Blockchain and P2P Lending: A Practical Guide for Investors and Borrowers

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Blockchain and the platform business model characterizing peer-to-peer lending is a natural fit. By taking advantage of the blockchain technology, p2p lending platforms can create new business models and enable transactions independent of trust relations between lenders and borrowers. However, the technology also possesses a potential threat to existing p2p lending platforms if they are not able to innovate and utilize the possibilities contained in the blockchain technology. The same is also very true for traditional banks and credit unions.

Blockchain is often talked about as a groundbreaking innovation that can lead to a new economic system sometimes referred to as the blockchain economy. In the blockchain economy, rules defined by smart contracts will make sure that agreed-upon transactions are enforced autonomously.

In this article, we will take a thorough look at the problems faced by traditional p2p lending platforms and how blockchain technology can help provide solutions to some of these problems. Blockchain is still a nascent technology, but some p2p lending platforms are already making use of blockchain in their operations. Therefore, we will also investigate how the technology is being put to use in P2P lending today and explain how it is possible to invest and borrow through blockchain empowered peer-to-peer lending.

What is Blockchain-based P2P Lending?

Peer-to-peer lending connects investors/lenders with borrowers through an online platform acting as a trusted third party. The three main agents involved in this process are:

  • Private individuals or institutions providing funding
  • An online p2p platform mediating the transaction
  • A business or private individual seeking funding

However, in the traditional P2P lending model, a bank, credit union or another type of financial institution is needed as an intermediary to assist the peer-to-peer platform in securing objectivity in the transaction and build trust. The need for intermediaries and regulation mean that transactions on traditional peer-to-peer platforms are subject to added cost and time requirements as well as security issues.

Blockchain is at the core of the FinTech revolution and has the potential to cause radical change to a large number of industries, including financial services and P2P lending. The key advantage of using blockchain technology in peer-to-peer lending is that it can remove intermediaries from the lending process. This has a large range of benefits that we will cover in the next section. First, we will provide a brief introduction to the blockchain technology and how the key features of blockchain are also relevant in P2P lending.

If you are new to peer-to-peer lending and want to learn more about what characterizes this type of lending, you might want to check out this article before reading on: What is Crowdlending aka P2P Lending?.

A Brief Introduction to Blockchain

So, what is a blockchain more precisely? A blockchain is a digital redesign of an archive or log system called a ledger. Since ancient times, commercial transactions have been stored in ledgers, but they have always been prone to errors because they have relied on human inputs, which leads to added costs and inefficiencies for both organizations and the economic system as a whole. To avoid this, the blockchain technology is based on a combination of cryptography and distributed networks. The technology is, therefore, also closely related to cryptocurrencies – the most famous example being Bitcoin launched in 2008 to provide “…an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” (Nakamoto, 2008).

Despite being introduced in 2008, a generally accepted definition of what the blockchain technology is has been lacking. In our opinion, the best technical definition of the concept is given by Seebacher & Schüritz (2017), who – based on a structured literature review of peer-reviewed articles on blockchain present the following definition:

A blockchain is a distributed database, which is shared among and agreed upon a peer-to-peer network. It consists of a linked sequence of blocks, holding timestamped transactions that are secured by public-key cryptography and verified by the network community. Once an element is appended to the blockchain, it can not be altered, turning a blockchain into an immutable record of past activity.

However, blockchain is not just a technological innovation, but also raises philosophical, cultural, and ideological questions by providing a valid alternative to traditional trusted intermediaries. Consequently, it is useful to add a legal and business perspective to the technological definition given above: From a legal point of view, blockchain can thus be defined as a technology to validate transactions, whereas from a business perspective it can be defined as a peer-to-peer network for transferring value (Rosati & Cuk, 2019).

Key Features of Blockchain and P2P Lending

The two main characteristics of the blockchain technology are its trust evoking and decentralized nature – both characteristics that are also essential for the development of P2P lending. In the blockchain technology, trust and decentralization are inextricably interconnected: To create a decentralized network you need mechanisms to build trust, and decentralization enables the users to get involved in the network and establish the foundations for a consensus mechanism that can eliminate the need of a trusted third party. 

