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Sharia-Compliant Digital Lending

Sharia-Compliant Digital Lending

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With global mobility down and no prospects for physical experiences in foreign lands insight, we are taking a virtual trip towards the Global Middle East! Towards Islamic credit markets, and towards yet another exciting opportunity in digital lending!

A Brief Introduction to Sharia-Finance:

Islamic finance refers to how businesses and individuals raise capital in accordance with Sharia-law, a set of rules that comply with the Quran, the Sacred Scripture of the Muslim community. Key concepts include the avoidance of riba (usury) and gharar (ambiguity or deception). Money is seen as a representation of value, not an asset in itself, leading to the saying’ money cannot make money.

Therefore, simply lending capital with interest (and therefore for profit) is considered riba – and prohibited under Islamic law.

The concept of risk-sharing must be considered when raising capital in accordance with Sharia law. The Sharia-compliant product uses a bank fee rather than an interest payment structure while keeping product features very similar. Lending activities must happen within a banking framework in which the financial institution shares in the profit and loss of the loan it underwrites. To comply with the risk-sharing approach of Sharia-compliant lending, the Islamic bank may pool investors’ money and assume a share of the profits and losses.

Why Sharia-compliant Digital Lending?

As the Islamic Finance Marketing Experiment 2020 found, consumer preferences for Sharia-compliant lending products over conventional products are relatively un-elastic when it comes to religious borrowers. In a randomized experiment in Jordan, the researchers found that Sharia-compliance increased the application rate for loans from 18% to 22%, which equates to a 10% decrease in interest rates.

*Source: Islamic Finance Marketing Experiment 2020

These barriers add to the intrinsic dislike of conventional loans for religious borrowers. The findings suggest that religious considerations are partially responsible for the low utilization rate of household credit in developing countries with a large Muslim-population. High lending rates, an exclusive attitude, complicated procedures, and bureaucratic policies of traditional FIs are common obstacles reported by (M)SME when getting a loan. Muslim-majority countries have a 24% lower participation rate in active borrowing from banks (10.5% versus 7.9%) and a 29% lower rate of having a bank account (40.2% versus 28.6%).

Sharia-compliant digital lending products could not only lower access barriers to Islamic finance, but they could also contribute to mitigating the region’s financing gap, which sits at $335bn for South Asia and $186bn for the Middle East. Digitization could also propel Islamic finance’s growth in general, which is experiencing moderate to sluggish growth (1-2% in the next 2-3 years, S&P Moodys 2020).

Global investments in Islamic economy-relevant companies are already rising. In 2020, VC and other direct investments amounted to 11.8 billion dollars (Dinar Standard , 2019). Almost half of the investment volume, namely, USD 4.9bn, is invested in Islamic Fintech, highlighting the objective of putting technology-enabled finance to use to mitigate the historical slagging growth of Islamic Finance in MEASA.

Notably, the UK accounts for the most registered Islamic Fintech Firms with 27, followed by Malaysia, the UAE, and Indonesia (IFN Islamic Fintechs, 2021). A growing number of more than 120 Islamic fintech firms already offer Sharia-compliant financial products, many of them in the form of digital loans. Examples of Sharia-compliant digital lending platform include MicroLeaP (Malaysia), Dana Syriah (Indonesia), Nusa Kapital (Malaysia)…

Tradition meets Innovation: The Opportunity

According to Dubai International Financial Center (DIFC), Sharia-compliant assets currently represent 25% of banking assets in the Gulf Council Countries (GCC) and 14% of total banking assets in MEASA. Globally, Sharia-compliant AuM are expected to reach $3.8 trillion by 2023, almost doubling their 2020 volume of $2 trillion and growing at a CAGR of 10-12%.

The S&P Islamic Finance Outlook 2020 emphasized the need for inclusive standardization by relevant authorities and stakeholders to sped up Islamic finance advancement. It also hints at the role of Fintechs for supplying the necessary innovations with regards to products and technological infrastructure and for achieving a financial landscape that aligned with ESG objectives.

