What is... | February 25, 2016

What is peer to peer lending?

In peer-to-peer lending, instead of borrowing funds through a middleman – typically a bank – a loan is arranged directly between two “peers” – the lender and the borrower.

The term P2P lending can be applied to a range of activities, with lenders varying widely in the specifics of how they operate. Essentially, P2P lending is just another way of attracting people to invest and then loaning the money out to individuals or businesses.

It typically differs from crowdfunding in that crowdfunded projects tend to ask for donations, instead of loans that must be paid back or offer a return.

Emerging alternative
People once had few alternatives to going to the bank to borrow money. But internet technologies have helped reduce the cost of running a company in certain high-end sectors – and financial services is no exception.

P2P lending is one example of an internet-based alternative to traditional banking that has sprung up as a result. It can be understood as part of the “fintech” – or finance technology – revolution.

A Cambridge/EY report on alternative finance suggests that P2P lending to ordinary people is the largest market segment, with €274.6 million lent out in 2014 across Europe, excluding the UK. On UK P2P platforms alone, about £1.2 billion (€1.5 billion) was lent to smaller businesses or individuals in 2014, the report notes.

State of play
The original P2P lenders were start-ups that operated independently of the banks, with many emerging around 2007 in the wake of the financial crisis. European Union-based examples include Germany’s Auxmoney, the UK’s Zopa, Estonia’s Bondora and Finland’s Fellow Finance.

Unsurprisingly, giants of the financial services world today may also invest in online lending platforms. This fact, especially as more regulation is introduced, means the differences between P2P or “marketplace” lenders and traditional financial institutions may shrink over time.

Carving a niche
Some P2P lenders may only offer money for particular purposes – such as LendInvest, which focuses on property investments. Others have entered into partnerships that invest in specific areas – such as RateSetter’s partnership with CommuterClub to provide loans to commuters to buy money-saving annual rail tickets in the UK.

What about the risk?
Attractive rates of interest are sometimes offered. As with other financial opportunities, however, this typically means accepting a higher level of risk. Some experts have noted that P2P lenders may not have to stick to the same rules and regulations that traditional financial services firms have to follow.

Adair Turner, a former UK City of London regulator, has suggested the P2P industry could be in line for major financial losses. Borrowers and investors alike should beware, not least because P2P firms may be lending to borrowers turned away by traditional banks, Turner says.

Here today, forgotten tomorrow?
In October 2015, publicly traded Swedish P2P lender TrustBuddy hit the headlines – for all the wrong reasons. The six-year-old company was delisted and declared bankrupt after irregularities were found in its accounts. Investors were owed millions of euros on which they had been promised returns, at one point, of up to 12% .

Based on every-day experience, a trend can seem like a real success and it can be easy to worry about missing out. It’s easy to fall prey to availability bias, or even survivorship bias, because we only tend to hear about the winners. The probability is there are also many losers – who have been forgotten or are no longer visible in the market.

Credit where it’s due?
The UK’s Peer to Peer Finance Association, which represents a large chunk of UK P2P lenders, says the default rate for the P2P loans is two to three percent. Borrowers are carefully assessed for creditworthiness, it says.

However, it never hurts to remain cautious when it comes to investing, especially if above-average returns are being offered. Consider what compensation might be on offer if the money is lost. There are no guarantees in life – and, as the saying goes, if something sounds too good to be true, it probably is.


eZonomics team
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