The Internet is famous for transforming unique new businesses into giant behemoths, seemingly overnight. Names like Amazon and Facebook are just two examples. While the recent Internet phenomenon of Peer-to-Peer (P2P) lending, now starting to accelerate in the U.S., may not experience nearly as much success, it certainly bears watching as a potential new source of consumer and small business credit.
Briefly, in P2P lending, a website is established to connect potential borrowers seeking consumer or small business loans to a myriad of largely unsophisticated lenders looking for investment opportunities. Typical borrowers desire loans of up to $35,000 at interest rates potentially lower than what banks, or finance and credit card companies might otherwise offer them. Lenders in turn seek returns above those available from deposit-taking institutions or from current bond yields.
In order to obtain credit, a potential borrower registers with the P2P website, describes the loan he (or she) is requesting, and makes certain financial disclosures, including as to his (or her) current income, debt-to-income ratio, credit score, employment status, home ownership, occupation, existing indebtedness and delinquencies, etc. The web operator then uses this information to assign a proprietary risk rating and interest rate to the loan. The risk rating, interest rate and supplied financial information, along with a fictitious borrower screen name, are then posted by the web operator to a webpage where potential lenders can subscribe for a portion of the loan requested, notably in principal amounts as small as $25. The borrower's identity is not disclosed to potential lenders, but is kept confidential by the P2P operator.
Potential lenders, whose identities are similarly not divulged, also register with the website. Once a sufficient number of lenders has subscribed for the requested loan amount, the loan is funded, often within a few days. All P2P loans are unsecured, have terms of one, three or five years, and are repayable in equal monthly installments over the life of the loan. Full and partial prepayments are permitted without penalty, an important feature that may not be available from financial institutions offering comparable loans. Lenders diversify their individual borrower risk by subscribing for small amounts from amongst a number of different borrowers across a range of asset classes. Assets classes include auto and RV loans, credit consolidation loans, home improvement loans and small personal loans, even wedding loans.
P2P operators take a percentage of the principal loan amount advanced as a closing fee, charge borrowers for late or failed payments, and charge additional fees to lenders for services rendered during the life of the loan, for example a one per cent servicing fee on the principal of loans outstanding. A collection agency recovery fee is charged if defaulted loans are assigned to a debt collection agency. A financial institution assists the P2P operator with the administration of ongoing payments and collections.
One current P2P operator in the U.S. advertises two million members and more than $670 million in loans advanced to-date1, while its main competitor recently reported a total loan volume over $1 billion as of 2012.2 P2P operators are even attracting high profile individuals to serve as directors on their company boards.3 More notably, sophisticated lenders have begun participating in the new marketplace, with at least one report suggesting that hedge funds and smaller U.S. banks are now lending at P2P websites as a means to earn returns ranging from 6 to 35%.4 To top it off, Google recently announced an investment of $125 million in one of the two main P2P web operators in the U.S., adding a measure of increased credibility.5 So far in Canada, at least one P2P lending foray has been attempted.6
Not surprisingly, there are a number of legal issues involved in setting up a P2P lending business, including under applicable securities laws, licensing laws, and laws governing personal privacy, information collection, electronic commerce, consumer protection, interest rate disclosure and usury to name but a few. Over the shorter term, these regulatory constraints will likely serve as high barriers to entry, especially in Canada where the P2P marketplace is likely to be much smaller than in the U.S. Nevertheless, over the longer run, regulators on both sides of the border may be inclined to ease some of the more onerous regulatory impediments in order to facilitate even greater access to limited amounts of consumer and small business credit at reduced cost, especially if the initial U.S. experience continues to remain positive.
Beyond the imposing regulatory issues, there are also practical hurdles as well. First and foremost is the fact that the Internet is seemingly infested with scams and scammers. P2P operators attempt to weed out the fraudsters by verifying the identity of the borrowers and by attempting to verify certain of the personal financial information supplied by borrowers, including by operator requests for backup documentation. Still, it may not be possible to accurately verify all the financial information posted by potential borrowers. Furthermore, as the principal loan amounts involved are small, formal enforcement mechanisms such as by court action may not be practical in most cases. Instead, debt collection agencies will likely be the preferred enforcement mechanism for P2P operators. And finally, even though default rates are apparently declining in the U.S., and additional sites now exist that assist lenders in predicting the creditworthiness of their P2P portfolios7, default rates may still vary widely, from less than one percent to as high as six percent, depending on the borrower, his (or her) financial status, and the asset class.8
What impact will this new and unique Internet business have on more traditional forms of consumer and small business lending if it ever crosses the border for good into Canada? For now, it seems hard to say given the relative size difference between the U.S. and Canadian credit markets. Whatever the expectation, it would probably be prudent for Canadian industry participants to watch the evolving US experience closely as this potential new source of consumer and small business credit continues to grow.9
Footnotes
1 See Prosper Market Place, http://www.prosper.com/, data current to 10/18/2013. A detailed report of the recent upsurge in loan origination at Prosper can be found here: http://www.orchardplatform.com/blog/?p=556 .
2 See Lending Club, https://www.lendingclub.com/, and specifically https://www.lendingclub.com/public/lending-club-press-2013-02-06.action .
3 See note 2.
4 "P2P Lending Pulls in Big Investors – Should you bite?", Feldman, A. and Pinsker, B., Reuters Money, 08/27/2013; http://www.reuters.com/article/2013/06/25/us-debt-loans-p2p-idUSBRE95O0M220130625 .
5 "Need a Small Business Loan? Google hopes so", Scarrow, K., The Globe and Mail, 05/09/13; http://www.theglobeandmail.com/report-on-business/small-business/sb-tools/small-business-briefing/need-a-small-business-loan-google-hopes-so/article11819232/ .
6 But CommunityLend appears to have suspended its operations in Canada as of February, 2012. (Press Release: http://www.financeit.ca/blog/2012/02/23/onwards-and-upwards/ .)
7 See Nickel Steamroller: http://www.nickelsteamroller.com/.
8 See note 4.
9 See generally Lend Academy, a website dedicated to advising potential lenders on various aspects of P2P lending, http://www.lendacademy.com/.
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