Peer-to-Peer Lending: The State Of The State.

A Review Of The Market, The Players, The Challenges And The Impact On The Future.

This is a sort-of stream-of-consciousness post wherein I try to provide an overview of the market for P2P lending, an assessment of the current players, an analysis of the impact of regulatory creep and a shameless plug for our new P2P paltform, iSellerFINANCE, the only TRUE social lending platform in the space.

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We know that the newly empowered Consumer Financial Protection Bureau is going to be debating with the Securities and Exchange Commission the merits of oversight transferring to the CFPB. That discussion will focus around the characterization of the loans made by the two leading players, Lending Club and Prosper defined as either financial products or securities. As of now, the definition is securities and the SEC has regulatory privilege.  We also know that in the immediate future (within the next 60 days) , Credit Bureaus and Collection Agencies will fall under CFPB regulatory oversight.

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So, what will be the impact on this embryonic market, the consumers, the investors, the borrowers, the two market leaders and the next entrants into this marketplace?

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And, what to make of the apparent contradictory trajectories of the increasing regulatory oversight evidenced by the SEC’s takeover of Prosper and the aggressive positioning of the CFPB on the one hand, and the bill that just sailed through the House in a unanimous (407-17) vote and is waiting for approval in the Senate which will allow anyone in the US to invest up to $10,000 in a start-up or business expansion on an Internet platform without SEC oversight (reporting only)?

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Let’s see what is happening in this space, and how newer players are entering without compliance with SEC regulations and what it means to consumers and investors.

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With the promise of high yields, peer to peer lending is attracting record amounts from institutional investors and individual lenders alike, even in the face of a cloudy regulatory future. Potential uncertainty aside, the attraction of an estimated $2.5 trillion industry is proving too hard to pass up for investors. The two largest P2P lending companies, LendingClub and Prosper have funded loans so far to the tune of over $500 million and $290 million respectively.

By way of background, peer to peer (P2P) lending microcredit institutions sprang up in 2005 in order to provide needy borrowers with viable alternatives to normal commercial bank loans. This industry had as its backbone, the seemingly novel concept of stripping out intermediaries, such as banks, and allowing lenders and borrowers to connect to reach their own financial terms for loans via the internet. The nascent industry made significant strides when even credit-worthy borrowers were locked out of the commercial credit markets due to the credit crisis.

        

There are many benefits to P2P lending, and from the aspect of the lenders, the most significant could be that it offers an entirely new asset category to invest in. With hedge funds, pension funds, mutual funds and wealth-managers requiring better returns on their capital, any diversification of their portfolios or investment models that can promise returns of 10 percent or better will likely be approached with piggy-banks cracked open.

The two leading P2P lending companies DO NOT operate on purely disintermediation models, where intermediaries, such as financial institutions, are removed from the picture. Contrary to what they present as their image, Lending Club and Prosper are actively involved in all lender/borrower transactions, not only through their own proprietary fee generation, but also in terms of how the transaction processes on their sites operate.

Both Lending Club and Prosper have systems that rate potential borrowers based on their credit histories and submitted information. Exactly like Banks. Notably, if a borrower’s loan becomes delinquent, the companies will appoint a collection agency to collect overdue amounts. Companies such as LendingClub and Prosper also have their hands in the proverbial profit cookie jar, as they take tidy sums from origination fees and loan servicing amounts.

The horizons looked rosy for P2P lenders, especially as their services came into demand as the credit crisis arose. The microcredit train came to a screeching halt in 2008 when the Securities and Exchange Commission landed a “cease and desist” order on Prosper. The heavy hand of the SEC came down on the industry, but more stringent regulatory oversight was always in the cards.

Prior to SEC intervention, the P2P lending industry was considered by many analysts to be far too lax. This was manifested in the early days by significant default rates which lenders had to bear the brunt of due to insufficient information when making their loan decisions. The SEC mandated clamp down on the industry was in direct response to default rates well above 20 percent on some platforms. In an industry where low default rates and high interest returns are the main attraction, the poor performances of the loans required the SEC to bring to heel the P2P lending companies in the interests of consumer investment safety. Presumably, Hedge Funds and Private Equity firms avoid SEC scrutiny because their investors are “sophisticated” and not some random dopes. My theory of course, has to do with the fact that our Congress is controlled by the Banking Industry, but I digress.

