Peer-to-Peer lending is a form of debt-based crowdfunding enabled by online P2P lending platforms that connect borrowers and lenders by circumventing conventional loan processes, requirements and intermediaries. The P2P lending market is showing impressive growth rates all over the world and provides much-needed finance to both startups and more established businesses. For investors, P2P lending offers (potential) stable returns in the form of frequent interest payments, why it can be a great supplement to more traditional asset classes like bonds and stocks. So far, P2P lending is still viewed as an alternative investment but with low interest rates on savings accounts as far as the eye can see, it is likely to develop into an essential part of a diversified investment portfolio.
What is P2P Lending?
P2P lending is a method of debt financing enabling individuals and companies to lend and borrow money through an online platform instead of making use of a traditional bank as an intermediary. Because the loans are split up in minor parts, many different agents can finance the loan.
Since the invention of money, individuals and institutions (lenders) with money have been lending to people and businesses in need of money (borrowers). Peer-to-peer lending represents a convergence between collective financing and informal funding (also known as insider funding), which is financing achieved by mobilising existing social relationships like friends, family, or professional acquaintances. These are both financing methods with a long history, and an early example of collective financing is the Statue of Liberty’s pedestal that was partly funded by an open call.
The explosive growth of the internet and social networks has significantly boosted the scope and potentials of P2P lending by enabling peer-to-peer lending platforms to establish online marketplaces that act as intermediaries between lenders and borrowers. This means that borrowers and lenders do not need to have existing social relationships with each other to make a transaction happen. Instead, the transaction is based on the credit information of the borrowers as well as the underlying assets backing the loan.
Lenders in P2P lending can be both private individuals and institutional investors, and P2P lending platforms increasingly allow traditional credit institutions such as banks to participate in the funding. The reward received by investors in peer-to-peer lending is interest payments that depend on the borrower’s risk of default and the term of the loan.
Borrowers in P2P lending can be both businesses and private individuals. While everyone who fulfils objective criteria’s like nationality, legal age, etc. can normally invest in P2P loans, borrowers must usually go through a credit rating system that defines whether it is possible to borrow and on what terms. Because borrowers achieve financing through an open call and it is made easy for everyone to participate in the financing, often investors/lenders are contributing to the assessment of borrowers by choosing whether they want to participate in a loan or not.
The Definition of P2P Lending
P2P lending is also known as crowdlending or marketplace lending, but these terms all refer to the same phenomenon. What term is preferred is largely based on regional differences with marketplace lending being slightly more used in the Americas region compared to other regions and crowdlending being almost exclusively a European term. However, in a worldwide perspective, peer-to-peer lending has in recent years developed into the most established term and it is commonly used in both regions that also tend to use marketplace lending and crowdlending. In regulatory and academic reports, you may also encounter the broader terms `lending-based crowdfunding´ or `debt-based crowdfunding´ that usually cover P2P lending and a few other business models like balance sheet lending and mini-bonds. You can get an overview of all debt-based crowdfunding models here.
Peer-to-peer lending is constantly developing – and in combination with the linguistic confusion described above – this has made it difficult to coin a precise definition of the phenomenon. Hence, an established, unifying definition is still lacking. Our suggestion is, therefore, to use a definition that establishes clear boundaries that separate P2P lending from traditional banking, but still leaves room for new business models like e.g. blockchain-based P2P lending. Following this logic, a draft for a simple and precise definition of P2P lending could be as follows:
P2P Lending Platforms
P2P lending platforms enable interactions between the demand (borrowers) and supply (lenders) side of the funding process. To create a well-functioning marketplace, the two most essential jobs for platforms are to recruit borrowers and lenders and to set the rules and terms of engagement. Besides market-making, key functions also include loan processing and activities contributing to building a community.
The main sources of income for platforms in peer-to-peer lending are origination fees charged to the borrower, repayment fees charged to the lender, and/or other fees like loan part trading and late fees. How a P2P lending platform earns revenue depends largely on the business model of the platform and how the investment is structured, which will also have a great impact on the risk structure faced by investors.
