Mitigating Risks In Digital Lending:
What Investors need to know
Digital lending has developed as an increasingly popular alternative to traditional lending methods in recent years. Investors are drawn towards the potential high returns and increase access to data, enabling them to provide capital to a wider array of borrowers.
Nevertheless, due to the rapid pace of change and innovation, investors often face an evolving landscape of risks that require effective risk mitigation strategies to match the speed of quick cross-border transactions. This article aims to explore the primary risks directly impacting digital lending and offer effective risk management solutions for investors.
Risks in digital lending
Anti-money laundering and countering terrorist financing
Anti-money laundering (AML) and countering terrorist financing (CTF) are important regulatory requirements that apply to all financial service providers, including digital lenders. AML policies are intended to stop using financial services for money laundering, while CTF measures aim to restrict the financing of terrorist activities.
Due to the large volume of online transactions and innovative technology like blockchain and cryptocurrencies, digital lending can be particularly vulnerable to AML/CTF risks. These innovative technologies may be misused by criminals and terrorists to conceal their identities and the source of their finances.
To mitigate these risks, investors should allocate their funds to digital lending companies with solid AML/CTF compliance programs. These programs usually entail conducting additional due diligence on borrowers, constantly watching out for suspicious transactional activity, and reporting it to the appropriate regulatory authorities. To share information and prevent illegal activities, digital lenders may also need to work with other financial services providers and law enforcement organizations. Failing to abide by AML/CTF standards may incur serious legal and financial penalties and reputation damage that may jeopardize the digital lending business’ future.
Consumer and merchant risk
In digital lending, the terms “consumer risk” and “merchant risk” signify the likelihood that a borrower (either a consumer or SME) would fail to make payments on time or will default on the loan, causing the lender to suffer a monetary loss.
Digital lending platforms rely on algorithms and data analytics to evaluate the creditworthiness of the borrowers by using alternative data sources (like social media activity or online purchasing behavior) apart from traditional credit history. This approach expands access to credit for borrowers who lack long credit histories, but it also elevates the risk of lending to individuals or companies that are not able to pay back the loan. Moreover, given the ease with which digital footprints can be fabricated, lending institutions must exercise caution to avoid being deceived by false data.
Given the risk inherent in the digital lending landscape, investors may suffer significant financial losses, by failing to receive loan repayments if a platform does not properly manage its capital. To avoid such scenarios, investors should consider digital lending companies with robust risk-management procedures incorporating advanced underwriting models that reliably assess creditworthiness, continuous borrower performance monitoring, and adequate provision of capital to absorb losses. Further, regulatory control and transparency in lending procedures can assist in guaranteeing that borrowers are not the targets of unfair or predatory lending practices that could put them at risk.
The risk of cybersecurity threats, such as fraudulent transactions, extortion, denial of service attacks, and credit card fraud, has increased in the FinTech sector due to the popularity of electronic wallet solutions. Such cyberattacks have the potential to seriously damage crucial economic infrastructures and jeopardize the stability of the whole financial sector by compromising sensitive information, purposefully harming the hardware, and disrupting services.
To minimize the cybersecurity risks in digital lending, it is crucial to remain vigilant of technology defects. This includes identifying potential security vulnerabilities in hardware, software, or network infrastructure.
Digital lending businesses should conduct regular risk assessments and penetration tests to spot any security weaknesses and address them properly. In addition, it is important to implement robust security protocols like encryption, multi-factor authentication, access controls and regular security updates. Training employees on cybersecurity risks through awareness programs is also necessary.
Fraud risk in digital lending refers to the possibility of cyber criminals engaging in fraudulent activities like false documentation, identity theft, or loan stacking, for obtaining funding from digital lending firms. The usage of the internet has made it simpler for fraudsters to conduct their activities as they can impersonate other parties or create unreal identities more easily. If these fraudulent actions go unnoticed, digital lending companies may suffer considerable financial losses or reputational harm.
To reduce the risk of fraud, investors should finance digital lending companies that have robust fraud prevention measures in place, including stringent identity verification and authentication procedures, advanced fraud detection tools, and effective transaction monitoring systems.
Additionally, investors should also consider companies that maintain strict control over their internal systems and conduct regular risk assessments to identify and address any potential fraud concerns. Collaboration with regulatory bodies and law enforcement organizations is likewise important for exchanging information and coordinating initiatives to prevent fraud.
Digital lending and the financial system are exposed to market risk because of their sensitivity to news and industry updates. This risk can be particularly observed whenever the market experiences sharp increases in interest rates or unanticipated economic shocks that cause extreme market reactions. Such situations might lead to serious solvency and liquidity problems, as observed in the case of the failure of Silicon Valley Bank earlier this year.
Market fluctuations can create excessive volatility, contagion, and pro-cyclicality, that may disrupt financial services. In these situations, customer support teams should produce ad-hoc solutions since contingency planning might no longer be able to provide adequate reaction.
Investors can mitigate the impact of unforeseen market events by investing in digital lending companies that implement robust risk management measures such as stress-testing models and contingency plans.
Additionally, it is crucial to ensure that these companies maintain sufficient levels of capital and liquidity to meet expected cashflow requirements and manage potential losses effectively. By following these guidelines, investors can minimize the risks associated with market volatility and make more informed investment decisions. To get more insights, read this article comparing traditional assets and digital lending.
