Is it really needed?
While the European crowdfunding industry is still waiting for a formally adopted regulation that will limit and set specific rules that platforms will have to comply with, each of them has the option to offer investors different ‘so-called' safety options. And here we are mainly speaking about the different guarantee funds with the aim to safeguard investor’s money in the case of defaulted projects. In this article, we will take a deeper look into two of the most common methods practiced in the industry – Provision Funds and Buyback Guarantees.
Of course, there are discussions about which method is the most useful and whether they are needed at all. While some find them misleading all together and think that these funds do not fulfill their basic idea, or even worse, they are just different labels of non-existing security. A survey made by P2P analysts Robo. cash showed that having a buyback guarantee is the second most attractive feature of crowdlending platforms. They have surveyed investors across 15 countries in Europe and 74% of investors have valued this function as attractive. Only the auto-lending feature was valued higher, with 79%.
How it works?
These features are not limited only to the FinTech crowdlending platforms. In a way, they have been long known in the traditional financial industry as well. For example, a definition from Investopedia states that a buyback, also known as a share repurchase, is when a company buys its own outstanding shares to reduce the number of shares available on the open market. Companies buy back shares for a number of reasons, such as to increase the value of remaining shares available by reducing the supply or to prevent other shareholders from taking a controlling stake. However, in P2P and P2B lending industry it has a slightly different interpretation.
In the crowdfunding, the purpose of these funds and guarantees is to offer a mechanism that ensures the payment of a certain amount of money to safeguard the Investor’s return in case the borrower is subject to a default and offer a proper buffer in case of a project’s failure. Platforms offer different guarantees with different types of calculation methods and the effects on both investors and platforms themselves. P2P Market Data has described the two most popular types of guarantees that were already mentioned above:
- Buyback Guarantee - based solely on the guarantee or promise of the entire company behind the platform/loan originator to be buying back defaulted loans.
- Provision Fund - based on a tangible amount of cash or other highly liquid assets, stored in a specific unit that is protected against the company/platform operational risks and with only one purpose: to pay lenders in case of a default.
P2P Market Data has also provided a solid list of all Buyback Guarantees and Provision Funds in the market of P2P Lending with a short explanation of how they are structured. Nevertheless, information about the CROWDESTOR’s method has been following the old example up until now, as we have decided a change was needed to be made. Let’s see how it looks now!
We have chosen the Provision Fund method not only by the wording, but also by its functionality. Since the aim of it is to safeguard the Investor’s return in case of the Borrower is subject to a default, we want to let the Fund fulfill its very essence and be a proper buffer in case of a project’s failure. Global default rates depend strongly on the loan model and risk category of the borrower. While the average P2P default rate is around 12%, P2B platforms are considered safer, and the average default rates on platforms vary between 1% and 10%. Therefore, we are implementing the 10% as the most secure ratio in the calculation of the amount to be reimbursed by our Provision Fund. So, in case of the default, the total amount of the funded loan for this defaulted project will be converted to a percentage of the total amount of 10% of all the outstanding loans. The same ratio is taken then from the Provision Fund and split between the investors of this project accordingly. See the example below:
A funded loan amount – 100’000 EUR
The total amount of all outstanding loans – 20’000’000 EUR
Provision Fund Status: 360’000 EUR
- 360’000x5%=18’800 EUR
So, in this case, the total amount of 18’800 EUR will be distributed to the investors in proportion to the amounts invested by them. CROWDESTOR is devoting a commission of 0,5% from each project that has been funded via CROWDESTOR’s platform into the Provision Fund. Status of the Fund will be updated in the first week of each month.
Taking Risks into account
One of the oldest P2P platforms, RateSetter, has been the pioneer of offering the provision fund model. However, as it is stated in the P2P Finance News, “although RateSetter’s provision fund has so far had a good track record, the company notes on its website that it is not a guarantee of the future and that investors’ capital is at risk if the provision fund were to be depleted by increased borrower defaults.” Indeed, it is important to understand that the existence of a fund does not guarantee the full or partial repayment of lost investments and investors must still take into account all the risks associated with them.
At the time when CROWDESTOR created this type of guarantee, we were one of the first P2B platforms in the region that offered such an option. Similar as in the case of the Rate Setter, it was never an intention to mislead the investors and it is important for investors to understand that the invested principal would not be reimbursed in full amount.
While in the case of a lender's default, traditional banks rely more on collateral, alternative online crowdfunding platforms differ in the way how they use this collateral because they are more inclined to lend to creditworthy companies that have fewer physical assets. Although risks and collateral are a very broad topic that should be discussed in more detail (and we promise to do so in one of our upcoming blog posts), however, we will have to touch on it a bit this time as well. Together with the diversification opportunities, P2B industry might also indicate higher risks. And we believe that the Provision Fund is an effective way to help manage the risks and alleviate investors uncertainty when choosing platforms and projects for investing.
Offering buybacks and provision funds do not guarantee success to platforms and do not exclude investment risks to investors, however, it clearly improves the chances of getting the desired outcome for both sides. While there still might be discussions in which features are being valued the most, one is clear - the investor’s success will guarantee the platform’s success. That is what we are aware of and strive for.