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.

Cybersecurity 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

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.

Market risk

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.

Operational risk

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.

Regulatory risk

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.

Additional readings:

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

About Exaloan

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.

Behind Exaloan stands an experienced team with extensive know-how in the areas of quantitative portfolio management, capital markets, machine learning, and software development.

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Review and reflection:
How can FinTech lending help SMEs access funding efficiently?

Small and medium-sized enterprises (SMEs) play a vital role in driving job creation and innovation, making them a critical component of a thriving economy. Nevertheless, these entities frequently encounter challenges in obtaining funding from traditional lenders due to demanding requirements such as collateral, extensive documentation, and lengthy approval processes. Consequently, a funding gap for SMEs has emerged, posing a significant obstacle to their growth and development. The Bank of England (2019) has reported that approximately 25% of small businesses seeking loans from banks are denied, resulting in a significant financing gap of £22 billion for UK SMEs.

The global emergence of FinTech companies has brought about a notable positive transformation in the finance industry in the past decade. These companies use cutting-edge technology to offer tailored financial products and services that meet clients’ diverse needs. They have embodied a new range of products made specifically for the needs of SMEs. For instance, P2P (peer-to-peer) lending, invoice financing, online supply chain financing, online trade financing, and e-commerce financing.

These alternative funding sources are particularly beneficial for Startups and businesses with limited credit history or collateral, who may not meet the eligibility criteria for traditional bank loans. Additionally, banks, as traditional lending institutions, are susceptible to different macroeconomic events, as evidenced by the recent collapse of Silicon Valley Bank (SVB), which marked the largest bank failure since the Global Financial Crisis. With assets exceeding $200 billion, SVB was a leading institution in the venture capital industry, primarily focused on Tech Startups. Its collapse has had adverse implications for SMEs that had secured funding through SVB, exposing them to external shocks and potentially jeopardizing their operations.

According to a paper published by ECB (2022), SMEs are more likely to turn to FinTech lending when they have relationships with banks that possess less stable funding sources, lower asset liquidity, and lower capital ratios. This suggests that one of the reasons for the shift towards FinTech is to mitigate exposure to banks that may not have the capacity to absorb shocks and are more prone to reducing lending activities during liquidity crises. These findings highlight the importance of the quality and resilience of banks in the decision to utilize FinTech lending platforms.

By obtaining loans from FinTech companies, SMEs can diversify their lending relationships and reduce their dependence on a single bank, thereby enhancing their financial stability. The findings indicate that the SMEs seeking access to FinTech platforms are motivated to decrease their vulnerability to potential shocks to the banking system. Such shocks can restrict their access to financing, consequently impeding their growth prospects. Notably, the lending sector has experienced significant changes due to FinTech innovations, particularly for SMEs (Feyen et al., 2021).

Five main influences of FinTech lending on SMEs

Increased Access to Financing

According to a report by the World Bank, approximately 70% of SMEs in developing economies lack access to credit. FinTech lending has helped bridge this financing gap by providing SMEs with access to credit that was previously unavailable to them. These credit lending platforms use alternative data sources and advanced analytics to evaluate creditworthiness. This way, they make it easier for SMEs to access the funds they need in a way that traditional lenders would have deemed too risky. Based on a study made by Nesta (2013), 33% of SME borrowers using marketplace lending platforms believed they would not have been able to obtain funding from other sources.

Decreased Borrowing Expenses

FinTech lenders have disrupted the lending market by offering reduced interest rates and fees in comparison to traditional lending institutions. They do so by applying Data Analytics and Artificial Intelligence to evaluate credit risks and determine loan eligibility, which can reduce borrowing costs for SMEs in several ways. Firstly, data-driven decisions can help lenders make more accurate credit assessments of SMEs, considering data points such as cash flows, payment history, and credit scores. This is made to ensure that only creditworthy SMEs receive loans, thus reducing the risk of default. Secondly, lenders can provide more personalized lending solutions by analyzing data on SMEs’ specific needs and characteristics. This assists SMEs in achieving their objectives without getting excessive debt, reducing again the likelihood of default. Through the usage of Data Analytics, lenders can develop early warning systems to detect potential signs of financial distress among SMEs, allowing them to take proactive measures to help SMEs avoid default. Also, by using Data Analytics and Artificial Intelligence, the lending process is more automated, from credit assessment to loan disbursal. This reduces the time and resources required to process loans, resulting in lower borrowing expenses for SMEs.

Efficiency and Effectiveness

Traditional lending processes can be time-consuming, with borrowers having to wait for weeks or even months to receive a loan. FinTech lenders have streamlined the lending process, making it faster and more efficient. According to a study by Harvard Business Review (2020), FinTech lenders can process loan applications in as little as 24 hours. This speed is particularly beneficial for SMEs that require financing urgently to take advantage of business opportunities or address cash flow challenges.

Increased Competition

The rise of FinTech lending has not only made it easier for SMEs to obtain the financing they need to grow and expand their businesses, but it has also increased competition among lenders. Traditional lenders have been forced to adapt to these changing conditions and innovate their own lending products to remain competitive in the market, thus offering a wider range of opportunities and better conditions for SMEs seeking financing.

Improved Customer Experience

Another benefit SMEs have from FinTech lending is the improved customer experience. Most FinTech lending allows SME borrowers to apply for a loan online. With a user-friendly interface offered by those digital lending platforms, SME borrowers can track their applications more easily, and the entire process is relatively transparent. It is safe to say that digital lending helps SMEs save time and energy to focus on their businesses.

Statistical Data

According to a report published by Allied Market Research (2021), the worldwide market for FinTech lending had a value of $449.89 billion in 2020 and is projected to increase by 27.4% (CAGR) from 2021 to 2030 to reach $4,957.16 billion. In the past year, 22% of European startups in the financial and technology sectors increased a sum of $22.2 billion, making FinTech the most well-funded industry in 2022 (Pun, 2023). As the FinTech lending industry continues to grow and evolve, SMEs can expect to benefit from even more innovative products and services that help them achieve their business goals.

A survey conducted by EY in 2022 showed that a significant percentage of SMEs are interested in accessing financing quicker. Specifically, 66% of SMEs expressed interest in faster access to funding, with 55% wanting to secure financing within one week and 31% seeking to do so within three days. While banks remain the preferred source of funding for the majority of SMEs (63%), the popularity of FinTech lending institutions has grown considerably (56%) since the onset of the COVID-19 pandemic. In light of these developments, SMEs are increasingly seeking digitally driven, simplified, and faster funding solutions. Consequently, if banks are unable to provide these services, more and more SMEs will turn to FinTech lending companies.

Concluding Remarks

In the future, it is likely that FinTech lending will continue to play an increasingly important role in providing financing solutions for SMEs, as FinTech lenders continue to refine their offerings and cater to the needs of this growing market. This could consist of solutions such as revenue-based financing, which enables SMEs to repay loans based on a percentage of their expected future revenues, or invoice factoring, which allows companies to receive an advance on their upcoming invoices.

Finally, as the global economy becomes increasingly digital, FinTech lending may end up becoming the main source of funding for SMEs across many nations. By utilizing the most recent technological developments, digital lenders can reach a broader range of customers than traditional lenders, especially those in emerging markets with limited credit histories. This could help drive economic growth and create new opportunities for entrepreneurs and businesspeople worldwide.

About Exaloan

Behind Exaloan stands an experienced team with extensive know-how in the areas of quantitative portfolio management, capital markets, machine learning, and software development.

Mitigating Risks In Digital Lending:
What Investors need to know

Risks in digital lending