This document summarizes the growth of online lending platforms and their impact on traditional banks. It discusses how online lenders have more efficiently served small businesses and consumers through streamlined online application processes. It also describes how some online lenders have partnered with large banks, such as OnDeck partnering with JP Morgan. This allows banks to utilize the online lenders' platforms and underwriting technologies to offer loans at lower costs than traditional in-person lending processes while keeping the loans on the banks' balance sheets. The partnership helps online lenders expand their reach while improving their resilience through the stability of banks' funding sources.

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Online Lending: A Prudent Disruption to the
American Lending Economy
How online lending platforms are seizing business from mega-banks that have
systematically underserved the American small business for years, and is reestablishing
solidarity between the main street and the lending institutions. After all, the ability of an
idea to become a reality is the foundational measure of economic prosperity. This
disintermediation not only creates dynamic investment opportunity, but is taking
profound steps towards reconciling the American Dream.
By David Nichols

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Abstract
For hundreds of years, in a globalized world revolutionized by technology, banking has
fundamentally gone unchanged. Borrowers go to their retail bank location, fill out
paperwork with a commercial banking agent, and then wait weeks for a decision to be
made on the approval of the loan. Meanwhile, bank borrowing costs have reached all-
time lows. The 2 year treasury yield that hovered around 4.5% prior to the financial
crisis now sits below 2%. However, the average unsecured interest rate still hovers
between 13% and 14%. While volumes of loans have dropped precipitously since the
2008 financial crisis, profits on this spread have widened. Banks, which were once
recognized as pillars of the community that supported the aspirations of small business
entrepreneurs, have commercialized the consumer. Since year 2,000, banks have
received about $1 trillion in interest expenses from their credit card customers.
Traditional lending is great… for mega-banks. However, what if the middle man was
eviscerated from lending and investors (in the case of banks the depositors) were
directly connected with borrowers. They could then agree to the terms of the loans
without the intermediation of retail banks or credit card companies. This may seem
quixotic, but marketplace lenders (and other online lenders) are facilitating this
detachment. Their form of intermediation is much more prudent and transparent to
both the investor and the borrower. Consumers whom have grown tired of dealing with
banks are readily moving their business to online platforms.
This trend stretches further than the individual borrower. The ability for an individual to
start and grow a business is the foundation of the US economy. Small businesses have
played a continuously integral role to economic growth, as two out of three jobs (over
the past two decades) were originated by small businesses. Thus, it is imperative that
small businesses are represented in the capital markets and given access to affordable

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credit to facilitate their growth. Innovation is stifled without the means of financing its
economic implementation.
The way that small businesses and consumers acquire credit is being revolutionized by
technological platforms, such as OnDeck and Lending Club. Advances in this industry are
expediting the process of applying for a loan to small businesses and consumers.
Marketplace lending, which connects individual borrowers and individual lenders in an
online platform to create liquidity in the credit markets, has been growing and
improving for nearly a decade. These platforms have leveraged sophisticated
partnerships with institutional partnerships and financial institutions and have utilized
direct lending and securitizations to support their growth.

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Background
Marketplace lending uses data-driven online platforms partnered with invested
capital to lend both directly and indirectly to borrowers (including both individual
consumers and small businesses).
This market has transformed from its prior state as a peer-to-peer platform, as it has
grown to include hedge funds, financial institutions, and other institutional investors.
Online marketplace participants share a few common themes. With their ability to
provide funding in less than 48 to 72 hours, they have effectively made credit more
quickly accessible to SMBs and consumers. Second, they have the structural capacity
to offer shorter-term loans, which does not fit the cost structure of most institutional
banks. Jamie Dimon, in a narrative describing the emergence of the online
marketplace, remarked that the costs are the same for smaller loans and substantially
larger loans (say, a $10,000 loan versus a $1,000,000 loan). However, the inflows
from these two loans are obviously drastically different. Consequently, larger financial
institutions pursue the more profitable, larger loans and have stepped away from
funding smaller loans as they fail to create an acceptable return on invested capital.
Third, online lenders do not have to rely on retail branch locations to support their
distribution (or origination, in their case) of loans. Instead, their business model is
entirely integrated into an online platform. The costs associated with operating the
online marketplace is much more efficient than operating in-person locations, which
traditional banks must do to support their offline model. Lastly, online lenders utilize
technology and algorithmic strategies to confirm the identity and data provided by
the borrower and ultimately assess their credit risk. These data sources are not
limited to the traditional inputs that banks have relied on for years; online lenders are
also able to include, for example, real-time business accounting, payment, and sales
history, online small business customer reviews (for example, OnDeck taps into the

