Person-to-person lending
Encyclopedia
Person-to-person lending (also known as peer-to-peer lending, peer-to-peer investing, and social lending; abbreviated frequently as P2P lending) is a certain breed of financial transaction (primarily lending and borrowing, though other more complicated transactions can be facilitated) which occurs directly between individuals or "peers" without the intermediation of a traditional financial institution. Person-to-person lending is for the most part a for-profit activity, this distinguishes it from person-to-person charities, person-to-person philanthropy and crowdfunding which also create connections between donors and recipients of donations but are nonprofit movements.
. The development of the market niche was further boosted by the global economical crisis in 2007-2010 when person-to-person lending platforms promised to provide credit at the time when banks and other traditional financial institutions were having fiscal difficulties.
The first person-to-person lending company to launch in the United Kingdom was Zopa
, in February 2005. The first person to person lending firm in the United States was Prosper, which launched one year later, in February 2006. The first company to launch in Canada for business financing was P2P Financial
in September 2010. For a full list of notable person-to-person lending companies, see person-to-person lending companies. For maps visualizing different geographical locations of the companies, see the maps created for Europe and Northern America.
In 2005, there were $118 million of outstanding peer-to-peer loans. In 2006, there were $269 million, and, in 2007, a total of $647 million. The projected amount for 2010 is $5.8 billion.
Reasons for peer-from-peer borrowing range from education and mortgage loans, and business funding to vet bills and weddings, the most popular loan being debt consolidation.
-based business models, such as employment portals (connect employees and employers), auction portals (connect buyers and sellers), and peer-to-peer lending platforms (connect borrowers and lenders).
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A special case of this model is community lending in microfinance
where a loan is made to a specific individual but the lending agreement is structured to hold the borrower's social group either directly accountable for the repayment of the loan (akin to "cosigning") or indirectly accountable, whereby the entire social group may face future consequences, such as reduced access to credit or higher future rates, if one of its members fails to repay an obligation.
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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). 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 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.
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.
As person-to-person lending companies and their customer base continue to grow, though, marketing expenses and administrative costs associated with customer service and arbitration, maintaining product information, and developing quality websites to service customers and stand out among competitors will rise, and compliance to legal regulations becomes more complicated. This causes many of the original benefits from disintermediation to fade away and turns person-to-person companies into new intermediaries, much like the banks that they originally differentiated from. Such process of re-introduction of intermediaries is known as reintermediation.
Person-to-person lending also attracts borrowers who, because of their past credit status or the lack of thereof, are unqualified for traditional bank loans. The unfortunate situation of these borrowers is, however, well known for the people issuing the loans and results in very high interest rates that verges on predatory lending
and loan sharking.
At the same time, because past behavior is frequently indicative of future performance and low credit scores correlate with high likelihood of defaulting, many person-to-person intermediaries have begun to decline borrowers whose credit scores are below a certain bound.
It seemed initially that one of the appealing characteristics of person-to-person 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.
The actual default rates for the loans originated on Prosper in 2007 were in fact higher than projected. As loss of principal is dependent upon when in the repayment cycle a particular loan defaults, it is more appropriate to speak of aggregate yield - rather than merely "default rate" - as a loan which "defaults" after making, say, 30 (out of 36) of its payments will impact return differently than a loan which defaults after making only a few payments.
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)%, for the 2009 vintage 8.10% - and independent projections for the 2010 vintage are of an aggregate return of 9.87%.
Person-to-person lending companies
Overview
Lending money and supplies to friends, family and community members predates formalized financial institutions, but in its modern form, peer-to-peer lending is a by-product of internet technologies, especially Web 2.0Web 2.0
The term Web 2.0 is associated with web applications that facilitate participatory information sharing, interoperability, user-centered design, and collaboration on the World Wide Web...
. The development of the market niche was further boosted by the global economical crisis in 2007-2010 when person-to-person lending platforms promised to provide credit at the time when banks and other traditional financial institutions were having fiscal difficulties.
The first person-to-person lending company to launch in the United Kingdom was Zopa
Zopa
Zopa is a UK-based company providing an online money exchange service, allowing people who have money to lend it to those who wish to borrow, instead of using savings accounts and loan applications at traditional banks. The process is sometimes referred to as peer-to-peer lending...
, in February 2005. The first person to person lending firm in the United States was Prosper, which launched one year later, in February 2006. The first company to launch in Canada for business financing was P2P Financial
P2P Financial
P2P Financial is Canada’s first internet-based business financing company. The company operates P2PFinancial.ca, an online website where businesses can request to get financing from potential investors. P2P Financial was founded in June 2009 by Matthew McGrath, a former vice-president of private...
in September 2010. For a full list of notable person-to-person lending companies, see person-to-person lending companies. For maps visualizing different geographical locations of the companies, see the maps created for Europe and Northern America.
In 2005, there were $118 million of outstanding peer-to-peer loans. In 2006, there were $269 million, and, in 2007, a total of $647 million. The projected amount for 2010 is $5.8 billion.