The SEC clamped down on P2P lending by requiring companies to register their notes, just like Broker/Dealers are required to do with securities. The fact that both Lending Club and Prosper aggregate loans and distribute them across loan requests based on credit-scoring distribution and lender preferences looked just like securities brokerage. LendingClub took the path of least resistance and filed a registration statement with the SEC in the middle of 2008. Perhaps envisioning the financial burden registration would take, Prosper took an alternative tack and was more direct with the SEC. It is no surprise now that LendingClub is the largest P2P lender in the U.S. By complying with the SEC early on, and applying more stringent qualifications on investors, the company was able to re-launch in the second half of 2008 and quickly asserted a market leading position.

In an industry that has not yet had enough time to fully develop and is still incubating, the SEC requirements have directly contributed to another significant issue. The cost of complying with the SEC is extremely high and this has had and will likely continue to have an anti-competitive effect in the industry at large. The industry already has consolidated around the two leading companies LendingClub and Prosper, although there are a few other niche category platforms as well.

SEC regulations were cited by Zopa (a UK P2P lending company that is active in numerous other jurisdictions) as being a primary reason why they would not launch in the U.S. It remains to be seen just how large the effects of regulation will be in this industry. With no new entrants that look like Lending Club and Prosper in sight, and with only two major players, the impact on consumers will have to be considered in light of potential Dodd-Frank regulations and further oversight by the Consumer Financial Protection Bureau.

If the CFPB and its new director Richard Cordray have as their main goal the protection of consumers, any further regulatory activity in 2012 will have to address the issues of overly expensive barriers to entry, anti-competitiveness that may harm consumers and the capacities of regulators to deal with the ever evolving P2P lending industry. In response to requirements in the Dodd-Frank Act, the U.S. Government Accountability Office released a report in the second half of 2011 with respect to P2P lending federal regulation.

This report highlighted two approaches to future regulation. First, the SEC centered approach, whereby potential risks to lenders and investors are regulated at the federal level by the SEC. This is a two level approach where there will be wide exemptions to individual state level securities regulations for P2P lending companies that are in compliance with federal regulations. Potential risks to borrowers will be regulated by state regulators to ensure compliance tied to credit extensions.

The second option is a CFPB centered approach which would bring together monitoring of lenders/investors and borrowers commercial ties under the auspices of the CFPB. The most fundamental change under this approach would be that instead of being considered federally regulated securities, P2P lending investments would be considered consumer financial products. So instead of an SEC led model, the CFPB would instead regulate relations between lenders/investors and companies.

The report is not prescriptive and it seeks to provide an overarching analysis of how the approaches would function while also providing a perspective on the positives and negatives to potential regulatory strategies. The report also acknowledges that any shift to a new regulatory regime would be rather speculative at the moment. As the industry is in its infancy, there is also the looming prospect that P2P lending as we know it could morph into a completely different animal with potentially new products and services offerings in the future, further adding uncertainty to any proposed regulatory regime.

What is certain is that there will be inevitably increased regulatory scrutiny on this industry going forward. Although it is a rather nascent business model, the invasion of institutional investors has signaled some level of maturity and growth has been sensational. (Charts courtesy of Peter Renton and his definitive P2P Lending blog: http://www.sociallending.net/)

One way around the SEC and potentially the CFPB, is to maintain a fixed transaction distance between the disintermediator (the web site) and the borrower/lender. This means that the platform never touches the money, doesn’t vet the borrower or lender, doesn’t match-make the deal, has no knowledge of the transaction and does not originate or service the loan.

One recent entrant into this market is a company called Weemba. Their business model is based on providing an introduction to lenders and borrowers, using a sort-of open market model. What the lender and borrower do after they are introduced is up to them and Weemba never knows anything about the transaction. Weemba charges a fee for the introduction, sort-of like the eHarmony of Finance. Weemba’s lenders are all commercial banks. There are no individual lenders, so nobody on the lending side requires protection. Since the Banks are already regulated, the borrower is protected from unscrupulous or predatory lending practices. (Hmm mm – didn’t I hear that somewhere before?)

Another new entrant is a company called PeerForm, which was cobbled together by a  bunch of hedge fund investors on a similar premise. The investors and borrowers are all accredited in accord with the SEC qualification requirements, so no regulatory oversight will be required. Maybe.