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Yelp database to assess consumers sentiment toward a specific small business), and a
plethora of other non-traditional information. Overall, OnDeck access more than
10,000 data points to make an automated decision in seconds.
This industry has grown to rely on two different business models. First, direct lenders
(the online lender) originate loans from a variety of marketing channels and
partnerships and retain the value and risk of the loan on their own balance sheet. The
second business model relies on an online marketplace to match investors with
borrowers, thereby creating originations and immediately moving them off their own
balance sheet and onto an investor’s. In this model, investors can either purchase the
whole loan or are issued securities of the loan. Securities enable members to buy part
of a loan. For example, Lending Club allows its investors to purchase as little as $20 of
an individual loan.
The direct lenders that originate loans and keep them on their balance sheet are
required to obtain licenses in most of the states that they operate in. However, they
are not treated as banks and are therefore not subject to a federal banking regulator’s
supervisory authority.

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Further, lenders that originate and hold loans on their balance sheet generally (and
increasingly) rely on credit facilities, whole loan sales, and securitizations of loans as
credit sources to support liquidity. Capital inflows come in the form of interest rate
fees paid by the borrowers and other fees associated with the loan, which can include
the fees of servicing a loan and selling it to a third party customer.
Platform lenders, such as Lending Club, partner with issuing depository institutions
(such as WebBank in Lending Club’s circumstance) in order to use their charter to
make loans in different states without having to obtain the necessary licenses to do so.
Therefore, the depository institution has to hold the loan for two days, generally,
before it can be distributed to the platform lender or purchased by on of their
investors. Investors who purchase the loan receive a stream of payments from the
borrower linked directly to the performance of the loan; these are called “member
payment dependent notes”. Consequently, the platform provider does not assume any
credit risk associated with the loan held by the investor. Although the platform lender

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does not pool the loans, investors can purchase loans in groups that meet certain
criteria specified by that investor.
Platform lenders pay the depository institution that they partner with in order to
originate loans a fee based on how many loans they purchase from the depository.
Even though the loans are only held for three days at most, the depository generally
earns interest on the loan. Platform lenders generate servicing fees from their
investors and transaction fees from the depositories for originating the loan.
Some products that are offered by these marketplace lenders to investors are not
technically loans. When Lending Club, for example, sells a fraction of a loan to an
investor, these security is issued in the form of a note to the investor. These types of
investments are referred to as “borrower payment dependent” notes; thus, these
notes reference the performance of the represented loan, but there is some form of
intermediation between transferring payments to the investor. It is meaningful to
draw a careful line between buying an actual loan and a note because the note
exposes you to the risk of both the issuer and the borrower of the loan. This is one of
these reasons investor appetite has not grown as ravenous as one might expect in this
market, as financing for marketplace lenders can quickly dry up in the event that their
loans start underperforming.
Online lenders have adapted their business models to the performance of the loans
they originate and have optimized their algorithms and scoring functions as they have
been able to compile more and more data. However, their business models are still
untested throughout a whole credit cycle, which leaves a lot of speculation as to how
they will perform when economic performance and credit metrics deteriorate amidst
a recession. This has inherently restricted their growth in the market, which will not
realize its full potential until online lenders prove their resilience to recessive
economic circumstances. In an effort to facilitate structural resistance to this looming
issue, OnDeck has established structural protection from economic weakness. By
developing a hybrid business model, OnDeck has maximized its operational flexibility

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by simultaneously running a marketplace model while also retaining loans directly on
its own balance sheet. Thus, as the economy permutates between cycles of prosperity
and laggard growth, OnDeck can fluidly adjust its risk. Additionally, since its loans
have an average duration of 1 to 11 months, OnDeck can almost entirely clear its
balance sheet of loans in under a year. Lending Club has also taken efforts to
safeguard its durability throughout a full credit cycle by adjusting its agreements with
its depository, WebBank, to defer payments over the lifetime of a loan and to tie them
directly with loan performance; this manifests an economic interest between
WebBank and the loan and continues their contractual relationship with borrowers
past the time the loans are sold.
MaximumTransparency AcrossAll Stagesof the Loaning CycleWill
Benefit Both Borrowersand Investors
The 2007 Financial Crisis was predicated by confusion across all points of originating
a mortgage, securitizing it, bundling together the misunderstood loans, and selling
them. Subsequently, both borrowers of loans and investors in securitized loans are
demanding complete transparency from the originators/issuers of loans. Online
lenders must clearly, extensively, and systematically disclose all material aspects of
these loans. Both Lending Club and OnDeck give their borrowers the most clear idea
possible of rates and terms of the loans they are given. Further, on both Lending
Club’s and OnDeck’s platform, investors are given real-time access to loan-level data,
including information regarding the performance of the loan. These data are much
more difficult to find for investors purchasing the synthetic mortgage backed security
CDO’s that contributed to the housing crisis, but are readily available on both online

