microNOTE #51 Person-to-Person Lending

Is Financial Democracy a Introduction Click Away? Direct lending between friends, family and neighbors has existed since before formal banks, legal agreements and even currencies. These loans were often small, and much like today’s “microfinance” loans relied on relationships of trust between individuals. Today, formal banks play a large role in financial intermediation, which has allowed for scale, transparency and efficiency, but has failed to meet the finan- cial needs of the poor. The concept of microfinance stems from this need to extend access to financial services to the poor and other unbanked communities. With the birth of the internet, and the suc- cess of online social networking, a new form of non-bank lending has arisen, borrowing from traditional reliance on trust within communi- ties but extending the concept of community beyond geographic

Photo Courtesy of MYC4 boundaries. Beginning with (www.uk.zopa.com) in the United “The loans I have received from MYC4 give me Kingdom in March 2005, person-to-person (P2P) internet sites are the opportunity to become an independent serving as marketplaces for borrowers and lenders in various devel- business woman so that I can support my oped economies. Platforms such as (www.kiva.org) and MyC4 household and pay for the schooling of my (www.myc4.com) have expanded P2P lending internationally, linking children.” lenders in developed countries to borrowers in developing countries. --- Catherine Akwir, spare engine part For the first time, retail investors have access to investments in mi- vender and MyC4 borrower in crofinance, an asset class previously reserved for institutional inves- tors and high net worth individuals. Although these platforms still Catherine Akwir is an example of one represent only a small portion of the financing available to unbanked of the many entrepreneurs who has communities, they are growing rapidly. By reducing, and in some received loans through MYC4, a Danish cases, eliminating the role of traditional banks and intermediaries, P2P platform focused on African they have the potential to democratize access to lending and borrow- ing in the future. entrepreneurs. She boasts on MYC4’s site that her first loan in 2007 enabled her to increase her monthly income by 30% making it possible to support her household and send her children to school. In May 2008 she received her second loan on MyC4 from 4 individual lenders. SEPTEMBER 2008 This publication was produced for review by the U.S. Agency for International Development under the AMAP/Financial Services, Knowledge Generation Task Force. It was prepared by Jennifer Powers of EA Consultants, in conjunction with Abt Associates.

Overview of the P2P their risk appetite and other per- information and to handle repay- Lending Market sonal preferences. Generally the ment and collection efforts. The interest rate is determined in an use of intermediaries has been After the launch of Zopa UK in open auction by lenders, not by the necessary, in part because potential 2005, there has been an impressive platform. borrowers do not have access to growth in the number of domestic, the internet and/or do not have the developed country P2P lending plat- “Intermediary” P2P model: financial, computer or even alpha- forms worldwide. Seven were Under this model, a website still numeric literacy necessary to apply launched in the first eight months serves as a marketplace for lenders, for a loan. Additionally, there is a of 2008 alone, bringing the total to who can search for and select their need for a local presence to ensure 20 to date. P2P investor usage is borrowers, but the loan is sourced, quality and to facilitate dis- also booming: as of August 2008, verified, posted, disbursed and ser- bursement because of limited avail- $164 million in loans had been viced by an intermediary such as a able information and cross-border transacted on US-based Prosper microfinance institution (MFI) or restrictions for financial transac- (www.prosper.com) and nearly $45 non-governmental organization tions. For example, in developing million had been arranged by Zopa (NGO) with a local presence. On countries, credit bureaus are not UK. Kiva, the first online P2P lend- some platforms the intermediary always available, accessible or reli- ing platform geared towards micro- sets the terms of the loan, while able, whereas in developed econo- finance in developing economies was others allow for lenders to bid on mies, lenders can use credit history, launched in November 2005. Kiva the terms. credit scores and some of their has facilitated nearly US$50 in mi- The “MicroPlace” model: Mi- own local knowledge to make lend- croloans worldwide and has in- croplace (www.microplace.com) ing decisions. spired the launch of six other offers a different approach to online platforms dedicated to pro- Democratizing Investor online lending, removing the inves- viding capital to micro, small and Access to Finance tor one additional step from the medium enterprises in the develop- final borrower. On Microplace an P2P marketplaces have the poten- ing world. individual invests in securities rep- tial to democratize asset manage- All these online lending sites ulti- resenting a portfolio of loans to ment and financial intermediation, mately connect those with surplus MFIs issued by an investment fund one of the few professions that capital to those in need of capital; such as Calvert Foundation or remains reserved for “elite” bank- however the manner in which they Oikocredit USA. The MFIs in turn ers and professional asset manag- do so varies dramatically. There are on-lend the funds to micro and ers. The main benefit that online three general models used to facili- small entrepreneurs, but the inves- P2P lending platforms offer retail tate on-line lending and investing: tor’s risk remains with the investors is that they provide easy issuer. While, MicroPlace cannot access to investments in loans to “Direct” P2P model: In this really be considered a P2P, it is in- micro, small and medium sized model, the platform serves as a vir- cluded here because of its potential businesses, an investment class pre- tual marketplace for lenders and for scale and its potential to im- viously reserved for institutional borrowers to meet and agree on prove the accessibility of microfi- investors or very high net worth the terms of a loan. Borrowers may nance and other social investments individuals. Developed country be borrowing for personal or busi- for the retail investor. P2Ps allow investors to play the ness needs. They post information role of a small bank. Investors use about themselves, what they plan to One of the major differences be- their own “deposits” to build indi- use the loan for and their maxi- tween the P2P lending platforms in vidualized loan portfolios according mum acceptable interest rate. developed economies and those to their personal risk preferences, Lenders can browse through the which target developing countries and social and financial criteria. loan “offerings” and chose who is the use of intermediaries to iden- P2P’s offer in- they would like to lend to based on tify, verify and register borrower

