Peer-to-peer lending

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Peer-to-peer lending commonly abbreviated as P2PL is the practice of lending money to unrelated individuals, or "peers", without going through a traditional financial intermediary such as a bank or other traditional financial institution. P2PL is not to be confused with peer to peer investing (P2PI). This lending takes place online on peer-to-peer lending companies' websites using various different lending platforms and credit checking tools. Many also use the abbreviation "P2P" when discussing the peer-to-peer lending or investing industries more generally.

Overview

Most peer-to-peer loans are unsecured personal loans. They are made to an individual rather than a company. Other forms of peer-to-peer lending include student loans, commercial and real estate loans, payday loans, as well as secured business loans, leasing and factoring.^[1]

The interest rates are set by lenders who compete for the lowest rate on the reverse auction model, or are fixed by the intermediary company on the basis of an analysis of the borrower's credit.^[2] Borrowers assessed as having a higher risk of default are assigned higher rates. Lenders mitigate the individual risk that borrowers will not pay back the money they received by choosing which borrowers to lend to, and mitigate total risk by diversifying their investments among different borrowers. The lender's investment in the loan is not protected by any government guarantee. Bankruptcy of the peer-to-peer lending company that facilitated the loan may also put a lender's investment at risk.

The lending intermediaries are for-profit businesses; they generate revenue by collecting a one-time fee on funded loans from borrowers and by assessing a loan servicing fee to investors (either a fixed amount annually or a percentage of the loan amount).

Because many of the services are automated, the intermediary companies can operate with lower overhead and can provide the service more cheaply than traditional financial institutions, so that borrowers may be able to borrow money at lower interest rates and lenders may be able to earn higher returns. Compared to stock markets, peer-to-peer lending tends to have both less volatility and less liquidity.^[3]

Characteristics

Peer-to-peer lending does not fit cleanly into any of the three traditional types of financial institutions—deposit takers, investors, insurers^[4]—and is sometimes categorized as an alternative financial service.^[5]

The key characteristics of peer-to-peer lending are:

• it is conducted for profit;
• no necessary common bond or prior relationship between lenders and borrowers;
• intermediation by a peer-to-peer lending company;
• transactions take place on-line;
• lenders may choose which borrowers to invest in;
• the loans are unsecured and are not protected by government insurance;
• loans are securities that can be sold to other lenders.

Early peer-to-peer lending was also characterized by disintermediation and reliance on social networks but these features have started to disappear. While it is still true that the emergence of internet and e-commerce makes it possible to do away with traditional financial intermediaries and that people may be less likely to default to the members of their own social communities, the emergence of new intermediaries has proven to be time and cost saving. Extending crowdsourcing to unfamiliar lenders and borrowers opens up new opportunities.

Most peer-to-peer intermediaries provide the following services:

• on-line investment platform to enable borrowers to attract lenders and investors to identify and purchase loans that meet their investment criteria
• development of credit models for loan approvals and pricing
• verifying borrower identity, bank account, employment and income
• performing borrower credit checks and filtering out the unqualified
• processing payments from borrowers and forwarding those payments to the lenders who invested in the loan
• servicing loans, providing customer service to borrowers and attempting to collect payments from borrowers who are delinquent or in default
• legal compliance and reporting
• finding new lenders and borrowers (marketing)

History

United Kingdom

The first company to offer peer-to-peer loans in the world was Zopa. Since its founding in February 2005, it has issued loans in the amount of 500 million GBP and is currently the largest UK peer-to-peer lender with over 500,000 customers.^[6][7] In 2010 Funding Circle became the first peer-to-business lender launching in August 2010 and offering small businesses loans from investors via the platform.^[8] Funding Circle is currently the second largest lender, having lent 170 million GBP as of November 2013.^[9] RateSetter became the first peer-to-peer lender to make use of a provision fund to safeguard lenders against borrower defaults, launching in September 2010.^[6] As a result of the provision fund, no lenders have ever lost money at RateSetter. In 2012 Lending Works entered the market, as the first peer-to-peer lender with insurance against borrower default as well as a provision fund.^[10] MarketInvoice became the first peer-to-business lender lending specifically against invoices.^[11] Assetz Capital, which started lending in 2013, has made the largest peer to peer loan in the UK to date, having made a £1.5m loan for development of some student accommodation in Nottingham.

