Peer-to-peer Lending (P2P Lending)

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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.

Contents 1 Overview 2 Characteristics 3 Comparison to other financial practices 4 History 4.1 United Kingdom 4.2 United States 4.3 Other countries 5 Legal regulation 6 Advantages and criticism 6.1 Interest rates 6.2 Credit risk 6.3 Government protection 7 See also 8 References

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

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

References

1. ^ Lepro, Sara (December 20, 2010). "Prosper Ditches Auction Pricing for Model Like P-to-P Rival's". American Banker. Retrieved July 31, 2012.
2. ^ Chapter 2 Section 5: Financial Intermediaries. Retrieved August 5, 2012.
3. ^ ^{a b c} Bradley, Christine; Burhouse, Susan; Gratton, Heather; Miller, Rae-Ann (Q1 2009), "Alternative Financial Services: A Primer", FDIC Quarterly (Federal Deposit Insurance Corporation) 3 (1), retrieved July 30, 2012
4. ^ ^{a b c d} Dunn, Sam (December 7, 2011). "Fears grow over safety of 'peer-to-peer' savings after lender Quakle goes bust". Daily Mail. Retrieved August 2, 2012.
5. ^ ^{a b c d} Gompertz, Simon (June 8, 2012). "Peer-to-peer lending via the internet hits £250m". BBC News. Retrieved August 3, 2012.
6. ^ ^{a b c d e} Goff, Sharlene (June 13, 2012). "Peer-to-peer lending: Model takes off worldwide". Financial Times. Retrieved August 2, 2012.
7. ^ ^{a b c d} Moulds, Josephine (June 9, 2012). "Are peer-to-peer lenders the future of banking?". The Guardian. Retrieved July 25, 2012.
8. ^ "Peer-to-peer lending exceeds £300million". P2P Money. July 31, 2012. Retrieved August 3, 2012.
9. ^ ^{a b c d e} Renton, Peter (May 29, 2012). "Peer To peer lending crosses $1 billion in loans issued". Techcrunch. Retrieved July 25, 2012.
10. ^ ^{a b c d e} Barth, Chris (June 6, 2012). "Looking for 10% yields? Go online for peer to peer lending". Forbes. Retrieved July 25, 2012.
11. ^ ^{a b} Alloway, Tracy; Moore, Elaine (April 23, 2012). "Mack moves to cutting edge of P2P lending". Financial Times. Retrieved July 20, 2012.
12. ^ ^{a b c d} Jane J. Kim (2009-04-28). "Peer-To-Peer Lender Relaunched". The Wall Street Journal. Retrieved July 25, 2012.
13. ^ ^{a b} Hendrickson, Mark (Apr 8, 2008). "Peer Lending Club Puts Hold on Lending Activity While It Sorts Out Some Legal Issues". Techcrunch. Retrieved August 2, 2012.
14. ^ ^{a b} "Lending Club Shuts Down (Temporarily?)". Peer-Lend. Retrieved April 8, 2008.
15. ^ "Quiet Period". Lending Club. Retrieved April 8, 2008.
16. ^ Jonnelle Marte (September 26, 2010). "Credit Crunch Gives 'Microlending' a Boost". The Wall Street Journal. Retrieved August 23, 2012.
17. ^ Asma Aziz (February 7, 2010). "Zidisha Set to "Expand" in Peer-to-Peer Microfinance". Microfinance Focus. Retrieved August 2, 2012.
18. ^ ^{a b} Kennard, Matt; Bond, Shannon (November 24, 2011). "Interest soars in US peer-to-peer lending". Financial Times. Retrieved July 20, 2012.
19. ^ ^{a b} Steinisch, Monica (June 2012). "Peer-to-peer lending survey". Consumer Action. Retrieved July 23, 2012.
20. ^ Paulson, Matthew (August 26, 2009). "Pertuity Direct Shuts Down Unexpectedly". P2P Lending News. Retrieved July 25, 2012.
21. ^ "Loan Performance Statistics". Lending Club. Retrieved August 13, 2012.
22. ^ "Prosper: Marketplace Performance". =Prosper Marketplace, Inc.. Retrieved August 13, 2012.
23. ^ Taylor, Colleen (June 6, 2012). "Lending Club Lands $17.5 Million from Kleiner Perkins and Morgan Stanley Chairman John Mack". Tech Crunch. Retrieved June 8, 2012.
24. ^ Menon, Nikhil (February 20, 2009). "Social entrepreneurship in India". Economic Times. Retrieved August 2, 2012.
25. ^ "PERSON-TO-PERSON LENDING: New Regulatory Challenges Could Emerge as the Industry Grows (Report to Congressional Committees)". United States Government Accountability Office. July 2011. Retrieved August 23, 2012.
26. ^ Sean Farrell (Sept 20, 2010). "Zopa calls on Government and FSA to regulate social lending sector". The Daily Telegraph. Retrieved July 25, 2012.
27. ^ Social Lending Network, accessed Sept. 21, 2010
28. ^ ^{a b} Person-to-person lending online gathers steam Associated Press, Nov. 27, 2007.
29. ^ http://www.lendstats.com/ Prosper.com - Loan Performance Summary - Independent Loan Analytics courtesy of LendStats.com
30. ^ Social Lending Network, accessed August. 13, 2012
31. ^ Superior Court of California, County of San Francisco, Docket: [Case Number: CGC-09-491736 http://webaccess.sftc.org/Scripts/Magic94/mgrqispi94.dll?APPNAME=IJS&PRGNAME=ROA22&ARGUMENTS=-ACGC09491736](retrieved 01-02-2011)