While market growth remains paced, it is gaining traction: Sharia-compliant digital lending operators in Indonesia have already doubled their Assets under Management between October 2019 and October 2020 (OJK, 2020). As recently as February 2021, the Bank Syariah Indonesia (BSI) was established after consolidating three state-owned banks. BSI has a net worth of $1.4 billion and works on the efficient integration of the three forming banks: Bank BRI Syariah, Bank Syariah Mandiri, and Bank BNI Syariah. The BSI shall allow platforms to better access credit scoring, e-KYC, and digital signature services. It will also integrate customer data from the forming three banks to help fintech companies partnering with BSI to offer services to its customers.

The digital lending market volume in the Middle East (MEA) has recently experienced impressive three-digit annual growth rates with complementing investments in several Arab lending platforms. Excluding Israel from the Middle East region, it is found that 95% of this digital lending volume stems from Debt-based instruments, roughly 5% from equity-based models, and 0.18% from non-investment models such as Waqf (donation)-based crowdlending (CCAF, 2019).

The biggest Sharia-compliant platform for SME lending in gulf countries is beehive, with approximately $170m in facilitated loans in 2020 (as of spring 2021). The platform recently partnered with government entities to roll-out a digital financing platform for micro and small Saudi Arabia enterprises. Across the UAE region, retail investors account for the dominant share of digital loan investments, with 90% against 10% institutional investors.

Another underlying driver is that since 2017, Islam is the fastest-growing religion in the world. It is already the second-largest religion after Christianity, and by 2025, approximately 30% of the global population will be Muslims. Sharia-compliant lending platforms are not only rolling-out products that their customers desire. They are entering an underserved growth market, while also captivating the general socially responsible investors and borrowers due to an emphasis on fair and equitable treatment of counterparties in the financing agreements.

We at Exaloan are excited to see where the market is headed! If you are interested in country-specific details, please contact research@exaloan.com.

 

Further Read / Interesting sources:

If you want to find out more about our ecosystem, please reach out to us.

We look forward to working with you!

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Credit Rating Agencies in Digital Lending

Credit Rating Agencies in Digital Lending

One of the fundamental issues for investing in digital lending stems from a lack of standardization and transparency in the market. Fragmented into hundreds of lending platforms, with equally many rating methodologies and rates, comparability among investment opportunities is a nightmare. Furthermore, lending platforms typically act as loan originators, brokers, and rating agencies at the same time. It’s an encompassing business model that has enabled digital lending to scale up rapidly, but it also creates an array of problems:

Crooked incentives

Agency problems root in the fact, that digital lending platforms benefit from scaling loan originating. A recurring feature of the digital lending market as of now is an excess demand for credit compared to available financing volumes . A common problem with platform business is balancing two sides of one coin: in this case supply of financing with demand for credit. With credit being a function of capital available, the incentive to jack up interest rates to attract and retain investors is imminent.

In the long-run, the resulting problems are various: painful interest obligations for borrowers, adverse selection of the crowd, the threat of sliding into bad credit segments, a weakened competitive position, and high risks for the lending platform’s longevity.  

In traditional fixed income markets, agency problems are mitigated by having not the originator, but an independent rating agency assesses the creditworthiness of the borrower.

So much for (resolving) agency problems.

Intransparency

Another problem is information asymmetries. Who’s to say the credit score assigned to the loans is trustworthy? One might argue, that if platform A’s rating cannot be trusted, one can always pivot to platform B. Bad for platform A. And a cumbersome and annoying process for the investor. And then again, how will she compare her investment opportunities if each platform has a unique rating scale and methodology to assess risk? How is she going to decide? Trial and Error? Seems unsustainable.

The lack of transparency, comparability, and standards in digital lending represents an enormous hurdle for investors. It also puts a ceiling on the industry as a whole with respect to cross-platform investments, scalability, and further institutionalization. Without a unified credit score, the comparability of investment quality across platforms is a nightmare. The problem is only amplified regarding investments across markets.

