It's not a great time to be a small-time Chinese investor. The Shanghai stock market lost 25 percent of its value last year, leaving tens of millions of retail investors nursing heavy losses. Last summer, the first cracks appeared in the country's massive housing bubble, when protesters gathered outside the offices of major developers, complaining that their new off-plan apartments had suddenly plummeted in value.

To top it all off, millions of small-time investors have lost their life savings, having invested in online peer-to-peer (P2P) lending platforms — a burgeoning segment of the finance industry that imploded suddenly following allegations of widespread fraud and mismanagement. The platforms that connect lenders and borrowers — often entrepreneurs and households not able to get credit from state-run banks — first sprung up in China more than a decade ago.

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The Chinese government this week confirmed it had frozen $1.5 billion (€1.32 billion) in assets from unscrupulous P2P lenders and around 100 executives are under investigation — some of whom have fled overseas. Thousands of platforms have gone bust or just disappeared over the past two years; many are accused of offering phony investment schemes, which many Chinese plowed money into, not fully understanding the high risk of loan defaults.

Miscalculated risk

"In a P2P platform, I become the banker. I directly bankroll whatever investment I engage in. This is a recipe for disaster if people don't understand the difference and correctly assess the risk," Max Kärnfelt, an economist at the Berlin-based Mercator Institute for China Studies (MERICS), told DW.

One of the first indications that not all was well came in 2015 when depositors lost 50 billion yuan (€6.9 billion, $7.82 billion) in online lender Ezubo, who regulators said was running a giant Ponzi scheme that scammed some 900,000 investors. Ezubo was one of at least 5,500 P2P lenders who at one point were lending more than 4 trillion yuan per year. Some platforms offered lenders guarantees on their initial capital alongside interest rates as high as 15 percent.

"This is impossible for any investment in the long term," noted Zennon Kapron, director of the Shanghai-based research firm Kapronasia, who has studied the sector for several years.

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"Essentially, many P2P [lenders] are doing similar things as loan sharks," Zongxin Qian, associate professor of money and finance at Renmin University of China's School of Finance in Beijing, referring to illegal lenders who prey on vulnerable consumers with high-interest loans, and the threat of violence in cases of default.

Slowing economy, increased defaults

Downplaying the extent of fraud within the sector, Qian believes a slowing Chinese economy is another factor that led to the P2P sector's struggles, as it has left millions of borrowers unable to repay their debts. "The aggregate economic climate matters because when the economy is in a boom, even high-risk projects can survive and repay," he told DW.

Numerous claims of sharp practices by lenders going back several years have led to criticism that the Chinese government failed to act to protect small-scale investors. Regulators took a "wait and see approach" as P2P served a useful purpose in the economy, where many everyday Chinese struggle to access credit, Kapron said.

"Arguably, the regulators waited too long and then initially regulated too little. Now they are in the position of having to force the industry to slow down through consolidation," he told DW.

P2P lenders have been ordered to register with local authorities, while the new regulations are meant to ensure the platforms remain purely conduits for lenders and borrowers. Industry insiders predict the market will now shrink from around 1,600 to just 50 lenders as a result of the tough reforms. Small-scale investors affected by the scandals, meanwhile, continue to demand that the government compensates them for their losses. But it appears to have fallen on deaf ears.

"A government bailout will create moral hazard and encourage excessive risk-taking," Qian warned, adding that Chinese authorities should instead focus on financial education programs to help investors make more "rational" decisions.

Millions affected

Regulators have remained quiet on the overall investment losses, but Kapron says "millions of people" were victims and "billions of RMB [Chinese yuan]" have vaporized. The number of new loans issued by P2P lenders has, meanwhile, plummeted — down 70 percent year on year in November alone, according to Diyi Wangdai, a website that reports on the sector.

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With investors unwilling to get burned again, those borrowers that used to rely on online lenders to fund major purchases have had their main credit lines cut off, which some fear could impact the wider economy, amid the slowest growth in 30 years. "There are indications that people have borrowed money from peer-to-peer lending to use for down payments or maybe the whole payment for apartments. Some students even borrowed spending money," Kärnfelt noted.

Most analysts DW spoke with predicted that the long-term effects of the P2P lending collapse would be limited. Most Chinese have only limited investment options, so the remaining platforms will likely maintain robust demand from retail investors, as long as they can quickly rebuild trust.