Reasons for peer-from-peer borrowing range from education and mortgage loans, and business funding to vet bills and weddings, the most popular loan being debt consolidation.
Characteristics
The main characteristics of person-to-person lending are disintermediation and reliance of existing social networks.Disintermediation
Disintermediation is a term that denotes the removal of intermediaries in a supply chain, and in the present context, the absence of traditional financial institutions as intermediaries between individuals ("peers"); an important impetus for this is a drop in the cost of servicing customers. The enabling technology for disintermediation has been the Internet that gave rise to several new crowdsourcingCrowdsourcing
Crowdsourcing is the act of sourcing tasks traditionally performed by specific individuals to a group of people or community through an open call....
-based business models, such as employment portals (connect employees and employers), auction portals (connect buyers and sellers), and peer-to-peer lending platforms (connect borrowers and lenders).
Reliance on social networks
Many peer-to-peer lending companies leverage existing communities and pre-existing interpersonal relationships with the idea that borrowers are less likely to default to the members of their own communities. The risk associated with lending is minimized either through mutual (community) support of the borrower or, as occurs in some instances, through forms of social pressure. The peer-to-peer lending firms either act as middlemen between friends and family to assist with calculating repayment terms, or connect anonymous borrowers and lenders based on similarities in their geographic location, educational and professional background, and connectedness within a given social network.Models
Various models and variations of person-to-person lending services have evolved based on different combinations of the following main parameter settings:- Direct vs. indirect lending
- Secured vs. unsecured lending
- Prior familiarity of lenders and borrowers
- Services offered
Direct lending
In this model, the lender lends money to one specific borrower based on his/her credit rating; the risk of capital and interest for the lender is that the borrower could default on the loan. Lenders have mitigated this risk by investing small amounts into a large number of loans so that only a small amount of money is loaned to any one person. See also direct loans.Indirect lending
In this model (also known as 'pooled lending'), the lender lends the money to several borrowers with similar credit ratings; the risk of capital and interest for the lender is defaulters in the pool. The risk of capital and interest of the lender is reduced considerably because the impact of any one default is made trivial in light of the timely payment of the vast majority of the notes outstanding; both many-to-one or one-to-many credit structures may be involved. This model is very similar to the traditional bank model and does not allow the lenders to select individual borrowers. See also pooled investment.Secured lending
In this model, the lender gives money to the borrower against the strength of the collateral given by the borrower. For loans that are originated in the United States it is common to file a UCC-1 form. Each state has a different form. See also asset-based lendingAsset-based lending
In the simplest meaning, asset-based lending is any kind of lending secured by an asset. This means, if the loan is not repaid, the asset is taken. In this sense, a mortgage is an example of an asset-backed loan. More commonly however, the phrase is used to describe lending to business and large...
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Unsecured lending
In this model, the lender gives money to the borrower based on the credit rating of the borrower. The lender runs the risk of the capital and interest in case of failure on the part of the borrower. Two variants have evolved in this space. See also unsecured loans.Unfamiliar lenders and borrowers
In this model (also known as 'marketplace lending'), the lenders and borrowers are previously unacquainted or do not have a prior personal loan agreement. The system enables individual lenders to locate individual borrowers and vice-versa and connects them through an auction-like process in which the lender willing to provide the lowest interest rate "wins" the borrower's loan. The marketplace process may include other intermediaries who package and resell the loans, but the loans are ultimately sold to individuals or pools of individuals.Familiar lenders and borrowers
In this model (also known as 'family and friend lending'), the lender lends money to a borrower based on their pre-existing personal, family, or business relationship. The model forgoes an auction-like process and concentrates on formalizing and servicing a personal loan. Lenders can charge below market rates to assist the borrower and mitigate risk. Loans can be made to buy homes, personal needs, school, travel or any other needs.A special case of this model is community lending in microfinance
Microfinance
Microfinance is the provision of financial services to low-income clients or solidarity lending groups including consumers and the self-employed, who traditionally lack access to banking and related services....
where a loan is made to a specific individual but the lending agreement is structured to hold the borrower's social group either directly accountable for the repayment of the loan (akin to "cosigning") or indirectly accountable, whereby the entire social group may face future consequences, such as reduced access to credit or higher future rates, if one of its members fails to repay an obligation.
Loan origination
The services offered include matching borrowers to lenders, calculating interest rates and repayment terms and disbursing funds. See also loan originationLoan origination
Loan origination is the process by which a borrower applies for a new loan, and a lender processes that application. Origination generally includes all the steps from taking a loan application through disbursal of funds . Loan servicing generally covers everything after disbursing the funds until...
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Loan servicing
The services offered include formalizing loans by creating written documents, establishing payment schedules, ensuring timely payments and collecting funds from one party and transferring them to another. See also loan servicingLoan servicing
Loan servicing is the process by which a mortgage bank or subservicing firm collects the timely payment of interest and principal from borrowers...