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lenders’ websites. Additionally, both companies allow institutional investors to
provide specific loan-level criteria when purchasing securitized loans through the
platform. After the security purchase, the institutional investors (just as general
investors) are able to easily access the loan-level performance data. It is important to
note that the Securities Act of 1933 does not apply to the private offerings of
securitized loans between online lenders and institutional investors.
Financial Institutionsand Their Relationshipswith OnlineLending
What used to be a very straight forward relationship with investors when online
lenders were generally referred to as being P2P platforms (general borrowers were
matched with general investors on an online platform, and the host of the platform
took a fee) has evolved into levels of much greater complexity. The image below
demonstrates the relationships that financial institutions have developed:

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Essentially, the relationships can be grouped into three different categories: business
models, investment related activity, and distribution strategies.
A. Business Models: Financial institutions can offer products such as credit
warehouse facilities to online lenders. More, depositories can use the online
platforms to source and originate loans.
B. Investment Related Activity: Financial institutions can purchase (through
securitizations and whole loan sales) the loans originated on the online
platforms, which they then hold as assets on their own balance sheets, thereby
assuming the risk of the loan.
C. Distribution strategies: Financial institutions can provide customer
acquisition services to online lenders through white label, co-branded, and
referred third party arrangements for a fee. These are very common and
important to the growth of the industry (as well as driving down the marketing
and distribution channel related costs of online lenders).
Online Lenders Partner with Financial Institutions to Optimize Their Distribution
Channels. Here is how:
Most distributional relationships between online lenders and financial institutions
serve to allow the financial institution access to the platform’s automated
underwriting technology. Direct and platform online lenders can be beneficiaries to
these relationships.
When an institution encounters a customer that does not meet certain loaning criteria
set for the bank (for example, a small business asking for a short-term loan is often
turned away by a bank) can be referred to an online lender from the depository. BBVA
Compass has arranged this relationship with OnDeck, where many of its small
business clients seeking short lines of credit and smaller term loans have been
referred to OnDeck. OnDeck pays the member depository a fee for every customer

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that BBVA compass refers. This has been a successful venture that has enabled
OnDeck to move away from more costly (and often morally misguided) funding
advisors. However, the outlook on its relationship with JP Morgan has revolutionized
the industry.
OnDeck’s Partnership with JPMorgan
Although online lending platforms have an exceedingly more cost effective strategy
than traditional banks, and are also endlessly more convenient for consumers,
traditional banks have the upper hand in their ability to collect data and their
protection from liquidity risks. Unlike online lenders, traditional banks source their
funding from depositors, which is inherently more stable than the resources at the
disposal of online lenders (credit facilities, securitizations, warehouses, etc.). This
stable funding particularly aids banks as the economy troughs between disparity and
prosperity. Deposits do not tend to fluctuate in correlation with macroeconomic
performance as greatly as investor appetite for risky investments, which online
lenders integrally rely on for funding. Additionally, although competitors such as
OnDeck and Lending Club have been collecting data for almost a decade, banks have
far more scale, which consequently accesses them to more data. Data is an imperative
input for continuously improving and innovating the algorithms operating the loan
approval and pricing platforms. Therefore, the industry will likely experience a
consolidation of online lending providers as the most distinguished competitors join
in partnerships with traditional lending institutions to manifest synergies between
their respective advantages. Banks can mitigate solvency risk and utilize their
enormous collections of data, and online lenders can provide access to their cost

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effective, convenient, and wide-reaching technology. OnDeck capital has already taken
steps to establish such relationships.
Last December OnDeck closed a deal with JP Morgan to enter into a strategic
partnership in which OnDeck will allow JP Morgan access to their proprietary
marketplace platform and OnDeck Score algorithm to underwrite and originate loans
online. JP Morgan, with over $2.6 trillion in assets and roughly $100 billion in annual
revenue made the move in an effort to revitalize its presence in small business
lending. Jamie Dimon has demonstrated incredible enthusiasm about the cost
efficiencies and opportunities that online platforms generate. This deal has been on
the table between OnDeck and JP Morgan since JP led their initial public offering in
2014. However, executives at the bank waited for OnDeck to further develop its
infrastructure to meet the strict requirements in order for the deal to happen. This
meant improvements in data, security, compliance, and more. Through the
partnership with OnDeck, JP Morgan will make smaller loans (which previously did
not fit their cost structure) through its account of more than four million small
businesses. Chase will use OnDeck’s online platform to more expeditiously
underwrite and approve loans for its customers at a much lower cost. The loans will
be Chase branded and will be kept on the bank’s balance sheet. OnDeck will be
compensated by origination and servicing fees.
Many of OnDeck’s loans, as a result of being shorter term in nature, do not meet
state’s usury laws, which JP Morgan must be compliant with as a bank. Consequently,
although management has not specified where in the product suite spectrum Chase
will make its loans, they will likely have to be longer term with lower interest rates.
Interest rates start at 5.99% for an OnDeck loan.
It is important to note how much faster and convenient this is for small business
owners compared to Chase’s old lending process. Prior to the parternship, all loans
were made in person at a retail branch. The process was tortuous, often taking weeks

