Today’s announcement by Funding Circle that – just after turning five – it  will shortly move from using reverse auctions to offering only fixed-rate loans will be seen as a watershed for all sorts of reasons. The idea of creating an “eBay for finance” has deep roots in the UK’s P2P movement but as The Economist pointed out in a recent issue, even eBay has been steadily moving away from the auction model for years as a growing percentage of sales take place at the fixed “buy it now” price.

 

Now Funding Circle has gone one step further. Ending the reverse auction system, in which investors bid against each other over seven days to offer more attractive rates to the borrower, undoubtedly sacrifices one of the founding principles of the company: the idea of a public market in credit where supply and demand balance out in real time. Auctions were a vital part of the business’s early proposition, helping to distinguish it from Britain’s deeply unpopular banks. They also appealed to FC’s early users, who were basically DIY investors that enjoyed the challenge of auction bidding. But for all of that model’s appeal, it is fiddly and labour intensive, and therefore unlikely to scale beyond a certain point.

 

Investors and companies like transparency and certainty. Borrowers want to know exactly what their loan is going to cost and they want the money as fast as possible. Investors want to get their money lent out as fast as possible: waiting seven days for an auction to close is frustrating because it leaves their cash idle when it could be earning a return. This “cash drag” dilutes their overall returns. The beauty of fixed-rate auctions is that they close as soon as enough money is offered, which means minutes thanks to the autobid system. That produces less cash drag for investors and quicker drawdown for borrowers and ultimately adds up to a fast, friction-free process that is easily scalable.

 

It also probably means that autobid, which already accounts for more than half the lending on the platform will become even more dominant than it is today. Given that fixed rate auctions are likely to fill in minutes, or even seconds, how could a DIY investor determined to pick his or her risks hope to be sure of getting into any of the deals? They would have to be the P2P equivalent of a day trader.

 

Some will regret the passing of the auction system, but it’s surely just an inevitable step in the growth of Funding Circle into a big – and hugely scalable – lending platform. As the platform points out, it simply brings the original UK SME loan market into line with Funding Circle’s property loans, which are all fixed-rate, as is its institutional whole loan market and its entire US operation. Looked at like that, the UK SME market was the anomaly and once it has shifted to fixed rates, the model that Funding Circle will use to roll out into other products and markets around the world will be absolutely clear and coherent.

 

Moving to fixed rate auctions also ends another anomaly that reverse auctions tend to produce – “pricing to liquidity” rather than “pricing to risk”. If interest rates are determined by the weight of money on the lending side, rather than the risk profile of the individual borrowers, then the likelihood of widespread mispricing of deals goes up enormously. This is why Funding Circle originally put in bid floors for each of its risk bands. Moving to fixed-rates takes that half-way-house initiative to its logical conclusion.

 

However, it will also put greater focus than ever on the quality of the platform’s credit underwriting and analysis – when lenders no longer take any responsibility for the pricing of the credit, the buck stops with the platform and the quality of its technology. Where it sets its fixed rates for each risk band and what criteria it uses to move them over time will be keenly watched and debated.

 

Finally, given that Funding Circle has 80%-85% of the SME P2P market in the UK, the move to fixed rates means that more than ever it effectively becomes that market. Over time as it grows, the fixed rates it offers could well become the benchmark by which borrowers judge the price of similar credit from other sources, including banks. That could make it increasingly difficult for other to charge significantly more for similar types of credit.

 

It’s possible that auctions will continue elsewhere for some time to come, but their days look numbered to me.