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Law, Trust, and the Development of Crowdfunding Law, trust, and the development of crowdfunding P. RAGHAVENDRA RAU † University of Cambridge June 2017 Abstract I analyze the economic determinants of crowdfunding using a unique hand-collected sample of crowdfunding volume obtained by surveying over 1,300 crowdfunding platforms worldwide. Crowdfunding is a developed market phenomenon that largely involves fixed income instruments sold to investors driven by financial motives. Emerging markets do not display large crowdfunding volumes. The quality of regulation, the financial development of the market, and ease of access to the Internet by investors are all positively related to crowdfunding volume while the ease of doing business is negatively related to volume. The level of trust in strangers is the only factor that appears consistently significant in explaining the volume on reward- or donation-based platforms. Keywords: Alternative finance, Distributed finance, Crowdsourcing, Crowdfunding, Law and finance, Peer-to-Peer, P2P lending, Equity crowdfunding, Social Finance JEL Classification: G21; G23 † Cambridge Judge Business School, Trumpington Street, University of Cambridge, Cambridgeshire, CB2 1AG United Kingdom, 310-362-6793; [email protected]. I would like to thank David Chambers and Tania Ziegler for helpful comments, and the Cambridge Centre for Alternative Finance, especially John Burton, Bob Wardrop, Bryan Zhang, and Tania Ziegler, for sharing the data from the 2016 Global Surveys. Electronic copy available at: https://ssrn.com/abstract=2989056 Law, trust, and the development of crowdfunding Abstract I analyze the economic determinants of crowdfunding using a unique hand-collected sample of crowdfunding volume obtained by surveying over 1,300 crowdfunding platforms worldwide. Crowdfunding is a developed market phenomenon that largely involves fixed income instruments sold to investors driven by financial motives. Emerging markets do not display large crowdfunding volumes. The quality of regulation, the financial development of the market, and ease of access to the Internet by investors are all positively related to crowdfunding volume while the ease of doing business is negatively related to volume. The level of trust in strangers is the only factor that appears consistently significant in explaining the volume on reward- or donation-based platforms. Keywords: Alternative finance, Distributed finance, Crowdsourcing, Crowdfunding, Law and finance, Peer-to-Peer, P2P lending, Equity crowdfunding, Social Finance JEL Classification: G21; G23 Electronic copy available at: https://ssrn.com/abstract=2989056 I. Introduction Crowdfunding, also sometimes referred to as alternative or distributed financing, is not a new phenomenon. Charities have long relied on donor drives that aggregate small donations to fund their causes.1 What is new is the global growth of crowdfunding platforms and the volume of financing they provide. From around $0.5 billion of funding through crowdfunded platforms in 2011, the volume has grown to nearly $140 billion in 2015, a growth rate of over 200% per annum, one of the fastest rates of growth of any type of financial innovation documented in recent history. Today crowdfunding is a global phenomenon with finance available in almost every country in the world. The growth has largely been fueled by technology, hence giving rise to the term fintech. 2 Despite this, there is no literature analyzing the determinants of growth of crowdfunding, the diversity of business models, or their evolution. In this paper, I analyze the economic determinants of crowdfunding around the world. Drawing on a unique survey-based global database of the volume of crowdfunding, I document the volume and determinants of crowdfunding in 152 countries across the world, covering a total of 1,362 platforms. Understanding the determinants of crowdfunding is important for at least two reasons. First, a large body of theoretical and empirical literature suggests that the expansion of financial systems is important in affecting economic growth and poverty in developing countries (see, for example, Levine, 2005, or Burgess and Pande, 2005). Bruton et al. (2014) argue that crowdfunding allows investors and entrepreneurs to connect directly, allowing investors access to new investment opportunities. Stigler (1971) and Rajan and Zingales (2003) argue that incumbents oppose financial development that increases competition, implying that crowdfunding offers countries with large unbanked populations last mover advantages in bypassing the formal financial system (Arner, Buckley, and Zhou, 2015). Crowdfunding has been suggested as a form of innovation that is likely to have the same impact on economic development as mobile phone penetration (Aker 1 A frequently cited example is Joseph Pulitzer’s campaign to fund the pedestal of the Statue of Liberty in 1885, described in BBC News Magazine (“The Statue of Liberty and America’s Crowdfunding Pioneer,”, April 25, 2013). 2 According to the Financial Stability Board in the UK, “‘FinTech’ consists of any technologically enabled financial innovation that could result in new business models, applications, processes, products, or services with an associated material effect on financial markets and institutions and the provision of financial services.” In this paper, I confine my attention to crowdfunding platforms, specifically online marketplace lending, equity, reward, and donation based crowdfunding. - 1 - and Mbiti, 2010) or microcredit (Johnson, 1998). However, there is no evidence on whether crowdfunding is more likely to penetrate financial systems in countries with little formal credit. Second, the law and finance literature (beginning with La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV), 1998) has argued that the extent to which a country’s laws protect investor rights, and the extent to which those laws are enforced, fundamentally determines how corporate finance and corporate governance evolves in that country. However, both the financial policies studied in the prior literature and the legal regimes have co-evolved over long periods. Hence, while the prior literature document correlations between legal regimes and forms of financing, it is difficult to convincingly argue that the legal regime causes forms of corporate finance and governance to evolve. Crowdfunding is a new form of financial innovation, that has rapidly increased in popularity in a very short period over which the legal systems have not adapted to these financing types. Hence, it is easier to attribute a causal effect to legal regimes in determining the volume and types of crowdfunding. Though the popular press often treats crowdfunding platforms as relatively homogenous, there are four distinct types of business models – debt (lending) platforms that specialize in debt financing, equity platforms that allow firms to raise equity financing from investors, reward-based platforms where funders promise backing in exchange for a non-monetary reward but little in the way of recourse should the reward not arise, and donation platforms, where funders receive nothing except presumably the satisfaction of carrying out a good deed, in return for funding. The first two types of platforms are financial return models while the latter two are non-financial return models. Examples of the four types include Prosper.com, a P2P lending platform, CircleUp, a United States (US) based equity platform, ArtistShare, a reward-based platform for artists where funders get access to extra material directly from the artists, and FundMyTravel, a donation platform hosting campaigns by travelers who wish to fund study or volunteer trips, or simply wish to travel abroad, respectively. Regardless of the type, crowdfunding differs in many respects from both traditional bank or debt market borrowing and venture capital equity funding. For example, the funders are usually geographically distributed and loosely organized, if at all. Almost all communication occurs in online open communities. Finally, crowdfunding is comparatively unregulated in its current form. Lending on a person-to-business (P2B) market, for example, leaves the lender with little recourse should the borrower default. - 2 - There is considerable variation in the number of platforms and the volume of financing provided in different countries. I investigate three dominant dimensions. The first is the overall transaction volume and number of platform business models originating in different countries. Of the total global volume of crowdfunding ($139 billion in 2015), China, the US, and the United Kingdom (UK) form the three largest markets with around $103 billion (74%), $28 billion (20%), and $5 billion (4%), respectively, of global volume originating in these three countries. The same pattern holds when I examine the number of platforms. 41% of all crowdfunding platforms originate in developed countries, while 59% originate in emerging markets. However, the largest portion of the emerging market volume is in China which accounts for 29% of all platforms globally. While the remaining 124 emerging markets account for 30% of all platforms globally, they account for only around 0.3% of global crowd financed volume. The univariate evidence suggests that crowdfunding is not a developing markets phenomenon. The second dimension is the split between volumes on financial and non-financial return platforms. 98% of global crowdfunding platforms are debt or equity platforms that investors use to earn financial returns. The volume of financing
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