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for loans to be approved (that is, if they were approved at all). Chase will replicate
OnDeck’s process, as described earlier, which is entirely integrated online.
Although this is the largest and most notable, this is not OnDeck’s first relationship
with a bank. In a much different partnership, OnDeck partnered with BBVA about 22
months ago where BBVA essentially refers its small business customers to OnDeck
(for which OnDeck pays a marketing fee). OnDeck is also able to use some of the
bank’s data to underwrite the loans given to customers through this channel, but they
ultimately receive an OnDeck loan.
Sam Hodges, a managing director at Funding Circle USA, spoke highly of the
relationship and belives it auspicates the future for online lending, saying:
This exciting news speaks to a broader trend where banks are
realizing that companies like ours are great partners to help them
handle smaller loans more efficiently and cost effectively – and get
exposure to assets they haven’t had access to in decades. We’re
already working with a number of banks here and in our other
markets; looking ahead we believe many banks will prefer to put their
small business loans through a platform like ours, as a great way to
deliver superior customer experience and credit outcomes.
This marks the beginning of what I believe will be a lucrative succession of
relationships with banks and other funding institutions for OnDeck, particularly given
how inaccessible small business borrowers have become to OnDeck, which will be
expanded upon later in this paper. OnDeck is in a perfect position given its
specialization in one of the most disrupted niches in the borrowing market.
The particular importance of this partnership cannot be overstated. JP Morgan admits
that its business model and lack of technological resources restrict its ability to issue
smaller and shorter-term loans to small business. JP Morgan is the largest bank in the

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United States, making this a landmark development in OnDeck’s David and Goliath
story. JP Morgan pulls in hundreds of billions of dollars in revenue per year; if OnDeck
can even originate a fraction of the loans associated with this revenue the impact will
be tremendous. Online lenders are unquestionably a disruptive force to the financial
services industry, as retail lending is clearly becoming the inefficient and antiquated
means of making loans. Banks that do not create some connection to the online
lending industry will be left behind.
Not only does this “disruption” create an excellent investing opportunity, but this
propagates the very ideals upon which the American economy was founded. Small
businesses have been perpetually underserved in the loaning economy, as regulations
and the inability to make profits drove banks farther and farther away. One
meaningful measure of a healthy economy is whether or not an entrepreneur is given
the opportunity of turning an idea into a reality, or growing a small business to
support a family. The receipt of a denial for a loan stifles innovation. Although this
may seem overly sentimental, it is hard to question the importance of the American
small business. Online lending is the facet which will finally reconnect small
businesses to the capital markets. Investing into OnDeck is not only financially
prosperous, but also societally impactful.
Market SizeOffers EnormousPotential for OnlineLenders
Online lending is a micro-fractional component of the US lending economy. However,
its economic efficiencies and convenience are perpetuating its rapid growth in the
space of consumer and small business debt. Analysts prognosticate that $1 trillion and
$100 billion of consumer debt demand and small business debt demand, respectively,
will be accessible to online lenders by 2020. These loan origination volumes express
enormous room for growth in the online lending industry. Small businesses that have

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historically gone underserved, as regulations and cost of capital have driven
traditional banks away will finally have opportunities to access the capital markets.
Students seeking to refinance existing student loans, individuals buying cars, and
consumers refinancing unconscionably expensive debt will propagate a surging
demand for this business model.
Investor interest has already catalyzed dynamic growth in online lending. OnDeck and
Lending Club were able to raise $230 million and $1 billion, respectively, following
their initial public offerings. Investor appetite, which has dwindle recently amidst
concerns of Lending Club’s $22 million case of fraud, created $7 billion in
securitizations in 2015.