PERSON-TO-PERSON LENDING 2 vestors the chance to invest di- progress towards reaching this goal. able to take out a loan from a bank rectly in international micro, small For example, RangDe or credit card company, but be- and medium businesses, a sector (www.rangde.org) boasts that one cause most of these platforms re- which has not been accessible in of its partners in India has ex- quire a minimum credit score of the past, and most provide some panded into rural areas previously borrowers, they exclude many po- level of discretion over which bor- thought to be unsustainable be- tentially credit worthy individuals rower an investor is financing. As cause of high costs of funds. In addi- who lack a credit history. The cur- investment minimums are so small tion platforms such as MyC4 and rent credit crisis in the United (as little as $10 to $20), investors Investors Without Borders States could potentially lead a are able to diversify their portfolios (www.investorswithout bor- greater number of people with significantly, especially on sites with ders.wordpress.com) are providing good credit histories to the P2P high volumes of transactions and access to finance to small and me- marketplace as banks close their large numbers of borrowers. Some dium-sized enterprises in develop- doors to all but the strongest cli- sites such as Prosper, Zopa UK, ing countries, which are often ents. LendingClub considered to fall into the “missing P2P platforms also have the poten- (www.lendingclub.com) and soon middle” in financing.1 They are tial to benefit borrowers by reduc- MyC4 even have mechanisms which largely excluded from the formal ing interest rates on loans. Direct allow investors to delegate their financial sector because they are P2P sites, which directly connect investment choices to automated informal or too risky for banks, yet lenders and borrowers are cutting tools on these sites based on a set MFIs generally do not offer prod- out the role of the middle man and of pre-established criteria. In addi- ucts or services appropriate for avoid costly fees to intermediaries. tion, many sites also offer higher their greater financing needs. Given The auction system used by many expected rates of return than in- much of economic growth and job models to determine borrower vestors might receive when trusting creation in developing economies interest rates further encourages a bank to make similar investments comes from the SME sector, im- rate reductions. In the Intermediary with their savings accounts or CDs, proving access to finance for these P2P Model which is prevalent in albeit at what is arguably a greater businesses can help not only the developing countries, however, we risk. individual entrepreneurs but overall have yet to see a significant impact development and poverty allevia- Democratizing Borrower on borrowers in the form of tion goals in a country. Access to Finance cheaper funds. One of the main For developed country oriented reasons for this is that many such Both domestic and international platforms it is less clear to what platforms do not monitor or limit P2P lending platforms provide bor- extent P2Ps are “democratizing” the spreads between funding and rowers with new sources of financ- access to finance rather than just lending rates charged by their local ing. Direct P2Ps allow borrowers providing alternative sources of partners. Intermediaries end up to directly appeal to individual finance. There are surely some in- with large margins ranging broadly lenders and hopefully receive a loan dividuals who are able to borrow from 20% to over 50% per annum, that better meets their financial through a P2P who would not be which seem excessive even to needs, while Intermediary P2Ps and cover the high cost of making mi- MicroPlace increase their partners’ \ crofinance loans. For those inter- ability to serve their local commu- 1 Sanders, Theirry and Wegener, mediary platforms that allow nities, populations traditionally ig- Carolien. “MESO Finance: filling the borrowers and investors to bid on nored by the formal banking sector. financial service gap for small interest rates, there appears to be Increasing access to finance is one businesses in developing countries”, room for a greater rate reduction. of the main goals of P2Ps in devel- NDCO, September 2006, available at http://www.bidnetwork.org/artefact- A market study conducted by oping countries and anecdotal evi- 40006-en.html. MyC4, revealed that despite the dence indicates that there has been often high fees charged by its local

