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This article is written by Sanket Deshpande pursuing Certificate Course in National Company Law Tribunal Litigation from LawSikho.

Introduction 

‘Free of the bad balance sheets, high costs and dreadful reputations which burden, most conventional banks will replace traditional banks and lead to a banking without banks.’ -The Economist

Development in the field of information technology has disrupted many business models. The changes in the field are making everything easy for the buyers and sellers since without investing much the sellers can sell and buyers can buy through just a click of a button and they do not require any mediators or intermediaries to sell or buy. And in all this development, the trading of capital is not an exception. The retail and institutional investors are, in the hope of getting more yield, turning to a system called ‘crowdfunding’. They turn to this business model because of the availability of higher yields. However, every benefit comes attached with a risk and that risk is sometimes specific only to ‘crowdfunding’. A UK-based firm named Zopa in the year 2005 was the first to launch a peer-to-peer lending platform and later it was launched by a US-based firm named Prosper in 2006. Later it started to spread to the Asian markets as well. These entities boast of making available a successful platform for connecting millions of borrowers and lenders and also of managing successful lending records over the years. Regulators are very slow to react to such types of new business models and there is a lot of time lag before the regulators can react to such business models with radical new regulations. 

Financial Technology has forced the banks and the central bank to reorganize. The banks and central banks are adapting themselves to this change by becoming web-based financial intermediaries. Traditionally the banks have always worked as intermediaries between the providers and demanders of financial money. However, the practice of ‘crowdfunding’ has always existed since time memorial. We all have given money to our relatives and friends in need either as a loan or as a help. The bank’s customer base has two camps; one camp is the camp of people who provide money to the bank i.e. the depositors, and another camp is the camp that borrows money from the bank and is the borrowers. Depositors who deposit money in the banks expect the returns by way of interest. Banks use the depositor’s money as its capital reserves to fund the loans to the borrowers and who afterward as per the term of the loan return the same to the bank with the interest. However in the case of banks, the depositors have no say or a choice in the reason or the purpose for which a bank may lend money to a borrower, it is completely at the discretion of the banks. This totally is different in the case of peer-to-peer lending (P2P) since in the case of P2P a person can choose the reason for which his money may be used by the bank. It helps generate a new asset class. Modern peer-to-peer lending takes place online. The process is user-friendly and is totally safe. Two unknown individuals can borrow money and also lend money to each other. The creditworthiness of a borrower is checked by a neutral institution. The effect of this type of lending is that the P2P models circumvent not only the banks but also the financial regulations since there is no control of any central bank on the amount an individual can lend or borrow and the interest or yield that person may earn or may have to pay. 

What is peer-to-peer lending and how does it work?

Peer-to-peer lending is based on “loan-based crowdfunding”. It includes the following – 

  1. Two parties interact with each other virtually on a common network and without any intermediary. 
  2. The meet is basically for loans that are unsecured. 
  3. Peer-to-peer lending from the perspective of the financial markets is lending of money to unrelated individuals i.e peer’s and that too without the intervention of the banks or traditional financial institutions. 
  4. Lending in the case of P2P is completely online.
  5. It is less cumbersome, unlike banks. 
  6. The registration is easy, there are fewer documentations, and the loan processing time is less.

The platform does a preliminary credit evaluation of the borrower to check his creditworthiness and also to check the risk associated. This report of the borrower’s credit evaluation is submitted to the lender and the lender then relies on the platform’s credit evaluation report to make his assessment and decides to lend the borrower. The borrower in this case has to pay a fee to the platform called the ‘loan origination fee’ and the lender will have to pay a ‘loan sourcing fee’ to the platform. This fee is decided on the basis of the terms of the platform and is mentioned in the contract between the parties. The interest to be charged is decided by the platform or sometimes it could be a case that the parties may mutually agree to the interest rate. The money is routed directly between the borrower and the lender, the same is only intermediated by the platform. 

