China online finance: Money to the masses

Alibaba Group's arrival in the internet finance space inevitably created shockwaves. Last year the e-commerce giant bought Tianhong Asset Management and within a few months the Yu'e Bao money market fund had swelled tenfold to RMB500 billion ($81 billion). Once the 50th largest fund house in China, suddenly Tianhong was in top spot. 

Investors flocked to the fund but only existing users of online payment service Alipay got access. Just as it had disrupted retail, so Alibaba was threatening to do the same to finance, using its unique reach to offer customers a potentially more lucrative alternative to bank deposits. As an added incentive, redemptions are permitted at any time - provided the proceeds are used to shop on the Alibaba platform.

The ripples were felt at all levels of online financial services, including peer-to-peer (P2P) lending. There were 600 P2P lending sites in China at the end of 2013, up from 240 in 2012 and 20 in 2011. As of June 2014, there were 1,263. Transaction volume reached RMB10 billion in the first half of the year - close to the full-year total for 2013 - according to the Internet Society of China.

The P2P premise is simple: People lend their money to strangers for virtually anything - a new car, home improvements - and in turn enjoy interest rates exceeding 15%, far more than the 3% offered by banks. More importantly, the online platform serves as a bridge between lenders and small-scale start-ups, many of which are unable to get bank funding.

Venture capitalists see it as an enormous investment opportunity, partly because the likes of Baidu, Alibaba and Tencent Holdings have yet to build a dominant presence in the space.

"There is a market window to invest in P2P platforms," says Ray Yang, managing partner at Northern Light Venture Capital (NLVC). "There are four large state-owned banks and more than 5,000 smaller banks nationwide. Online P2P platforms are shaking up the traditional banking system and adding value to it. Internet giants like Alibaba cannot monopolize the entire P2P online lending landscape because it's out of their current ecosystem."

However, exposure to the industry requires a high level of risk tolerance. When the first P2P site was launched in 2007, there were no specific rules. The explosion in activity has made the regulators sit up and take notice. If and when they do impose stricter requirements in order to protect customers, it will bring additional pressure to an already fiercely competitive industry. Consolidation is all but certain.

VC investment in the space is rising in tandem with market interest. According to AVCJ Research, about $99 million has been invested in four online P2P sites so far this year, while the valuations for six more deals have not been disclosed. This compares to $143 million for two disclosed deals in 2013 and $25 million for one transaction in 2012.

At the same time, market research firm Reportstack estimates that 71 of the 800-plus online lending platforms it tracked went bankrupt last year.
Official support.

P2P lending has existed for years as part of the shadow banking sector, but it has become more prominent in response to liquidity tightening at central bank level. Unable to borrow money through conventional channels, the small and medium-sized enterprises (SMEs) that contribute up to 70% of GDP but receive only about 37% of total financing must look elsewhere. Moody's estimates that the balance of outstanding shadow banking products in China stands at RMB21 trillion ($3 trillion).

Non-banking financial institutions raise funds from retail investors through selling wealth management products. However, some of these products have trumpeted their potential returns but offered little detail as to the actual underlying assets, and many investors have been left disappointed. Online P2P lending sites are seen as a means of improving the current system.

"The online P2P platforms help provide an alternative investment product that should be more transparent as to the risk involved and also more formalized in terms of distribution, which will help both lenders and borrowers," says Zennon Kapron, managing director at consultancy Kapronasia in Shanghai.

The government has reiterated its support for P2P lending as a concept. In May, the term "internet finance" appeared in a government work report for the first time as Premier Li Keqiang pledged to promote the healthy development of the industry. In response, Yi Gang, governor of the People's Bank of China (PBoC), noted that despite being supportive of innovation, the central bank will take appropriate measures to minimize risk.

"The authorities support the industry and won't surprise people with new rules, for example saying that all online P2P lending sites are illegal," says Raymond Wang, managing partner at Beijing-based law firm Anli Partners. "That's why we're seeing VC investors feel more comfortable about investing in this sector."

Most of top 20 P2P lending platforms have received VC funding. PPDai, founded in 2007, was among the first batch of start-ups and has raised capital from Lightspeed China Partners, Sequoia Capital and Noah Holdings. Yooli.com, started by a former executive at TPG Capital, received backing from Morningside Technologies and Softbank China.

Meanwhile, Dianrong.com, launched by Soul Htite, co-founder of US-based Lending Club, and Kevin Guo, an intellectual property lawyer, has raised two rounds of funding from NLVC and Hong Kong financial institution Sun Hung Kai & Co. Jimubox, which came online in August last year, recently got $37 million from smart phone maker Xiaomi and Shunwei Capital Partners.

Unlike online payment firms - a former venture capital darling - P2P lenders are reasonably differentiated and it is unlikely that one or two players will dominate the market.

Alipay was an early mover in online payment and built up a head of steam thanks to business from Taobao and TMall, Alibaba's C2C and B2C platforms. It now has a 50% market share and regarded by many as unsurpassable. In contrast, the P2P online market is large to accommodate various business models, based on different underlying assets. For example, a P2P platform that specializes in providing loans for SMEs in Beijing may not have a similarly strong local network in Shandong province.

A blurred line

However, these differentiated business models are a potential headache for the authorities. The China Banking Regulatory Commission (CBRC) is seeking to impose some rules on the industry because of concerns that individual lenders will fall victim to illegal fundraising and poor credit management by platforms.

"It's clear that the CBRC mainly allows P2P platforms to serve as information intermediaries, but not financial agencies. This means online operators can't manage capital on their own accounts and they can't provide loans guarantees to lenders, which is usually what the traditional banks do," says Anli's Wang.

