Lending Works Shield: How The Reserve Fund Has Radically Changed
Lending Works has boosted allowances to cover future possible bad debts from £3 million to £5.5 million, by budgeting for more borrower interest to be paid into the Lending Works Shield.
While that means much greater coverage that will better match expected bad debts, it comes with a radical change to how the Shield works.
What's happened and what does it means for lenders?
Shield cash balance
Neil mentioned that a lot more cash is being freed up to cover future expected bad debts in Is Lending Works Still A Good Investment? But how this is happening is also important to take in.
Two figures make my point:
- At the end of June 2019, Shield contained £1,000,000 in cash.
- At the end of December 2019, Shield had £75,000 in it. That's the latest figure we have, taken in February 2020. We'll get updates on the cash balance in Shield every quarter, probably with about 20 days' delay. Annual quarters end on March, June, September and December.
In the meantime, the total amount of outstanding loans covered by Shield was stable, meaning it's still covering the same amount of loans.
So, if Lending Works has really diverting more money to Shield to boost it to £5.5 million, why has it got less money in it?
More borrower income is being diverted each day
It's all because of Lending Works' radical change to Shield.
Lending Works has taken the deliberate decision of lowering the amount of cash that sits in Shield up front to a small amount sufficient for the best part of a week – or a few weeks at best.
Meanwhile, it's dramatically upped the amount of money that Shield takes from daily borrower payments.
Back in June 2019, it was intending to collect just £2 million from borrowers over the course of the outstanding loans.
Now, the total that existing borrowers are expected to pay into the Shield by the time they have fully repaid is £5.5 million. So this is big jump in a short time.
Is there enough money in Shield now?
The first question is: Is the Shield now in danger of running out of money if bad debts come in too fast for a few days? The answer is a resounding No.
Lending Works' borrowers pay in over £100,000 per working day, or £2 million to £3 million per month, on the £90 million in outstanding loans.
Over half of loans (50%) would have to go bad before the Shield might not have enough cash to ensure that lenders punctually receive the money they are expecting. This is far, far more than could ever realistically go bad. There's zero statistical probability of that happening, in any market conditions. Zilch.
This easily ensures that the Shield doesn't run out of money due to bad debts.
It's not the plan for Shield to gobble up lots of money
Yet Shield isn't supposed to greedily munch up all the borrower payments, like a money-eating Pac-Man. The flow of money at Lending Works is supposed to work like this:
- Lenders lend to borrowers.
- Different borrowers repay the loan on different days of the month. The money that was lent all goes back to the lenders as the money comes in.
- Borrowers also pay interest at the same time. Latest borrower rates average at least 14%.
- A large share of the interest payments made by borrowers on a given day goes to lenders. The lending interest being paid out is around 5% per year, on average, for 2020 loans.
- A share of the borrowers' interest, based on the latest forecasts of bad debts, is earmarked for Shield. Currently, Shield's share of borrower interest is similar to the amount paid to lenders.
- And the remainder is supposed to go to Lending Works itself, mostly to cover the costs it faces in running individual lenders' lending business for them. One day, a very small part of this share will be Lending Works' actual profit. One day.
If more money is diverted to Shield, lender rates will come down
So, when all is going as smoothly as any lenders can hope, money will move around according to the flow above.
What if it isn't?
If, day after day, Shield needs more money than has been earmarked for it on its 2020 loans, it's easily done.
More money from the flow of daily borrower loan repayments and interest will be diverted to Shield. As I've already mentioned, the amount coming in will be toweringly higher than any daily amount of bad or late debt could ever be.
But Shield isn't funded from thin air. Any extra money over and above expected bad debts that is diverted to Shield needs to be paid for.
So, at the start of the next quarter, existing lenders who are lending in loans issued in 2020 would then see their lending rates reduced. The difference will now get paid into the Lending Works Shield. This change formalises the shift of the money from lenders to Shield, and makes it permanent.
The lower rates set by Lending Works would reflect the higher bad debts already experienced. Also, any lower rates would include an adjustment for a forecast of higher bad debts between now and when the loans are fully repaid.
Lenders might sometimes have their rates reduced even if Shield has taken on less bad debt than expected. This would be the case if Lending Works amends its forecasts for other reasons, such as improved bad-debt modelling. This shouldn't happen very often though, and adjustments like this should get smaller over time as Lending Works continues to refine its forecasting.
Why excess bad debts are covered by lenders, not Lending Works
Lending Works won't subsidise lenders by diverting its own share into Shield – certainly not permanently.
Like most peer-to-peer lending companies, it prioritises its own fees. It does this because it has to cover the costs of running the business, and because it will never make anything like as large a profit as lenders do.
Lenders are taking the risk of suffering bad debts, but are rewarded for it with the lion's share of the profits.