Platforms in P2P lending generally operate with lower operating costs compared to conventional credit institutions, which enables them to offer attractive conditions for both lenders and borrowers by transferring these lower costs across both the supply and demand side (or so is the claim). Thus, in the best-case scenario lenders are offered attractive returns compared to other savings and investment products and borrowers are offered access to capital, competitive interest rates, and a swifter process compared to similar products offered by banks. In addition, according to Cummins et al., lenders are attracted by risk diversification, lower transaction costs, and access to market, while borrowers are attracted by transparency and the promise of non-collateralised loans.
There are several ways of categorising peer-to-peer lending platforms with the most used being borrower type, business model, and/or loan use:
- Business model: Traditional P2P Lending, P2P Lending with Loan Originators, Bank-funded P2P Lending or Balance Sheet Lending
- Borrower type: P2P Consumer Lending (natural person) or P2P Business Lending (legal entity)
- Loan use: Real estate/property, invoice financing, agriculture, education, social impact, car purchase, payday consumption, travel etc.
- Collateral: Invoice, real estate, car, business etc.
Besides, technological developments also open for other categorisation based on the technology empowering the lending process. At the moment, the best example of this is blockchain-based P2P lending.
Business Models in P2P Lending
When you invest in peer-to-peer lending, it is particularly important to understand the business model of the platform you invest on as this has a major impact on the risk you face as an investor. This same applies if you are a borrower looking to raise funds for your business or some other purpose. Currently, four general business models exist in P2P lending: 1. Traditional P2P Lending, 2. P2P Lending with Loan Originators, 3. Bank-funded P2P Lending, and 4. Balance Sheet Lending.
In traditional peer-to-peer lending (business model 1) there is only one middleman (the platform) between you and the investor, which makes both the business model and the incentive of the platform fairly easy to understand. In P2P lending with loan originators (business model 2), there are two independent parties between you and the borrower (the platform and the loan originator), which makes it a bit more complex and it can be harder to comprehend the incentive of the platform and who is borrowing at the platform. The last two business models are closer to shadow banking and it is up for discussion whether these should be included as P2P lending. We have chosen to include both bank-funded P2P lending and balance sheet lending in this review to give you a complete idea about the business models you might encounter as an investor interested in P2P lending.
Below, we will explore these business models and highlight the pros and cons of each.
P2P Lending Business Model 1: Traditional P2P Lending
The traditional understanding of peer-to-peer lending is that you lend or borrow money to/from your peer with a middleman, the peer-to-peer lending platform, to mediate the transaction. This makes the traditional P2P business model pretty straightforward:
- Lenders (private individuals and/or institutional investors) invest excessive cash flow in loans on the platform and receives principal and interest in return.
- The borrower (a consumer or business) receives financing and pays interest on the loan amount in return.
- The platform is handling administration and attracts both borrowers and investors.
An illustration of the traditional P2P lending business model can be found below. To emphasize the different actors in the funding process, the supply-side (lenders/investors) is highlighted in blue and the demand-side (borrowers) is highlighted in red. In the middle, the P2P lending platform’s role as an intermediator between the demand- and supply-side is illustrated:
In return for a fee, the platform handles administration, the loan contract, take care of missed payments, make sure borrowers pay on time, deal with bad payers and sort out the legal issues of retrieving as much of the loan as possible in the case of a bankruptcy or loan default.
Thus, the peer-to-peer lending platform is administrating the financing business between the lenders and the borrower and takes care of attracting both borrowers and investors. If investors leave the platform because of bad returns, there is nobody to supply funding to the borrowers – and the platform will eventually go out of business. If the borrowers leave the platform because of bad treatment and terms, there is nobody to provide investors with a return – and the platform will eventually go out of business.
In traditional P2P business lending, the risk of investors is placed at the borrower. This means that if the borrower does not pay back the borrowed amount the investor might lose capital. Consequently, a platform that uses the traditional P2P lending business model is dependent on its market position and on having a reputation as a fair and profitable marketplace for facilitating loans.