In 2011, Quakle, a UK peer-to-peer lender founded in 2010, closed down with a near 100% default rate after attempting to measure a borrower's creditworthiness according to a group score, similar to the feedback scores on eBay; the model failed to encourage repayment.^[6][12] In May 2012, the UK government promised to invest £100 million to small businesses through alternative lending channels, including peer-to-peer lenders, hoping to bypass the mainstream banks that are reluctant to lend.^[12][13] The peer-to-peer companies are predicted to issue up to £200 million of loans in 2012.^[14]

The peer-to-peer industry adheres to standards set by the Financial Conduct Authority. Peer-to-peer depositors do not qualify for protection from the Financial Services Compensation Scheme (FSCS), which provides security up to £85,000 per bank, for each saver^[13] but the Peer-to-Peer Finance Association mandates the member companies to implement arrangements to ensure the servicing of the loans even if the broker company goes bankrupt.^[12] As of October 2013, UK peer-to-peer lenders have collectively lent 600 million GBP.^[15] rebuildingsociety.com launched in September 2012 by internet entrepreneur Daniel Rajkumar and Gary Lumby.^[16] The first loans were completed in February 2013.^[17] The UK government announced that the Financial Conduct Authority will regulate the industry from April 2014.^[18] The British Business Bank came under criticism from rebuildingsociety.com for its execution of the Funding for Lending scheme, where it has created unfair competition in the UK Peer-to-peer lending industry by concentrating financial support via the largest platforms.^[19]

United States

The modern peer-to-peer lending industry in US started in February 2006 with the launch of Prosper, followed by Lending Club and other lending platforms soon thereafter.^[20] Both Prosper and Lending Club are located in San Francisco, California.^[21] Early peer-to-peer platforms had few restrictions on borrower eligibility, which resulted in adverse selection problems and high borrower default rates. In addition, some investors viewed the lack of liquidity for these loans, most of which have a minimum three-year term, as undesirable.^[5]

In 2008, the Securities and Exchange Commission (SEC) required that peer-to-peer companies register their offerings as securities, pursuant to the Securities Act of 1933.^[20][22] The registration process was an arduous one; Prosper and Lending Club had to temporarily suspend offering new loans,^{[23][24][25][26]} while others, such as the U.K.-based Zopa Ltd., exited the U.S. market entirely.^[23] Both Lending Club and Prosper gained approval from the SEC to offer investors notes backed by payments received on the loans. Prosper amended its filing to allow banks to sell previously funded loans on the Prosper platform.^[5] Both Lending Club and Prosper formed partnerships with FOLIO Investing to create a secondary market for their notes, providing liquidity to investors.^[27] Lending Club had a voluntary registration at this time, whereas Prosper had mandatory registration for all members.^[28]

This addressed the liquidity problem and, in contrast to traditional securitization markets, resulted in making the loan requests of peer-to-peer companies more transparent for the lenders and secondary buyers who can access the detailed information concerning each individual loan (without knowing the actual identities of borrowers) before deciding which loans to fund.^[23] The peer-to-peer companies are also required to detail their offerings in a regularly updated prospectus. The SEC makes the reports available to the public via their EDGAR (Electronic Data-Gathering, Analysis, and Retrieval) system.

