In ye olden days it was called P2P Lending. You can still see the vestiges of that model in services such as Lending Club and Prosper. Everything happened on one service. However as these marketplaces grew, a networked ecosystem has started to emerge. We are 100% confident that this networked ecosystem will replace the incumbent vertically integrated bank model, even if we cannot see exactly which ventures will thrive and in what timeframe. Many of the problems that drove the news cycle around Lending Club and Prosper in the last few weeks can be seen within the context of this shift from single end to end service platforms to a networked ecosystem. In this research note we outline the players in this networked ecosystem and try to figure out where the puck is headed.
5 Links in Value Chain between Borrower and Lender
Marketplace Lenders still get borrowers/customers in a remarkably old-fashioned way by sending out direct mail to people with high credit card balances. They are in the business of competing with credit cards for lending, but use the same marketing techniques as the credit card companies.
Where the puck is headed:
- Entry of the Internet Platforms. How much they want to get into Lending remains to be seen, but they are undeniably good at delivering potential customers/borrowers (using search and social).
- Just In Time At Point Of Sale. People get high credit card balances because that option is available at the point of sale. Crack that nut and you don’t need to spend all those marketing dollars to find all those who have high credit card balances. One interesting startup in this space is Credit IQ.
- Entry of Personal Financial Management (PFM).These help you to see your overall financial picture and therefore plan how to reduce your interest costs by replacing your lender. The data in PFM is also an unexploited goldmine to do credit analysis (a Ferrari compared to the FICO bicycle).
One reason why Marketplace Lenders grew so fast is simply that they have better technology to quickly process and analyse borrower applications. The usual rule is you can either build or buy technology. Two companies in the buy category include:
- Provenir is a revenue funded New Jersey, USA, based software company that offers analytics for fraud prevention. Klarna is a client (and the Klarna model is the most fundamental threat to the credit card networks). Fraud prevention is key to keeping default rates within range.
- eOriginal from Baltimore, Maryland, provides all the technology behind the electronic signature. They work for all kinds of lenders, traditional as well as Altfi. The key is that the data they deliver meets the standards required by lenders.
Two companies offering origination technology to Credit Unions could branch out:
Specific to the USA and within a niche one could call Regulation As A Service are the banks that Lending Marketplaces formally originate loans through or use for securization such as:
Where the puck is headed:
- More software companies enter this market. This is a great market – big, fast growing – and origination technology is key to competitive advantage.
- Origination As A Service. Some of the companies offering Origination Technology may move into providing the full stack, including using Internet Platforms for marketing, to deliver customers/borrowers on a revenue share basis.
- Pivoting to B2B. More companies that struggle to get to scale in consumer markets will pivot to B2B (ie will offer to license their technology or provide Origination As A Service).
This the core function of a marketplace – think of stock exchanges. This is where network effects rule – if you get a lot of borrowers, this will attract a lot of lenders and vice versa. However the matching functionality alone may not be so profitable, which is why the big Marketplace Lenders have so far aimed to control as much of the value chain as possible.
Credit Analytics and Aggregation
This is where there is a lot of innovation today. Nobody wants a repeat of the subprime mortgage blow up. So Lenders want to analyse the underlying loans as best they can. Origination technology will be judged on a mix of a) Customer Acquisition Cost and b) the quality of the data used by lenders for their analysis (because analytics is always a garbage in, garbage out problem). Lenders also want simplicity, so these platforms also offer aggregation aka portfolio construction. The magic quadrant is the mix of easy to invest and ability to drill down and analyse to the individual loan level.
On the consumer side we have:
On the institutional side we have:
This is the traditional world of Banks, Hedge Funds, Family Offices, Insurance Companies. As the Marketplaces grew, they needed capital quickly, so they courted these Intermediaries, rather than relying on consumers to lend (ie P2P Lending). However as the Marketplaces court these intermediaries they need to remember two things:
- P2P Lending is slow to scale but highly sticky/loyal. People who started lending have found they get good returns if they are careful and so they do more. This is slow but steady growth. If you offer great returns, a Hedge Fund will use their capital but they are like the person at the party always looking over your shoulder to see if there is somebody more interesting to talk to.
- These Intermediaries are being disrupted. The whole Wealth Management and Capital Markets value chain is changing at a rapid pace thanks to the democratisation of technology that we write about every week under the heading of WealthTech.
This New Asset Class is just getting started
Today the market has been mostly about re-financing high cost credit cards or overdrawn accounts of SMEs, but the innovation is now also happening in invoice financing, mortgages and real estate.
Today it is mostly about borrowers in America, but the attention is now shifting to China and from there to the rest of the world. Kreditech is an example of a firm going after the emerging markets with some success.
The scale of the opportunity is hard to exaggerate and this is a game where a few big winners will dominate. Apart from traditional network effects based on Metcalfe’s Law, we also have the scale advantage of data. There is no person with a law named for this AFAIK, but it it key to marketplace lending – the more data you have, the better your credit analysis works, the better your credit analysis works, the more borrowers and lenders you get leading to the more data you have…
What will be interesting to see will be the degree to which the winners are vertically integrated (like a traditional bank) vs networked marketplaces. Companies like SOFI and Avant loan from their own balance sheet and Avant sells on 50% of the loans using a random allocation. The Marketplaces such as Prosper, Lending Club and Funding Circle innovated by opening up the Lender side of the market to an ecosystem, which is why we are seeing so much innovation on that side. The next stage may be opening up the origination side so we get a true marketplace with an ecosystem on both sides of the market. Then we will truly have a new asset class.