In traditional fixed income markets, these information asymmetries between borrowers and investors are mitigated by independent rating agencies. In an independent assessment, a unified score is derived that enables the investor to compare and select amongst various investment opportunities. The rating assigned thereby shows an agency’s level of confidence that the borrower will meet its debt obligations as previously agreed. Some risk and uncertainty always remain, and investors are obliged to trust the agency and the results of its assessment. But having a third-party validator is best practice. Most of all it is helpful in creating more liquidity.

So much for (resolving) information asymmetries.

Why don’t we have an independent rating agency in digital lending?

A rating agency in the digital lending market must score millions of individual loans based on a unified methodology that can be applied to the entire ecosystem in real time. Quite frankly, it may seem unnecessary given that most platforms already have tested and trustworthy credit risk assessment processes in place. However, for the sake of scalability and institutionalization, it will be necessary. And it must come from an independent party.

It’s number crunching at scale. It requires massive amounts of qualifiable data. But the beauty of this new lending era lies in being digital. Which means, the underlying processes are automatable, and which means the ecosystem is highly scalable.

Introducing Loansweeper

We have developed software, that derives a standardized and platform-agnostic credit score in real-time, enabling investors to get a transparent and comparable risk assessment on investment opportunities in digital lending. From an independent third party. And all in on hand on our global B2B marketplace across numerous lending partners.  

We developed our software because digital lending will fundamentally disrupt the global credit markets. It is already happening with regards to the loan application and assessment process. However, to open this market to institutional investors, we built the necessary technology to not only digitize, but standardize the funding process in digital lending.

If you want to learn more about how we can provide you with one interface to the source, score, and ultimately fund millions of individual loans across markets, reach out to us.

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Rise of Digital Lending

 

 

2020 – A year that put a spotlight on Digital Lending 

 

After an exciting, disruptive, and challenging year 2020, it is time for us to recap the rise of digital lending. How did 2020 shape the nascent industry, and where is it headed? Let’s have a look.  

 

 

The Origins – Building on the Crowd

Digital lending emerged in line with the expansion of digital financial services. Its origins are thereby largely based in Crowdfinancing.

 

Crowdfinancing is a concept that describes the opportunity for individuals, entrepreneurs, and companies to raise funds online by applying to a pool of investors, typically in the form of a campaign. Crowdfinancing platforms lower the threshold for borrowers and investors to partake in a transaction alike, by enabling direct and more fragmented interactions. The use of technology allows for improvements in speed, transparency, and costs. Various technologies are deployed to automate the entire credit process, from online-only applications, to data-driven risk assessments and automized matchmaking and allocation processes. Furthermore, borrowers can directly test the market value of their endeavor by being directly exposed to potential financiers.

 

Common Crowdfinancing models include Equity-based Crowdfunding or “Crowdinvesting”, Reward-based Crowdfunding, Donation-based Crowdfunding, and ultimately Lending-based Crowdfunding or “Crowdlending”. Crowdinvesting thereby describes a form of equity financing, while Crowdlending is a debt-based financing solution.

 

In Equity-based Crowdfunding, the loan is granted in the form of shares or mezzanine financing instruments. Accordingly, the investor acquires a share in the company and participates in its success, i.e., in the profits.

In Reward- and Donation-based Crowdfunding, the borrower may provide a material consideration to his investors for contributing their capital, although the reward is not necessarily of financial nature, but may be idealistic. With donation-based Crowdfunding, the investor does not receive any financial or material consideration for his investment, but donations are made for ideological reasons only.

Lastly, lending-based Crowdfunding describes a concept akin to a bank loan. As with any debt security, every investor that financially participates in the corresponding crowdlending project receives a fixed interest rate in return for his investment for a certain period of time and is repaid the principal.

 

The latter is what is also commonly referred to as Digital Lending.

 

 

The Rise – Redefining the Lending Value Proposition and Driving Financial Inclusion

Lending is traditionally banking business. In more established credit markets, efficiency concerns drive digitization in the credit process, enabled by technological advancements and changing business requirements. Speeding up the lending process by means of automation is a significant advantage of Digital Lending over traditional lending products. It enables players to cater to changing consumer preferences for speedy and flexible financial services. Through automation, Digital Lending has extensively reduced the amount of time needed to obtain a loan from a couple of months to just a few hours. Furthermore, procedures from application to risk assessment and disbursement are becoming more transparent. Meanwhile, a lot of waste linked to cumbersome, manual processes is reduced by paperless and largely data-driven systems.