As per a report which was published by Global Findex Database in the year 2017 which was issued by the World Bank, globally around ‘1.7 billion adults remain unbanked – without an account at any bank or without the use of any mobile – money service provider’. This was seen as an opportunity by the P2P lending industry and they utilized this high demand of borrowers and yield-hungry lenders for their benefit. 

What are the types of P2P lending?

The peer-to-peer lending platforms are broadly categorized into consumer, business, and lending against the property; 

  • Consumer lending

This is the most traditional method of peer lending. When Zopa was started, the borrowers started intimating to the platform the reason for which they need the money and the lenders were free to choose the projects which they can back. The requirements of the individuals can be for many reasons: to repair their house or buy a new house or to start some new business. However, the biggest drawback of this is that the loans which the lenders lend are totally insecure and there is always this risk of the lenders losing their money due to default of the buyers. So in order to avoid this, the lenders shield themselves by charging very high-interest rates so that they can just set – off the risk associated with the lending. 

  • Business lending

The companies which are looking to maintain their cash flows, fund their growth and purchase materials look up to this P2P business lending. This type of lending is very secure for the lenders since it involves the personal guarantee of the directors of the company. 

  • Lending against the property 

This type of lending is very risky in nature, the reason it involves short-term lending like refurbishment or repair. There is also a risk attached to it since it may so happen that the property against which the project is funded by the lenders may fail. However, one benefit of this lending is that the lenders always stay secure as they have the property as collateral and can sell it off in case the borrowers fail. 

What are the advantages and disadvantages of P2P lending? 

  • Advantages for borrowers

  1. It is a useful alternative for those who have been rejected by a bank and are finding it difficult to secure funding. 
  2. It is entirely online and so it is a fast and efficient way of getting online funding. 
  3. It helps borrowers because of the fixed monthly payment, and lower interest rates. 
  4. It does not require collateral. 
  • Disadvantages for the borrowers

  1. If the creditworthiness of the borrower is low, like if suppose the score is below 630 then the borrower may find it difficult to secure a loan with a lower interest rate, he or she may have to settle for an interest higher than normal rates. 
  2. There’s a cap on the amount one can borrow. 
  3. Some platforms charge very high fees for origination. 
  4. Just like other banks or financial intermediaries, if you miss a monthly installment or repayment then it may damage the credit score.
  • Advantages for lenders or investors

  1. The lenders can earn Personal Saving Allowance(PSA) in the case of P2P. It ideally means every taxpayer can earn some € 1000 for the savings. 
  2. It is easily accessible for the lenders, which means that unlike in the case of property investments which may take sometimes months to get returns. It may fetch higher returns. 
  3. It is also a good alternative for investors to diversify their investment portfolio instead of investing in stocks, bonds, or property. 
  4. It is also an ethical way for the investors to invest funds by helping others who can have access to seed money for the business ventures. 
  5. In the last few years, bank’s interest rates have always remained low. This has resulted in a spike in the transactions via P2P. It helps the investors earn higher interest rates and that too without any terms and conditions from any financial intermediary like a bank. 
  6. P2P is safe because there’s always a stricter check about the borrower’s creditworthiness. 
  7. Many sites have their own contingency schemes to shield the investors from the default of the borrowers. Sites create this fund by charging some interest rate on the borrower. This helps the investors not losing their funds. 
  • Disadvantages for lenders 

  1. There are many lenders who view P2P lending as a form of saving, which is not a good intention, since there is always a risk associated in case the borrower defaults in payment. 
  2. Another big problem in the early or late payment of the money by the borrowers, in case the buyer pays early then the lender has to then look for lending it to the other borrower, but then the risk here is the lender may not get to lend at the same higher interest rate as the previous buyer. 
  3. The P2P platforms may take time to lend them money, and then you may not accumulate any interest. 
  4. Another important problem with P2P lending is that they may not be able to withdraw the savings for a long period of time, since some of the platforms lock their savings for a period sometimes of 1 to 5 years. 
  5. Not all investors have access to it, there is sometimes restricted access. 
  6. Another bigger problem with the P2P lending platform is that it is relatively new, and came into the scene only in the year 2005, and is still in a nascent stage. Lendy a peer-to-peer platform collapsed in 2019 costing 9000 investor’s up to 90 million euros. (details available on the page of lendy)

