Peer to Peer Lending - rising star or ticking time bomb?

What is crowdfunding?

An alternative to more traditional fundraising models, such as traditional bank lending (currently constrained by banks' need to rebuild balance sheets following the credit crunch and stricter regulation) and equity raising. It is one of the fastest-growing areas of the financial services industry.

What types are there?

Broadly speaking, crowdfunding takes the following forms:

-  Peer-to-peer lending (or loan-based crowdfunding): platforms on which money is lent to   consumers and businesses whilst allegedly circumventing traditional banks.   This is most helpful for borrowers that do not fit the description of a supposedly   desirable borrower for banks (for example start-ups and non-asset based businesses).

 - Investment-based   (or equity-based) crowdfunding: platforms on which money is invested in unlisted shares or debt securities issued by businesses. This can be further   classified into equity-based crowdfunding and debt security crowdfunding.

 - Donation-based   crowdfunding: platforms on which money is donated to projects for philanthropic reasons with no expectation of a return.

 -  Rewards-based   (or pre-payment) crowdfunding: platforms on which money is donated to projects for a reward, service or product (such as Kickstarter).

Is loan-based crowdfunding big business?

From virtually a standing start in 2008 (the first platforms were established in 2005 but achieved negligible growth prior to the financial crisis), loan-based crowdfunding has grown into a market worth around US$6.4 billion worldwide in 2013, and continues to double in size every year. Although its absolute size remains small – in the United States alone the total amount of private sector debt is over US$35 trillion – it is already attracting the attention of regulators, the media and traditional   financial services institutions. If it continues to grow at its present rate it will quickly become large in absolute terms - Morgan Stanley has estimated that peer-to-peer lending could become a US$290 billion market globally within five years. The growth of loan-based crowdfunding has been encouraged   by a period of ultra-low interest rates (encouraging those with capital to seek   higher rates of return) combined with constraints on lending by banks.

Can peer-to-peer   lending replace traditional banks?

Peer-to-peer lending won't replace banks as long as there are still traditional classes of borrower offering types of security palatable with the "big banking" business model. However,   traditional banks have been cautious to offer finance to non-traditional borrowers such as start-ups or non-asset based businesses. In the information age, the gap left by this approach has expanded as more and more businesses develop around inventions, discoveries and ideas. Peer-to-peer lending helps to bridge that gap.

However, whilst peer-to-peer lending started life as a way of obtaining small amounts of investment monies from a very large group of lenders (as opposed to the traditional debt model involving obtaining a large amount of money from few investors), the majority of money for peer-to-peer lending now seemingly comes from institutional investors, primarily banks and hedge funds.

For some this is a move away from the peer-to-peer ideal of "democratising" finance, however the increasing involvement of institutional investors is a clear indication of the rapid maturing of the sector and demonstrates the potential for it become a permanent feature of the lending market.

So if big banks are   getting in on the act, how is it different from traditional lending?

There are a number of ways in which peer-to-peer lending differs from traditional bank lending, including:

• Types of borrowers – peer-to-peer lending is most useful for ideas based (rather than asset based businesses) businesses
• Transactions take place over the internet – peer-to-peer lenders do not have branches
• Lenders are not protected by government insurance schemes
• Regulation tends to be more light touch

How is crowdfunding regulated?

In the UK, the Financial Conduct Authority (FCA) is responsible for regulating investment-based and loan-based crowdfunding (donation-based and rewards-based crowdfunding are unregulated).

Whilst the FCA has introduced regulations to protect consumers borrowing from or lending to crowdfunding platforms, to date it has   sought to strike a middle path between protecting the interests of market   participants and not restricting the development of a sector in which the   country is a world leader (London is home to two of the five largest   crowdfunding platforms, RateSetter and Zopa, and the latter was the first in the world to offer peer-to-peer loans). The continuing very fast level of growth in the UK crowdfunding sector since 2014, when the majority of regulations were introduced, suggests that it has so far been successful. The FCA has announced that it will conduct a full post-implementation review of its regulation of crowdfunding in 2016.

Worldwide, regulation of crowdfunding is highly inconsistent at present. Regulation across the EU varies widely although the introduction of EU-wide rules appears likely. The European Banking Authority and European Securities and Markets Authority have both launched initiatives looking at the regulation of crowdfunding in the EU and in April 2015 the European Commission launched a study to gather and analyse data on crowdfunding markets across the EU and carry out events studies to see how national legislations may have impacted the markets.

What is the future for peer-to-peer lending?

Whether peer-to-peer lending is a rising star or a ticking   time bomb remains to be seen, particularly when it comes to underlying borrower defaults and how this might look. However the success or failure of the sector will depend upon how well its growth is controlled and the way that the regulators (both locally and globally) react to it. That it is being used more and more heavily as an   investment platform by institutional investors is an indication of the rapid maturing of the sector.

If properly managed and regulated, peer-to-peer lending offers an exciting new layer to the debt market which can help drive forward the knowledge economy.