There are several small players in various niches within P2P. There are a couple of players in the P2P niche characterized as family or friend to friend lending. Those would be WikiLoan and LendFriend. How they plan to avoid SEC or CFPB scrutiny is anyone’s guess. If you are really willing to post a loan request to your Facebook friends, then go for it. A platform called Greenote targets student loans and one called ZestCash is a remake of the Pay-Day Loan Sharks on-line. P2P Financial, SoMoLend,  and IOUCentral are targeted to small business lending. Many of these operate in only one or a few states and have complied with those regulatory requirements.

iSellerFINANCE, scheduled to launch later this year, will accommodate people willing to finance their goods and services over time. It will also provide a platform for lenders and borrowers and will be positioned to enable crowdfunding once the Access to Capital Bill (HR2930) becomes law. iSellerFINANCE will operate in a similar fashion to Weemba, in that it will charge a small introductory fee when buyers and sellers and borrowers and lenders are ready to meet. Unlike Lending Club and Prosper, iSellerFINANCE is a pure social lending site, connecting people to people, based on affinities, preferences and needs.  

It will however, be registered as a loan servicer as it intends to become the first P2P credit bureau in the industry by tracking loan re-payment performance and building new credit profiles. Using its proprietary credit-scoring engine, iSellerFINANCE scores credit very differently than the big-3 by factoring things like geography, employment, social clout and great recession events.  iSellerFINANCE will provide the tools to create syndicates which allows investors to spread risk and uses a unique reciprocal inter-insurance exchange that provides a level of insurance against risk. Borrowers and investors contribute a small percentage of the loan to an escrow account where it will be used to cover defaults. This is a not for profit insurance exchange that returns excess funds to the borrowers and lenders when the loans are paid as agreed.

In keeping with the SEC guidelines, the iSellerFINANCE crowdfunding platform will match accredited investors with business plans and/or business expansion proposals enabling them to invest up to $10,000 and entrepreneurs to raise up to a million dollars, complying fully with SEC reporting requirements. iSellerFINANCE will also provide a suite of start-up and small business services in much the same way as incubators did during the original Internet bubble. These will include mentoring, legal and shared infrastructure services like accounting, recruiting, human resources, administration, governance, data center and information services.

iSellerFINANCE will enable lenders and investors to contribute a portion of their interest earnings to an NPO (Non-profit Organization) of their choosing, from among the 100 such organizations registered with iSellerFINANCE, and iSellerFINANCE will match the contribution. No one else does this.

Done with shameless plug. That was as complete a review of the participants in the P2P space as of this writing that you will find. On to the political problem.

This is my conundrum: How on the one hand, can the regulatory agencies drop the hammer so hard on the Lending Club and Prosper business models, and yet, on the other hand, open up an online marketplace for every con-artist and Murphy Artists on the planet? At iSellerFINANCE, we have bullet-proof identity verification software and processes to assure people are who they say they are and we enjoy state of the art privacy and data security, but will other new entrants be as well prepared and vetted? The Regulators will also have to consider how much impact their actions will have on the only credit vehicle available to most American consumers in need, as conventional (banking) credit faucets are dry and will remain so for the foreseeable future. And, may even become further exacerbated by the looming financial crises in Europe.  If their job as they see it, is to look out for the American consumer, they will quickly arrive at a principle crossroads. The new economy will be driven by populist sentiment.

I guess much will be revealed as this bill becomes law and the SEC and CFPB duke it out over territory. The playing field continues to tilt around as regulators grapple with Dodd-Frank implementation, and Congress tries to figure out how to find their rear ends with two hands and a flashlight. It will certainly be an interesting year. There will be new players in the P2P space. There will be more Banks disguised as social lending platforms. There will be more institutional investors as the Lending clubs and Prospers of the world continue to generate 10-15% returns with low default rates.

There will be a rash of European players now operating in the crowdfunding space in Europe, that will come rushing into this space once the crowdfunding bill is signed into law. Entrepreneurs will have a field day raising venture capital, and the Angel investing model will quickly be disintermediated. Maybe even the traditional Venture Capital model for smaller B and C round deals will be in for a challenge. Though there will be additional and new opportunity for Venture Mentoring that can be filled by the Angel community, so while they may be affected by disintermediation, they may reap an offset through start-up consulting.

There will be unprecedented access to capital for small business. And, there will be a rush to participate in the next Google or Facebook by the random Joe or Jane. There will also be tremendous job and capital creation for private placement lawyers, insurance companies, and all of the other elements required to start a company including the labor necessary to get and keep them going.  I guarantee that traditional banks will begin to pay attention to this space.

But, in the end, I truly believe this space has the potential to not just re-create the banking industry, but to create brand new credit channels, brand new paths to access capital and a whole new infrastructure in which to conduct finance. Social Finance. Stay tuned. And, thanks for reading this.