Peer-to-peer lending (also known as person-to-person
lending, peer-to-peer investing, and social lending;
abbreviated frequently as P2P lending) is the practice of
lending
money to previously unrelated individuals or "peers" without the
intermediation of traditional
financial institutions (banks). It takes place on online lending
platforms that are provided by peer-to-peer lending companies on their
websites and is facilitated by
credit checking tools of varying complexity.
Overview
Most peer-to-peer loans are
unsecured
personal loans, i.e. they are made to an individual rather than a
company and borrowers do not provide
collateral as a protection to the lender against
default. Business loans are offered by some companies.
The
interest rates are set either by lenders who compete for the lowest
rate on the
reverse auction model, or are fixed by the intermediary company on
the basis of their analysis of the borrower's credit.[1]
Borrowers assessed as having a higher risk of default are assigned
higher rates. Lenders mitigate the risk that borrowers will not pay back
the money they received by choosing which borrowers to lend to and by
diversifying their investments among different borrowers. Lenders'
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 the lenders’ 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
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 provide the service cheaper than traditional financial
institutions, so borrowers may be able to borrow money at lower interest
rates and lenders earn higher returns.
Characteristics
Peer-to-peer lending does not fit cleanly into any of the three
traditional types of financial institutions (deposit takers, investors,
insurers)[2]
and is sometimes categorized as an
alternative financial service.[3]
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 loans to invest in
- the loans are unsecured and 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, and extending
crowdsourcing to unfamiliar lenders and borrowers open 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)
Comparison to other financial practices
Peer-to-peer lenders offer a narrower range of services than
traditional banks, and in some jurisdictions may not be required to have
a
banking license. Peer-to-peer loans, are funded by investors who can
choose the loans they fund; sometimes as many as several hundred
investors fund one loan; banks, on the other hand, fund loans with money
from multiple depositors or money that they have borrowed from other
sources; the depositors are not able to choose which loans to fund..
Because of these differences, peer-to-peer lenders are considered
non-banking financial companies.
Similar to
retail banking, peer-to-peer lenders execute transactions directly
with consumers, rather than businesses or secondary financial
intermediaries.
Like
community development banks and
alternative financial services institutions, some peer-to-peer
lenders originally targeted customers from "financially underserved",
low- to moderate-income demographics by providing loans that they could
not practically obtain from traditional banks. This feature has been
decreasing because such borrowers are more likely to have difficulties
with paying back the loans, and peer-to-peer lenders have started to
refuse their loan requests.
Peer-to-peer lending differs from
cooperative banking,
credit unions,
savings and loan associations,
building societies,
mutual savings banks and other similar non-bank
mutual organizations in that lenders and borrowers do not own the
intermediary and are not granted membership or voting rights to direct
the financial and managerial goals of the organization; the roles of
both borrowers and lenders are kept distinct from that of the owner. The
borrowers, lenders and owners are not required to share any common bonds
(such are of locality, employer, religion or profession). Operating
costs are funded not only by customer fees but also by investments from
private investors. The goals of operation are neither
non-profit nor
not-for-profit but to maximize revenue.
The latter characteristic distinguishes peer-to-peer lending also
from
person-to-person charities, person-to-person philanthropy,
collaborative finance and
crowdfunding which create connections between donors and recipients
of donations like peer-to-peer lenders but are non-profit movements.
Peer-to-peer lending differs from
microfinance by not lending to (small) businesses and groups of
micro-entrepreneurs but to unrelated individuals for their individual
needs. It differs from
microcredit by lending to borrowers with verifiable credit history;
the loan amount can be larger than microloans and although collateral is
not requested, it is not assumed to be non-existent.
History
United Kingdom
The first company to offer peer-to-peer loans in the United Kingdom
was Zopa.
