CONCLUSION

When we talk about FinTech in the P2P lending space we see that FinTech 1.0 platforms, initially a lower fee based and better accessible (internet) middleman platform, have evolved into more robust, structured and intelligent lending marketplaces with additional financial services, hybrid or in catch up mode when it comes to AI and blockchain.

From 2010 we see FinTech 2.0 platforms enter the stage who are fully blockchain based and a hundred percent AI driven, hence able to make quickest investment decisions with the goals of maximum risk spread and returns at low cost from efficiencies generated by e.g., smart contracts. Although FinTech 1.0 lending platforms and traditional lenders are embracing and infusing 2.0 technologies in their own models, it might not be enough, if not too late, to withstand the formidable competition coming from the pure FinTech 2.0 players.

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