This thought piece provides a broad overview of what practices define the term “marketplace lending” and to what types of assets these pertain – primarily consumer and small business loans. Given its low-cost structure, marketplace lending offers advantages over more traditional methods not only through increased financial incentives to both borrowers and investors (proxy lenders), but also by creating access to credit where it was previously limited or completely unavailable. Although increased scrutiny from federal agencies has grown alongside the industry, no significant regulation has hindered marketplace lending yet, and with the potential to help refinance billions or even trillions of existing outstanding debt, it is definitely an asset class to watch.
What is Marketplace Lending
“Marketplace lending is the process of connecting non-originator loan investors with borrowers.”
Although there are a variety of definitions that include tools or set rules for what a “marketplace lending” platform may look like, it is really as simple as this straightforward definition.
There are generally three methods for funding a loan. First, loans can be funded by deposits, which is how banks operate. Second, loans can be funded by the balance sheet of a loan origination company. These are generally called balance sheet lenders. Third, and finally, loans can be funded by investors who are not related to the originator (unlike a balance sheet lender), but who do take on both the financial risks and rewards of those loans (unlike depositors). Marketplace lenders typically fall into this third bucket, although many take some of that second bucket’s balance sheet risk. There are a variety of arguments for what amount of balance sheet risk would disqualify a platform from the marketplace lending bucket, but the Marketplace Lending Association assigns an upper ceiling of 25% of origination on balance sheet to qualify.
Technology is often cited as a mandatory part of marketplace lending platforms, but technology is really just a tool that has helped allow marketplace lending to emerge and grow. Traditional mortgage brokers are technically a form of marketplace lending, despite there being much less technology forming that marketplace or driving its underwriting. While it should still be classified as marketplace lending, few would put it in that category.
Types of Marketplace Lending
Current marketplace lending generally involves one of four primary asset classes: unsecured consumer debt, student debt, small business debt (generally loans of $500K or less), and real estate. Real estate encompasses a variety of debt (in some cases convertible or even equity) types, including project financing and mortgages. However, most marketplace lending references are to unsecured consumer debt due to the early roots of notable marketplace lending platforms, such as Lending Club (2007), Prosper (2006), and Zopa (UK 2005). The first small business marketplace lender is traditionally considered Funding Circle (UK 2010).
Crowdfunding is often overlapped with marketplace lending, however crowdfunding is just a subset of marketplace lending in the United States. While Lending Club and Prosper started as peer-to-peer (P2P) lenders where all loans were funded by multiple investors (i.e., crowdfunding), in early 2013 these two platforms began to offer up whole loans where larger – generally institutional – investors could purchase the entire loan. This addition opened up a much larger channel of distribution for marketplace lending platforms and spurred much of the growth from 2013 onwards. Today, there are actually very few platforms that fractionalize loans for the purpose of crowdfunding, primarily due to the expensive legal and regulatory barriers to entry.
Advantages of Marketplace Lending
Marketplace lending provides significant benefits to the lending industry, primarily driven by the natural market dynamics or the “wisdom of the crowds.” The platforms strive to create an attractive value proposition for both sides of the marketplace. The Marketplace Lending Association highlights how the low-cost operating model for platforms allows for lower rates for borrowers as well as solid returns for investors. Lending Club touts a survey where their borrowers reported reducing the interest rate on their credit card balances by 6.6% on average (from 20.6% down to 14.0%). Similarly, Lending Club reports that roughly 99.8% of diversified portfolio investors have seen positive returns on their portfolios, with the platform averaging a net annualized return of just above 7% since 2007.
Investors then close the circle on the marketplace by deciding if these net returns are worthy of their investment portfolios’ required rate of return. To begin with, investors have the ability to choose among platforms, opining on which platforms provide the best products, highest potential returns, lowest perceived investment risks, and least counterparty risk. Operational and platform risk is at the core of investor decision-making in this industry. Next, investors can often pick among multiple product offerings within each platform. Examples of this are different credit classes (e.g., prime vs. near prime), asset types (e.g., student vs. unsecured personal), duration products, or debt types (e.g., revolving vs. term). Finally, some platforms allow for even more nuanced credit grade or loan-level selection within those product types. The ability to customize their portfolios is highly attractive to investors, and this has allowed the marketplace to thrive as platforms vie for investor capital.