Building Trust in P2P Lending Using Blockchain Technology

Transparency

A P2P lending platform based on blockchain would ensure a larger degree of transparency by making information available to both borrowers and lenders participating on the platform. Both past and current transactions can be viewed by all participants giving full disclosure of all activities and when a new transaction occurs, it is broadcasted through the entire network. The interaction is, thus, both public and shared. Also, as no single intermediary controls the system, lenders and borrowers can interact directly reducing friction in the transaction.

Data Integrity

The integrity of data is secured through peer verification of transactions and the facilitation of direct interaction through public-key cryptography. As a consequence, every user can verify the correctness of broadcasted transactions based on predefined rules.

Data Immutability

The last key feature in building trust is the immutability of data. A database build using blockchain technology is designed so that transactions are unable to be altered once they have been added to the blockchain. The process of adding a transaction to a block happens through a consensus mechanism requiring proof-of-work – a computational puzzle, which solution must be verified by other network participants if a user finds the solution.

Enabling Decentralization in P2P Lending Using Blockchain Technology

Privacy

Depending on the type of blockchain, the identity of the users will be covered by pseudonyms. This, combined with the usage of public-key cryptography to secure interactions, will facilitate a degree of privacy for users of P2P lending platforms. Learn more about the different types of blockchain in the section “Types of Blockchain” below.

Reliability

Reliability of the system is established by sharing and storing information on transactions throughout the system and by the facilitation of automatic measures reducing the need for manual intervention and, thereby, the risk of individual mistakes.

Versatility

The blockchain technology allows peers to participate in the development of the underlying code supporting the database creating an open and versatile system where participants can develop and distribute their own code and functionality. This enables the creation of smart contracts – a contractual agreement between two parties, e.g. a lender and a borrower in P2P lending, based on a piece of code programmed to automatically fulfill the terms of the contract. More on this below.

The main source for the descriptions above is characteristics of the blockchain technology provided in the research paper Blockchain Technology as an Enabler of Service Systems: A Structured Literature Review. If you want to dig deeper into the possible uses of blockchain technology, this is a great article for further reading.

The Use of Smart Contracts in P2P Lending

Largely due to the huge attention received by Bitcoin, blockchain is in the general public mostly known for its ability to process financial and monetary transactions. Nevertheless, another important aspect of the use of blockchain in peer-to-peer lending is the ability to create smart contracts, which ensure that transactions agreed upon by the parties (lenders/borrowers) are enforced autonomously following rules defined by the smart contract. In other words, a smart contract is a file with self-executing code based on parameters specified in the contract. Blockchains supporting the functionality of smart contracts are also referred to as blockchain 2.0.

In P2P lending, a smart contract would contain the initial loan amount and the repayment terms, including penalties if payments are late or missed. If a business makes a loan of, for example, $100,000 with a repayment term of 24 months at $5,000, the smart contract will automatically execute the payment requests, receive the payments, and adjust the due amount without the need of involving any intermediary. Also, it is possible to embed automatic compensation functions in the smart contract, like deducting percentages for early loan repayment, adjusting credit ratings, or converting to a higher yield currency.

Types of Blockchain

Blockchain is often talked about like it is all the same, but in reality, different types of blockchain exist. When most people talk about blockchain, they are actually talking about a permissionless public blockchain like Bitcoin or Ethereum (see table below), but other types of blockchain exist as well. While all types of blockchain share common features like a distributed network, cryptography, and timestamped transactions, there is a crucial difference in the ability of users to read and submit transactions to the blockchain. This ability depends on their access to transactions and carries important implications for how peer-to-peer platforms can utilize blockchain in P2P lending. An overview of the different types of blockchain with examples can be found below.

