person-to-person

Person-to-person lending

Person-to-person lending or peer-to-peer lending or Social Lending is, in its broadest sense, the name given to a certain breed of financial transaction (primarily lending & borrowing, though other more complicated transactions can be facilitated) which occurs directly between individuals ("peers") without the intermediation/participation of a traditional financial institution. See also disintermediation. An enabling technology for person-to-person lending has been the Internet, where person-to-person lending appears in two primary variations: an "online marketplace" model and a "family and friend" model.

The marketplace model of person-to-person lending on the internet enables peer lenders to locate peer borrowers and vice-versa. This model connects borrowers with lenders 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.

The "family and friend" model forgoes the auction-like process entirely and concentrates on borrowers and lenders who already know each other, as with two friends or business colleagues formalizing a personal loan. Whereas the primary benefit of the marketplace model is the "match making" aspect, the family and friend model emphasizes online collaboration, loan formalization and servicing.

Traditionally, lending institutions have benefited from scale and diversification. By pooling the available money supply and lending it out again, the impact of any one default is made trivial in light of the timely payment of the vast majority of the notes outstanding. The downside to this model is that it has introduced greater transaction overhead and removed community loyalty from the equation. Person-to-Person or Peer-to-Peer Lending models attempt to reintroduce the social components that are lost in traditional centralized banking models, while maintaining a mixed quantitative/qualitative balance of diversification - as opposed to the purely quantitative diversification available through institutional lending. They also attempt to take advantage of the lack of overhead, thereby reducing the traditional bid/ask spread implicit in traditional bank lending models. For example, a bank may offer its deposit customers a meager 1% return, yet, at the same time, lend those same customer funds out for a much higher rate of interest. Peer to Peer Lending attempts to correct this inefficiency and create a "virtuous cycle" which would allow those who have funds to lend to garner a better return, while, at the same time, providing a more favorable interest rate to those who need to borrow. It also allows individual participants to directly control their own funds, as opposed to the traditional banking/lending models which pool all funds together and completely remove individuals from decision-making.

Community lending is a form of Peer-to-Peer Lending which involves intra-group many-to-one or one-to-many credit structures. It has as its theoretical premise the notion that pre-existing interpersonal relationships or other types of social connections between the transacting parties will foster increased fiscal responsibility and thereby improve repayment performance.

Similar types of mutualized credit systems are already quite often successfully employed by microfinance institutions in developing nations. For example, a microfinance institution may make a loan to an individual who is a member of small group in a certain locale, but may structure its lending agreement 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). The principle behind this form of transaction being that it is better to diversify risk over a smaller pool of "related" individuals, rather than just a single borrower, so that the borrower's immediate community- or social-group could be positively incented to affect repayment, either through mutual ("community") support of the borrower or, as occurs in some instances, through forms of social pressure. Community lending, however, occurs (rigorously) "only" when this form of lending and borrowing is transacted on a purely intra-group basis between members of a specific community (without the involvement of a corporate institution on one side of the transaction - though the argument can be made that this model, in some ways, serves to "incorporate" pre-existing social groups).

In 2005, there was $118 million of outstanding peer-to-peer loans, and there were $269 million and $647 million in 2006 and 2007 respectively. The projected amount for 2010 is $5.8 billion.

Evolution of Banks

Traditionally there was no concept of banks or financial institutions. There was only person-to-person lending or there were rich money lenders who were lending money to the needy.

With the increase in trade and commerce, society evolved institutions which acted as intermediaries between lenders and borrowers.

Advantages

  • Lenders get a fixed return
  • Risk management is moved to the institutions
  • Borrowers can get loans with or without collateral from these institutions based on the financial strength of the borrowers.
  • Intermediary institutions gains are based on economies of scale and on the spread between the lending and borrowing rates.

Disadvantage to this model developed over a period of time :

  • Many of these institutions failed and lenders and depositors lost their capital due to failures in the risk management of these institutions. This happened even though these institutions were regulated by the central banks of their respective countries.
  • Inefficiency started increasing when the central banks started using these institutions to fund government deficits. Banks were asked to maintain cash and a certain percentage of the deposit in government securities with lower return rates than the loans.
  • Central banks started evolving deposit guarantee schemes, however the amount of such coverage was for small deposit holders and the large deposit holders were unsecured creditors for the banks. So in case the banks failed, these depositors were getting paid on paripassu on left over monies.

Intermediaries charged the spread for the following reasons :

  • Credit Risk
  • Risk Management Cost
  • Operational cost
  • Operation Risk
  • Profit margin for the intermediaries.

Dis-intermediation

With the growth of internet technologies new business models evolved to remove the intermediaries like

  • Employment portals - get employees and employers together
  • Auction portals - get buyers and sellers together

A natural extension of these was person-to-person lending or peer-to-peer lending. In principle two models have evolved in the P2P lending space: secured P2P and unsecured P2P lending.

Secured person-to-person lending

In this model, the lender gives money to the borrower against the strength of the collateral given by the borrower. The advantage of this model is that the capital and interest of the lender is secured to the extent of the realizable value of the collateral. The Dis-intermediator provides risk management as per the terms and condition agreed upon by the lender and the borrower.

Unsecured person-to-person 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.

Pooled Lending - the lender lends the money to a pool of borrowers with similar credit ratings. In this model 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. See Zopa or Lending Club for examples.

Direct Lending - the lender lends money to a borrower based on their credit rating. In this model the risk of capital and interest for the lender is that the borrower could default on the loan. See Kiva, The Open Source Science Project, Prosper or Loanio for examples.

Companies

North America

  • Fynanz - (US) P2P financing for student loans.
  • Lending Club - (US) P2P lenders and borrowers matched through social connections.
  • Loanio - (US) Stealth phase P2P lending starting, scheduled for launch in 2008.
  • Prosper Marketplace - (US) America's first P2P lending/borrowing auction-style marketplace.
  • The Open Source Science Project - (US) America's first research microfinance platform.
  • Virgin Money - (US) Person to person lending focused on pre-existing relationships.
  • Zopa - (US) In the US, Zopa offers guaranteed CDs to lenders and loans to borrowers.

Europe

  • Monetto - (Poland) Most safety Polish P2P lending site
  • Kokos - (Poland) Polish first P2P lending site
  • Loanland - (Sweden) First P2P lending company in Sweden. See www.loanland.se
  • PRETp2p.com - (France) Second and biggest P2P lending site in France. See http://www.pretp2p.com
  • smava - Germany's first P2P lending/borrowing marketplace.
  • Zopa - (UK) In the UK, Zopa employs a direct person to person lending model.

Asia

  • dhanaX - (India) India's first online/offline P2P lending/borrowing marketplace.
  • maneo - (Japan) First P2P lending site in Japan.
  • PPDai - China's first P2P lending site.
  • Wokai - (China) leverages the internet to connect lenders to local agents for starting small businesses
  • Oneclick.com - (Korea. republic of) P2P lending & Borrowing Marketplace in Korea.

Australia

  • Fosik - (AUS) Person to person lending service offering DIY loans and launching a loan market in Australia
  • iGrin - (AUS) Internet Group Invester Network

International

  • Kiva.org - World's first person-to-person micro-lending website, individuals lend directly to unique entrepreneurs in the developing world.

References

External links

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