 

In developing markets, the lack of traditional credit options has led to an enhanced proliferation of digital financial services. Globally, millions of people still lack access to traditional financing institutions due to structural barriers or simply because they do not fulfill conventional customer requirements. The result of an insufficient financial infrastructure is that a suboptimal amount of capital finds its way into these economies. By offering digitized solutions, digital lending platforms can also contribute to financial inclusion and make credit more widely accessible by reaching previously excluded borrower segments. Since credit is the backbone of economic growth, improved lending services are widely regarded as a key element in financial and capital systems. The potential value of Digital Lending for the real economy is largest in emerging economies that are characterized by a flawed banking system, high demand for credit and a young, and tech-savvy population.

 

Digital Lending also opens a new segment for investors, leading to a broader, more diverse investable ecosystem. Compared to traditional asset classes, Digital Lending thereby offers an attractive new investment opportunity characterized by steady income generation, short duration and competitive returns. It can be accessed by technology-enabled players who can exploit process efficiencies using standardized default predictions based on qualifiable data and applied machine learning techniques.

 

 

Current Situation – New Regulation and Institutional Capital Needed

Digital alternatives thrive, where traditional services and products fail or become outdated. As of now, only a small fraction of lending activities is truly digitized. Of the trillion-dollar global lending market, a few hundred billion in transaction volumes are covered by digital lending platform activities every year – although at rapidly increasing growth.  

 

We count more than 1,500 digital lenders globally, facilitating around 300bn USD in digital credit on an annual basis. At the same time, we observe that, on average, less than 20% of approved credit applications ultimately receive financing with the existing (mostly retail-based) investor basis. The fact that the demand for digital credit widely exceeds available funding volumes is a worldwide phenomenon. Now that the pandemic and subsequent economic scrutiny has forced many private investors to retreat their capital off digital lending investments, this problem is likely to persist.  

 

The findings are critical, given the already existing financing gap of more than 5bn USD annually, which hinders in particular SMEs in developing countries to receive appropriate funding via traditional channels. 

 

With these considerations in mind, several regulators in emerging economies have adopted progressive Fintech frameworks to incorporate digital financial services – and digital credit – into their conceptualizations for new, inclusive, and sustainable economic systems. With the groundwork of Fintech regulations almost done, in Southeast Asia, it is assumed that by 2025 around 8% of the local lending market will become digitized, representing more than 100bn USD in aggregated loanbook values across the region (Google, Bain & Temasek, 2020).

 

A significant development this year has also been the proposal for a new European crowdfunding regulation by the European commission. The regulation, which is aimed to come into force in November 2021, acknowledges not only the importance of a Pan-European, harmonized regulatory framework for digital lending activities, but also the difficulties for the necessary institutional capital to enter the market. Proposed measures should ease the entry of institutional money.

In line with these developments, few prominent players are opting for institutional capital as their only source of funding in the future, as the AltFi team reports in their alternative lending predictions for 2021.

 

While these are favorable outlooks, one may put the careful caveat that the necessary technology for standardized, large-scale institutional investments in digital credit is yet to be implemented. Nonetheless, the introduction of large-scale institutional capital is certainly what Digital Lending needs to transform successfully into a full-fledged digital financial market. 

 

 

Outlook 2021 – Great Fundamentals & Key Year Ahead

Overall, 2020 has been a stress-test for the industry, highlighting the advantages and challenges with Digital Lending activities. Regulators all around the world, established financial institutions and governments locked their focus on digital lending platforms, closely eying their ability to distribute capital and process loan request rapidly and efficiently without personal contact over the past months of the pandemic.

 

We have seen businesses being driven out of the market as their investor base crumbles. Other players have mobilized to adopt and conquer the challenges of 2020 successfully by means of new collaborations and improved risk management.

Digital lending is still relatively young, but its sound fundamentals and far-reaching value proposition indicate, that the credit platform economy will continue to shape lending as we know it.