Indeed, these functions are not supposed to be performed by a P2P platform based on the Western model. In China, though, over half of the lending sites currently in operation are handling money and therefore behaving like banks. In some cases, money is channeled into projects without the lender's knowledge.

Renrendai, Jimubox and CreditEase - the largest P2P lender in China - have started creating online financial products where, for example, RMB50,000 is raised from multiple lenders at annual return of 10% but the end use of the capital is not specified. Once the money has been raised they seek out borrowers capable of paying above a 10% interest rate.

The business model is therefore not to earn a commission on each transaction, but to profit through interest rate arbitrage.

In contrast, PPDai and Dianrong are among the few that source the borrowers first and then put them in front of prospective lenders. Both platforms claim to differ from many practitioners due to their strong risk controls, with several dimensions of analysis conducted to determine a borrower's probability of default.

"When we build a P2P company, we have to decide to have a transparent model. Our revenue model is based on how many lenders and borrowers we help, not how much borrowers are paying in interest," says Htite, co-founder of Dianrong. "There is a clear line that distinguishes us from banks - we do not get involved in the transaction. Of course, to do what banks do requires a license."

Dianrong aims to help high-quality borrowers get lower interest rates, but this can be achieved by creating customized products for specific industries. For example, a restaurant in Shanghai, which operates a cash business, is more likely interested in making daily payments then borrowing money for a long period of time.

The platform's verification process is similar to the underwriting services used in banks: a prospective borrower's identity is confirmed, their capacity to pay is assessed, and inquiries are made to ensure the loan will be used for the stated purpose. On the lender side, the platform allows lenders to commit small amounts across thousands of loans without Dianrong performing any money management role. Lenders can say which borrowers will receive their capital.

The downside to this approach is that it takes much longer to achieve scale than platforms that acquire the customers first. Yooli launched in February of last year and already has more than 790,000 registered lenders with total transaction value exceeding $300 million since inception. PPDai has been around six years longer but its transaction volume is a fraction of that size. Dianrong has the same issue.

"Although our practices are close to what the regulators expect, it's difficult to scale up quickly," says Guo, Dianrong's other co-founder. "If a small company wants to borrow RMB30,000 within a three-day window, it is very hard for us to accommodate them. We have to evaluate the borrower's debt repayment capability even though we might assume the borrower is able to make payments on time."

Credibility questions

Dianrong's transaction volume stands at RMB100 million per month and it has a risk management team of more than 300 people. The company has also sought to build up its market reputation through a partnership with China Orient Asset Management, a state-owned fund house.

Other P2P online platforms have also teamed up with third-party guarantors to help drive confidence in the industry. Yooli uses a third-party guarantor to ensure that lenders receive the monthly returns they have been promised. It also sources funding projects from guarantors, including small credit leasing firms, to raise funds online. In such cases, Yooli might not know who the borrowers are.

While relying on guarantors means the platform itself is exposed to minimal risk, the lenders' risk is substantially higher because neither they nor the platform know where the money is going. VC investors are therefore cautious. "The problem in China is that third-party guarantors are immature and their potential default risks are high," NLVC's Yang says. "You can't fully rely on them."

Industry participants also express reservations about CreditEase's credit assignment model.Instead of collecting money from lenders, Tang Ning, the company's founder and CEO, will firstly lend his own money to the borrowers. Then he sells the loans to other investors who in turn become the lenders.

"This structure is legal according to the law. Another reason for taking this approach is that technology was lagging eight years ago. It was impossible to use digital signatures to help complete transactions over the internet. Since the technology has improved, the majority of borrowers and lenders on our platform now enter into loan agreements directly. This is a good example of how technology helps transform finance," Tang says.

Founded in 2006 as a bricks-and-mortar operation, CreditEase has expanded rapidly and now offers a range of consultancy services, including wealth management. It has received investment from the likes of IDG Capital Partners, Morgan Stanley Private Equity Asia and KPCB.

Now the company is also in the process of moving online. One investor familiar with the firm suggests that a network of physical stores could reassure potential customers unfamiliar with internet finance. A P2P player that starts online could face questions about reliability and sustainability and by extension its ability to operate offline.

"It's not too difficult to set up a pure online platform but it takes a long time to build up a risk management culture and credit risk management ability, just like traditional financial services," the investor says. He adds that, unlike more developed markets, credit risk management is about more than a borrower's ability to repay the debt; in China fraud risk is a key consideration too and scams are sometimes very well-organized.

It is unlikely that the Chinese authorities will unveil rules for online P2P platforms this year. The regulators require time to continue familiarizing themselves with the industry and come up with an appropriate approach. But few in the industry are under the illusion that this will not happen.

The natural consequence is smaller firms exiting the business, either because they don't have the resources to address unsustainable lending practices and poor credit risk management, or because they don't have the will to try. In that context, cooperation with traditional financial institutions is important - these groups have the staff and facilities to meet with borrowers and verify submitted information.

At the same time, traditional banks and other financial institutions are also trying to build out their own online presence. However, unlike the P2P lenders - at least for now - they face significant regulatory requirements and have a host of other issues to deal with, such as non-performing loans, interest rate liberalization and increased competition on main street as well as online.

"These challenges make it difficult to innovate in the same way that we're seeing from the technology companies," says Kapron of Kapronasia. "Certainly, this could change going forward, but it will take significant investment and a change in mindset for them to be able to compete effectively. We could see institutions buy some of the larger online players."

This week Dianrong became the first online P2P platform to form a partnership with a local bank. It will work with Bank of Suzhou on providing lending services to SMEs in Jiangsu province - cost-effectively and online.

 

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Financing
• Financials
• Venture
• Early-stage
• China
• Financial Services
• Northern Light Venture Capital