In 2009, the US-based nonprofit Zidisha became the first peer-to-peer lending platform to link lenders and borrowers directly across international borders without local intermediaries and institute borrower risk analysis in the absence of digital records of financial history.^[29] More people turned to peer-to-peer companies for lending and borrowing following the financial crisis of late 2000-s because banks refused to increase their loan portfolios. On the other hand, the peer-to-peer market also faced increased investor scrutiny because borrowers' defaults became more frequent and investors were unwilling to take on unnecessary risk.^[30]

As of June 2012, Lending Club is the largest peer-to-peer lender in US based upon issued loan volume and revenue, followed by Prosper.^[20][21][31] Lending Club is currently also the world's largest peer-to-peer lending platform.^[32] The two largest companies have collectively serviced over 180,000 loans with $2 billion in total:^[14][20][21] as of March 22, 2012, Lending Club has issued 117,412 loans for $1,512,560,075^[33] while Prosper Marketplace has issued 63,023 loans for $433,570,651.^[34] With greater than 100% year over year growth, peer-to-peer lending is one of the fastest growing investments.^[20] The interest rates range from 5.6%-35.8%, depending on the loan term and borrower rating.^[35] The default rates vary from about 1.5% to 10% for the more risky borrowers.^[21] Executives from traditional financial institutions are joining the peer-to-peer companies as board members, lenders and investors,^[14][36] indicating that the new financing model is establishing itself in the mainstream.^[22]

In October 2013, the UK based peer-to-business lender, Funding Circle, announced that it had raised $37 million investment. Accel Partners led this round of funding, which brings the company’s total to $58 million. New investor Ribbit Capital contributed, along with existing investors Union Square Ventures and Index Ventures.^[37] Additionally, Funding Circle announced it was launching in the US and joined forces with Endurance Lending Network. Endurance now trades under the Funding Circle name.^[38]

The latter half of 2013 saw increased interest from Wall Street investors in these peer-to-peer assets.^[39] In November 2013, alumni-based student lender SoFi (Social Finance, Inc.) announced a deal with Barclays and Morgan Stanley to create a bond backed by peer-to-peer student loans, and this would create the first securitization of these loans to receive a credit rating.^[40]

China

A colloquial term for P2P lending in China is grey market, not to be confused with grey markets for goods or an underground economy. Offline peer-to-peer lending between family and friends is a popular practice and has been around in the country for centuries. In recent years a very large number of micro loan companies have emerged to serve the 40 million SMEs, many of which receive inadequate financing from state-owned banks, creating an entire industry that runs alongside big banks.

As the Internet and ecommerce took off in the country in the 2000s, many P2P lenders sprung into existence with various target customers and business models. The most prominent among them are CreditEase, Lufax, Tuandai, China Rapid Finance and DianRong (former SinoLending).^[41][42] CreditEase runs a huge offline network with branches in major Chinese cities, and the latter has links to Lending Club in the U.S. and concentrates on the online market.^[43][44]

The first P2PL in Hong Kong is WeLab Holdings, which has backing from American venture capital firm Sequoia Capital and Li Ka-Shing's TOM Group.^[45]

New Zealand

In New Zealand, peer-to-peer lending became practicable on 1 April 2014, when the relevant provisions of the Financial Markets Conduct Act 2013 came into force. The Act enables peer-to-peer lending services to be licensed.

The Financial Markets Authority issued the first peer-to-peer lending service licence on 8 July 2014, to Harmoney.^[46] Harmoney officially launched its service on 10 October 2014.^[47]

United Arab Emirates

Launched in November 2014, Former Emirates NBD CEO Launches Online SME Lending Platform in the UAE. Called Beehive, the marketplace is the region’s first peer-to-peer (P2P) online lending platform. A new online platform for SME funding was launched in the UAE by Rick Pudner, the former group CEO of Dubai’s biggest bank, Emirates NBD, in November 2014. Beehive is the GCC region’s first peer-to-peer (P2P) online lending platform and aims to directly connect established businesses with investors.

