10 Reasons Why a BuyBack Guarantee is Better than a Provision Fund

This summer, the rebuildingsociety team launched, created a major innovation in P2P lending, the Peer-to-Peer Lending Buyback Guarantee (BBG). It allows a primary lender to act as guarantor to microloans they sell onto secondary lenders, in exchange for a premium of its value. This is the first example of a scenario where the risk and reward are divided between two lenders on the same loan. The FCA was consulted at various stages of design.

Guarantors must be sophisticated or HNW lenders to provide guarantees, but anyone may buy microloans with a guarantee. Purchasers incur a temporary loss as they pay a premium, in addition to the value of the capital on the loan, in exchange for the interest receivable on the original microloan. Effective Buyer Rates vary from 4% to 10%.

To help manage lender exposure and risk, we’ve created various limitations and restrictions to Guarantors, for example, they must maintain a portfolio whereby the value of guaranteed microloans does not exceed 40% of the value of their portfolio. It’s early days still, but the oversight and monitoring suggest that all guarantees will be honoured.

The Better Known ‘Provision Fund’

Provision funds have been used by many peer-to-peer lending platforms for a number of years, with varying levels of success.

Provision funds work by ‘pooling’ a margin taken on each of the loans and then promising to pay out in the event of default. The level of payout and the time from default to payout varies as they tend to be administered at the discretion of each platform.

Why an Alternative?

For several years, we have wanted to introduce a risk-mitigating structure that helps protect risk-averse lenders, however recognising the weaknesses of a provision fund, we wanted to find another way.

Let’s consider the advantages of the BuyBack Guarantee scheme over a provision fund:

  1. Provision funds are universal. You can’t opt-out of a provision fund.
  2. The BBG is flexible. You can manage how much of your portfolio you want to be guaranteed. New, or very risk-averse lenders may want 100% guaranteed microloans. As your risk appetite changes, you may increase the proportion of microloans without a guarantee.
  3. Unlike a provision fund (or traditional insurance), premiums are not pooled. They go to a lender who can immediately re-employ the capital & premium. Provision funds are ring-fenced and become restricted funds that cannot be put at risk. This creates cash drag, whereas the re-employment of funds supports the compounding of returns.
  4. There is no ‘claims process’. The BBG is automatically triggered from day 61 (past any due repayment). Many provision funds work at the discretion of the platform, so lenders don’t always know when to expect a payout or the level of the payout.
  5. Provision funds are hard to balance. They generally have too much money sat idle, or too little, undermining the protection they are intended to provide.
  6. Defaults and enforcements are transitioned to people who accept and understand the legal enforcement process, its delays and complexity. A provision fund mitigates part of this, but there can still be some of your portfolio lost to bad debt.
  7. Provision funds cost money. In addition to the administration, oversight and regulatory implications, the depletion of a provision fund can have major confidence ramifications for a platform. Remember when RateSetter decided to park the losses with shareholders, instead of its lenders?
  8. Provision funds work for platforms whose lending strategy is predicated on diversification. The BBG allows lenders with a concentrated successful strategy to profit from successful underwriting done by the platform and the lender themselves.
  9. Better alignment of risk and reward. The honeymoon phase of any P2P platform represents the best time to be able to lend early and sell quickly. This is essentially an ‘investment hack’ that benefits the innovators and early adopters, over the laggards. It can be tricky to balance a marketplace, and lenders who know how to exploit this can take advantage of the timeliness of their involvement. Active and diligent investors, earn better returns. The profit motive allows people with time and skill to realise a quick margin from performing loans. With offering the BBG, the risk of ‘losing everything’ is isolated to those who also stand to gain the most.
  10. The BBG is educational. It offers a path to learning more about investments and becoming a professional investor. If you do well managing your own funds, you can profit by doing it for others. Someone who studies credit risk, and gets good results can build the confidence to assume some of the risks for those who are new to the asset class.

Are there any disadvantages? Well, so far, the BuyBack Guarantee is relatively unproven. We’re still in beta, and we may need to tweak a number of things depending on the data. If there was a major, simultaneous failure in most loans, then a liquid provision fund provides an immediate contribution to offset some losses but is likely to provide less depth of cover than a BBG, which might take longer to disburse.

Stephen Wallis, Non-Executive Risk Director says:

“I’ve seen provision funds implemented at Ferratum and Elavon, with mixed success (although these are different areas of financial services). Also, during my time at Standard & Poor’s in the lead-up to the financial crisis, I’ve seen credit default swaps implemented badly at an institutional level – when companies look to utilise them in a non-plain-vanilla way.  As with anything like this, the success of any risk mitigation structure comes down to the design and implementation. We’re confident that the Peer-to-Peer lending buyback guarantee gives a clear correlation of risk and return, whilst respecting that individuals have varying appetites to risk.”

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