Performance of P2P model globally 

The global performance of the P2P industry is giving banks a run for their money in a literal sense, in 2019 it touched a global high of € 46,706 million, as stated earlier it all started with Zopa in the UK and Prosper in the US. China too then started to have a boom in the industry and started its own P2P industry in 2007. As per ‘S & P Global Market Intelligence Report’ the loan origination through P2P amounted to ‘£ 5.7 billion in the UK, and according to AltFi’ there was annual lending of  ‘£ 6.17 billion in the UK in the year 2019’. The cumulative CAGR volumes of 175% of loan origination were reported in between the first quarter of 2005 and 2019, and it is now a statistics that the global P2P lending market is valued at USD 34.16 billion in 2018 and it is estimated to reach USD 589.05 billion by 2025, with the growth mainly led by China. 

As per a report the market lending for consumer P2P lending is expected to be at ‘36,622 thousand users by 2023’. With an estimated growth of 52% annually, the ‘P2P industry has a very promising future as a FinTech industry’ and since the internet penetration is increasing, the global P2P industry is bound to increase even further since the market penetration is also increasing, the companies are trying their best to make stringent terms and pass on the services to the borrowers and the lenders to win their confidence. In fact, a recent report by CrowdExpert clearly shows that the P2P industry accounts for 70% of all the activities related to crowdfunding. 

Globally USA takes the lead in P2P lending followed by China and three European countries. The P2P industry is available to fund various avenues like small and medium enterprises, student loans, auto loans, etc., it is necessary therefore to check for the performance of P2P worldwide.

In the United States of America  

The USA has been a pioneer in the global P2P lending industry since its advent in 2006. Some US platforms like Lending Club, Prosper, On Deck, Upstart has strides in the P2P lending industry and have registered astronomical growth, which is usually contributed by the development in the field of digital technology and a good amount of tech-savvy population. We all know how bad the subprime crisis in the USA was, and in the aftermath of that, many banks turned away individuals fearing default. It was only then that the P2P lending platform created a good amount of an avenue for the needy borrowers, and this is how it became popular in the US. Lending Club in the US is one of the most famous P2P lending platforms, right since its inception it has contributed to ‘US $ 50 billion of loan operations’ and has also added ‘3 million customers’. By December 2018, Lending Club reported in its filings a delinquency rate of 3.5%. Even Prosper has done well since its origin and its total contribution stood at $ 16 billion. 

The new UpStart has also done well relatively in the last so many years and its contribution stood at $ 5.5 billion right since its inception. The entire US market on P2P lending is driven by these three companies, with the total origination levels at $ 24.068 billion in the year 2019. The reason behind such strong performance can be attributed to the acceptance by the people of the USA of the P2P platform as a safe and reliable source. The P2P platforms are being very cautious in doing a background check of the level of Fair Isaac Corporation (FICO). The companies also check for the lending pattern of the individuals and their day-to-day activities. 

In the United Kingdom 

In the UK, Funding Circle, Zopa, Rate Cutter are some popular P2P platforms, it is estimated that in the UK the P2P market is around $ 8.03 billion in 2019. Funding Circle has reported a figure of £ 5.8 billion lendings, and Zopa £ 5 billion. In fact, in the year 2011, these three leading lending platforms came together in the UK to start P2P Financial Authority (P2PFA), the object was, ‘as a self-regulatory body for the sector to promote high standards of conduct and consumer protection’. The UK government has introduced a lot of measures to support the P2P lending market. The ‘Innovative Finance Individual Savings Account (IFISA) helped give a push to the P2P industry due to its tax advantage status’. On 1st April 2014, the Financial Conduct Authority entered as a regulator for the P2P industry. 

