What today’s shake-out in China’s peer-to-peer lending market means for Fintech

2018 will go down in Chinese economic history as the year the high-flying peer-to-peer (P2P) lending industry plunged back to earth.

It seems as if a week doesn’t go by without a couple of P2P founders announcing they’re shutting down. In the first half of 2018 alone, 300 P2P platforms went out of business. Yet, even with such a massive number of closures, another 1,800 P2P platforms were still operating as of July, according to Wangdaizhijia, a website that tracks the industry.

Since June, defaults have skyrocketed, as investors have become more aware of the substantial risks attached to these products. Defaults have posed serious liquidity challenges: In the first half of July, more than 50 platforms defaulted, resulting in estimated capital losses of around 35-40 billion RMB. One of the largest of these failed platforms was Niubanjin (牛板金), which affected around 820,000 users with 3 billion RMB in investments. In Hangzhou, victims of the troubled P2P lender filled two of the city’s largest sports stadiums, which local government authorities had set up as temporary complaint and appeal centers.

The swift deterioration in China’s P2P lending market has not gone unnoticed by equities investors. Stock prices of listed companies such as Yirendai, the first Chinese online lending company to go public on the New York Stock Exchange, and Paipaidai, have dropped more than 70 percent from their highs. The many other online lenders that had once pinned their hopes on a breakout IPO are now facing a market in which investors have soured toward the sector.

The Great Leap Forward on P2P

Just a few years ago, P2P lending was the epitome of digitally-enabled Fintech innovation in China. Lending volumes even surpassed those in the US, where pioneers such as LendingClub invented the industry a decade ago.

Here’s how it works: an individual borrower can be matched with a corresponding investor (or a few like-minded investors) who is interested in lending to the individual, with an agreed upon interest rate and duration. In theory, this unlocks unlimited potential for individual borrowers to find lenders, at lower rates for the borrowers, and at higher interest rates for the lenders, as banks and traditional finance companies get “disintermediated.”

Since all of this would take place online, many of the transaction costs and inefficiencies associated with traditional financing would be removed. And this financial revolution would be led by nimble startups armed with talent, technology, and funding.

So what went wrong?

First, retail investors flocked towards these P2P platforms in search of higher yields for their cash. China boasts one of the highest personal savings rate in the world: 46 percent, compared to less than 4 percent in US. Yet, investors in China still have very few attractive investment options to choose from.

China’s retail investors are also accustomed to investment products that are “guaranteed.” Since most financial institutions in China are still owned by the state, investors expect their money will be safeguarded.

When products fail in China, investors typically make a big fuss, prompting the regulator to compel the deep-pocketed state-owned institutions to back-stop the product. Unsurprisingly, retail investors have been more than eager to experiment with P2P products that have promised annualized returns ranging from 8 percent to as high as 20 percent.

As the industry grew, investors piled in at sky-high valuations of these platforms, looking to discover the next new thing. By 2013, there were nearly 800 P2P players. But the stampede was only beginning: By 2014, more than 1,000 P2P platforms were established, and by 2015, over 2,500 players had entered the market.

Capital soon flooded in from a variety of investors that included state-owned enterprises, venture capital firms, and privately-listed companies, pushing up valuations which inspired even more investors to chase after the bubble.

The P2P mania also attracted a number of less scrupulous players that created P2P lending platforms simply as a fast and convenient channel to raise short-term funding from individual investors.

From 100 billion RMB in 2014, the outstanding P2P loan balance in China swelled to 1.3 trillion RMB by June 2018, a number that dwarfs the estimated outstanding balance of $120-150 billion in the US.  

The beginning of the end

Signs of strains in the market surfaced as early as 2015, when Ezubao, one of the largest lenders at the time with 900,000 investors, went bust. It turned out to be a Ponzi scheme that at its peak had reached 59.8 billion RMB (around US$9 billion).  

As regulators, journalists, and industry veterans began to scrutinize the industry, the full extent of abuse and amateurish practices started to surface. Some P2P platforms were found to be creating fictional information about borrowers in order to form asset pools, and then funneled funds they collected to support their own business needs.

Many platforms extended credit without having proper risk assessment tools or processes in place. Many more were operating as “shadow banks," where they offered high interest rates from individual investors, and lent the money out to businesses at even higher interest rates. These were all packaged as wealth management products and sold online.

These abuses eventually attracted the attention of China’s regulators, which in 2016 began to impose increasingly strict regulations, which included  the appointment of a custodian bank, full disclosure on the use of investments, and caps on the maximum lending amounts that could be extended to individuals (1 million RMB) and companies (5 million RMB).

These were also instituted as part of a broader effort by China’s central bank to reduce financial risks, and included the unveiling of a new set of far-reaching rules on the asset management sector, including regulations that set limits on leverage levels and banned implicit guarantees.

The collapse of China’s P2P market has been as swift as its rise. While players were forced to search for new business models to survive, market scandals made it difficult to raise capital, and investors started to withdraw their investments, causing “runs” on the platforms. Tightening credit markets and a softening economy--especially in the real estate sector--also meant that corporates who borrowed from these platforms were more prone to default on their loans.  

Implications of the P2P crisis

So, what lessons have been learned from the turbulence of the past few years? And what’s next for China’s P2P lending industry?

First, a number of industry-dominating leaders are likely to emerge from the crisis. While the industry undergoes a massive shake-out, some of the leaders in the industry are busy transforming their businesses. Lufax, one of the earliest P2P players to reach scale, has positioned itself as a wealth management platform and has opened an overseas platform in Singapore.

Creditease’s P2P platform, Yirendai, which listed on the New York Stock Exchange in 2015, is leveraging technology to build an online wealth management service for mass affluent customers. 

As the market weeds out undisciplined and unscrupulous competitors, players like Lufax and Yirendai will be poised to benefit from a less crowded and more professionalized market, and they are likely to earn the blessing of the regulator.  

Second, regulators learned an important lesson on how to balance innovation and risk. In a market as big as China, risks can spread quickly. But regulators must strike a delicate balance: Establish rules that are too onerous and you discourage experimentation and stifle innovation. Make the rules too loose, however, and you invite abuse from rogue players that try to circumvent or game the system. Fostering innovation while controlling for risks will continue to be one of the biggest challenges that financial regulators in China --and indeed in the rest of the world—need to grapple with.

Third, while the first phase of the P2P craze is now over, the wave of start-ups that have emerged in recent years has ignited a whole range of Fintech innovations in areas such as payments, blockchain, credit, and small business applications. Many of these Fintech startups in China today are already leading globally in their level of innovation, technological sophistication, and user-adoption. But startups don’t hold a monopoly on innovative ideas and business models: Many large and well-established financial institutions have awakened to the enormity of the opportunity and are investing heavily in this space.

As the dust settles and the P2P industry emerges from its first major crisis, the next chapter for Fintech in China will hopefully see the survivors apply the lessons they’ve learned to build stronger and more sustainable businesses. Innovation is, after all, a process of “failing fast” and learning from those failures.

I'm the Managing Partner of McKinsey & Company’s Greater China Practice. Please reach out and connect or follow me here on LinkedIn.