Peer-to-peer lending: how it works and the risks regulators name

What peer-to-peer lending is

In peer-to-peer (P2P) lending, you lend money through a website or an app to people or businesses who want to borrow, and they repay you with interest. The UK’s Financial Conduct Authority (FCA) describes it this way: “Peer-to-peer crowdfunding connects people who want to borrow money directly with those willing to lend it.” You “lend money to a borrower and receive repayments over time, usually with interest. The platform takes a fee for arranging and managing this.”

Some platforms lend to individuals, others only to businesses. Malaysia’s Securities Commission (SC) describes P2P financing as “a lending and borrowing activity between businesses and investors, facilitated through an online marketplace”. The EU’s crowdfunding rules also cover only loans to businesses: they do not apply to crowdfunding for “project owners that are consumers”.

This guide recommends no platform. It explains what can go wrong and what regulators that publish rules on P2P lending require.

Where the return comes from

Your return is the interest borrowers pay, minus the platform’s fees and minus the loans that are never repaid. The FCA reminds lenders that “Higher rewards usually come with higher risks, including the risk of losing your money.”

EU rules make the losses visible. A platform must “disclose annually the default rates of the crowdfunding projects offered on their crowdfunding platform over at least the preceding 36 months”, and any target return it shows must take “fees and default rates” into account.

An illustration with made-up numbers: you spread 1,000 across 20 loans of 50 each at 14% a year. If two borrowers stop paying early and nothing is recovered, you lose about 100. The other 18 loans earn about 126 in a year, so your gain shrinks to about 26 — 2.6% — before fees and tax. Three or four defaults would leave you with a loss.

The risks regulators name

• Borrowers default. “If the company you’ve invested in fails, you might lose all the money you have invested.” (FCA)
• No guarantee of any return. The EU’s standard warning reads: “You may not receive any return on your investment.”
• You may not get out. The FCA: “You also may not be able to get your money back quickly, or at all should you need it.” Some platforms let you sell loans to other lenders, “subject to a delay, although you may not get back all of the money you invested.”
• No deposit insurance or compensation. In the UK, loan-based crowdfunding is high-risk, and “you won’t have access to the Financial Services Compensation Scheme (FSCS)”. In the EU, platforms must tell clients that their services are not covered by the deposit guarantee scheme, and the standard warning says the investment is not covered by investor compensation schemes either.
• The platform itself fails. The EU requires platforms to have business continuity plans “addressing the risks associated with failure of a crowdfunding service provider”, which could include “the continued servicing of outstanding loans”. Ask any platform who would collect repayments if it closed.

Rules that limit what lenders risk

Where P2P lending is regulated, the rules aim to stop people from lending more than they can afford to lose:

• European Union: before giving full access, a platform tests a new non-professional investor’s knowledge and asks them to simulate their ability to bear loss, “calculated as 10 % of their net worth”. Each time such an investor puts in more than “the higher of either EUR 1 000 or 5 % of that investor’s net worth”, they must receive a risk warning and give explicit consent. They can withdraw an offer during a reflection period that expires “after four calendar days”. The standard warning adds: “This is not a savings product and we advise you not to invest more than 10 % of your net worth in crowdfunding projects.”
• Malaysia: platform operators “Must be registered with SC”, and a business must raise at least 80% of its target before the funds are released. There is no legal cap for investors, “but retail investors are encouraged to limit their P2P investment exposure at RM50, 000 at any given time.”
• United Kingdom: the FCA’s general guidance on high-risk investments is to put “no more than 10% of your total net assets in high-risk investments”.

If a platform is not licensed where you live, none of these protections may apply to you.

Before you lend

1. Check on your regulator’s own website that the platform is licensed; in the UK, the FCA calls this the Firm Checker.
2. Read the platform’s published default rates and how it calculates them.
3. Ask what happens to your loans if the platform closes, and where your uninvested cash is held.
4. Ask whether you can sell loans early, how long that takes and what it costs.
5. Remember that small amounts across many loans limit the damage of one default, but not of a downturn that hits many borrowers at once. Lend only what you can afford to lose.