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Peer-to-peer lending is not risk free
Peer-to-peer lending does involve taking some risk, and they are not currently covered by the FSCS (Financial Services Compensation Scheme). The value of a lender's loan book will vary and can fall as well as rise, with the possibility of a complete loss.
What are these risks and how can lenders mitigate them?
Borrower does not repay
This is perhaps the most likely risk, and perhaps "risk" is actually the wrong word as it is almost a certainty. In this category most borrowers will be unable to repay, but there will be some who are unwilling to repay, and possibility some that are fraudulanty, but ultimately the outcome is the same. The peer-to-peer platform may take the borrower to court and have a CCJ placed - or worse, but if the borrower can't replay then the lender will be left out of pocket.
Lenders can mitigate this by spreading their funds as thinly as possible. We would recommend no more than 0.5% of the total fund exposed to any one borrower. Some peer-to-peer platforms, such as RateSetter, operate a provision fund that will step in and repay the outstanding capital, and these funds are paid for by the platform charging the borrowers more than platforms that don't operate such a scheme. Other platforms, such as Wellesley & Co, have loans secured on assets, so if the borrower is unable to replay the asset can be sold and the funds used to repay lenders.
Platform goes out of business
In the years since Zopa launched there have been several peer-to-peer companies that have ceased trading or gone out of business. Some business fail because they are unable to manage the supply and demand between lenders and borrowers. A company where bad debts start to rise and lenders loose confidence and start withdrawing funds is likely to fail unless they can quickly turn the situation around. Despite FCA regulation there is the possibility that a platform may be affected by fraud.
Most of these companies have run down lenders loan books in a controlled manner, but others have simply gone offline and lenders have been left out of pocket. The FCA regulations required peer-to-peer companies to have a contingency fund which would pay for the administration of loans after a company ceased trading, but there is no guarantee that this would be sufficient to run down a 5 year loan book and chase late payments.
This is perhaps the hardest risk to quantify, but lenders can mitigate this by speading their funds between providers. Lenders should also look for companies that are members of professional bodies, particually the P2P Finance Association.