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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 securitySecurity (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
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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). 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 in the U.S., the Ontario Securities Commission
Ontario Securities Commission
The Ontario Securities Commission is a regulatory agency which administers and enforces securities legislation in the Canadian province of Ontario...
in Ontario, Canada, the Autorité des marchés financiers in France and Quebec, Canada, or the Financial Services Authority
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
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.
Advantages and criticism
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%). The advantages for lenders are higher returns than obtainable from a savings account or other investments.. Both of these benefits are the result of disintermediation, the lack of high overheads to traditional financial institutions with many employees and costly locations. The paucity of administrative procedures in person-to-person lending has the additional benefit that loan application and the transfer of funds takes less time and both borrowers and lenders can access their money faster.As person-to-person lending companies and their customer base continue to grow, though, marketing expenses and administrative costs associated with customer service and arbitration, maintaining product information, and developing quality websites to service customers and stand out among competitors will rise, and compliance to legal regulations becomes more complicated. This causes many of the original benefits from disintermediation to fade away and turns person-to-person companies into new intermediaries, much like the banks that they originally differentiated from. Such process of re-introduction of intermediaries is known as reintermediation.
Person-to-person lending also attracts borrowers who, because of their past credit status or the lack of thereof, are unqualified for traditional bank loans. The unfortunate situation of these borrowers is, however, well known for the people issuing the loans and results in very high interest rates that verges on predatory lending
Predatory lending
Predatory lending describes unfair, deceptive, or fraudulent practices of some lenders during the loan origination process. While there are no legal definitions in the United States for predatory lending, an audit report on predatory lending from the office of inspector general of the FDIC broadly...
and loan sharking.
At the same time, because past behavior is frequently indicative of future performance and low credit scores correlate with high likelihood of defaulting, many person-to-person intermediaries have begun to decline borrowers whose credit scores are below a certain bound.
It seemed initially that one of the appealing characteristics of person-to-person 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.
The actual default rates for the loans originated on Prosper in 2007 were in fact higher than projected. As loss of principal is dependent upon when in the repayment cycle a particular loan defaults, it is more appropriate to speak of aggregate yield - rather than merely "default rate" - as a loan which "defaults" after making, say, 30 (out of 36) of its payments will impact return differently than a loan which defaults after making only a few payments.
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)%, for the 2009 vintage 8.10% - and independent projections for the 2010 vintage are of an aggregate return of 9.87%.
See also
- Alternative financial servicesAlternative financial servicesAlternative financial services are financial services provided outside traditional banking institutions, on which many low-income individuals depend. In developing countries, these services often take the form of microfinance...
- Crowd fundingCrowd fundingCrowd funding describes the collective cooperation, attention and trust by people who network and pool their money and other resources together, usually via the Internet, to support efforts initiated by other people or organizations...
- CrowdsourcingCrowdsourcingCrowdsourcing is the act of sourcing tasks traditionally performed by specific individuals to a group of people or community through an open call....
- DisintermediationDisintermediationIn economics, disintermediation is the removal of intermediaries in a supply chain: "cutting out the middleman". Instead of going through traditional distribution channels, which had some type of intermediate , companies may now deal with every customer directly, for example via the Internet...
- Social peer-to-peer processes
- Peer-to-peer car rentalPeer-to-peer car rentalPeer-to-peer car rental is the process whereby an existing car owner makes their vehicle available for use to other drivers in their area in exchange for payment...
- Peer-to-peer bankingPeer to Peer BankingPeer-to-peer banking is an online system that allows individual members to complete financial transactions with one another by using an auction style process that lets members offer loans for a specific amount and at a specific rate. Buyers have the option to look for an amount and rate of interest...
Person-to-person lending companies
- MicrocreditMicrocreditMicrocredit is the extension of very small loans to those in poverty designed to spur entrepreneurship. These individuals lack collateral, steady employment and a verifiable credit history and therefore cannot meet even the most minimal qualifications to gain access to traditional credit...
- MicrofinanceMicrofinanceMicrofinance is the provision of financial services to low-income clients or solidarity lending groups including consumers and the self-employed, who traditionally lack access to banking and related services....
- Social commerceSocial commerceSocial commerce is a subset of electronic commerce that involves using social media, online media that supports social interaction and user contributions, to assist in the online buying and selling of products and services....
External links
- Peer-to-Peer Banking - CNN Money: Business 2.0 Magazine, Aug. 1, 2005
- Credit Lending Online Service - ABC News, Nov. 23, 2005
- Avoiding the Pitfalls of Family Borrowing - National Public Radio, Oct. 6, 2006
- In Credit Crunch, Lending To Each Other - CBS Evening News, March 21, 2008
- Hey, Buddy, Can You Spare $10,000? - Time Magazine, Feb 29 2008
- Social Lending Offers Alternatives - ABC News, Oct. 28, 2008
- Forget Citibank, Borrow From Bob - Harvard Business Review, Jan. 1, 2009
- The Money Web - American Way Magazine, July 1, 2008
- Peer-to-Peer Lending Refuses to Die - The Wall Street Journal, Jan. 22, 2009
- Social entrepreneurship in India - Economic Times India, Feb. 20, 2009