 

At Exaloan, we look forward to an exciting new year for digital lending and welcome the unique challenges and opportunities of 2021!

 

PS: Which topics would you like to read about in 2021? Let us know, which aspects of the digital lending investment ecosystem you would be interested in learning more about by submitting your feedback via info@exaloan.com

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Revisiting the effect of COVID-19 on the digital lending market

Revisiting the effect of COVID-19 on the digital lending market

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Months into the pandemic, we are taking another look at the global digital lending market and its response to COVID-19. As we approach the last weeks of 2020, loan origination volumes are still significantly down compared to 2019 levels, but a few signs of a potential recovery are starting to emerge. At the same time, further consolidation among lending platforms is likely. Credit defaults have remained quite well under control, albeit the full effect of the COVID-19 shock on lending platform loan books remains to be monitored. Some fintech lenders have demonstrated great flexibility in expanding their lending activities under government-backed programs, which indicates a sound basis for further recovering lost ground in terms of origination volumes. Having access to an institutional investor base thereby continues to be key for digital lending platforms’ future growth.

 

Origination volumes & performance

We see an expectable decrease in origination volumes across the product palette, particularly for consumer loans and mortgage loans. This trend is manifesting and likely to continue for a short-to-medium term outlook. 

In Indonesia, one of the largest digital lending markets in Southeast Asia, with more than 9bn in originated loans as of September 2020, credit demand is slowly returning to pre-COVID levels, but loan performance continues to worsen. TKB, a measure of non-performing loans (NPLs) after 90 days, increased 4.8% YTD, standing at 8.27% in September 2020. In January 2020, TKB stood at only 3.6%. 

Looking at Europe, origination volumes are also regaining pace. For Mintos, one of the largest European players, monthly originations in September stood at 87m EUR (Euro-Area only), a volume comparable to October 2018 levels. Nonetheless, the development marks a steep recovery from 40m EUR in April, especially since several loan originators listed on the Mintos marketplace have been defunct or closed operations during the summer. 

Finland-based digital lender Fellow Finance also shows a reduced amount in funded loans, standing at 11.4m EUR in October 2020, down from 15.5m in January, but up by about 37% from the April low of EUR 8.3m. Since average interest rates have been raised by roughly 2% across the board since Q2 2020, demand for new loans has been sluggish. Nevertheless, a significant amount of loan applications remains available for funding, and further investment interest following the higher rates is likely.

 

Loan performance across the digital lending segment is holding up reasonably well so far. With extended repayment schedules and extensive restructuring, some established lenders have managed to contain pre-COVID adjusted defaults. Still, we observe that delinquencies are starting to rise across outstanding loan origination vintages for several fintech lenders. With tighter credit conditions and modified risk assessment models, new loans originated after the COVID shock in April are performing seemingly well. However, the evolution of default rates across the loan book remains to be monitored in the upcoming months. 

 

 

Collaboration and institutionalization

Apart from demonstrating the need to rapidly deploy funds through technology, the pandemic has also invoked an unprecedented wave of collaboration between governments and Fintech companies. French SME lender October secured almost 160m EUR in support of European SMEs. The platform is now offering state-backed loans to French companies in the tourism sector as well as state-guaranteed loans to Italian SMEs. The Danish lender Flexfunding has also secured state-support, now offering specialized debt-instruments to Danish companies. In the UK, Europe’s most established digital lending market, the Coronavirus Business Interruption Loan Scheme (CBILS) has already accredited more than 100 bank and non-bank lenders to help UK’s small businesses affected by the pandemic in accessing finances.

 

Positive investment signals in Fintech lenders also come from the private sector. Germany-based SME lender Creditshelf recently set up a new direct loan fund, backed by its founders and EIF, to support German SMEs hit by Covid-19. In a similar fashion, the largest German Fintech lender, Auxmoney, secured 150m Euro from US private equity firm Centerbridge Partners to expand its leading market position and announced to be funding up to EUR 500m in loans along with other investors on its own marketplace.