Another benefit of marketplace lending is that it allows for greater transparency than was previously available to investors in these types of lending products. Providing loan-level credit and performance data is an integral feature of marketplace lending. Historically, access to consumer credit has come through credit card ABS, where portfolio stratification was the deepest level of data provided to investors, or fixed income funds, which might provide high-level exposure information at best. With almost every marketplace lending platform, investors can access deep transparency on their loan portfolios.
Finally, increased credit availability is a significant benefit of this industry, especially in lower prime consumer credit and lower dollar size small business loans. Starting at the middle range of the prime credit spectrum, credit availability for unsecured term loans from banks becomes scarce. Borrowers of that or lower credit profiles primarily access personal credit through the credit card market, where rates can fluctuate significantly. Borrowers at the low end of near prime and in the sub-prime category start to lose credit card availability and are forced to utilize payday lenders for credit. The unsecured personal loan marketplace lenders are attempting to address all of these under-served borrowers with new credit availability. Additionally, small business lending from banks has dried up significantly over the past decade. “Small business loans on the balance sheets of banks are down about 20%” from the financial crisis through mid-2014, primarily due to regulatory constraints, fewer community banks, risk consolidation, and lower profitability on underwriting small dollar loans. Marketplace lenders have stepped in to provide credit to small businesses needing less than $1M, and more significantly to those needing less than $500K.
Regulation of the Industry
The marketplace lending industry in the United States has been through a variety of regulatory challenges. The first and most significant challenge came in 2008 when the SEC approached Lending Club and Prosper in regards to selling unregistered notes and securities. As a result, both platforms ended up registering their fractional notes in a shelf offering with the SEC.
More recently, a variety of regulatory bodies have started reviewing the industry to understand the benefits and protect borrowers and investors if and as they see fit. The Treasury initiated an RFI, which was followed by a white paper detailing their analysis of the industry. Separately, Congress has held multiple hearings on small business lending, the Consumer Financial Protection Bureau has acknowledged the industry by allowing direct complaints and responses by marketplace lending platforms, and the FDIC and US Government Accountability Office – among others – have issued comments or reports on the industry. That said, very little hard regulation has been put in place yet, as these regulators continue to explore issues and discuss solutions.
Perhaps the most significant regulation has come in the form of case law set by the Second Circuit regarding Madden vs. Midland. This case challenged the ability to charge interest rates above state usury caps, which is typically allowed by federal preemption of state usury laws on loans that are originated in one state to borrowers in another state and then sold to another party – a standard part of most marketplace lending platforms’ issuance structures. The effect this ruling could have on the marketplace lending industry remains to be seen, as the decision has been challenged by many, and the case was appealed to the Supreme Court before being sent back down to the district court for further review.
Growth and Future
Marketplace lending has experienced significant growth since its inception roughly a decade ago. After Lending Club and Prosper together originated a little under $1B of loans in 2012, we estimate that the four largest unsecured consumer marketplace lending platforms together originated roughly $15.5B in 2015. Similar growth paths have been seen for small business and student loan originations by marketplace lending platforms in aggregate.
However, the real potential for this asset class may be significantly larger. Most studies put the unsecured consumer credit market at almost $1T in total size. This primarily consists of unsecured credit card debt, which represents over $800B of assets, and is the primary target market for refinance and consolidation marketplace lenders. Student loans similarly are now over $1T in outstanding debt. Small business loans under $1M are estimated at roughly $300B in total size. And, of course, the elephant in the room is the mortgage market at almost $9T outstanding. Amazingly, this is only in the United States. While these markets may never move entirely to marketplace lending, a shift has clearly started.
 Harvard Business School, “The State of Small Business Lending”, Karen Gordon Mills, July 22, 2014