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DiverseFinancing Optionsfor Consumers and Small Businesses:
As demonstrated by the graphic above, traditional banks and online lenders generally
provide the same product offerings. However, due to their optimized low-cost
structure, some online lenders are able to offer more affordable APR’s, shorter-term
ranges, and provide to a wider demographic of borrowers. OnDeck even offers loans
for a term range as short as 3 months. Although the APR’s might seem unrealistically
high, they are offered to OnDeck’s customers on an amount-pair-per-dollar basis.
Therefore, since many of OnDecks have a significantly shorter term than one year, the
APR measure of fees inflates the cost of the loan.
Loans that are originated in the marketplace are not exempt from many federal
regulations that traditional banks are subject to. Legal consumer protection

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provisions apply equally to traditional financiers and online/marketplace lenders.
Dodd-Frank granted the CFPB supervisory authority over non-bank lenders to ensure
its sovereignty over this emerging source of capital. However, it is very important to
distinguish between small business loans and consumer loans when analyzing the
legal implications of online lending, as consumer protection laws are limited to only
protect consumers. Thus, these laws do not apply to loans made to a small business
(with the Equal Credit Opportunity Act and the prevention of unfair and deceptive
acts provision of the FTCA’s section 5 as exceptions). However, with price term and
performance transparency as an important competitive advantage for OnDeck over
traditional lenders, these acts pose no legitimate threat to its operations.
Post Crisis Consumer Credit Market
Tightening lending standards by traditional financial institutions opened the door for
online lenders after the financial crisis of 2007 (even though their existence actually
predates the financial crisis, as the first online lone was originated in 2006).
Additionally, demand for personal loans surged as individuals sought to refinance
higher-rate loans made before the crisis to lower-rate fixed term loans. Online
lending’s low-cost lending model has made its rates more competitive for a majority
of consumers seeking debt consolidation and refinancing. The graphic below
demonstrates this emphatic shift:

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These loans, however, still
represent a miniscule portion of
the $3.5 trillion consumer
lending market. As seen in the
graphic, lending club originated
just a little more than $6 billion
in originations in 2015 and still
reports that around 68.5% of its
customers reported using their
loans to refinance existing debt
and to pay off credit cards. Debt
consolidations, credit card
repayment, and demand for
other small capital needs has dominated the demand for online lending.
Small Business: A Forgotten Borrower Given Opportunity by Online
Lending
Small businesses play an integral role in the US economy. 57 million people are
employed by roughly 29 million small businesses, which makes up nearly 50% of the
private sector workforce. According to the Small Businesses Bureau, they have been
responsible for roughly 60% of net new jobs. However, small business borrowers
have been historically underserved by credit institutions, a problem that goes well
beyond the financial crisis. One reason being that it is more costly to market to the

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small business segment than to consumer borrowers; outreach alone imposes a cost
that makes it much more expensive to lend to small businesses than to the consumer
markets which is an easier niche to find, quite simply. To put this into practical
perspective, when you run an advertisement on the television, every viewer that you
reach is a consumer. However, how many of those viewers could possibly be small
business owners? In short, it is difficult to directly access this channel. Additionally,
the information required for these loans (business performance records, tax records,
etc.) is more difficult to collect for traditional lenders. Naturally, small businesses
have far more informational opacity than big corporations, as they are generally not
required to publicly file detailed financial statements surmising their operations.
Consequently, once a small business borrower is found by the lender, the
underwriting, servicing, and collection of the payments associated with the loan are
also comparatively expensive.
The financial crisis only exacerbated these problems faced by small businesses
seeking financing. The standards imposed on commercial banks’ lending to small
businesses tightened enormously in 2008 and 2009. Although liquidity has improved
in the small business lending market since the crisis, small businesses continue to
struggle today. The table below from the New York Federal Reserve Small Business
Survey details the percentage of fully funded small business loans and the average
financing shortfall:

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As seen in the table above, micro-loans still systematically go underserved. Cash flow
and the costs of running a business comprise 41% of businesses challenges faced by
small businesses; micro loans are a means of resolving these issues, but they have
become less and less profitable for commercial banks to provide. According to the
Federal Reserve’s small business survey, micro-loans make up 90% of the demand for
small business loans. The table below demonstrates the top challenges faced by small
businesses, data which was also drawn from the New York Fed’s small business
survey:
Small businesses obviously require smaller loans than larger corporations. The
median loan for a firm with less than 10 employees is only about $18,000 to $25,000.
According to information collected by various Federal Reserve Banks, only about half
of small business employers were given the full amount of the loan that they
requested. Also, as stated earlier, small businesses loans are generally for minor
capital expenditures/equipment acquisition, staffing employees, meeting tax needs,

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and working capital requirements. Therefore, since the cost of a small loan and a large
loan are nearly identical for a traditional bank, these loans do not fit their expected
return on deployed capital.
In response to these problematic realities, small businesses have begun turning
their attention to online lenders for financial needs:
As demonstrated by the figure
to the right, online lenders
(OnDeck) originated
approximately $1.9 billion in
small business loans. This
number includes both term
loans and lines of credit for
SMBs. The annual Small
Business Credit Survey
showed that 70% of small
businesses that applied for a line of credit through an online lender (which about 20%
of the respondents to the survey did) were approved for the loan. This statistic is
staggering considering that normally only about 15% of small business loan
applications are initially approved, and that small businesses have to visit
approximately 3 banks on average to be approved. The most active applicants to
online lenders are in the following industries: healthcare education, finance,
insurance, and business services (information gathered from the Small Business
Credit Survey).
Online lenders such as OnDeck are able to develop ‘sticky’ relationships with the small
businesses they service. Small businesses generally find that time spent researching

