Banks have been the traditional institutions to approach when it comes to borrowing money. But Daniel Foggo explains SMSFs are beginning to step into this fold.
Our financial system has undergone a structural shift in its balance sheet and now it’s undergoing a technology-enabled transformation. This is enabling innovative new businesses that use efficient technology to cut out traditional middlemen, such as peer-to-peer (P2P) lenders, to open up a range of compelling new investment opportunities for SMSFs.
Banks have had it good for a long time
Which investors in Australia have privileged access to the most attractive asset classes? Based on empirical data, it could be argued the answer is, perhaps surprisingly, not the large investment funds, but the banks. One only has to look at the profits Australian banks make year in, year out from investing in loans, whether personal loans, business loans or property loans, despite their enormous cost bases and inherent inefficiencies. Personal loans possibly provide the best example of this privileged access. According to the latest Reserve Bank of Australia data, the average fixed-rate unsecured personal loan in Australia is currently 14.1 per cent a year, while the average default rate is currently around 1.7 per cent (and has been within a reasonably tight range over the past 20 years). This implies an average annual return, before operating costs, of over 12 per cent, which is attractive, especially in the current economic environment.
But what if there’s a recession and default rates rise? Australia has not had a recession since the early 1990s, but we can look overseas, specifically to the United Kingdom and United States, to develop a picture of how similar personal loans performed during the depths of the recent and severe financial crisis. Many would be surprised by how robustly personal loans performed. For example, in the US, personal loan defaults remained below 2.5 per cent a year at their peak in 2009/10, not so far above their usual 1 per cent to 2 per cent range and significantly below commercial loans and both residential and commercial real estate.
So should we be envious the banks have such privileged access to these loans? Yes, we should.
Structural shifts in our balance sheet
Since the implementation of compulsory superannuation in Australia in 1992, there has been an enormous transition in the make-up of our household and national balance sheets. Money that would have once accrued in bank accounts is now accruing in large superannuation funds and SMSFs. This structural shift will continue for some time. In fact, the Murray report forecast superannuation balances to reach $9 trillion by 2040 and that superannuation may overtake banking as the largest segment in financial services. Taking a step back to think about this structural shift, it is strange there has not been a corresponding shift in how the other side of our national balance sheet is funded. That is, one might have reasonably expected that loans historically funded by banks might now be proportionately funded by superannuation funds and SMSFs. This hasn’t happened – yet.
Our technology-enabled era
Technology is moving at breakneck speed and most of us are embracing it. However, in finance it could be argued it’s been difficult to see how such technology advancements have really improved the value delivered to customers, be they borrowers or investors.
Although progress is now starting to be made. We are now starting to see a vast array of exciting technology-led developments in finance and more often than not these are being led by smaller, more innovative businesses. To appreciate the pace of change, you only need to look at how many exciting businesses have launched in the past few years to compete with incumbents across all areas of finance from payments to wealth management, insurance and lending. Much as we have seen in industries such as publishing, transportation and accommodation, these disruptive new businesses are delivering better value and providing more convenient services to consumers.
Arguably the most significant benefit these advances in technology will bring is a corresponding structural shift in how our lending markets are funded. Technology advancements mean a business no longer needs to be a bank to receive loan applications, look up applicant credit scores, assess the risk of a borrower defaulting or to manage a loan.
Consequently, highly attractive credit classes, previously monopolised by the banks, are now being opened up to other investors, including superannuation funds and SMSFs. The rewards for these investors could be very significant indeed.
P2P – the enabler
Put simply, P2P lenders provide online marketplaces that connect investors and borrowers without a traditional middleman taking their cut. They use the internet and clever information technologies to identify applicants, establish the creditworthiness of applicants, price risk, establish loan contracts, provide the marketplace for loans to be funded by investors, and then administer loans and payments to investors. By cutting out traditional middlemen and using modern technology to streamline processes, these platforms are significantly more efficient than traditional banks, greatly benefiting both borrowers and lenders.P2P lending can introduce greater competition in loan markets and support greater economic growth by reducing friction in financial services, while also removing the liquidity risks and reliance on wholesale funding inherent in our ‘too big to fail’ institutions. And if there is one lesson we should take from the Great Recession, it is that diversity fosters resilience. That is one of the reasons why the industry is benefiting from political and regulatory support in a number of geographies.