The share that Lending Works pays itself is a small fraction of the loan and interest payments on any given day.
Shield is no longer a reserve fund, but a liquidity fund
So Shield is no longer a pot of money in reserve to pay for bad debts. Instead, it provides something called liquidity from the “float”.
This means that the money floating through the system all the time can be diverted at any time to keep lenders receiving their expected monthly interest and to take over any new bad debts.
The Shield's function is to share bad debts out fairly, and without interruption to the daily payments to lenders.
By covering all bad debts on a daily basis from a pool of borrower payments, Shield ensures that no lender has to suffer a big hit because one or two of your loans have gone bad at the same time.
The new Shield is more honest and sustainable
Investors often say “cash is king”. By this they mean they like to see the money exists, and ideally they like to see it up front, sitting in an account somewhere.
In the wider world of investing, cash up front is often better than the alternatives. An actual segregated pot of money is possibly more likely to protect you from negligence, for example.
(Although experience shows the best protection against negligence by far is to stay clear of any P2P company that gives you even a whiff of uncertainty. Read Fend Off Peer-To-Peer Lending Fraud & Incompetence – A Checklist.)
But this new Shield has two substantial advantages over the old one: it's more honest and more sustainable.
Why the new Shield is more honest
It's more honest, because a reserve fund can give a false sense of security.
When lenders see a large pot of cash protecting them, they expect that their bad debts will always be covered by it in full. But a reserve fund is to cover expected bad debts and to take the edge off higher than expected ones.
No matter how good a peer-to-peer lending company is, lenders should at times expect that their lending rates will have to come down to cover any excess bad debts that are greater than the forecasts.
Using this more honest approach has a side benefit. When lots of lenders think a reserve fund makes them completely safe, they pile into the loans. Too many lenders push the lending rates down, as they compete with each other to lend.
Ironically, that makes lending less safe. If you earn less interest, you have fewer earnings to cover any excess losses.
With Shield now having just a small amount of cash up front, it still offers the same benefits to lenders, but it makes you think a little more about it what it does – and what it doesn't do. You recognise more easily that these funds don't guarantee your interest rates.
Why a liquidity fund is more sustainable
A reserve fund has to be paid for somehow. As we have seen elsewhere in peer-to-peer lending, its often seeded using money from the P2P lending company or its founders. Over time, it becomes harder to sustain such a fund, especially as the lending platforms grow and get more loans.
In the end, keeping a large pot of money might require heavy payments to be taken at the start of a loan, which is not easy to do. You often can't charge borrowers an up-front fee because that will drive them to borrow elsewhere. And you can't ask lenders to pay into the Shield at the start of every loan.
The more natural way to pay for any kind of fund is by taking small slices of it with each repayment made by the borrower. After all, that's how both lenders and Lending Works are getting their shares, too.
There might be another advantage
Another argument I've heard is that this also makes Lending Works' business more stable. Since it's receiving payments regularly, instead of all up front, it can keep going more easily when going through less busy patches where it's arranging fewer loans.
I don't want to stretch this argument too far, but there's probably a little something in it.
What are the potential downsides of a liquidity fund?
A liquidity fund requires lenders' trust – although not much more than a reserve fund.
In trusting Lending Works, you're assuming it won't deliberately lower its forecasts of bad debt so that it can pay itself more money.
It's clear that Lending Works is not that kind of organisation and that it also has suitable structures in place to protect lenders. Such as the trustee company it has set up for lenders, with a sensible mix of board members.
It's just one more reason to stick to P2P lending companies that make you feel very confident that they're honest, professional and competent.
Eventually, we'll need more information
To keep this liquidity fund honest, at some point in the near future Lending Works will need to start providing more information.
We've asked Lending Works a lot of questions and got a great deal of data and useful answers covering the most important points. Still, more questions continued to arise as my colleagues and I worked through it all.
For example, will it explain at what point it will decide to free up Shield cash from one cohort to pay into an underperforming one?
It seems that each year's loans – each annual cohort – is effectively going to have a separate allocation in Shield. So Lending Works needs to let 4thWay, lenders and prospective lenders know what each cohort's allocation is, and how much of the allocation has been used up already.
It's not urgent, because we're at the start of this new system. But as each quarter passes it will become more useful for assessing the strength of its new Shield.
Currently, so long as it's projected to keep covering bad debts, I would therefore expect to see the pound amount rise in the Shield every quarter, even if Lending Works says that the Shield doesn't need the cash immediately.
It will be interesting to find out how it goes about this, such as whether it will distance lenders further from the idea of a pre-funded, ringfenced pot of cash by taking any excess, unneeded funds for itself or leaving it in the pot for future cohorts.
The other articles in this series are:
Read the Lending Works Review.
Links to other pages mentioned above:
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