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European P2P lending prone to mispricing and inefficiencies, new study claims

European peer-to-peer lending platforms are prone to mispricing and are riddled with inefficiencies, according to new research.

Many investors are getting returns inversely related to the riskiness of the loans they fund, turning the principles of modern finance on their head, according to the study, which analyzed more than 3,000 loans from 68 platforms across Europe.

The results cast "severe" doubt on the sustainability of P2P lending, according to Gianfranco Gianfrate, professor of finance at EDHEC Business School. Gianfrate authored the report together with academics from Vienna Graduate School of Finance and Florida Atlantic University.

High risk, low returns

Platforms that have been in existence for only a short time can lack the historical information to price loans fairly, he said in an interview. Another problem is that P2P companies can prioritize loan volumes ahead of quality as they seek to grow their platforms.

The end result is that borrowers can end up investing in higher-risk projects that offer relatively low returns, Gianfrate said.

That said, lenders on P2P platforms may not be motivated solely by getting the highest rate of return possible; for example, they may be willing to accept lower rewards if the project they are funding is "green," such as clean energy or clean tech projects, he said.

Even so, he finds the mismatch troubling, calling the mispricing of loans a "systematic" problem in European P2P finance.

The paper, titled "Risks and Returns in Crowdlending," also argues that there is a tendency toward "herd" behavior — another factor that bodes ill for the sustainability of the P2P industry. This can happen when investors pile into loans that already seem to be attracting interest on a platform.

The research comes after a challenging period for the P2P lending industry, with U.K.-based Lendy going into administration in May 2019, leaving many investors out of pocket, and a wave of platforms including ThinCats and Landbay Ltd. closing their doors to retail investors in November and December 2019.

A nuanced picture

But other alternative finance experts said that things are not necessarily as bad in European P2P as Gianfrate and his co-authors would have us believe.

P2P platforms can be inefficient at matching risks with return, but the reality is more nuanced, according to Raghavendra Rau, professor of finance at Cambridge Judge Business School, and former president of the European Finance Association.

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Larger peer-to-peer lenders such as London-based Funding Circle have moved to an "auto select" model.

Source: Funding Circle

The model of lenders picking and choosing the individual loans that they want to fund can definitely result in mispricing, but this is now considered an outmoded way of doing P2P, he said in an interview.

Larger platforms such as Zopa Ltd. and Funding Circle Holdings PLC have shifted to an "auto select" model, in which the lender decides how much money they want to put in and what kind of risk they are comfortable with. The platform then distributes their investment across a portfolio of loans.

In newer models, the P2P platform is acting more like an asset manager than a bank, meaning that pricing is likely to be more efficient, he said.

A number of large European platforms offer both styles: Latvian-based Mintos Marketplace AS, now one of Europe's biggest P2P lenders with around €4.4 billion invested on its platform since its 2015 launch, has both an "invest and access" option, which automatically puts lenders' money to work against a basket of loans, and a primary market, in which investors can select individual loans by criteria including geography, industry and loan-to-value ratio.

Pricing methods

Claus Lehmann, an independent consultant and publisher specialized in P2P finance, agreed that the P2P platforms of today are more efficient mechanisms than they are given credit for.

"I doubt that any P2P lending platform actively encourages herd mentality," he said in an email. "Herd mentality can occur, as with any other asset class. Personally I think this risk is overstated."

He said pricing methods have matured.

"While auctions with underbidding were very common in the early days (pre-2014) most platforms have moved away from setting the price this way and now operate on a fixed-rate model with the rate set by the platform," he said.

The auto investment model is becoming more popular, but there is still room for classic P2P lending whereby investors personally select the loans that they want to fund.

This is especially true with real estate focused platforms, such as the U.K.'s The House Crowd and Kuflink Ltd., and Irish-headquartered Grupeer, which still give lenders the chance to pick and choose individual loans.