The global P2P lending industry is currently small relative to the size of global debt markets, with only around $25 billion in loans facilitated by P2P lending platforms in 2015 (excluding China). However, the industry is growing rapidly and there is an expectation this growth will continue for some time. Investment bank Morgan Stanley estimated last year that in Australia the industry would grow to nearly $20 billion by 2020, although this may prove optimistic.
Connecting investors and borrowers
There are two main P2P lending models – the ‘Lending Club’ model, named after the largest US-based operator, and the ‘RateSetter’ model. With the Lending Club model, investors can choose to invest in different loan categories, generally ranked by the relative probability of default of the relevant borrowers. Under this model the investor is directly exposed to any borrower defaults and it is therefore important to gain significant diversification across a number of loans. Operators typically simplify the diversification process with options to automate investments across different loan categories and across loans within each category.
Under the RateSetter model, launched in the UK in 2010 and used by RateSetter in Australia since its launch in 2014, every borrower who takes out a loan pays a fee into RateSetter’s Provision Fund, which is a pool of money set aside and held in trust to help protect investors from any borrower late payment or default. The provision fund structure has ensured every individual investor has received every amount of principal and interest due to them.
Having the Provision Fund also simplifies the investment process in that the investor only needs to choose a lending term – one month, one year, three-year income or five-year income – an amount they wish to lend, and the rate at which they wish to lend. The interest rate in each of RateSetter’s lending markets is not set by RateSetter, but determined dynamically by the supply and demand for money from lenders and borrowers.
P2P lending is a regulated industry
RateSetter forged the path for true P2P lending in Australia: RateSetter was both the first to gain a financial services licence specific to P2P lending from the Australian Securities and Investments Commission (ASIC) and the first to allow investment by retail investors and SMSFs. The regulatory framework for P2P lending in Australia is, in our view, best-in-class. While the form of regulation may depend on the operator’s exact business model, operators will ordinarily need to hold an Australian credit licence (ACL), an Australian financial services licence (AFSL) and structure investments through and comply with the regulatory requirements of a managed investment scheme (MIS). Sensibly, to be allowed to accept retail investors, an operator needs to adhere to much higher regulatory thresholds, governance and reporting obligations, including qualifying to operate an MIS that is registered with ASIC (as opposed to an ‘unregistered’ MIS), which provides additional protections for investors.
P2P lending provides a middle ground for your SMSF portfolio
P2P lending has a strong track record internationally for providing investors with attractive and stable returns. The introduction of the industry to Australia hence provides investors with a much-needed middle ground between low-yielding bank accounts and higher-risk equites. The fact most bank accounts in Australia are currently providing negative real returns, and that globally listed equities are currently experiencing significant volatility, only adds to the appeal of this middle ground.The industry also lends itself well to SMSF investors who are seeking attractive longer-term investment opportunities. By way of example, RateSetter’s five-year income market rate is currently over 9.5 per cent annually, after fees with the added protection of the provisional fund structure. Furthermore lending markets currently on offer can appeal to SMSF investors both in the accumulation and pension phases, as they allow investors to automate the reinvestment of borrower payments such that all amounts are invested, or where an income is required, just the capital amount, with interest paid to the investor as a form of regular income.
The attractions of P2P lending for SMSFs are not going unnoticed. At RateSetter we have experienced a significant increase in SMSF investor interest over recent months, with SMSF funds now representing around 25 per cent of all funds being invested on our platform.
Looking ahead, it is our belief this trend will continue and P2P lending will soon commonly feature in any well-balanced SMSF portfolio. We expect to see investors reduce their bank deposits and holdings of bank shares, and use P2P lending platforms to invest directly in the assets the banks have historically monopolised. We think this will be good for investors, borrowers and the broader economy.