Adapted from Beck et al. (2018)

How to Invest and Borrow on Blockchain-based P2P Lending Platforms – A Blockchain Use Case

The peer-to-peer lending industry is already disrupting traditional providers of debt by providing an interesting opportunity for investors to achieve attractive and stabile returns and diversify their investment portfolio as well offering a fast and customer-friendly way to meet the financing needs of borrowers. However, the lending industry is still dominated by banks and traditional financial institutions. To disrupt the industry more profoundly, P2P platforms must develop the peer-to-peer business model further. Here, blockchain technology is likely to play a key role.

Below, you will find examples of P2P platforms utilizing blockchain technology to offer peer-to-peer lending. We will explain how each platform is taking advantage of the blockchain and provide you with a step-by-step guide on how to get started as an investor or borrower. On some platforms, you can earn interest by using fiat money like USD, EUR, or GBP. Other platforms are operating as pure P2P crypto lending platforms why it is necessary to acquire one or more cryptocurrencies.

BlockFi

BlockFi was founded in 2017 with the aim to enable holders of cryptocurrency to do more with their digital assets. At the moment, BlockFi offers two financial products to holders of cryptocurrencies: 1. an interest account where you lend your crypto to earn compound interest and 2. crypto loans. Unlike other crypto lending businesses, all BlockFi’s financing came from institutional investors and not from an ICO (initial coin offering). BlockFi is based in New York.

The BlockFi Interest Account

With the BlockFi interest account, you can lend your Bitcoin, Ether, or GUSD to earn compound interest in the cryptocurrency of your choice. This can be achieved simply by storing your cryptocurrencies at BlockFi that will then use your crypto assets to generate interest. The interest is paid out monthly and you can expect to earn up to 6% interest annually.

To generate interest, BlockFi lends the assets held in interest accounts to corporate and trusted institutional borrowers – typically in the form of overcollateralized crypto-backed loans in a structure similar to the crypto-backed loans offered by BlockFi (see more below). This means that BlockFi is running a very centralized lending business model as they do not directly match borrowers and lenders, but act as the lender themselves. A nice thing to highlight is that the BlockFi client funds are structured to be at the top of the capital stack, meaning that BlockFi will take a loss before any client would in the case of defaults. This creates a healthy incentives structure where it is always in the interest of both BlockFi and their clients to control the risk of the loans issued.

To earn interest on BlockFi you must have a minimum balance of 0.5 BTC or 25 ETH, so the entry barrier is quite high, but for investors with large cryptocurrency holdings the BlockFi interest account could be an interesting option to earn interest while HODLing.

You can sign up here.

Crypto-backed Loans with BlockFi

BlockFi is offering crypto-backed loans to holders of Bitcoin, Ether, and Litecoin, which allow crypto holders to access liquidity in USD without selling their cryptocurrencies. This can be an interesting option for cryptocurrency investors in the need for fiat money for some reason, but at the same time want to maintain ownership of their crypto.

In a traditional bank, you would normally have to provide some sort of collateral to obtain a loan. This could be in the form of, e.g. a business or real estate. To obtain a crypto loan at BlockFi, you must stack either Bitcoin, Ether, or Litecoin as collateral. The amount of collateral you need to provide depends on the loans LTV (loan-to-value). BlockFi offers loans with an LTV of up to 50%. This means that if you stake 1 BTC, BlockFi will allow you to take out a loan in USD with a value of 0.5 BTC.

When using crypto lending you need to be aware of margin calls, which will be activated if your crypto assets decrease in value. At BlockFi the first margin call occurs at 70% LTV, which means that the crypto asset used as collateral has dropped by 50% since your loan was issued. To avoid liquidation of a portion of your collateral, it is required that you bring down the LTV to a healthy range, which can be done by either adding additional collateral in the form of crypto or by paying down the loan balance. If no action is taken, BlockFi will lower the LTV back into the safe zone by liquidating some of your collateral. You will receive notification emails if your LTV is approaching 70%.

Applying for a loan is easy and you will receive a loan offer within business day. There is no prepayment penalty if you decide to repay your loan early.

You can apply for a loan here.

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