Common themes are apparent when examining business models disrupted by technology. Amazon sells products more cheaply and conveniently than traditional retailers. Uber and Lyft disrupted the cozy monopoly of taxicabs, creating a more pleasant experience for consumers frustrated by rude drivers and dirty cabs. Apple changed the way in which people “consume” music, while Zipcar and Airbnb were trendsetters in the growth of the flexible “sharing” economy. BlackRock and Vanguard’s asset growth demonstrates a form of technology disruption, as their index ETFs take market share from high-cost actively managed mutual funds.
Banks may be vulnerable to the factors that inspired disruption in other industries. Consumer respect for banks fell dramatically during the global financial crisis, and the fake account scandal at Wells Fargo renewed public anger toward the banking industry. Regulatory scrutiny has made most banks more bureaucratic in their lending practices, with the mortgage process particularly challenging for most consumers. Credit cards continue to be an important profit center for many banks. Although banks are benefiting from a low cost of funds given today’s low interest rate environment, average credit card rates have remained high. Technology-enabled innovators such as marketplace lenders see an opportunity to capture market share from banks, offering better prices and a more convenient customer experience.
Marketplace lenders and online lending
Marketplace lenders originate loans through online portals rather than “brick and mortar” branches, a convenient and easy to use experience for an increasingly technology-savvy audience. Lending Club and Prosper were the first marketplace lenders in the U.S., founded in 2006. Today, there are more than 200 marketplace lenders. Marketplace lenders specialize in a wide variety of loan products, including small-business loans, consumer debt consolidation, student loans and mortgages.
Technology is a focal point in the user experience, streamlining the process for obtaining documents from borrowers and accelerating the credit decision-making process. Marketplace lenders can be more nimble in their use of technology than banks that typically are shackled to legacy technology systems and processes. Marketplace lenders, however, don’t have recognizable brand names, a competitive disadvantage against banks that have spent decades building their brands.
Operating costs may be much lower for marketplace lenders that don’t have the cost burden associated with maintaining physical branches, enabling marketplace lenders to be aggressive in pricing loans.
Digital loans can be a lower-cost alternative to credit cards. With major card issuers offering average credit card rates above 20%, a digital loan with an interest rate in the low to mid-teens can offer a significant financial benefit to borrowers committed to paying down debt. Marketplace lenders typically make money by charging a loan origination fee to the borrower, and a loan servicing fee to the investors who buy the loans.
Marketplace lenders were originally peer-to-peer lenders, matching individual borrowers and lenders with one another. As marketplace lending has grown in popularity, with institutional funding mechanisms becoming the more dominant form of matching borrowers and lenders. U.S. consumer marketplace loan origination grew to over $25 billion in 2017, which is a small percentage of the nearly $500 billion of credit card balances.
Marketplace lending funds
Stone Ridge Asset Management and RiverNorth Capital Management offer marketplace lending funds registered under the Investment Company Act of 1940. Both are structured as closed-end interval funds that allow investors to deposit money at any time, but restrict redemptions to quarterly intervals. Marketplace lending funds may provide diversification by geography, borrower type and loan term. Consumer, small-business and specialty loans such as student loans are among the types of loans that may be included in a marketplace lending fund. Marketplace funds invest with multiple originators of digital loans in order to spread risk. Stone Ridge and RiverNorth portfolio managers provide professional management — completing due diligence on marketplace lenders, creating diversified portfolios and monitoring risk among the loans owned by the fund. Marketplace lending funds focus on prime and super prime borrowers, though some of the loans fall into the near-prime credit range.
Investors in marketplace lending funds should expect and demand a liquidity premium, given the lack of an active secondary market for loans. Quarterly liquidity is offered but not guaranteed, as a rush to the exits could prevent investors from obtaining all their money when requested. High coupons may provide a margin of safety from defaults, but management fees, loan servicing fees and default losses can erode the return on double-digit interest rate loans. The net return from marketplace loan products may compare favorably to the returns available in today’s low interest rate environment.
Marketplace lending funds focus on shorter-term, amortizing loans that repay principal and interest on a preset schedule. Consequently, the funds are relatively insulated from the risk of rising interest rates. However, the marketplace lending segment has grown during an economic expansion. Employment trends have been positive, helping to support considerable improvement in consumer balance sheets. Consumer delinquencies and defaults are at a low rate, in stark contrast to the environment faced by traditional banks during the global financial crisis. Marketplace lending funds are untested by recession, and underwriting models may fall short of expectations if unemployment rises dramatically in the future.
A recent Federal Reserve Bank of Cleveland study was critical of marketplace lending. The study pointed out that marketplace loans are “earmarked” for debt consolidation, but often end up adding to existing debt. The study was also critical of the “stacking” of debt from borrowers who take out loans simultaneously from multiple marketplace lenders. Industry insiders have countered the study, highlighting improvements in underwriting models and real-time reporting designed to address the risk of “stacking” among borrowers.
Marketplace lending is an innovation that may disrupt the pricing for loans, while offering faster and more user-friendly loan origination. Banks may be forced to compete more aggressively on price and service, which would be a welcome development for many frustrated consumers and small-business owners. Marketplace lending funds may also be an interesting investment alternative for yield-starved investors, potentially offering higher returns than are available through most fixed income investments. Investors should do their homework, however, given the relatively short performance history and potential for the funds to struggle during an economic downturn.