Peer-to-peer lending

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Peer-to-peer lending, sometimes abbreviated P2P lending, is the practice of lending money to individuals or businesses through online services that match lenders with borrowers. Since peer-to-peer lending companies offering these services generally operate online, they can run with lower overhead and provide the service more cheaply than traditional financial institutions. As a result, lenders can earn higher returns compared to savings and investment products offered by banks, while borrowers can borrow money at lower interest rates,^[1][2][3] even after the P2P lending company has taken a fee for providing the match-making platform and credit checking the borrower.^[4][5][6][7] There is the risk of the borrower defaulting on the loans taken out from peer-lending websites.

Also known as crowdlending, many peer-to-peer loans are unsecured personal loans, though some of the largest amounts are lent to businesses. Secured loans are sometimes offered by using luxury assets such as jewelry, watches, vintage cars, fine art, buildings, aircraft and other business assets as collateral. They are made to an individual, company or charity. 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.^[8]

The interest rates can be set by lenders who compete for the lowest rate on the reverse auction model or fixed by the intermediary company on the basis of an analysis of the borrower's credit.^[9] The lender's investment in the loan is not normally protected by any government guarantee. On some services, lenders mitigate the risk of bad debt by choosing which borrowers to lend to, and mitigate total risk by diversifying their investments among different borrowers. Other models involve the P2P lending company maintaining a separate, ringfenced fund, such as RateSetter's Provision Fund, which pays lenders back in the event the borrower defaults, but the value of such provision funds for lenders is subject to debate.^[10]

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 (tax-disadvantaged in the UK vs charging borrowers) or borrowers (either a fixed amount annually or a percentage of the loan amount). Compared to stock markets, peer-to-peer lending tends to have both less volatility and less liquidity.^[11]

Characteristics

Peer-to-peer lending does not fit cleanly into any of the three traditional types of financial institutions—deposit takers, investors, insurers^[12]—and is sometimes categorized as an alternative financial service.^[13]

Typical characteristics of peer-to-peer lending are:

• it is sometimes 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 online;
• lenders may often choose which borrowers to invest in, if the P2P platform offers that facility;
• the loans can be unsecured or secured and are not normally protected by government insurance but there can be protection funds like those offered by Zopa and RateSetter in the UK;
• loans are securities that can be transferred to others, either for debt collection or profit, though not all P2P platforms provide transfer facilities or free pricing choices and costs can be very high, tens of percent of the amount sold, or nil.

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:

• online 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 borrowers
• 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 over £1.99 billion in loans.^[14] Funding Circle became the first significant peer-to-business lender launching in August 2010 and offering small businesses loans from investors via the platform.^[15] Funding Circle has lent over £1.93 billion as of January 2017.^[16][17] Both Zopa and Funding Circle are members of the Peer 2 Peer Finance Association (P2PFA).^[18]

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.^[19][20]

By June 2012, the top three peer-to-peer companies in the UK - RateSetter, Zopa, and FundingCircle - had issued over £250 million of loans.^[21] In 2014 alone, they issued over £700 million.^[22]

In 2012, the UK government invested £20 million into British businesses via peer to peer lenders. A second investment of £40 million was announced in 2014.^[23] The intention was to bypass the high street banks, which were reluctant to lend to smaller companies. However, this action was criticised for creating unfair competition in the UK, by concentrating financial support in the largest platforms.^[24]

Investments have qualified for tax advantages through the Innovative Finance Individual Savings Account (IFISA) since April 2016.^[25] In 2016, £80bn was invested in ISAs,^[26] creating a significant opportunity for P2P platforms. By January 2017, 17 P2P providers were approved to offer the product.^[27]

Many more peer-to-peer companies have also set up in the UK. At one stage there were over 100 individual platforms applying for FCA authorisation, although many have now withdrawn their applications.^[28]

Since April 2014, the peer-to-peer lending industry has been regulated by the Financial Conduct Authority.^[29] Peer-to-peer investments do not qualify for protection from the Financial Services Compensation Scheme (FSCS), which provides security up to £75,000 per bank, for each saver,^[30] but regulations mandate the companies to implement arrangements to ensure the servicing of the loans even if the platform goes bust.^[31]

In 2015, UK peer-to-peer lenders collectively lent over £3bn to consumers and businesses^[32] although on an annual equivalent basis the value of the loan book figure was £2.3bn in 2015 which increased to £3.2bn in 2016.^[33]

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.^[34] Both Prosper and Lending Club are located in San Francisco, California.^[35] 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.^[13]

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.^[34][36] The registration process was an arduous one; Prosper and Lending Club had to temporarily suspend offering new loans,^{[37][38][39][40]} while others, such as the U.K.-based Zopa Ltd., exited the U.S. market entirely.^[37] 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.^[13] Both Lending Club and Prosper formed partnerships with FOLIO Investing to create a secondary market for their notes, providing liquidity to investors.^[41] Lending Club had a voluntary registration at this time, whereas Prosper had mandatory registration for all members.^[42]

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.^[37] 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.