In China

The Chinese P2P industry has seen a meteoric rise in the last so many years, in fact, the rise has been so much so that more than 4000 P2P platforms are operating, being a communist regime, Chinese people do sometimes face this difficulty in securing the loans, due to very extensive state regulations. Lufax, Ppdai.com, Credittease.cn, WeLab, and Yirendai are some of the Chinese platforms which are operating in the P2P industry. However, there has been a controversy about the Zenbao which was marred by the allegations of having a Ponzi scheme, so much so that it wiped away 50 billion yuan of around 900000 investors. This led the Chinese Government to introduce reforms in 2016. 

Is peer-to-peer lending circumventing financial regulations: an analysis 

Since peer-to-peer is an entirely web-based and online platform, right form its inception it has been a matter of immense concern for the governments’ world over, the reason being a lack of central authority like the Central Bank and any proper financial regulation in place. As and when the potential risks of the P2P platforms started coming to the fore, as stated above, Zenbao the infamous Chinese Ponzi scheme literally wiped out billions of dollars from the market, a thought started appearing that the uncontrolled regime of peer-to-peer lending is literally making things tough for the world and the circumvention of Financial policy is becoming evident. 

The European Commission has made a lot of efforts in forming one European Capital Markets Union (CMU). In spite of that, there has not been a single regulatory framework for crowdfunding or crowd investing, or for peer-to-peer lending. The EU Commission is basing on consumer laws to regulate the online financial platform investors, and they have also mostly invested in the national laws of the EU member states. The regulation therefore of crowdfunding in Europe remains a herculean task for the regulators and authorities. In fact, even today, the EU Commission believes that there is no particular reason to have central regulation for crowdfunding, in 2016 the EU said that, ‘Given the predominantly local nature of crowdfunding, there is no strong case for EU level policy intervention at this juncture. There is therefore a need to have a uniform regulation across Europe, a uniform regulation in Europe will open up the market opportunities and give the users a lot of confidence in trading through platforms like crowdfunding. 

In the year 2015, the European Banking Authority (EBA) assessed the risks associated with crowdfunding and the regulations available to regulate the funding. It concluded that that the business models of lending-based crowdfunding platforms do not fall inside the perimeter of credit institutions and their typical business model as defined in the EU legislation. The Payment Service Directive (PSD) is considered to be one way out in case of the regulation of the P2P platform, however, the EU Commission is of the opinion that it would cover only lending-based directive and not the entire one. 

From the above analysis of the EBA, it is clear that the national legislators are facing a dilemma, that dilemma is the risks that the P2P platforms are exhibiting by unbundling themselves into small business models. These risks mainly are sector-specific or platform-specific. The current financial regulations are therefore insufficient for crowdfunding platforms, and the approach of modifying and adapting existing laws. 

However, one more thing which is important is that it is not only the legal side that challenges legislators and regulators. It is also the institutional challenges that are to be met, of the internal organisation of these platforms. The effective way of controlling the platforms is to prevent them from taking too many risks. The legal framework must safeguard a fair and transparent mediation process, and as per this process, every platform user is well informed and is able to assess the risks associated with the platform.

It is considered that the P2P lending platforms are missing two core elements:

  1. The investor information must be more detailed concerning the expected risks which an investor might face and the returns on investment, with clear definitions of what information should be given across platforms. In the UK this is something that is missing because it mentions under FCA that the information should be clear and specific but it does not state what information should be given?. ‘At present, high-level rules require firms to provide potential investors with information so they are reasonably able to understand the nature of the investment and associated risks and, consequently, to take investment decisions on an informed basis. The information must be fair, clear, and not misleading. It must be accurate, balanced, sufficient for the needs of the investor, presented in a way that is likely to be understood, and important information and warnings must be given clear prominence.’ The platforms must also be transparent in stating what information of the potential borrowers they use for the credit assessment of the borrowers. 
  2. The regulators should also ensure that every investor is given equal rights and opportunities, and also ensure that they do not give any favourable treatment to institutional investors. These restrictions should include the capping of the investment of the institutional investors and also deter institutional investors from investing a fortune in the crowdfunding market. It will divert the institutional investors to a well–regulated and organized security market. The recent inflow of money into the crowdfunding market is also worrisome since it needs to be investigated that the recent inflow of money into the crowdfunding market is to get more yield in order to do away with the stricter financial regulations in the stock market.  

As this kind of marketplace lending gains its size, it is obvious that it will become the target of regulatory attention. There is an argument that P2P lending will make the financial stability of the countries weak and the regulators may find it difficult to monitor the large-scale distribution of the lending platform. There is also an issue of fraud and also the issue of widespread loss. There is a possibility that the platforms with impressive high returns on yield and low default might attract more investors. Prof Jan Kregel of the Levy Economics Institute warned regulators thus: ‘The new payments systems have the ability to evade or distort regulation on financial institutions, and P2P lending systems replace due diligence of banks with algorithms. The regulation of this system is thus critical. P2P lending is the modern-day equivalent of Securities Affiliates, which were at the centre of fraud in the run-up to the Great Depression. These systems eliminate normal due diligence, and they pose a huge threat to stability in the system’.

Regulations

There have been a lot of efforts to regulate P2P lending. Many countries which have P2P lending business booming have been coming up with a framework as stated below to regulate P2P.

  • United States of America

In 2006, the USA first came up with a series of regulations, the P2P’s in the USA are regulated by the SEC, the SEC will monitor the lending and the investing procedure. Whereas there are certain other agencies like ‘the Consumer Financial Protection Bureau (CFPB)’ and ‘the Federal Trade Commission (FTC)’ that monitors the borrower side operations. The states in the US have been allowed to frame their own laws as required, in fact considering the dangers and the risks associated with the platforms some states like Texas have already banned the operations of P2P. SEC has imposed strict conditions like the listing of companies, shelf-registration of loans and uploading disclosures through ‘EDGAR (Electronic Data Gathering, Analysis, and Retrieval system)’ it led to the sophistication of the loan disbursal process.

  • United Kingdom 

In the UK, the FCA is the regulatory body that governs P2P. The FCA has stipulated that the company be treated only as an intermediary. The Quakle saga alerted the FCA and it came to be realised that the regulations were far too relaxed and that a certain strong framework was required, and therefore in view of that the UK regulators introduced a lot of reforms, including the creation of a reserve fund or the provision fund to help the lenders by doing a reimbursement of the funds in case the borrowers default. 

  • China 

The fall of Ezubao led the Chinese government to introduce a flurry of changes to the P2P platforms operating in China. Cyberspace Administration of China has made it mandatory for the P2P authorities to file documents with all the relevant local financial authorities, periodically releasing the lender-borrower details to ensure transparency. They have to maintain a separate account of their funds. They have been prohibited from accepting public deposits. 

  • Australia 

The Australian Securities and Investment Commission (ASIC) is the authority that governs the P2P platforms in Australia. The P2P platforms have been made mandatory to acquire an Australian Financial Services license and Australian Credit License.

  • Canada 

In Canada, Canadian Securities Administrator is the authority that governs the P2P platforms. The P2P platforms come under the ambit of the Securities Act issued by the Ontario Securities Commission.

  • Germany 

The Federal Ministry of Finance (Bundesministerium der Finanzen) is the authority that monitors the P2P platform. The German Banking Act is applicable to P2P’s as well. This Act allows only banks to raise money or lend, which means the P2P has to partner with the banks. 

  • India 

In India, the Reserve Bank of India is the central bank monitoring all the banking operations. It issued certain master directions in non-banking financial companies, peer-to-peer lending platforms in the year 2017. The said directions contain all the details about the way rules the P2P industry has to follow. 