 

With retail investors retrieving their capital during economic uncertainty, such collaborations are vital for Fintech lenders to continue distributing loans efficiently via their tech platforms. Qualifying as eligible distributors of government aid schemes also signals increasing acceptance of Fintech lenders into the mainstream. 

 

Outlook

The pandemic is the first real stress-test for the industry. While some digital lenders have found themselves at a crossroads, several established players have adapted well to the circumstances and struck new partnerships to cater to borrower segments in need of funding. Still, the most recent events have shown that access to a broad institutional investor base continues to be the essential growth driver of marketplace lenders. At the same time, loan selection and analysis will be essential to generate a solid investment performance for investors in digital lending.

If you want to learn more about how we can provide you with one interface to the source, score, and ultimately fund millions of individual loans across markets, reach out to us.

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The Global Financing Gap: MSME Credit conditions and their implication on alternative lending

The Global Financing Gap: MSME credit conditions and their implication on alternative lending

Alternative finance has been gaining more and more momentum throughout the years. Its role is becoming even more crucial especially now that the traditional financial systems are failing to provide the services they were designed to. In this post, we look at the global financing gap, the disadvantageous credit conditions for Micro, Small, and Medium-sized Enterprises (MSMEs), and the implications for alternative lending markets.

With the belief in future economic success, credit, issued by financial institutions is commonly known as the backbone of economic developments. A financially sound system may be characterized by a sustainable balance of supply and demand for financing. In reality, this service is provided unequally across markets, adding to the imbalance of power between large and small corporates and putting a burden on entrepreneurship and innovation.

 

The global financing gap is an estimation by the SME Finance Forum as the difference in financing supply available and potential local demand. Effectively it measures the need for external funds for the private sector which could potentially be addressed by financial institutions. The estimation assumes that the restricted firms have the same willingness to borrow money and would exhibit that willingness akin to their counterparts in developed countries if they were given the opportunity.

The Global Financing Gap

The first well-known estimate of a global financing gap was given by the IFC and McKinsey in 2010. Back then, the circulating number was $2 trillion per annum. With more statistically sound data, the current global finance gap for MSMEs has been reassessed to amount to a staggering $5.2 trillion per year.  For reference, $5 trillion is roughly the sum provided by global governments in Covid-19 relief packages by June 2020, according to the IMF. In other more SMEs, mostly in developing markets, miss the same amount of funding that is now being pushed into the economy in a massive rescue and mitigation effort – every year!

The financing gap represents the aggregated failure of our global financial markets. It highlights how we neglect the importance of SMEs in our societies and economies. 9 out of 10 new jobs worldwide are created by small businesses. They contribute the largest share of GDP, play a crucial role in economic development and foster entrepreneurship and innovation. We rely on these businesses, not only in emerging markets, where we will need nearly 3,3 million jobs per month to absorb the growing workforce, but everywhere.

The map below shows the current financing conditions for Micro, Small and Medium sized Enterprises in developing economies. Given their underdeveloped local capital markets some MSMEs are calling for 3,4, or 10 times the amount of financing available.

As these economies maintain momentum in their development, only few will be able to mobilize the necessary funds to finance their businesses. Assuming that their growth trajectory and subsequent need for financing will continue, few will be able to mobilize adequate financing volumes necessary to maintain momentum.

Financing Gap 2

Without sufficient access to credit or suitable alternatives, MSMEs may be forced into detrimental credit conditions.

 

Credit is a function of available capital and interest rates are subsequent, hence it is unsurprising that interest rate levels for MSMEs vastly exceed those for established companies. The global average interest rate spread between small enterprises and large corporates hovers between 2 and 2.5 percentage points. Since 2010, a slight decrease from 2.48% to 2.18% has been observed. In emerging and developing markets, most foremost Latin America and Eastern Europe, the overall interest rate level and spread between small and large companies is significantly higher.

 

This discrepancy in financing costs is vicious; (M)SME’s are adversely more affected by high financing costs than larger enterprises; they already operate under more uncertainty, higher stress and have lower liquidity reserves to balance economic downturns.

 

Looking at the global financing gap and the disadvantageous credit conditions for MSMEs the imperative for alternative lending operations becomes obvious.

