Now that we know how platform lending works, let's look at a business model and main risk factors. Platform or P2P lending can broadly be classified into two types, P2C and P2B. Now the word P or peer is misleading because first of all, these platforms are not de-centralized peer-to-peer networks. They're instead central funding hubs. Second, on these platforms, the peers could be anyone. Both individual investors and institutional investors like hedge funds, venture phones, and even banks could participate in either type of platforms, and they're increasingly doing so. That's why perhaps platform lending is a more accurate terminology. Given that the first type of lending platforms, primarily catered to individual borrowers. Platform lending originated from this type, with LendingClub and Prosper among the earliest innovators that popularized this concept. The model has since been expanded to incorporate other non-financial data and spread to other countries around the world. The second type of lending platforms, primarily catered to businesses, particularly, small to medium-sized enterprises or SMEs that traditionally have a hard time getting financing from banks. Because of their smaller size, they usually don't have a credit rating or a long business history. Online lending platforms, on the other hand, will try to connect these businesses, directly to lenders who desire to have this type of risk exposure, may be presenting their data that shows the credit profile of these businesses in non-traditional ways. Funding circle is probably the most well-known P2B platform in the United States. But this model is again used in countries all over the world. But despite the different power types, these platforms work in a very similar way. They're like any other online marketplace, that directly matches buyers and sellers. In this case, they match the buyers and sellers of credit, and just like other online marketplaces, they aim to bypass the traditional brick-and-mortar institutions, by putting a heavy emphasis on efficient data analytics. As we've seen earlier, instead of a reaching a decision in a matter of weeks, the platforms could perform the data analytics in a matter of minutes. Moreover, because of their online focus, in many markets, they're able to incorporate other non-financial data, like social media data or online shopping behavior into the risk model to build a more complete profile for the borrower and the banks. Other platforms like Upstart, for example, use borrower's school of graduation, academic performance, and work history to get a updated risk model beyond just FICO scores. On the business side, large online retailers like Amazon had begun to leverage the rich transaction level data from the millions of merchants on their platform to estimate their credit profiles and provide direct lending solutions to these merchants. So what we have seen in the last couple of years is a real change in the lending landscape. At the beginning, the online platforms went up to a really the low grade borrowers who wouldn't be able to get any financing from a bank otherwise. Now, they have expanded into the mainstream and are being used by more prime great borrowers as a means to consolidate existing liabilities and financing new consumption or investment. Because these loans will ultimately be underwritten and serviced by banks, they also represent new customers and new businesses for these banks. But the picture is not all rosy, because just like any other type of lending, platform lending comes with a sizable set risks that platform or otherwise, need to be considered by investors and inspiring businesses before jumping in. The first type of risk is macroeconomic. We've seen that by cutting each loan into many smaller pieces of notes and allowing investors to hold a diversified portfolio of these notes in the same category, the platforms could reduce investors exposure to idiosyncratic default risks. However, no diversification would reduce systematic default risks, risks that hit all borrowers at the same time. A prime example is the macroeconomic condition. This graph from the Federal Reserve Bank of St. Louis shows the default rate over time for all loans, all consumer loans, and all credit card loans over the last three decades. As you can see, there's definitely a pattern to these defaults. During the recessions in 1998 and 2008, for example, defaults shut up across the board, and many borrowers are forced to default or at least delay payments because of the tough economic conditions, regardless of their long grade. This poses a challenge from the marketplace perspective. Because during these periods of concentrated defaults, the investors will also tend to stay away altogether. So precisely, during periods where people need credit the most, we might have the highest level of market imbalance by having the fewest investors on these platforms. During the last financial crisis of 2008, platform lending was just getting started, and concentrated defaults have remained low since then. Therefore, we should keep a keen eye out for the impact on these platforms, should macroeconomic conditions change in the future. The other type of risk of platform lending is microeconomic in nature. The industry is just incredibly competitive because you don't really need much to become a lending platform. Have a website, a risk model, and a bank partner, you can launch a platform. Consequently, the business has expanded dramatically, particularly, in emerging markets like China, where P2P lending business has been ubiquitous. Well, this is good for the platform participants because the platforms compete aggressively on fees. It's also bad for the participants because there could be unscrupulous players among the new entrance. Regulators, especially in markets like China, hadn't really paid too much attention to these platforms until recently, and as a consequence, there was a boom in fraudulent P2P platforms, which were essentially Ponzi schemes where there were no real borrowers, and investors were paid with new investor money. Another beneficial consequence of the high competition is that the platforms are constantly seeking to differentiate themselves with new products and solutions. One example is the opening of the secondary market for the platform loans. That is, in addition to being just a lending marketplace that originate these loans, sells them to the investors and let him holding onto it for the entire term, why not also open a parallel marketplace for these investors to trade the loans among themselves as well. This way, the investors connected their positions before the loans mature, and the platforms can collect extra revenue from the trading service fees. We'll continue to see innovations like these in the platform lending space.