Risk of platform default

The regulators are facing this severe problem with the regulation of platform default in the P2P space, there have been cases where the P2P platforms have literally vanished and have defaulted. The repayment of loans is hampered in this case. This has been the case traditionally with the banks too since most of the time borrowers become insolvent, but after the advent of P2P transactions which are internet-based, this risk is becoming more severe. This is how they are circumventing financial regulation. Verstein (2012) impressively illustrates how the US model of P2P regulation, in fact, increases the risk for lenders;

‘In the US, P2P platforms are seen as issuers of securities, with the Securities and Exchange Commission (SEC) being responsible for their regulation. According to him, and as expressed in section 2.1, the legal nature of the securities issued under the US model leads to lenders having claims against the platform instead of the borrower. As a consequence, lenders not only have to evaluate the creditworthiness of the borrower but that of the platform as well. Verstein (2012) argues that investors will lose money if either the borrower or the platform default, a problem that is ignored by most P2P lenders in the US and makes P2P lending in fact riskier than traditional banking.’

Liquidity risk and secondary markets  

There is another big problem associated with peer-to-peer lending and that is the problem of ‘liquidity risk’ and ‘secondary market’. This happens because the platforms cannot use short-term deposits to fund long-term like banks. Also when the borrowers default there is always an absence of a secondary market to fund the growth. There is still a problem of trading bad loans. P2P markets with less sophisticated investors provide fewer opportunities to deal in junk investments. The bad loans are traded with significant discounts. The Lending Robot, an automated robo-advisor, was implemented in the lending club. By using investment algorithms and a high degree of automatic diversification robo-advisors intend to help investors by automating (re-)investments. This option also applies to secondary market transactions and, in turn, strives to improve liquidity for P2P markets. 

There is therefore an imminent need to introduce uniforms and a model framework which makes it necessary for peer-to-peer lending platforms to comply with the laws of the state, and unchecked activity will be harmful and there is a possibility that we may be looking at another crisis like the subprime or great depression. 

As can be seen from above, the level of regulatory response has varied significantly globally, and as a result of that, the characteristics of the market have also changed. Despite all these regulatory efforts, there are certain issues that still remain. The incentives which have been given to these platforms are entirely problematic, especially to those which rate credit and originate the loans. The investors have no incentive to distinguish among risk categories. As we are aware from the China model, the P2P’s are engaging in Ponzi schemes. To that extent, even the stringent regulation in the USA has prohibited the new entrant. It is necessary therefore for the regulators to be very mindful of these risks while also ensuring that the sector continues to progress unhindered. In that way, we can safely answer that ‘P2P is circumventing financial regulations, however, if the regulators decide they can always make a safe avenue for the investors by encouraging compliance’.                               

Conclusion 

Ultimately, one can say that recently introduced regulations have started recognizing the industry. However, it still is a case that the regulators have erred on the side of caution. As technology advances, P2P lending is going to be a novel way to cut the lending by banks. Web-based financial intermediation will prevail as a superior form of the organization compared to the traditional banking business. If the banks entrench themselves into the thick walls of regulation then other non – bank companies which are active on platforms other than the real economy may conquer financial markets. Therefore, a unified regulation is required for crowdfunding to provide financial services users and their intermediaries legal confidence to expand their activities freely in the financial markets. If not, then the risk of losing more and gaining less may be the norm.

Traditional banking businesses are overburdened with a lot of regulations and there is a possibility that the banks may not have an option of ‘go–to’ resort if they just sit and do nothing. The world is based on a face-paced financial economy, the finances are the need of the businesses for every microsecond and if those finances are not made freely available and the people are not given the freedom to earn money then there are always such mechanisms like P2P FinTech which will come to the rescue and in doing that they will always show less disregard to Financial Regulations – circumventing it.

References


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