Digital lending companies encounter operational risk in various cases such as when their established procedures and operational norms cannot keep up with the pace of work, unpredictable market conditions, and sudden unexpected changes.
Unlike traditional financial institutions that have time in their favor, digital lending companies operate at an incredibly fast pace. They are more exposed to real-time operations management, where 99% of the most crucial errors happen. The reliance on technology and automated processes increases the chances of facing operational failures from system malfunctions or cyber-attacks as well.
To mitigate operational risk, it is recommended that investors consider digital lending companies that have robust operational risk management procedures in place. These measures should include maintaining a strong control environment, providing regular training to staff, and implementing effective oversight and compliance monitoring.
Additionally, it is important for digital lending firms to adhere to regulatory requirements to minimize the risk of operational failures. By partnering with companies that prioritize operational risk management, investors can minimize the potential impact of operational issues on their investments.
Regarding laws and compliance, the whole FinTech industry places a strong emphasis on risk. Authorities must ensure that FinTech companies accurately assess risk and put risk-reduction measures in place.
However, regulative scope in many nations lags the pace of technological advancement. This suggests that for digital lending companies, regulatory norms are changing quickly, making it difficult to standardize compliance methods. While some FinTech sectors are not as strictly regulated as conventional financial institutions, regulations like PSD2 and GDPR set standards for data protection and system security processes, which have an impact on the entire European FinTech industry. Digital lending companies are frequently subject to additional regulations imposed by national agencies, such as the CFTC and SEC in the United States, FCA in the UK, BaFin in Germany, and ACPR & AMF in France.
If these requirements are not carefully followed, businesses run the risk of being found in noncompliance, suffering penalties, and losing their reputation in the market. To avoid this, investors and digital lending companies should stay informed about regulatory changes and understand how these changes might impact their business. They can do so by participating in different industry events and by monitoring relevant published papers or news. Creating and maintaining strong relationships with regulators by seeking their guidance is also important. FinTech companies should also execute regular audits to guarantee compliance with regulations and detect spaces for improvement. for improvement.
What investors need to know
As an investor, you can take several measures to mitigate the risks that come with investing in digital lending institutions. To start with, before investing your capital in a company, you should make sure you have properly understood the business model of the company, its financial performance, market position, its cybersecurity measures, and regulatory compliance. Without doing due diligence, investors will be more prone to facing the above-mentioned risks in the future.
Diversification of the portfolio is another fundamental principle in any investment strategy, that leads to lower risk exposure and optimized returns. By distributing your capital to multiple companies with varying risk profiles, within the digital lending sector, you can reduce your exposure to any specific company or market segment. In this way, you can protect yourself from experiencing significant losses from adverse market circumstances.
It is critical to take a proactive approach to investment management and to monitor your investment portfolio regularly. Particularly in the dynamic FinTech industry, in which economic trends and events can affect the performance of individual companies and the broader financial environment. By being updated with the latest news, you will make more informed future decisions. To gain important insights into your investment portfolio’s potential, you will want to track the performance of the firms in which you decided to invest by calculating key financial performance metrics and indicators.
Last but not the least, if you are looking to invest in digital lending companies that you believe have the premises to transform the industry in the future, you will need to seek professional advice provided by third parties that are not directly affiliated with them. They can help you to create a better understanding of the company’s business model, growth prospects, and competitive landscape.
By leveraging the expertise of these professionals, you can gain a better understanding of the company’s financial performance, market trends, and regulatory challenges. Having access to this information empowers you to make better-informed choices concerning your investment portfolios. Apart from that, seeking advice from independent professionals can offer an unbiased perspective of the potential risks and returns of a specific investment. By adopting this approach, you can avoid any conflict of interest that can emerge while seeking counsel from individuals that are directly affiliated with the digital lending platforms that you want to invest in.
Bank, W. (2021). Consumer Risks in Fintech – New Manifestations of Consumer Risks and Emerging Regulatory Approaches. Open Knowledge Repository. https://openknowledge.worldbank.org/handle/10986/35699?show=full
Digital lending: Regulatory trends. Retail Banker International. (2022, March). https://www.retailbankerinternational.com/comment/digital-lending-regulatory-trends/
Pascual, A. G., & Natalucci, F. (2022, April 13). Fast-moving fintech poses challenge for Regulators – IMF. https://www.imf.org/en/Blogs/Articles/2022/04/13/blog041322-sm2022-gfsr-ch3
Exaloan is the leading technology provider for institutional investments in digital loans. Its mission is to close the global funding gap for individuals, entrepreneurs and SMEs by connecting institutional capital with digital lending platforms. By operating a global B2B marketplace, the company opens up digital lending as a new asset class.. As an independent agent and validator, Exaloan provides a fully digital investment infrastructure with a standardized risk assessment of each single loan through its Loansweeper™ platform. At the core of its business, Exaloan uses big data and predictive analytics to generate an independent real time credit analysis as well as dedicated insights and reporting for institutional investors, banks, and lending platform partners. Insights cover topics such as sustainability reporting, advanced portfolio analytics, and market research.
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