Digital Lending To Improve Access to Financing For (M)SMEs

Where banks fail to provide adequate services, alternative finance may step in. With a distinct focus, innovative mindset and by leveraging the power of technology, they mitigate information asymmetries, automate application and KYC processes, and enable those previously excluded from traditional credit markets to receive much-needed financing – in a convenient, cheap and efficient manner. While the infrastructures are being built to distribute credit to borrowers in need, we are far from achieving a sustainable digital lending ecosystem. Digital lending processes can only work with digital funding processes.

 

At Exaloan we aim to mitigate the discrepancy in available financing and supply by institutionalizing and digitalizing funding processes for alternative lenders. Why? Because our lending platform partners perform an essential service to society, by standardizing and automating investments in digital lending. Exaloan offers an infrastructure to allocate institutional capital into the markets that demand it.

Disclaimer

This document is provided for informational purposes only and does not constitute investment advice and must not be relied on as such. This document may include information that is based on assumptions, models, and/or analysis as well as on data provided by external sources. While having applied due care and diligence in preparing this document, Exaloan makes no representation or warranty as to the completeness, accuracy, or reliability of the information provided. Exaloan takes no responsibility to update this document or any of the information contained herein. Actual developments may differ materially from the opinions expressed herein. Past performance is not necessarily a guide to future performance.

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Does Digital Lending Add Value to an Investor’s Asset Mix?

Does digital lending add value to an investor’s asset mix?

Digital lending is a hot topic. And as we commented in our last post, even a global pandemic has not mitigated the segment’s momentum. Quite the opposite in fact. However, further growth will only be sustained if institutional investors start entering the stage to fuel the supply side with bigger cheque sizes – and if some key questions about digital loan performance are addressed.

In this post, we take a closer look at why digital lending and private debt receive so much attention and whether it might be a good idea for institutional investors to have a closer look at this space (Spoiler alert: yes, it is).


In a nutshell, we modeled the investment opportunity set of traditional asset classes available to a European institutional investor and compared the results with an enhanced set that includes digital lending.


Market Data and A Lot of Number Crunching 

For our benchmark opportunity set, we created 1 million different portfolio allocations with the monthly return series of indices representing the following asset classes: equity, real estate, corporate bonds, sovereign bonds, and private equity (1). To take a more meaningful perspective across the last decade, we considered the historical return observations from January 2011 until June 2020.

Since the digital lending market is still relatively young and not standardized, a benchmark index with a long data history is unfortunately not readily available (Spoiler alert #2: we are working on it). For now,  we turned to academic research and number crunching. Following the methodology in “The Components of Private Debt Performance” proposed by Giuzio et. al. in 2018 in the Journal of Alternative Investments, we approximated the returns in digital loans on the basis of European bank lending rates. (We will shed more light on the method behind our madness in another post).

(1) For equity, we used the MSCI Europe, an index that comprises 435 European Corporates and captures roughly 85% of the market cap of European Industrial Nations. For Real Estate we looked at the MSCI Europe Real Estate Index, a free float-adjusted market capitalization index that consists of large and mid-cap stocks in the real estate sector across 15 Developed Markets (DM). Furthermore, Euro-denominated, investment-grade corporate bonds, and sovereign bonds were proxied using the iBoxx EUR Non-Financial and iBoxx EUR Eurozone bond indices. Private Equity is represented by the STOXX Europe Private Equity 20 Index, which is designed to measure the performance of the 20 largest private equity companies in Europe.

Visualizing Our Results: Digital Lending Is an Interesting Piece in the Asset Allocation Puzzle

To build the opportunity sets, we created all allocations using no-leverage assumptions & no-short-selling constraints. We also constructed the respective efficient frontiers and color-coded the Sharpe Ratio of each individual portfolio for better comparability. The results we get when constructing portfolios with varying allocations using the traditional asset classes are displayed on the left in Figure 1. On the right-hand side, digital loans are added to the mix.

