Before banking or financial systems, individuals provided either cash or an item to another individual within an arrangement that the borrower would return said cash or item to the lender with or without interest in the future. Peer to Peer lending occurs when a lender and borrower transact business without the role of any intermediary. P2P lending differs from traditional lending whereby a financial institution serves as an intermediary, mobilising capital from its client base and lending.
The fast-paced fintech innovation has driven peer-to-peer lending. According to The Business Research Company, global P2P lending is valued at US$143.64billion in 2023.
Peer-to-Peer lending is categorised into:
Informal P2P lending – wherein an individual within a circle of friends or colleagues requests a loan, usually through face-to-face interaction or phone call. The transaction is usually undocumented and trust-based – on the network’s ability to influence the behaviour of a borrower to pay up. The blacklisting of an individual borrower becomes an incentive to pay up on time; however, the absence of a mechanism for enforcement is a challenge.
Formal P2P lending – which uses digital tools like online platform to connect a borrower and lender to transact loans, involving a limited role for an ‘intermediary’ who provides and maintains the platform to facilitate loan processing. The ‘intermediary’ is not a party to the transaction, unlike a bank that serves as an intermediary in similar loan transactions.
All risks are borne by both parties. The U.K.’s largest P2P lender, Funding Circle for small-to-medium enterprise lending; Lending Club; Prosper; SoFi; Upstart and Peerform; CreditEase; China Rapid Finance and Dianrong are examples of formal P2P lenders around the world.
The advancement of emerging technologies such as blockchain gave rise to the third type. Facilitated by Decentralised Finance (DeFi) – which promises to revolutionise financial services by replacing the ‘intermediary’ in formal P2P lending processing with a decentralised system powered by blockchain. In effect, anyone with an Internet connection can network with others to transact financial services. It is estimated that loans issued through DeFi lending protocols is increasing at an annual rate of 800%+ to US$23billion. (DeFi Risk, Regulation and the Rise of DeCrime)
Risks and challenges
A key challenge affecting most P2P lending platforms is little or zero restriction on borrower’s eligibility, which can lead to high borrower defaults. Some lenders on the P2P lending platforms may not have liquidity to finance loans. Irrespective of the P2P lending type, it is risk-associated.
Top of the list is high default due to inability to enforce transactions. It must be noted that financial institutions face the same risk. The key risk with P2P platforms is the absence of direct regulation by financial regulators, exacerbating the risk levels. An example is China’s Ezubao P2P lending platform; before it ceased operations, over 900,000 P2P lenders collectively lost US$7.6billion.
Also, DeFi-based P2P lending has new risks – like hacking, money laundering and other frauds. Other risks related to P2P lending include misleading advertising and standardised disclosure in terms and conditions.
Given the high level of risks in P2P lending, it is imperative for platform operators to ensure: detailed information is provided on the risk borne by lenders; identity of users is protected; and measures are implemented to prevent misconduct by both parties. Also, such platforms must implement protection for transactions – including the use of bank escrow account services to manage lenders’ funds and borrowers’ payments. Further, P2P lending platforms should ensure user-friendly interfaces.
Regulations
Regulators are still crafting ways to regulate P2P platforms. Hence, many of these are either unregulated entities or taking advantage of regulatory arbitrage – whereby they package P2P lending products to ensure they take advantage of cross-sectoral regulatory gaps, or are offered outside existing legal frameworks. Banking and Security Exchange regulators are working on formulating rules to caution and protect clients.
Some banks are partnering with P2P lending platforms or thinking about creating services similar to P2P platforms, in order to service SMEs clients whose lack of credit scores, records or business history makes them high risk.
Some key benefits of P2P lending platforms include access to lending services for all; democratic and transparent loan acquisition; lower transaction costs and interest than traditional loans; and efficient loan processing, hence faster service delivery.
Wrapping up, P2P lending – given its long history – is here to stay. Regulators must ensure they regulate operations while P2P platform providers ensure a responsible lending environment. Borrowers and lenders must take cognisance of its risky nature to mitigate risks.
>>>the writer is a Tech Innovations Consultant. You can reach him at [email protected]