PERSON-TO-PERSON LENDING 3 partners, loans originated on MyC4 difference between success and platforms as their novelty wanes. usually offered the cheapest or failure over time. They have yet to develop a model second cheapest funding available to ensure a reliable revenue or do- However, the sustainability of P2P to these types of business in the nation stream. Both non-profit and platforms as a consistent and long countries. for-profit P2P platforms also face term funding source for microfi- challenges in finding the right mes- nance institutions has yet to be Impact on the sage and breadth of product offer- proven. P2P lenders often base Microfinance Industry ing for investors, creating the their decisions on personal prefer- Perhaps one of the greatest bene- necessary local partnerships, deal- ences and can be fickle. As funding fits of P2P platforms for the micro- ing with complex regulatory envi- from P2P platforms match the finance industry has been their ronments, and ensuring short-term tenor of the underlying ability to reach out to new and di- transparency at the borrower, in- client loans, changes in investor verse demographics to raise not vestor and public levels. In addition, preferences can present liquidity only funds, but awareness of micro- platforms that cross international challenges for MFIs whose P2P finance and its need to strive for borders face additional political and funding represents a large percent- universal access to finance. P2P currency risks. age of their portfolio. In addition, platforms such as Kiva, MicroPlace it is important to note that there Marketing has been a constraint to and MyC4 have been featured on are often hidden costs to MFIs of growth for younger P2P platforms shows like Oprah and CNN and in P2P funding which are not always which have not yet gotten the trac- publications like the taken into consideration, such as tion they need with investors to and Time magazine. For MFIs and the time spent posting loans and quickly fund loans. Access to af- other MSME lenders the growing creating specialized reporting and fordable marketing channels and success of the P2P marketplace monitoring processes. One Kiva finding the right message for the offers an opportunity to increase client estimated that these non- targeted investor segment are im- access to capital and diversify fund- direct costs amount to approxi- portant. MicroPlace’s model, for ing sources by attracting a new in- mately 5% of the total amount of example, does not provide the vestor class of small, socially loans funds. While still cheaper same kind of personal connection motivated investors. Combined, than most commercial microfinance between investors and borrowers Kiva, MyC4, and MicroPlace have investment funds, these costs as those sites where investors lend channeled nearly $60 million to- should not be overlooked. directly to borrowers; thus the wards the microfinance industry. message used to attract investors Funds from P2P platforms may also Issues and Constraints to must also be different. By offering prove to be more inelastic during Scalability real returns on investments versus financial and credit crises, as retail Reaching scale in a nascent industry zero-interest loans, platforms like platforms tap into a different inves- is never easy and both the domes- MicroPlace, will attract a different tor base, that balances social and tic and the international P2P mar- type of investor, one focused on the financial return objectives. In addi- kets face substantial challenges to social return but also attracted to tion, the availability of lower cost their growth. Despite the rapid the diversification potential of the funds through P2P sites may allow growth posted by many of the P2P platform. Platforms are also realiz- mission driven MFIs that lend to platforms interviewed for this re- ing that one key to achieving poorer clients to continue their search, none have yet reached sus- greater scale is to offer a greater efforts without needing to drift tainability or break-even. Non- variety of products. Many plat- toward more profitable larger loans profit platforms such as Kiva and forms are considering offering and larger clients. Their ability to RangDe have based their business shorter-term or more liquid prod- tap into new socially oriented funds plans on the assumption that dona- ucts; others are considering a including P2P platforms may be the tions will grow, but face the risk greater range of potential returns that donors will grow tired of these or investments in complementary

