Nickolas G. Muscat

Written By Nickolas G. Muscat

On: August 28, 2019


How to Reduce the Risk of P2P Lending


There are a number of risks to be taken into account when investing in Peer to Peer Lending (P2P) platforms. In this article we are going to discuss each risk involved and how you can best mitigate said risks. This will allow us to maximise returns while minimising any potential losses.
It is important to note as always, while all the information is provided in faith that it is accurate and reliable. It is to be noted I am NOT a financial adviser and information given is purely my opinion on discussed matters. It is always recommended you speak to a financial adviser before making any financial decisions you may not be sure of.

Main risks that can be mitigated if understood:

Platform Risk

Platform risk refers to the risk posed by the P2P platforms themselves. E.g. Ratesetter, Truepillars or Wisr. Each one of these businesses runs the risk of going bankrupt and in this case you would most likely lose your funds. So, in essence when you invest in one of these platforms loans you are somewhat investing in the platform itself.
This risk can be reduced by researching the platforms and understanding their stability by looking at factors such as their time of operation, previous performance and management. Making sure you only invest in those that are stable and trustworthy. Similar to what you would look at when investing in a business directly such as when looking to buy stocks.
The other important thing to do is to invest across platforms. I personally do this as another form of diversification in addition to investing in various loans to reduce borrower risk. While we are not as lucky as the UK or US in regards to the number of platforms available to retail investors, there is definitely room to diversify!

Borrower Risk

Borrower risk is also known as credit risk or default risk and refers to the risk of a default (where the borrower fails to pay back the loan). The first and most obvious thing to do here to reduce risk is to invest across multiple borrowers. This reduces the amount of capital that would be lost in the case of a default or late repayment, similar to how investing across multiple platforms reduces the amount of capital that would be lost if a platform went bankrupt. For example, with my investments with Truepillars I invest up to $100 but aim for $50 where possible across over 30 loans.
The other thing you can do, if the platform allows it, is to make sure you research your borrowers. For example, while Ratesetter does not let you choose your borrower, P2P platforms like Truepillars do, they provide comprehensive information on each business so you can pick for yourself which ones you would like to lend to.
Here is what Truepillars said:

Investors may consider diversification as one way of reducing the risk of a negative portfolio return. In the context of TruePillars, this would mean spreading your total investment across several different loan opportunities, rather than concentrating it in only one or a small number of loan opportunities. Cash Drag

Cash Drag

Cash drag refers to the risk of a reduction in ROI (return on investment) as a result of funds sitting idle in a holding or similar account. The Product Disclosure Statement (PDS) of most of these platforms made it clear you will not receive interest for any funds that are in a holding account. It is important to mitigate this risk by monitoring your investments and having multiple platforms and borrowers you can move that money to ASAP to avoid the effects of cash drag.

Other risks to be aware of:

Policy Risk

There is always the chance of governmental rule implementation or changes that can affect an investment. However, since P2P lending is so new, and specifically so in Australia, there is a higher risk that rules may be implemented or changed that could adversely affect your investment.

Market Risk

Market risk is the risk that comes from the fluctuations and movements of the entire financial market such as interest rates. While you cannot avoid this risk, you can reduce the risk that comes with a portfolio that is only diversified within one type of investment. E.g. P2P Lending. This can be done by simply investing across multiple investment instruments.

Network Risk

As P2P lending is an almost completely online business, there lives a high risk of attacks from hackers looking to take information, money and more. This is often referred to as network risk. I believe the only way to mitigate this is to only invest with established platforms and ones shown to have anti-hack measures in place. These are much more likely to have strong measures in place to avoid such attacks.

Liquidity

Liquidity is not so much a risk to your capital but is rather just an important consideration. However, if you were to need to access your money early, assuming the platform allowed it, you would likely incur heavy fees as well as a loss of interest.

While there are many advantages to P2P Lending, liquidity is not one of them. It is important to note this, and you should always have an emergency fund (I like to have 6 months' worth of living expenses saved up), separate to any money used to invest. This is particularly true when investing in P2P Platforms.

Here is what Ratesetter said:

You are only able to withdraw (or reinvest) your funds at the end of the indicative term of the lending market in which they are invested...

Summary:

-Research any platform you are considering investing in

-Invest across multiple platforms

-Invest across multiple borrowers

-Research your borrowers (If applicable)

-Monitor your investments to avoid cash drag

-Understand the lack of liquidity

-Understand the other risks that come with P2P Lending

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