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Person-to-person lending

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Person-to-person lending (also known as peer-to-peer lending and 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.

Models

The marketplace model of Person to Person Lending on the Internet enables individual lenders to locate individual 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 one another, as with two (or more) 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 the traditional model is that it has introduced greater transaction overhead and removed community loyalty from the equation.

Person-to-Person 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 implicit in being primarily online ventures, thereby reducing the infrastructure costs (such as physical branches) inherent in traditional bank lending models. These cumulative savings may serve to narrow the bid/ask spread. For example, a bank may offer its deposit account customers a meager 1% return, yet, at the same time, lend out those same customer funds (on deposit) to the bank's other customers who need to borrow - and for a much higher rate of interest - while pocketing the difference. Person to Person 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, by removing the bank from the equation.

Person to Person Lending allows individual participants to directly control the allocation of their own capital, as opposed to the traditional bank lending models which pool all funds together and completely remove the individuals who actually own the money from the decision-making process regarding who may borrow that money, for how long they may borrow it, and under what rates and terms.

Community Lending is a form of Person to Person 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 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.[1]

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 pari passu 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. The first P2P lending company to launch was Zopa in the UK in February 2005.[citation needed] 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-intermediary provides risk management as per the terms and condition agreed upon by the lender and the borrower.

Further this model can expand the market to the extent of the market capitalization of the economy or to the extent of debts issued in the economy.

Chances of this model surviving is more as this model provides security of capital and interest to the lender.

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 MicroPlace, Zopa USA (discontinued), Pertuity Direct (discontinued) for examples. This model is very similar to the traditional bank model and does not allow the lenders to select individual borrowers.

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. 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 Prosper, Lending Club or Zopa UK for examples.

Family and Friend Lending - the lender lends money to a borrower based on their pre-existing personal, family, or business relationship. 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. See ZimpleMoney for an example.

Person-to-person lending and microfinance

Peer-to-peer platforms have also developed in the microfinance sector. Some of these platforms enable microfinance institutions to access capital, they might have not got otherwise through conventional sources of credit such as local banks. Peer-to-peer platforms allow the general public to participate in alleviating poverty by lending, guaranteeing or contributing to micro-entrepreneurs.

Lend to micro-entrepreneurs

Kiva.org launched in 2005 and is the first micro-lending Website that enables an individual to quasi-lend money to a micro-entrepreneur in the developing world through a microfinance institution. In fact, the money provided by lenders on the Kiva site typically back fills the loan that have already been disbursed by the MFI. Kiva argues that it is peer-to-peer lending because lenders assume the risk in the event a borrower defaults and the MFI is then not responsible for repayment. As of November 2008, over 100 field partners have collaborated with Kiva, dramatically extending its scope and reach.

MYC4 (Denmark) launched in 2007 and new platforms which connect lenders to micro-entrepreneurs are emerging on the web: Rang De (India), dhanaX (India).

ZimpleMoney - ZimpleMoney launched in 2008 and is the first platform that allows organizations to sponsor their own microfinance activity using the micro-finance platform. Organizations play a unique role of determining what social finance projects receive funding and can engage their donors in tracking their investment or donation at work.

United Prosperity - United Prosperity is a Website that enables an individual to micro-lend money as a guarantor for a micro-entrepreneur in the developing world. The loan itself comes from a local bank, enabling the micro-entrepreneur to build a relationship with their local bank for future loans.[2] As the guarantee amount is lower than the actual loan, lending the guarantee provides greater leverage than directly lending the loan, enabling more micro-entrepreneurs to be assisted.

Contribute to micro-entrepreneurs

Wokai (lending to China) allows contributors to contribute towards micro-entrepreneurs they choose to connect and support. Since the contribution is a donation, contributors in the United States may also get a tax-deduction.

Similarly, UYDO - United Youth Development Organization - facilitates a youth movement which allows young people globally to raise funds which can be invested in young entrepreneurs in sub-Saharan Africa.[3]

Groups are formed and, having raised funds through many different ways, they choose which young entrepreneurs to invest in. Profiles of the entrepreneurs UYDO and their microfinance parnters (MFIs) work with are available on the UYDO website and groups can browse the profiles and invest as much in as many entrepreneurs as they wish.

Upon repayment of the loan, the money is returned to the group who invested it initially, and they get new funds to invest in another set of entrepreneurs. The money raised initially nevers leaves this cycle and therefore has the potential to provide small loans to may thousands of young entrepreneurs.

See also

References

  1. ^ Hoak, Amy. (01-28-08) How to use peer-to-peer lending sites to borrow money. FiLife. http://www.filife.com/stories/borrowing-from-p2p-lending. Retrieved 6-13-08.
  2. ^ The Daily Tell, Nonprofit Uses Social Guarantors to Support Strugging Entrepreneurs, 27 August 2009, accessed 25 October 2009
  3. ^ http://www.UYDO.org/
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