Mitigating the Risks of Crowdlending

Each and every
investment in this world has a certain degree of risk associated with it, right
from a near-zero risk savings account to the riskiest investments like
cryptocurrency. The returns, understandably, are always proportional to the
risk that the investor is willing to take. The smartest of the investors do not
shy away from risk and instead spread their investments across the entire risk
spectrum.

While the choice
of asset classes is crucial for management of investment risks, the execution
of investments in each asset class is equally (or perhaps more) important for
effective mitigation of risks and generating great returns. One of the emerging
asset classes that are gaining increased attention from the investing class is
Crowdlending (also called P2P Lending). This growth in investments in the space
is largely fuelled from word-of-mouth promotions by the early investors in
Crowdlending, who have been able to generate phenomenal returns over the past
few years. In this post, we will discuss in detail the risks associated with Crowdlending
and strategies to mitigate those risks to ensure good returns and minimize
chances of loss.

Don’t Put All Your Eggs in
One Basket

5X-15X
returns compared to savings accounts are of course very tempting, but you will
be subjecting yourself to huge financial risks by investing your entire money
into Crowdlending or any other medium-high risk asset class. The future is
always uncertain. We have witnessed everything from triple-digit returns to
entire markets vanishing overnight due to regulatory changes. The wisest
strategy is to keep your investments spread out across asset classes, from FDs
to stocks to relatively risky investments such as crowdlending and so on.

Diversify, Diversify,
Diversify

The
single most important rule for making profitable investments, especially in
asset classes falling towards the higher side on the risk spectrum, is to
diversify as much as possible. The same holds true for Crowdlending as well. To
start with, it will be prudent to not invest the entire money you’ve decided to
allocate to Crowdlending on just one platform. You need to do your research and
try to identify at least 3-4 good P2P lending platforms to make your
investments in. Such a practice protects you against the possible failure of
the lending platforms.

Crowdlending counts among the asset classes that
offer almost unmatched possibilities of diversifying your investments. As an
investor, you need not commit to funding a full loan. You can choose to fund a
small slice of that loan, with many platforms offering an option to invest as
little as €5-€10 in a loan. You are advised to make full use of this facility,
and make small investments in a large number of loans to reduce the overall
impact of a possible default.

Further, almost every platform offers investment
opportunities ranging from low to high risk (and proportional returns). To
optimize returns while keeping the risk in check, you must spread out your
investments across the interest rate spectrum.

Borrower Due Diligence

If you have ever
applied for a loan from a bank, you can’t forget the pains of the process and
the piles of documents they ask from you. The process, while irritating and
cumbersome, is a necessary evil and has managed to keep loan defaults at
single-digit figures over the last century. The onus of due diligence, when it
comes to crowdlending, shifts to us, the investors. It would be impractical to
aim for bank-level due diligence, but using common sense to estimate the
chances of a default based on available facts is a better tactic than blindly
investing. Almost all the platforms conduct their due diligence before they
place loans for investment on their platform, but platforms present different
levels of information to investors. It is always safer to go for more
transparent platforms that present maximum loan-level information to facilitate
decision making.

Lender Due Diligence

Depending on the model of the crowdfunding platform, the loans are either originated on the platform itself or already originated loans are placed by the lenders for investments. Investment in the second category of platforms runs an additional risk of default/bankruptcy of the lender. While investing in such platforms, you also need to research the lender(s) before investing in their loan. Again, exhaustive diligence is not practical, and a look at the lender history, licensing, country of origin and local regulations, loan volume and historical default rates suffices in most cases.

Platform Due Diligence

From nil
regulation a few years back, the Crowdlending industry today is subject to
ever-increasing regulation. The current level of regulatory requirements,
however, is way below the stringent norms for traditional financial
institutions. When centuries-old banking institutions can collapse, it is
relatively more probable for a crowdlending platform to fail. It is thus
crucial for you to put effort and select a few good platforms for investment
after due diligence. Platform history (age, volume, default rates, average
interest), founding team, VC backing, and media coverage are among the
important things to consider.

Liquidity Considerations

Most of us have
days in our lives when proceeds from the regular source of income do not
suffice and we need to tap into our savings/investments. If you count among
those who have insufficient liquidity to sail through difficult times, you
should avoid longer-term investments in Crowdlending. Some platforms just don’t
allow investors to withdraw investments, while some charge huge penalties for
premature withdrawals. The best ones facilitate liquidity through secondary
markets and buyback options. The choice of platform is also important from this
perspective.

Platform Protections against Default

To make their
offering attractive to investors, an increasing number of platforms are
offering a buyback guarantee in the event of a default. Most of the platforms
offer only principal protection, but some rare ones compensate for the loss of
interest as well. The presence of this protection on a platform is a big plus,
but we need to go beyond the mere presence of this feature and understand the
source and operating mechanism to get a true sense of the protection. It is
usually better if the guarantee is given directly by the lender. If that is not
the case, it means that the guarantee is facilitated by the platform that
purchases defaulted loans using its contingency fund. In that case, the ability
of the platform to cover for the losses is limited by the size of its
contingency fund. You can, thus, give preference to platforms/loans with this
feature while keeping the source and operating mechanism in mind.

Another
protection mechanism slowly making its mark in the market is insurance. Insured
loans are way safer, but only a handful of platforms are currently offering
them. Besides, such loans come at significantly reduced interest rates offered
to investors. As the insurers get better at quantifying the risks of crowdlending
and start offering this protection at better prices over time, this protection
mechanism is expected to gain prominence.

Money Drag

No one likes it
if their money is sitting idle. Such a situation can arise with crowdlending,
even when many of the platforms offer auto-invest options. The platform on
which you have invested needs to have a steady flow of loans matching your
criteria for that to not happen. You must also set a frequency (monthly or
fortnightly) to review the status of investments in all crowdfunding platforms
to prevent this effective loss (if we account for inflation) from happening.

Conclusion

Each and every
investment is bound to have an associated risk, which is compensated through
higher returns. To ensure great returns on the investments, one must practice
and perfect the art of balancing risk and returns. Investors, both
institutional and retail, today are willing to explore new, emerging asset classes
like crowdlending and are reaping benefits. We encourage you to invest in crowdlending
while taking care of the above pointers to make your investments less risky and
more rewarding.

If you are just
starting, please start small and gradually increase exposure as you learn the
ropes. To reap true benefits, you need to invest for reasonable periods to gain
from the effects of compounding, just like any other asset class. Happy
Investing!

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