In peer-to-peer marketplace lending, knowledge may not be king
When it comes to peer-to-peer lending, what’s good for the goose isn’t good for the gander.
More specifically, when a marketplace lending platform makes an increasing amount of detailed information available to lenders, sophisticated investors often benefit; unsophisticated investors are often disadvantaged, and the platform as a whole may suffer.
This according a new study co-authored by Yao Zeng, an assistant professor of finance at the University of Washington Foster School of Business and Boris Vallée, an associate professor of business administration at Harvard Business School.
Their study investigated how sophisticated lending marketplace investors use advanced information and who benefits—the savvy, the unsavvy, or the platform itself. The conclusion? In peer-to-peer lending, information transparency is not always a good thing.
“There’s an optimal point at which we must think about how much information the platform should provide to investors,” says Zeng.
In the case of lending marketplaces, information transparency can eliminate competition among different investors, especially among investors with different levels of sophistication.
A new form of lending
Fintech is changing the game in lending. The emerging model of marketplace lending is not like traditional bank lending, wherein the bank performs vigorous due diligence: heavy initial screening, evaluation of FICO scores, office visits for business loans and more.
In the peer-to-peer lending space, new marketplace platforms such as LendingClub and Prosper collect information from loan applicants without extensive screening and then present that information, and the loans, to investors. Then, a marketplace composed of sophisticated investors and unsophisticated investors alike picks the best loans to fund.
Zeng and Vallée define unsophisticated investors as those who typically buy loans passively, or without utilizing advanced information. They are the everyman of investing.
Sophisticated investors are investors with advantage and expertise—hedge funds and pros like Warren Buffett. They actively produce information and use proprietary modeling to further screen loans. Sophisticated investors also are able to utilize advanced information that a platform provides—typically for a cost—to their advantage in evaluating loans. When more sophisticated investors have access to and use additional information from the marketplace, they screen loans differently and outperform less sophisticated investors. That overperformance shrinks when sophisticated investors have less information.
Advantage: information and speed
Zeng says that sophisticated investors typically have two advantages over unsophisticated investors: information and speed.
They can typically procure additional intelligence about individual borrowers and loan risk then purchase a high-value loan within seconds. Investors with less of this information—unsophisticated investors—are left waiting for informed investors to move before they can buy a loan. By the time the unsophisticated investor gets to the platform, mediocre or risky loans are often all that remains.
A paucity of quality loans can drive unsophisticated investors from the marketplace.
Yet equilibrium in the marketplace is critical. “At the end of the day, the marketplace cares about two things: the volume of loans and the quality of the loans,” Zeng explains.
So, having both kinds of investors in the marketplace is crucial to a platform’s success. Sophisticated investors help the platform pick the best loans and improve the overall quality of the loans being offered. The cost, however, is that such sophisticated investors drive average investors out of the marketplace.
If a marketplace lending platform is filled with only sophisticated investors, the quality of loans may be exceptionally high but, because the number of lenders has been driven away, the volume of loans will be low. Alternately, if the marketplace is filled only with unsophisticated investors, then the volume of loans will be high, but the quality is low.
Recognizing that information was at the crux of sophisticated investors’ advantage, Zeng and Vallée conclude that, when it comes to lending marketplaces, information transparency may not be the best policy. Rather, to keep the market balanced and competition level, a platform should provide some, albeit limited, information to all parties.
Lowering information provisions not only evens the playing field for different kinds of investors, it subsequently maximizes both loan volume and quality. It would be a win for the platform, investors and loan seekers.
In the end, the optimal distribution of information in marketplace lending turns out to be less-is-more.
“Marketplace Lending: A New Banking Paradigm?” was published in the May 2019 issue of The Review of Financial Studies.