Since its founding in February 2005, it has issued loans in the amount
of 244 million GBP and is currently the largest UK peer-to-peer lender
with over 500,000 customers.[4]
In 2010,
RateSetter became the first peer-to-peer lender to make use of a
provision fund to safeguard lenders against borrower defaults,[4]
and
Funding Circle became the first peer-to-business lender using the
same concept, followed by ThinCats and Market Invoice.[5][6]
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; model failed to encourage repayment.[4][7]
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.[5][7]
The peer-to-peer companies are predicted to issue up to £200 million of
loans in 2012.[6]
The peer-to-peer industry adheres to standards set by the
self-governing Peer-to-Peer Finance Association. 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[5]
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.[7]
As of July 2012, UK peer-to-peer lenders have collectively lent 300
million GBP.[8]
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.[9]
Both Prosper and Lending Club are located in San Francisco, California.[10]
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.[3]
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.[9][11]
The registration process was an arduous one; Prosper and Lending Club
had to temporarily suspended offering new loans,[12][13][14][15]
while others, such as the U.K.-based Zopa Ltd., exited the U.S. market
entirely.[12]
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.[3]
Both Lending Club and Prosper formed partnerships with
FOLIO
Investing to create a secondary market for their notes, providing
liquidity to investors.[16]
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.[12]
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.[17]
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.[18]
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.[9][10]
Smaller companies have included Pertuity Direct,
Virgin Money US and Peerform,[12][19]
with the two first ones no longer functional in the U.S.[20]
The two largest companies have collectively serviced over 100,000 loans
with $1 billion in total:[6][9][10]
as of October 31, 2012, Lending Club has issued 83,454 loans for
$996,451,975[21]
while Prosper Marketplace has issued 64,810 loans for $421,009,931.[22]
With greater than 100% year over year growth, peer-to-peer lending is
one of the fastest growing investments.[9]
The interest rates range from 5.6%-35.8%, depending on the loan term and
borrower rating.[19]
The default rates vary from about 1.5% to 10% for the more risky
borrowers.[10]
Executives from traditional financial institutions are joining the
peer-to-peer companies as board members, lenders and investors,[6][23]
indicating that the new financing model is establishing itself in the
mainstream.[11]
Other countries
In 2008, the social lending site DhanaX was launched in started
Bangalore, India to finance local
NGOs.[24]
Peer-to-peer platforms have been also becoming popular in Germany and
China that has millions of micro-entrepreneurs and up to 200million
rural poor who may not be able to access finance from traditional
sources, making it a big market for peer-to-peer groups.[6]
In Sweden a service know as Loan Land tried to establish, but failed
earlier than 2010. The service never reached any significant volumes,
and had problems with fraud. The owner of Loan Land
sold/transferred/gave away all lenders and borrowers to the company
Trustbuddy.
Trustbuddy is a company based in Norway, and is active in Norway,
Sweden, Germany and Finland. The company was started earlier than 2009
and the owners has background in On-line poker business. The service has
some resemblance with SMS-based short term loans with high interest, a
legal form of loan-sharking with bad reputation. Trustbuddy had some
early controversy with sending unwanted SMS with a high fee for the
recipient. Trustbuddy focus on short term loans, and relatively small
amounts. The business model can be compared to Credit card companies,
with no early fee but high fee if loaners fail to repay the loan within
2 weeks. Trustbuddy is 2012 much smaller than similar UK companies.
Legal regulation
In most countries, soliciting investments from the general public is
considered illegal and
crowd sourcing arrangements in which people are asked to contribute
money in exchange for potential profits based on the work of others are
considered a
security.
Dealing with financial securities is connected to the problem about
ownership—in case of person-to-person loans, 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).[13][14]
This question arises especially when a peer-to-peer lending company does
not just connect lenders and borrowers but 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
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 General Account
Office explored the potential for additional regulatory oversight by
Consumer Finance Protection Board or the Federal Deposit Insurance
Corporation, though neither organization has proposed direct oversight
of peer-to-peer lending at this time.[25]
In the U.K., the emergence of multiple competing lending companies
and problems with
subprime loans has also called 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.[26]
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%.[27])
The advantages for lenders are higher returns than obtainable from a
savings account or other investments.[28]
Both of these benefits are the result of disintermediation, since
peer-to-peer lenders avoid the costs of physical branches, capital
reserves, and high overhead costs borne by traditional financial
institutions with many employees and costly locations.
The on-line trading platforms provided by peer-to-peer lenders have
the benefit that loan application and the transfer of funds takes less
time and both borrowers and lenders can access their money faster.
As peer-to-peer lending companies and their customer base continue to
grow, marketing and operational costs continue to increase, and
compliance to legal regulations becomes more complicated. This can cause
many of the original benefits from disintermediation to fade away and
turns peer-to-peer companies into new intermediaries, much like the
banks that they originally differentiated from. Such process of
re-introduction of intermediaries is known as
reintermediation.
Credit risk
Peer-to-peer lending also attracts borrowers who, because of their
credit status or the lack of 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.[18]
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.[4]
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.[28]
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.[29]
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%.[30]
Since inception, Lending Club’s default rate ranges from 1.4% for
top-rated three-year loans to 9.8% for the riskiest loans.[10]
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, and 2.8% for
Funding Circle. 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.[7]
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.[5]
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 allege 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 are seeking rescission of the loan notes,
rescissory damages, damages, and attorneys’ fees and expenses.
[31]
See also