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different loan product offerings and different providers is frivolous and tend to
maximize the time spent focused on the operations of their business. Therefore, long
lasting relationships with online lenders will become ideal for such small scale
businesses. Through this relationship, small businesses and online lenders will
mitigate the informational opacity inherent in this niche of the market by gathering
data from the business used to assess its creditworthiness. As the business grows, its
online lending partner will be able to provide less expensive product offerings.
OnDeck has focused its efforts on customer retention. Last year, 50% of their direct
loan revenues came from repeat customers.
Integrationofthe Student Loan Marketplace into Online Lending
Student loan online lenders have predominantly offered their service to refinance
and/or consolidate existing student loan debt. However, some online lenders have
made new loans to students attending graduate schools that, prior to the loan,
attended elite institutions and have a history of high paying entry jobs, of which most
are super-prime borrowers with no to little credit history. $6 billion in originations in
2015 were related to refinancing, consolidating, or creating entirely new student loan
debt.
Marketplace Lenders are Better Suited for Issuing Millennials Loans:
Too Risky for Banks

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From a bird’s eye view, in traditional lending a bank accumulates funds from a host of
depositors, which it holds as liabilities on its balance sheet, and loans these deposits
out to borrowers, which are conversely held as assets on the bank’s balance sheet. In
this model, the depositors are not required to assess the creditworthiness of the
borrowers, and often have no idea as to how risky the bank’s loans are, the ratio of
loans to liquid securities in the bank’s asset reserve, etc.
In the space of P2P lending, there are no depositors. Instead, the marketplace directly
matches investors with borrowers’ loans, which are therefore uninsured. Thus, the
investor (as opposed to the bank) runs the risk of borrower default. Additionally,
investors can buy as little as $25 of one specific loan, which allows further risk
diversification capabilities that a traditional bank obviously cannot offer to both
individual and institutional investors. And, again, the marketplace lender ultimately
makes money through transaction and servicing fees associated with originating the
loan. Consequently, this business model allows marketplaces lenders to operate with
far less capital requirements than traditional banks, as their balance sheets are
substantially smaller. However, since the sale from the borrower to the investor is not
immediate, marketplace lenders do need to source additional funding to cover the
time between originating the loan and selling it to an investor; most marketplace
lenders do this through warehouse funding from a bank.
Online lenders are not the first to use to internet for banking purposes. Traditional
banks offer online services for a variety of needs: monitor your account balance,
transfer funds between banks, schedule bill payments, even take pictures of a check to
be deposited to your bank. Some banks even allow customers to apply for loans
online. On the other hand, marketplace lenders distinguish themselves by creating an
experience similar to social media on their platform, as the investors’ and borrowers’
activities are made much more transparent. SoFi (Social Finance) is a perfect example
of this which launched in 2011. Referring to their borrowers as members, the
platform offers a partner program to connect members that have business
relationships with potential or existing SoFi members. Through the “Community” tab

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on the website, members can even receive notification fro community dinners, happy
hours, and career seminars with other members; here, members can also see
“Member Stories” and engage in job search services.
Another major difference between banks and marketplace lenders is the
incorporation of non-traditional credit criteria utilized by marketplace lenders. SoFi
even utilizes data such as SAT scores, school
attended, and current job (in addition to other
traditional metrics) to evaluate their borrowers.
SoFi has expanded, but first began as a way for
Stanford School of Business graduates to offer
refinancing options to incoming students of the
business school. Still, their platform tilts towards
giving business to highly educated millennials,
predicting that they will be “HENRY”’s: high
earners, not rich yet. This business model
emphasizes another advantage realized by
marketplace lenders, which is their ability to
target and specialize within niches in the consumer credit market. This is particularly
advantageous in this niche of the market (loaning to millennials) as data regarding
their borrowing history is often short or nonexistent. However, this business model
inherently contains much more uncertainty surrounding how loans provided to a
borrower with scarce credit history will perform. Thus, investors should be patient
with this business model, as its idiosyncrasies could become dangerously exacerbated
by economic downturns.
Again, marketplace lenders are not treated as bank and therefore operate without
being audited by bank regulators. However, it is important to note that in 2008, the
SEC placed a cease and desist order on Prosper Marketplace (which it found to be in
violation of the Securities Act of 1933) and has since treated all participants in P2P
lending as securities exchanges and requires them to register with the SEC.

