Is the answer to recent woes in fintech … more fintech?
Recently allegations of fraud against Lending Club and several Chinese marketplace lenders have some observers calling for more daylight on the loans sold on these marketplaces. Specifically, they're floating the idea of a technology and service that would register and track ownership of the loans and validate basic facts about them and the borrowers.
This could not only prevent marketplace lenders from altering loan dates the way Lending Club allegedly did (to fit a buyer's preset criteria), but prevent fraud of all kinds, bring transparency to the market and calm investors' rattled nerves. BlackRock and Citigroup are among major investors that have reportedly backed out of the market.
"To restore a high degree of confidence from investors in marketplace lending, some kind of independent data repository is essential," said Cormac Leech, founder and director of Liberum Alternative Finance, the fintech incubator subsidiary of the London and New York-based investment bank Liberum (it's a Latin word meaning "freedom of expression"). "It's one thing to say 'If we do all this lending without banks we can save a lot of cost.' But you need to be sure it's happening in a robust way."
Without central data repositories and third-party validations, he said, you're relying on the platforms to do what they're supposed to be doing.
"The concept is sound," agreed Bo Brustkern, managing director of Denver-based Arcstone Partners, which values complex securities and peer-to-peer loan portfolios. He's also co-founder and CEO of NSR Invest, a peer-to-peer lending tech company that provides access to online lending marketplaces for financial advisers, institutional investors and individuals. "It would provide a valuable service for the industry."
Brustkern said he hasn't had grave concerns about the validity of loan data up to this point. But "it was [lack of] data validation that got us into a great deal of trouble in the subprime mortgage crisis," he said. "Avoiding any possibility of that happening in this industry is insurance against that potential dark future."
A validation platform would verify the fundamental data points Arcstone uses to assess loans — "everything from 'Does this borrower exist?' to 'Is this person employed in the way they've stated?' and everything in between," Brustkern said.
Recent events have caused investors to cast a wary eye on marketplace loan portfolios.
"In fintech there's a substantial risk of attracting the greediest or the less-scrupulous people because it's a Wild West at the moment and it's very susceptible to fraud," Leech said. And because investors don't expect to get their cash back for several years, it's the perfect raw material with which to create a Ponzi scheme.
In some cases, marketplace lenders based overseas have posted fake loan deals and spent investors' money on luxury items for themselves. This was the case with the Chinese online lender Ezubao, which stole $7.6 billion in a Ponzi scheme reported in February and whose leaders bought a $20 million Singapore villa, a $1.8 million pink diamond ring, luxury limousines and watches.
A Swedish peer-to-peer lending company, ironically called TrustBuddy, declared bankruptcy in October, after management revealed that millions were missing from client accounts.
Marketplace lenders could also subsidize existing investors' not-so-good returns with new investors' money, the way Bernie Madoff did in his early days, Leech theorized.
There's also the practice of "stacking" in which borrowers obtain loans from multiple online lenders at the same time, slipping through their automated systems due to hasty algorithmic underwriting and patchy reporting of the resulting loans to credit bureaus. This can result in marketplace lenders making loans without the full picture of the borrowers' obligations and deteriorating ability to pay.
And then there's the potential for fraudulently changing loan information, as Lending Club allegedly did to make its aging loans appear fresh. An internal investigation found that Lending Club falsified the documentation on a package of loans worth $22 million.
"The Lending Club thing focused on people's minds that the whole thing is wide open to fraud," Leech said. "Lending Club was the flag-bearer of the space, seen as the highest-quality player. If they're seen to be doing fraud, then imagine what the third-rate guy who's really desperate is doing."
Despite the black eyes, marketplace lending will continue to flourish and will be a substantial, profitable business 10 years from now, Leech predicted.
"I think the genie is out of the bottle," he said. "But to get from here to there, we do need to put infrastructure in place and the challenge is to do it in a way that's cost-effective." Rather than hire an army of compliance and audit people, the market needs a fraudproof, automated system of checks and balances.
"Effectively what we need to do is create very efficient, low-cost robots that go around checking to see that everybody is doing what they say they're doing," Leech said.
One option was launched in May by Global Debt Registry, a company that was originally created to verify and track consumer debt, to bring order and transparency to the rough-and-tumble world of consumer debt collection. It called itself the Carfax of accounts receivable management. (It's still doing this and has several clients, but it's waiting for the Consumer Financial Protection Bureau to issue rules about debt buying that it hopes will free banks to use it.)
GDR has rebuilt its technology to serve a second purpose — validating and tracking marketplace loans. The platform captures loan data at the time the loan is made and registers it, so it can't be altered later. It verifies the identity of the borrower, checks her Social Security number, FICO score, and credit profile, and makes sure she's not on a deceased list. ("Dead people don't pay," noted Mark Parsells, GDR's chief executive.) It makes sure the loan is real and hasn't been bought by someone else, and that the collateral hasn't been pledged elsewhere. Most of the validation happens by pulling data from credit bureaus, anti-money-laundering/know-your-customer databases and LexisNexis.
The ability to verify the flow of money would be critical to such a platform, Leech said, to prevent a marketplace lender from pocketing funds that a borrower is supposed to receive and deviously telling the borrower his loan was not approved. Or from stealing the principal and interest borrowers repay and telling investors the borrowers missed their payments. A service might need to do screen scraping to conduct such checks. For its part, GDR says it is working with banks to have them verify the borrower actually received her loan.
GDR's pivot preceded Lending Club's woes. It came about nine months ago, when a large private equity investor asked it to look into creating an independent service to bring transparency to the consumer loan space, according to Parsells, who in previous work lives was president of Citibank online, chief privacy officer of Bank One and chief compliance officer of the U.S. merchant division of American Express. GDR hired a compliance consulting firm, Bridgeforce, to talk to all the players in the marketplace lending ecosystem.
Investors and warehouse lenders told GDR and Bridgeforce they wanted to know if the loans are real, if the borrowers are real, and if the loan-level data is accurate. "Particularly the warehouse lenders wanted to know, is the collateral being double-pledged?" Parsells said. "They want to have some kind of central place to ensure the collateral being pledged to them is not being pledged to someone else."
Marketplace lenders support GDR's approach, Parsells said, because they want to attract more permanent capital. The company is in pilots with three of the largest ones.
"Our mission in this space is to drive confidence in the underlying assets in the ecosystem," Parsells said. "In the evolution of marketplace lending, this is the next natural step — to put in place new structures that increase confidence and trust in this new asset class."
GDR's work is a start. Others will probably offer other versions of this approach. Like the debt registry idea, this is a common-sense concept that could benefit the industry, including the banks that underwrite and purchase many of these loans.