Figure 1: Results with traditional assets vs. Results when adding Digital Loans

The color scale on the far right indicates the value of the Sharpe Ratios (red = high, blue = low). The results show that adding digital loans to a traditional asset mix can significantly improve the investment opportunity set as evidenced by the higher Sharpe ratios of portfolios that can be constructed. For simplicity, the risk-free rate is set to 0 in all our calculations. The results indicate that adding digital loans can help diversify an investor’s traditional asset mix,  and improve investment performance. Part of the result can be explained by the low correlation of digital lending to traditional asset classes.

For a better display, we also contrast the different opportunity sets without the noise from the individual portfolios. You can see our calculated efficient frontier in Figure 2. The direct comparison shows that the efficient frontier including digital loans clearly dominates the attainable results without digital lending.

Figure 2: Efficient frontier of Traditional Asset Mix vs. Adding Digital Loans

Our findings show that adding digital loans to a portfolio could be an interesting new way for investors looking to diversify their portfolio holdings, particularly given the backdrop of a low yield environment.

 

Exaloan is working on standardizing and automating digital loan investments for institutional clients across the globe. We are convinced that digital lending is a highly interesting and impactful emerging new asset class and with studies like these we hope to invite more interested parties to our dialogue.

Leave a comment or a question, we appreciate the input.

 

As mentioned, we will dive deeper into the return construction for digital loans in one of our next posts. Follow us to stay up to date. 

If you would like to read the full research paper, or find out more about how we enable institutional investors to tap into the digital lending market, click the button on the right!

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The effect of Covid-19 on the digital lending market

The effect of Covid-19 on the digital lending market

Covid-19 crisis has increased the need for digital lending platforms and their products more than ever. Yet, most platforms are facing a major lack of funding.

The Covid-19 pandemic and its subsequent lockdowns have confronted many people with the challenges of raising funds – fast, and without personal contact. While optimally positioned to supply financing in the form of digital credit, the pandemic has had adverse effects on alternative lending platforms.


In Indonesia, one of the largest markets for digital lending with 7.4bn USD in distributed loans as of June 2020, credit demand is surging – with the regulatory authority reporting a 166% year on year increase in requested loan volume. Investment appetite registered by Singapore-based SME lending platform Validus is now surging above pre-crisis level as investors realize the benefits of digital lending, including its low correlation to public markets in times of economic uncertainty. Digital lending platforms across the globe have alleviated credit financing for businesses and SMEs to help secure the liquidity needed to mitigate the effects of the sudden economic downturn.


Simultaneously, balancing demand with funding supply imposes a challenge to many bilateral marketplace modelsLending Club one of the largest digital lenders globally, experienced a 90% yoy drop in loan origination volumes in Q2 2020. The pandemic also threw monthly loan origination levels in April and May 2020 of Mintos, the largest loan origination aggregator, back to 2017-levels.


The Frankfurt-based SME credit platform Creditshelf was highly affected by the pandemic, leading to a decrease in the loan volume by 31% in the first quarter of 2020 compared to the same quarter of the previous year and almost by 70% from the last quarter of 2019. Even though the requested credit volume rose by 60%, only 2.3% of the loans could be granted. Meanwhile, loans distributed by the Finnish Fellow Finance platform have been providing positive investment returns, which has even improved from the same period last year. They facilitated 10.7m USD of loans in June and the number of investors has been rising since the beginning of 2020.


Similarly to loan volumes and investment returns, default rates were also adversely affected by the pandemic, increasing both in Europe and Southeast Asia. Among European digital lending platforms, default rates vary between 3%-6%, where the highest ones were captured in the past two months. Meanwhile, in Southeast Asia, they slightly increased in comparison with the last quarter of 2019 ranging between 13%-16% and reached their peak in March.


While the pandemic will undoubtedly drive out unsustainable lending businesses in the long run, the necessity to further the digital lending market is obvious. Direct lending has long offered attractive risk-adjusted returns compared to traditional investments, and due to its low correlation to the public bond and equity makers, now might be an ideal time to begin exploring how to invest in it at a scale – and help businesses continue distributing necessary funds to their borrowers.

Learn more about how we can provide you with one interface to the source, score, and ultimately fund millions of individual loans across markets.

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