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OnDeck (ONDK):The Perfect Investor Entry Point into Online
Lending
Small businesses are fed up with the unconscionably inconvenient process of applying
for loans through traditional banks. According to research gathered in the New York
Fed’s annual small business survey, only 50% of small businesses are approved for a
loan. Additionally, only 37% of businesses asking for $100,000 or less are approved
by traditional institutions. Entrepreneurs looking to avoid this hassle and focus on
growing their business can apply through OnDeck’s online lending platform and have
a decision in 15 minutes.
As alluded to throughout the report, OnDeck is a leading online platform for small
business lending. Small businesses can apply through the online platform and obtain
funding as early as the same day. Since 2007, ONDK has originated more than $4
billion worth of loans. This growth has been fueled by traditional banks retreating
from their business with small businesses, as well as a broader shift of small business
functions to the internet. By analyzing roughly 2,000 data points per application
across dynamic sources, an approval decision is made in seconds. The market for
small business loans is massive; ONDK’s roughly $1bn in managed loans represents
only a fraction of what the FDIC estimates is a $193bn in, $250k US small business
loans. The FDIC also estimates that there is roughly $80bn to $120bn in unmet small
business line of credit demand. As discussed thoroughly earlier in the report, the
inability of traditional banks to fit small business loans into this cost structure has
creates this supply slack. OnDeck is positioned perfectly to pick up the slack.

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Products Offered to SMBs, Overview:
Term loans
- Range from $5,000 to $500,000
- Term ranges from 3 to 36 months
- Average 41% APR (can be as low as 5.99% APR)
- Automatic ACH collections allow OnDeck to directly collect daily payments (for
term loans) and weekly payments (for lines of credit) directly from the
borrowers bank account
- Used by small businesses for hiring new staff, marketing purposes, and
purchasing inventory
- Offer renewal opportunity once 50% of the outstanding principal has been
paid down. Renewals are usually offered at a discount rate
Lines of credit
- From $6,000 to $100,000
- Just began purchasing lines of credit from issuing bank partners in 1Q2016
- 13.99% - 39% APR
- 33.8% average APR
- Used by small businesses for working capital requirements
- Funds can easily be drawn on-demand by logging onto OnDeck’s website
OnDeck’s Products Become Cheaper as the Algorithm Proportionately Becomes
More Sophisticated and the Data More Abundant

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As demonstrated by the graph below, OnDeck has been able to simultaneously shift
towards higher quality small business borrowers and improve the quality of its
creditworthiness scoring algorithm to compress the interest APR’s on the products it
offers. Its continuous improvement in this capacity will make their products
increasingly attractive to small businesses seeking cheaper financing options.
Simplicity, Speed, and Convenience Benefits
1. App Process: Application can be completed online in minutes (about as time
consuming as a credit card application). The same process takes about 33
hours on average through a traditional bank.
2. Approval: Can take a bank months to approve a loan
a. “On Deck Score” takes seconds to evaluate the borrower’s
creditworthiness
b. Gathers data from more than 100 data sources and collects an average
of 2,000 data points for each applicant.
c. OnDeck estimates that the process is about 89% more effective than
traditional FICO score analysis
3. Funding: For what can take months at a traditional bank, borrowers can be
funded as quickly as the same day through OnDeck.
Weighted Average APR
(Term Loans and Line of
Credit)

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Diversified Funding Mix
OnDeck relies on a diverse funding platform to finance its originations. OnDeck
differentiates with its hybrid model, whereas it uses its own balance sheet and
investors through its marketplace model to generate revenue. In order to provide
liquidity for its direct originations (the loans OnDeck holds on its own balance sheet),
ONDK relies on debt facilities with various financial institutions. OnDeck also offers
private securitization deals to its institutional clients. OnDeck has closed two of these
deals since 2014; its most recent deal created $250 million of new notes. Lastly,
OnDeck also utilizes a marketplace platforms through which it sells whole loans to
sophisticated institutional investors.
Although there is a higher risk premium associated with holding loans originated by
OnDeck on their balance sheet, the unit economics are more lucrative to do so. For
marketplace loans, OnDeck receives a single gain on sale when an investor purchases
a whole sale package. On the other hand, OnDeck receives interest income over the
Funding Mix

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entire life of the loan (which is usually less than a year), but is usually about 3 times
the inflow. Later in the report the implications of this strategy on OnDeck’s short term
profitability will be explained in further detail. Below is an image from OnDeck’s 10-K
detailing the unit economics of the two different models.
OnDeck is Structurally Protected from Risk
Structural protection from economic risk is inherent in the OnDeck platform’s
business model. First, OnDeck benefits from a virtuous and continuous collection of
data from its borrowers. The more data that the OnDeck platform is given access to,
the more efficiently the ‘OnDeck Score’ (its proprietary credit scoring algorithm) can
assess the creditworthiness of prospective borrowers. A more successful
underwriting algorithm means more business which allows the process to perpetuate.
With this real time monitoring and data, OnDeck can immediately amend
idiosyncrasies in its business model that may otherwise build up and create more
severe delinquency issues.
Additionally, unlike Lending Club which entirely relies on securitizations from its
institutional customers and investor appetite in its marketplace, OnDeck is the
beneficiary of a diversified funding model. OnDeck can draw capital from its bank
facilities and can also finance its operations through both securitizations and the
OnDeck marketplace. This is the most diversified funding model among its
competitors. Consequently (a problem which Lending Club is currently facing) when

