New academic research has cast doubt on the sustainability of peer-to-peer (P2P) lending, warning of the risks in underestimating the inherent inefficiencies with such alternative finance.

In a new paper, EDHEC Business School professor of finance Gianfranco Gianfrate questioned the sustainability of matching lenders to borrowers on a smaller scale through online platforms.

The UK's P2P market has flourished in recent years and is now worth around £17 billion by volume, but the failure of some platforms and reported cases of malpractice have led to increased regulatory scrutiny.

The collapses of Collateral, Lendy and Funding Secure this year caused the Financial Conduct Authority to bring in new rules this month, aiming to raise standards in risk management, governance, disclosure, marketing and wind-down planning.

The EDHEC-authored paper pointed out critical risks in terms of the misallocation of capital in the economy due to the absence of relevant incentives for the crowdfunding platforms to select and monitor borrowers. This is not only because they do not generally retain any part of the loan on their own balance sheet, but also because they need to deal with a huge volume of demand for both loans and investment opportunities.

The result is that low-quality borrowers will be flooded with capital and nobody is monitoring the issued loans or bonds, wrote Gianfrate.

The recent surge in crowdfunding activity has been realised during a relatively booming phase of the economic cycle, which may generate an accumulation of risks that could be dangerous if higher than expected insolvencies were to occur.

"Moreover, there are risks connected to the bankruptcy of the crowdfunding platform, which would cause in many cases the interruption of the debt servicing activity they provide on outstanding loans," the paper noted. "Therefore, it is important to ensure that platforms have good risk management systems."

Platforms are experimenting with new methods of credit scoring that rely on big data and machine learning, stated Gianfrate, adding that while these techniques are promising, in many cases they are still untested, with due diligence and scoring models currently not supervised.

A recent study by EDHEC examined 6,000 loans transacted on 73 distinct European P2P crowdlending platforms between 2012 and 2018. It revealed that the returns promised were not consistent with the risk borne by lenders - with high risk loans offering, on average, low returns.

The mispricing of loans was particularly pronounced for the loans to green businesses: investors seemed to be willing to accept low returns for initiatives that will benefit society at large.

"Financial regulators are right in keeping an eye on crowdlending and more stringent regulation may be needed soon," the report concluded. "People should be extremely careful when investing their money on crowdlending platforms and remember that there is no savings safety guarantee: the entire investment can go bust."

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