Beehive’s online marketplace will facilitate flexible funding for established businesses seeking investment between Dhs100,000 and Dhs500,000. Individual investors need to invest a minimum of Dhs100 and can bid to lend money, choosing the amount and the interest rate. Beehive then facilitates the loan agreement between the business and investors, charging a small percentage fee of the loan amount, the statement said. The exact percentage size was not disclosed. The business receives funding in around seven days and investors receive monthly repayments at target rates of between eight to 12 per cent.^[48][48][49]

Sweden

Peer-to-peer-lending in Sweden is regulated by Finansinspektionen.^[50] Launched in 2007, the company Trustbuddy AB was first out on the Swedish market for peer-to-peer-lending, providing a platform for high risk personal loans between 500SEK and 10,000SEK. In 2014, Lendify AB^[51] launched, targeting the mainstream market with personal loans between 5,000SEK and 350,000SEK. A third actor, Toborrow AB,^[52] provides a marketplace for loans to small businesses since 2015.

Israel

Several peer-to-peer lending services have appeared at 2014, such as BLender,^[53] CreditPlace & Incredita.^[54] Following the economic uprising of 2011,^[55] the public opinion about these platforms is positive. Incredita & BLender are focusing on consumer loans while CreditPlace is focusing on small businesses. BLender is strongly relying on Big Data ^[56] to asses borrowers risk and has shown strong growth rates ^[57] since its establishment. BLender is offering consumer loans that range between 10,000NIS and 30,000NIS with a duration of 1 to 3 years. The maximum interest rate in Israeli P2P Arenas is limited by the "Non-Banking Lending Regulations".^[58]

Other countries

In 2009, Zidisha became the first peer-to-peer lending service to operate across international borders without local intermediaries. Managed by a nonprofit organization in the United States, Zidisha's web platform connects individual lenders in wealthy countries with computer-savvy microfinance borrowers in developing countries, allowing the borrowers to access small loans at dramatically lower cost than is available from local lenders.^[59]

In Germany, several peer-to-peer lending services have appeared, following the model of Lending Club such as auxmoney, Lendico, Smava or Zencap. The responsible regulatory agency BaFin has previously stated that every company engaged in commercial lending needs to be in possession of a full banking license.^[60] Accordingly, all peer-to-peer lending services have chosen to partner with commercial banks (e.g. Lendico, Zencap and Wirecard, auxmoney and SWK Bank or Smava and Fidor Bank).^[61]

Emergence of P2PL in Canada has been slow, but it has become a cause of concern for the country's five major banks and need for to invest in new technology to head off these non-traditional lenders.^[62] Domestic P2PL have mostly targeted small businesses or consumers, but large lenders have been primarily US-based.

Legal regulation

In many countries, soliciting investments from the general public is considered illegal. Crowd sourcing arrangements in which people are asked to contribute money in exchange for potential profits based on the work of others are considered to be securities.

Dealing with financial securities is connected to the problem about ownership: in case of person-to-person loans, the problem of who owns the loans (notes) and how that ownership is transferred between the originator of the loan (the person-to-person lending company) and the individual lender(s).^[24][25] This question arises especially when a peer-to-peer lending company does not merely connect lenders and borrowers but also borrows money from users and then lends it out again. Such activity is interpreted as a sale of securities, and a broker-dealer license and the registration of the person-to-person investment contract is required for the process to be legal. The license and registration can be obtained at a securities regulatory agency such as the U.S. Securities and Exchange Commission (SEC) in the U.S., the Ontario Securities Commission in Ontario, Canada, the Autorité des marchés financiers in France and Quebec, Canada, or the Financial Services Authority in the U.K.