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investor appetite retreats, OnDeck maintains sources of liquidity that are independent
from investor demand. Conversely, Lending Club’s management has announced that it
will have to tap into its own cash reserves in 2016 to continue originating loans, as
around 50% of its investors have announced they are temporarily discontinuing their
business with the marketplace platform. If their investor base were to ultimately dry
up, Lending Club wouldn’t be able to support originations for a year with the cash on
their balance sheet.
There is strong evidence
to show that OnDeck is
moving up the market.
That is, they are
increasingly loaning to
the highest credit
borrowers in the market,
which is evidenced by the
simultaneous drop in
provisions, 15 day
delinquency rates (which
they are actually the only
online lender to disclose in their public filings), and the effective interest rate yield.
15 Day Delinquency Ratio

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The belief that OnDeck is just another PayDay
lender that that is destined to fail when the
credit cycle recesses is
completely unfounded. Its
ability to increase the
credit quality of borrowers
while compressing the
effective interest rate yield
is a strong indication of
this. OnDeck has been able
to do this by optimizing its customer pipeline by relying less on expensive (and
occasionally fraudulent) funding advisors and more on its strategic partnerships with
banks and small business service organizations to drive its origination growth. These
strategic partnerships are both a cheaper and more effective means of growing the
customer base. Further, OnDeck relies heavily on repeat customers, which comprised
57% of its business in 2015, which is up from 50% in 2014.
Repeat customers tend to be higher quality (as they have been able to use OnDeck’s
funding to promote the growth of the business). Small businesses are naturally
stickier borrowing relationships than seen with individual consumers due to their
consistent working capital needs. OnDeck’s net promoter score, a measure of
customer loyalty, is rated at 76. For comparison, national banks received a score of 9,
19 for regional banks, and 46 for community banks. In order to continue a borrowing
relationship with OnDeck, 50% of the prior loan must be paid down, the SMB must
have no outstanding delinquency history, and the business must be fully underwritten
and determined to be of adequate credit quality.
Unlike Lending Club, OnDeck uses bank facility funding to originate loans and hold
them on their balance sheet. As demonstrated in the last section of the report, the unit
economics make this more profitable. However, this is at the expense of assuming
internal credit risk. However, OnDeck’s loans are very short-term. Their average term
Stabilizing EIY

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loan is collected in approximately 11 months and the lines of credit last 6 months. In
less than a year, OnDeck could collect principal from almost every loan on its balance
sheet and use this capital to support its marketplace and partnerships. Herein lies the
advantage of the hybrid business model. OnDeck also links directly to the SMB’s bank
account so that it can directly with draw daily payments for term loans and weekly
payments for lines of credit, making these payments unavoidable if there is a balance
in the account.
Industry’s Poster-Child, Lending Club, Under Scrutiny for Fraud
Last May, upon the uncovering of questionable business practices and subsequent
recognition of LC’s former CEO Renauld Laplanche, LC’s stock price tacked a 40% loss.
Mr. Laplanche had a personal stake in Cirrix Capital which was receiving $10 million
in investments from Lending Club that he negligently failed to disclose. This, in
conjunction with an internally reported improper sale of $22.3 million in loans to
Jefferies, ignited hysteria in the industry. Problems associated with these loans were
flagged by an engineer Andreas Oesterer, who informed the CEO that he was asked by
his manager to push the dates of origination forward on $3 million worth of loans to
be given to Jefferies, presumably to expedite the process of selling the notes. Although
this arguably did not change the implied value of the loans, these dates did not comply
with the guidelines set forth by Jefferies.
However, this was not enough to dismantle the relationship between Lending Club
and Jefferies, which still have a relationship to securitize loans. Lending Club agreed
to purchase the loans back from the bank at their par value. Even though this problem
was seemingly resolved without much acrimony from either side of the deal, anything
that might malign investor confidence in online lending marketplaces to any degree is
extremely problematic, as this is what Lending Club relies on for originating loans.
Unlike OnDeck, Lending Club does not disclose detailed loan performance statistics
and on their credit decisions. This lack of transparency is not enough to make

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investors confident about their operations at a larger scale. This is a major
differentiating factor between OnDeck and Lending Club.