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.^[43]

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.^[34][35] Lending Club is currently also the world's largest peer-to-peer lending platform.^[44] The two largest companies have collectively serviced over 180,000 loans with $2 billion in total:^[21][34][35] as of March 22, 2012, Lending Club has issued 117,412 loans for $1,512,560,075^[45] while Prosper Marketplace has issued 63,023 loans for $433,570,651.^[46] With greater than 100% year over year growth, peer-to-peer lending is one of the fastest growing investments.^[34] The interest rates range from 5.6%-35.8%, depending on the loan term and borrower rating.^[47] The default rates vary from about 1.5% to 10% for the more risky borrowers.^[35] Executives from traditional financial institutions are joining the peer-to-peer companies as board members, lenders and investors,^[21][48] indicating that the new financing model is establishing itself in the mainstream.^[36]

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.^[49]

The first P2PL in Hong Kong is WeLab, which has backing from American venture capital firm Sequoia Capital and Li Ka-Shing's TOM Group.^[50]

Ezubao, a website launched by Yucheng Group in July 2014 purporting to offer P2P services, was shut down in February 2016 by authorities who described it as a Ponzi scheme.^[51] As 900,000 customers had invested 50 billion renminbi in Ezubao, its closure might undermine confidence in P2P in China.^[52]

In China, in 2016 there were more than 4000 P2P lending platform in total, but 2000 of them had already suspended operations.^[53] As of August 2016, cash flow on all P2P lending platform have already exceeded 191 billion Chinese Yuan (29 billion USD) in the month.^[54] Lender's return rate across all P2P lending platform in China is about 10% per annum on average, with a few of them offering more than 24% return rate.^[55]

Australia

In 2012 Australia's first peer to peer lending platform, SocietyOne, was launched.^[56] As of June 2016 the Australian Government has been encouraging the development of FinTech and peer to peer lending startups through its 'regulatory sandbox' program.^[57]

New Zealand

In New Zealand, peer-to-peer lending became practicable on April 1, 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 July 8, 2014, to Harmoney.^[58] Harmoney officially launched its service on October 10, 2014.^[59]

India

In India, peer-to-peer lending is currently unregulated. Reserve Bank of India, India's Central Bank, has placed a consultation paper to regulate P2P lending^[60] and the final guidelines are expected soon.^[61] There are over 30 peer-to-peer-lending platform operating in India as of 2016.^[62] Even with first-mover advantage many sites were not able to capture market and grow their user base, arguably due to the reserved nature of Indian investors or the lack of awareness towards this type of debt financing. In a positive impact, Peer-to-peer lending platforms in India are helping a huge section of borrowers who were previously rejected or unqualified for a loan from banks.^[63]

Sweden

Peer-to-peer-lending in Sweden is regulated by Finansinspektionen.^[64] 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. Trustbuddy filed for bankruptcy by October 2015, a new board cited abuses by outgoing leadership.

Israel

Several peer-to-peer lending services initiated operation and loan origination during 2014, Following the economic uprising of 2011,^[65] and public opinion regarding these platforms is positive. The maximum interest rate in Israeli P2P Arenas is limited by the "Extra-Banking Lending Regulations".^[66]

Canada

Peer-to-peer lending had not been permitted by Canadian securities regulators until the emergence of Lending Loop, coinciding with the launch of OSC launchpad in late 2016.^[67] In October 2016, Lending Loop became the first peer-to-peer lending company in Canada after obtaining regulatory approval to offer its platform to Canadians.^[68]

Brazil

In Brazil, the lack of credit scenario and the rise of interest rates began to make room for a loan market on the internet.^[69]

To operate in the country, these companies need to comply with certain rules of the domestic financial market. While in most countries the peer-to-peer lending operations are carried out without the intermediation of a financial institution, in Brazil that is not possible. To stick to the rules, the platforms need to act as a correspondent bank, helping to structure a loan that is accomplished, in fact, by the partner bank.^[69]

Latvia

In Latvia, peer-to-peer lending market is shared by two platforms, Mintos and TWINO, both established in 2015. In the first three quarters of 2016, both platforms showed highest growth rates among peer-to-peer lending platforms in Continental Europe. As a result, Latvia ranked third in peer-to-peer consumer lending market volume in Continental Europe with EUR 107.3 million funded through Latvia-based peer-to-peer platforms in the first three quarters of 2016.^[70]

 

In 2015, the Ministry of Finance of Latvia initiated development of a new regulation on the peer-to-peer lending in Latvia to establish regulatory requirements, such as rules for management compliance, AML requirements and other prudential measures.^[71]

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).^[38][39] 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 Québec, Canada, or the Financial Services Authority in the UK.

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.^[72] In 2016, New York state sent "warning letters" threatening to require 28 peer-to-peer lenders to obtain a license to operate unless they "immediately" complied with responses to demands to disclose their lending practices and products available in the state.^[73]

In the UK, 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.^[74]

Advantages and criticism

Interest rates

One of the main advantages of person-to-person lending for borrowers can sometimes be better rates than traditional bank rates can offer.^[75] The advantages for lenders can be higher returns than obtainable from a savings account or other investments, but subject to risk of loss, unlike a savings account.^[76] Interest rates and the methodology for calculating those rates varies among peer-to-peer lending platforms. The interest rates may also have a lower volatility than other investment types.^[77]

Socially-conscious investment

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.^[78][79]

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.^[43] 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.^[19]

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.^[76]

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.^[80] 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%.^[81]

Since inception, Lending Club’s default rate ranges from 1.4% for top-rated three-year loans to 9.8% for the riskiest loans.^[35]

The UK peer-to-peer lenders quote the ratio of bad loans at 0.84% for Zopa of the £200m during its first seven years of 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.^[20]

At the other end of the range are places such as Bondora that do lending to less credit-worthy customers, with default rates varying up to as high as 70+% for loans made to Slovak borrowers on that platform, well above those of its original Estonian market.

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, in the US 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 way bank deposits are.^[82]

A class action lawsuit, Hellum v. Prosper Marketplace, Inc. was held 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.^[83] On July 19, 2013 the class action lawsuit was settled. Under the settlement terms Prosper will pay $10 million to the class action members.^[84]

See also

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

References