Securities offered by the U.S. peer-to-peer lenders are registered with and regulated by the SEC. A recent report by the U.S. Government Accountability Office explored the potential for additional regulatory oversight by Consumer Financial Protection Bureau or the Federal Deposit Insurance Corporation, though neither organization has proposed direct oversight of peer-to-peer lending at this time.^[63]

In the U.K., the emergence of multiple competing lending companies and problems with subprime loans has resulted in calls for additional legislative measures that institute minimum capital standards and checks on risk controls to preclude lending to riskier borrowers, using unscrupulous lenders or misleading consumers about lending terms.^[64]

Advantages and criticism

Interest rates

One of the main advantages of person-to-person lending for borrowers has been better rates than traditional bank rates can offer (often below 10%.^[65]) The advantages for lenders are higher returns than obtainable from a savings account or other investments.^[66] Interest rates and the methodology for calculating those rates varies among peer-to-peer lending platforms. The interest rates also have a lower volatility than other investment types.^[67]

Socially Conscious Investment Possibility

For investors interested in socially conscious investing, peer-to-peer lending offers the possibility of supporting the attempts of individuals to break free from high-rate debt, assist persons engaged in occupations or activities that are deemed moral and positive to the community, and avoid investment in persons employed in industries deemed immoral or detrimental to community.^[68]

Credit risk

Peer-to-peer lending also attracts borrowers who, because of their credit status or the lack thereof, are unqualified for traditional bank loans. Because past behavior is frequently indicative of future performance and low credit scores correlate with high likelihood of default, peer-to-peer intermediaries have started to decline a large number of applicants and charge higher interest rates to riskier borrowers that are approved.^[30] Some broker companies are also instituting funds into which each borrower makes a contribution and from which lenders are recompensed if a borrower is unable to pay back the loan.^[6]

It seemed initially that one of the appealing characteristics of peer-to-peer lending for investors was low default rates, e.g. Prosper's default rate was quoted to be only at about 2.7 percent in 2007.^[66]

The actual default rates for the loans originated by Prosper in 2007 were in fact higher than projected. Prosper's aggregate return (across all credit grades and as measured by LendStats.com, based upon actual Prosper marketplace data) for the 2007 vintage was (6.44)%, for the 2008 vintage (2.44)%, and for the 2009 vintage 8.10%. Independent projections for the 2010 vintage are of an aggregate return of 9.87.^[69] During the period from 2006 through October 2008 (referred to as 'Prosper 1.0'), Prosper issued 28,936 loans, all of which have since matured. 18,480 of the loans fully paid off and 10,456 loans defaulted, a default rate of 36.1%. $46,671,123 of the $178,560,222 loaned out during this period was written off by investors, a loss rate of 26.1%.^[70]

Since inception, Lending Club’s default rate ranges from 1.4% for top-rated three-year loans to 9.8% for the riskiest loans.^[21]

The UK peer-to-peer lenders quote the ratio of bad loans at 0.84% for Zopa of the £200m during its seven-year lending history. As of November 2013, Funding Circle’s current bad debt level was 1.5%, with an average 5.8% return after all bad debt and fees. This is comparable to the 3-5% ratio of mainstream banks and the result of modern credit models and efficient risk management technologies used by P2P companies.^[12]

Government protection

Because, unlike depositing money in banks, peer-to-peer lenders can choose themselves whether to lend their money to safer borrowers with lower interest rates or to riskier borrowers with higher returns, peer-to-peer lending is treated legally as investment and the repayment in case of borrower defaulting is not guaranteed by the federal government (U.S. Federal Deposit Insurance Corporation) the same way bank deposits are.^[13]

A class action lawsuit, Hellum v. Prosper Marketplace, Inc. is currently pending in Superior Court of California on behalf of all investors who purchased a note on the Prosper platform between January 1, 2006 and October 14, 2008. The Plaintiffs alleged that Prosper offered and sold unqualified and unregistered securities, in violation of California and federal securities laws during that period. Plaintiffs further allege that Prosper acted as an unlicensed broker/dealer in California. The Plaintiffs were seeking rescission of the loan notes, rescissory damages, damages, and attorneys’ fees and expenses.^[71] On July 19, 2013 the class action lawsuit was settled. Under the settlement terms Prosper will pay $10 million to the class action members.^[72]

See also

• Alternative financial services
• Comparison of crowd funding services
• Customer to customer
• Lending Works – peer to peer facilitation company
• Non-bank financial institution
• Peer-to-peer banking
• Peer-to-peer lending companies

References