Credit risk and reward: P2P offers returns but needs cautious investments

Limit your allocation to 5-10% of your fixed-income portfolio and stick to highly-rated borrowers

Around Rs 3,000 crore was lent by peer-to-peer (P2P) lending platforms in 2021-22. According to IndustryARC, a research and consultancy firm, the Indian P2P lending market is expected to grow at a compounded annual rate of 21.6 per cent between 2021 and 2026.  

Millennials, in particular, are increasingly adopting these digital lending and borrowing platforms. According to the The Financially Independent Millennial report 2022 by CASHe, an artificial intelligence-driven financial wellness platform, about 12 per cent of millennials (the survey covered 20,000 people) had participated in peer-to-peer (P2P) lending.

Eliminating the intermediaries P2P platforms remove traditional intermediaries such as banks and non-banking financial companies (NBFCs) from the lending and borrowing process.

Neha Juneja, chief executive officer (CEO) & co-founder, IndiaP2P.com says, “Instead of parking their money with a bank that lends it further to make a return, a retail investor can now lend directly.”

A P2P lending platform offers investors higher returns than traditional fixed deposits (FDs) or debt mutual funds. “Investors will take higher risk by lending directly but also earn a lot more on these platforms,” says Juneja.  

These are regulated platforms. Bhavin Patel, co-founder & CEO, LenDenClub, says, “The P2P lending and borrowing mechanism is regulated by the Reserve Bank of India (RBI).”

How they work

While some P2P platforms lend to salaried individuals, others target Micro, Small, and Medium Enterprises (MSMEs). All loans are collateral-free.

The procedure for lending on a P2P platform is simple and entirely digital. The customer first has to complete a standard KYC. Next, he has to choose from the borrowers or loans available on the platform.

“Borrowers are typically charged an interest rate of 18-20 per cent. Deserving customers with high credit ratings can get as low a rate as 11-12 per cent,” says Juneja.

Some platforms allow lenders to choose the borrower and negotiate the interest rate. Yet others don’t permit interest rate related negotiations but allow them to select the borrower. Others have algorithms that manage the lender’s money.  

They charge a fee (which varies across platforms) from both lenders and borrowers.  

Varied models

P2 platforms have a variety of offerings. IndiaP2P.com, for instance, focuses on women business owners with good records of loan repayment. Juneja says, “We only have borrowers who have existing, good credit bureau scores. We also physically meet and verify each borrower.”

LenDenClub and a few others offer Fixed-Maturity Peer-to-Peer Plans (FMPP) that offer 10 to 12 per cent return with 99 per cent certainty. Patel says, “FMPP works on the principle of hyper-diversification. The invested amount is allocated across numerous borrowers, thereby reducing risk.”

Some platforms operate in the cryptocurrency P2P space. Tether (USDT) is an Ethereum token pegged to the value of the US dollar. WazirX, a cryptocurrency platform, can transfer the Indian rupee (INR) to a peer who wants to convert his USDT to INR.

“WazirX currently offers only USDT/INR pairs for P2P trades to keep things simple and ensure high liquidity. USDT is a stablecoin and its price fluctuation is extremely narrow. So, it is very similar to trading in a fiat currency,” says Rajagopal Menon, vice president, WazirX.

Regulated sector

The RBI has regulated P2P lending platforms since 2017. Only licensed platforms can operate. Juneja says, “An investor can invest a maximum of Rs 50 lakh in P2P lending while a borrower can borrow a maximum of Rs 10 lakh.”

How to enhance safety

P2P platforms don’t assure either return of principal or payment of interest.

Juneja says, “The risk of a borrower defaulting is always present. To minimise this risk, first choose safer, already well-rated borrowers and then diversify, i.e., split your investment across multiple borrowers, ideally across different geographies, income sources, and so on.”

Patel adds, “Spread your money across various maturity buckets to reduce risk and increase overall return.”

Lending on these platforms is not the same as investing in a bank fixed deposit. Only lenders having higher risk tolerance should lend on these platforms. The potential higher return offered on these platforms is meant to compensate the lender for the higher risk taken.

Vishal Dhawan, board member, Association of Registered Investment Advisors (ARIA) says, “One way to mitigate risk is to avoid investing more than a defined percentage, say, 5-10 per cent, of your fixed-income allocation to these strategies.”

Some platforms promise that you can take back your money anytime. Dhawan says, “The liquidity that is promised may not always be available as it is based on an assumption that not more than a certain percentage of lenders will seek their money back within a short period.”

Look for transparency

Borrowers should stick to platforms that score high on transparency. Adhil Shetty, CEO, BankBazaar, says, “A good platform will transparently display information on all relevant aspects of borrowing on it. This includes the credit assessment process, processing fee, application process, terms of repayment, and grievance redressal, among others.”

The availability of all these details will allow the borrower to take an informed decision. The absence of any or all of this information, on the other hand, should serve as a potential red flag. “If you do not know the repayment terms, you could inadvertently make prepayments and be penalised for it,” says Shetty.

Dhawan adds, “While these platforms make it easier to borrow, compared to other sources of finance, borrowers should carefully weigh all the options available to them and then zero in on the most efficient source of financing.”

P2P platforms: Weighing up
 

Pros

1. Lenders can potentially earn higher returns on their investments
2. Can generate passive income with a smaller amount of capital, compared to a traditional alternative like real estate
3. Can diversify portfolio beyond traditional avenues

Cons

1. The possibility of default by a borrower, resulting in loss of principal, is always present
2. Many of the borrowers borrowing from P2P platforms do so because they have low credit scores, are unable to get loans from traditional sources, and hence carry higher risk
3. If the platform allocates money across borrowers, as some do, the lender can’t do his own due diligence on the quality of the borrower