Peer-to-peer platforms offer high returns, but they're not risk-free.

Peer-to-peer (P2P) lending has potential risk written all over it.

Don't get me wrong - I love the concept of cutting out the bank as middleman and earning far higher interest than term deposits offer. It's just that investors need to be aware of what they are agreeing to, and what can go wrong.

The way it works is that investors lend money to borrowers via a "platform" such as Harmoney, LendMe, Lending Crowd or Squirrel Money. The investors then earn interest direct from borrowers, minus a "platform fee".

After nearly two years of P2P in New Zealand, some Harmoney investors were unhappy about some frauds on the Harmoney platform this year. The investors were aggrieved that they picked up the tab for the frauds, with their capital written off after Harmoney had approved the fraudsters' loans.

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While the investors were upset, that risk is included in the Harmoney contract and the possible impact of fraud is mentioned on its website.

A Harmoney spokesman assured me that these were ordinary identity theft frauds that were typical in the business of consumer lending, rather than being anything more complex.

I received an email with a complete documented history of the run-around one investor received over several months when he tried to find out more about $125 that had disappeared from his account.

He was finally told that it was money laundering and as a result Harmoney couldn't release details thanks to Section 46 of the Anti-Money Laundering and Countering Financing of Terrorism Act.

Senior Harmoney staff members have, however, discussed details of some of the frauds on Sharetrader.co.nz with investors.

The investor subsequently sent a copy of his case notes from Financial Services Complaints Ltd to the Herald, documenting every communication. When I asked Harmoney about the case, it sent me a statement saying it did not involve money laundering, but says the Act still applies.

The statement also said that 0.08 per cent of loans had been fraudulent. That amounts to $232,000 of fraudulent loans. Being consumer lending it's almost inevitable that more will emerge over time.

It turns out that an A-grade borrower may not always be what you and I would consider to be a top-notch risk.

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Harmoney says that $232,000 amounts to "less than 1 per cent of the $290 million paid out to investors since inception."

It believes that fraud figure compares well with other financial institutions.

One of the other possible risks with investing in privately-held P2P lenders is that they don't have the prudential regulation that applies to banks, or the continuous disclosure requirements of stock market-listed financial institutions.

How the P2P platforms deal with the inevitable frauds differs.

Harmoney investors take a haircut when frauds occur. Squirrel Money takes 1.9 per cent from the interest paid to investors and keeps it in a reserve fund to protect investors from losses when a borrower defaults on a loan.

And LendMe says all of its borrowers have to see their solicitor before drawing down the funds. Online-only application processES could make some P2P platforms vulnerable to fraudulent schemes such as identity theft.

One of the big risks of P2P lending I've become aware of as the investment model beds in, is that of proprietary risk ratings. Each company develops its own rules as to what an "A" or "F" grade borrower is.

It turns out that an A-grade borrower may not always be what you and I would consider to be a top-notch risk.

Many of the loans I have made via Harmoney are to "A-grade" homeowners who are paying 9.99 per cent to 17.15 per cent for purposes such as debt consolidation, home improvement and holidays.

Logically, if they were a home-owning A-grade risk - in the eyes of the big banks - they'd simply extend the mortgage at 5.45 per cent over the same number of years to cover these costs.

Investors here have to trust what the companies tell them, and not all are happy with that.

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The grades go right down to F5 and some investors get giddy at the idea of being able to receive 39 per cent from this end of the market.

The problem is that lending money is easy. Getting the borrowers to pay it back is the hard part and there's no guarantee that the loans are correctly priced even at 39 per cent.

Another risk faced by investors is whether the P2P platform has an adequate collections process. When loans are charged off, as some of mine have been, the file is passed to a collections agency.

I note - though my own experience doesn't carry any statistical weight - that of my 12 failed loans with Harmoney, 29c of my outstanding capital has been recovered so far and some of those loans were written off in early 2015.

One problem for investors is that the risk of the various P2P platforms could vary hugely, but unlike the UK, where risk ratings for the platforms are available from P2P specialist 4thWay, New Zealand platforms have no such independent analysis.

Investors here have to trust what the companies tell them, and not all are happy with that.

Investors need to consider, for example, the relative risks of each platform's target market for lending and make a judgment as to whether the risk is priced correctly.

Are they secured or unsecured loans?

Lending Crowd, for example, only offers loans secured by vehicles, and founder Wayne Croad says this is because he and the other directors lived through the Global Financial Crisis and understand that retail investors have a low appetite for risk.

Another theoretical risk is the potential for poor front-end loan application risk assessment by a lending platform.

The reality, as Harmoney chief executive Neil Roberts and others point out, is that so far investors have lost very little and their returns have been good.

Harmoney, for example, says its investors have achieved "an average realised annual return since inception of 11.85 per cent."

While that is obviously attractive, the P2P model in New Zealand hasn't yet been through a downturn and that could be telling, as P2P analysts Pitchfork pointed out. It questioned whether the rapidly growing industry will weather any future storms.

I do believe that P2P lending as a concept is good. But I recommend that anyone who wants to invest in P2P really should undertake as much due diligence as possible about the platform they wish to invest in and P2P lending theory in general.