PERSON-TO-PERSON LENDING 4 new sectors. While most platforms Regulatory issues are a constraint a marketplace for equity in the fu- continue to have greater demand for nearly all of the P2P platforms ture. Such a product would open for loans than supply of investor interviewed for this study. While up and democratize a whole new capital, many Intermediary P2Ps P2P lending is not a new phenome- asset class-private equity- that was also expressed supply side con- non, the formalization of P2P lend- previously reserved for the “elite” , cerns to growth, specifically finding ing is, and most countries have not and has the potential to put much and screening the right local part- determined the government’s role needed seed capital into the hands ners. More than once, Kiva has in regulating this industry. Because of entrepreneurs, reinvigorating the completely sold out the loans on its the regulatory environment differs SME sector. The MicroPlace plat- site because of unexpected in- in each country, it is also difficult to form is already being used for creases in investor demand and the replicate a given model exactly in other social finance sectors such as time require for partners to post other countries. For international low-income housing, and because of new, relatively small, loans. P2P platforms, the regulatory envi- the model it employs, it would be ronment can be even more compli- easy to leverage for other asset Transparency is a major issue which cated. Platforms must abide by classes such as equity and for other threatens the growth of the P2P lending regulations within their sectors such as renewable energy lending industry, specifically finding home countries as well as in those and healthcare. New online plat- a balance between protecting the countries where they have borrow- forms have also recognized the po- privacy of borrowers and the inter- ers or lenders. In addition, plat- tential of using the concept of ests of lenders. There is an inher- forms must comply with social networking to make markets ent asymmetry of information in restrictions on capital flows be- more efficient. PeerFX any lending relationship, only the tween countries and withholding (www.peerfx.com) in the US and borrower truly knows whether or taxes where applicable. The com- Canada provides travelers with a not they plan to repay the loan. This plexity of these regulations requires venue for exchanging currencies. asymmetry is amplified in P2P lend- significant spending in legal counsel Partizipa (www.partizipa.com) in ing where borrower and lender do and if not addressed could drasti- Spain and Valuna (www.valuna.de) in not meet in person and where in- cally inhibit the international P2P Germany offer retail investors the formation provided by the bor- industry’s ability to achieve scale. opportunity to invest directly in rower is often not checked. P2P businesses, or peer-to-company platforms also have a need and Conclusion investing. P2P platforms can also perhaps an obligation to be as The potential for scale and growth provide a valuable venue through transparent as possible themselves. of the P2P model is immense. which borrowers and lenders can Specifically, they need to be trans- Many of the platforms have been interact. Such interaction not only parent about the interest rates designed in such a way that they facilitates loans or investments, it charged to end borrowers in order allow for a multitude of products can also lead to the creation of to avoid borrower or investor out- and services to be transacted business relationships and oppor- rage in the future. The majority of through the sites. Prosper is work- tunities. platforms charge origination and ing on a shorter maturity product facilitation fees to borrowers, which While the P2P lending space has to make payday loans a feasible increases the real cost of their loan, shown signs of quickly adapting to product for the site. MyC4, the and when intermediaries are in- market changes and to broadening Denmark based platform targeting volved, they often also charge high access to financial intermediation MSMEs in , is considering fees for sourcing, posting and man- for both borrowers and lenders, it opening a secondary market for aging the loan. Thus a 0% interest is still a nascent industry and has loans which would make the sector loan on Kiva may ultimately cost yet to demonstrate fully its poten- more liquid and more appealing to the borrower 30%, 40% or even tial for scalability. Constraints in- a larger range of investors. They 50% annually. cluding regulatory hurdles, limited are also considering expanding into and inconsistent transparency of

PERSON-TO-PERSON LENDING 5 information, and marketing chal- lenges are significant, and could sti- Microfinance Oriented Selected Developed fle industry growth. The current Platforms Country Platforms credit crunch and complex envi- ronment for financial services dhanaX (India) Boober (Netherlands) worldwide will likely test these www.dhanax.com www.boober.nl models and provide greater clues Globefunder (India) Cashare (Switzerland) as to whether the democratization www.globefunder.in www.cashare.ch of financial intermediation is really a Investors Without Borders Igrin (Australia) click away. Three years ago, bor- www.investorswithoutborders.wor www.smava.de rowers in many countries had rela- dpress.com tively easy access to credit, and as LendingClub (United States) the recent credit crisis has shown, Kiva (Global) www.lendingclub.com it was more than they could handle. www.kiva.org Prosper (United States) The ensuing credit crunch and the MicroPlace (Global) www.prosper.com burden of existing debt on families www.microplace.com Smava (Germany) in the United States, for example, MyC4 (Africa) www.smava.de have likely attracted many borrow- www.myc4.com ers to the P2P marketplace. None- Zopa (United Kingdom) theless, lenders have adjusted to RangDe (India) www.uk.zopa.com the credit crisis, even on P2P plat- www.rangde.org Zopa (United States) forms, where many lenders are www.us.zopa.com now favoring less risky, higher rated borrowers. While the P2P market has not completely shut out riskier borrowers, lenders are demanding higher interest rates. It is not clear whether this marketplace will pro- vide any relief for some of the casualties of the credit crisis. However, it is encouraging to see signs that the model incents pru- dent lending behavior that adapts to market conditions and risk perceptions.

DISCLAIMER The views expressed in this publication do not necessarily reflect the views of the U.S. Agency for International Development or the U.S. Government.

PERSON-TO-PERSON LENDING 6