P2P Lending Business Model 2: P2P Lending with Loan Originators
Compared to traditional P2P lending, the second business model involves an extra layer, a loan originator, which makes it a bit less intuitive to understand for investors.
A loan originator is a non-bank financial institution that uses marketing to acquire borrowers looking for a loan. The two main jobs of loan originators are to convince borrowers that their lending terms are the best and to help borrowers navigate the closing table. However, for both investors and borrowers, it is important to keep in mind that a loan originator is a sales entity first and a loan approval adviser second.
Loan originators have traditionally been focused on mortgage loans, but many have seen a potential in the peer-to-peer lending market. Here, loan originators can find financing for their loans by making agreements with P2P lending platforms that their loans can be facilitated on their marketplace. At the same time, this provides P2P lending platforms with a steady flow of loans for their lenders to invest in.
The use of loan originators in P2P lending started in 2009 when Twino as the first P2P lending platform started using loan originators as a key element of their business model. Since then many platforms have followed and some of the largest and most famous P2P lending platforms today are operating using this business model, e.g. Europe’s largest P2P lending platform Mintos.
Business model 2 is illustrated below – again with the supply side in blue and the demand side in red, but added to the illustration is the loan originator as a provider of loans to the P2P lending platform:
In business model 2, loan originators take care of the demand-side by providing loans to the platform, which enables platforms to focus their marketing only on attracting lenders/investors (the supply-side). Thus, the main difference between business model 1 and business model 2 is that the loans available for investing in business model 2 is originated outside of the platform. This allows the platform to facilitate larger loan volumes faster and provide a more stable short-term cashflow compared to platforms using the traditional P2P lending business model. However, it also makes the loan process and risk structure less transparent to investors.
Since the loan originator’s loans are facilitated on the platform’s marketplace, it is possible for the platform to remove the loan originator if it provides bad returns and instead try to find someone more reliant. This could happen if, for example, the borrowers the loan originator provides to the platform repeatedly do not pay back their loans. This will lead to investors losing money, which will force the platform to react because it must make sure investors see good returns to keep them on the platform.
Buyback Guarantees and Other Insurance Products
To convince investors they will not lose their money, P2P lending platforms that use business model 2 often structure the investments to include a buyback guarantee or another insurance-like product. This sort of “guarantee” is a deal, which gives the investors a promise from the loan originator that it will buy back bad loans after a given period, usually between 30-90 days of delinquency – if they have enough money in their company to do it.
At first glance, this might seem safer than traditional P2P lending, but in the end, the one that pays your return as an investor is the one borrowing the money. In P2P lending, the ultimate risk of losing capital for investors is when borrowers do not pay back the money they have lent. Compared to the traditional P2P lending business model, P2P lending with loan originators moves the risk to the loan originator company that in the end has its risk at the borrowers. The incentives for the P2P lending platform to make sure the loans on their platform is worthy of investment might, therefore, be weaker than in traditional peer-to-peer lending. However, there are also benefits of using platforms operating with loans covered by a buyback guarantee, such as better predictability of the cashflow and interest earned from your portfolio of loans.
You can read more about buyback guarantees in P2P lending here. Also, make sure to check out our List of Buyback Guarantees & Provision Funds in P2P Lending.
Pros & Cons: Traditional P2P Lending vs. P2P Lending with Loan Originators
|Business Model 1||Business Model 2|
P2P Lending Business Model 3: Bank-funded P2P Lending
Besides traditional P2P lending and P2P lending with loan originators, two other business models will sometimes be counted as part of P2P lending: bank-funded P2P lending and balance sheet lending. These business models are, however, closer to traditional bank lending than traditional P2P lending and P2P lending with loan originators and are, therefore, sometimes regarded as shadow banking. More on this in the next section.
Bank-funded P2P lending resembles that of traditional P2P lending in that the platform matches borrowers and lenders, but instead of transferring money from lenders to the borrower after loan origination, the loan is originated by a bank. This also means that the borrower will sign a promissory note with the loan terms to the bank. Immediately after the bank has originated the loan, it will sell it to the P2P platform that buys it with money raised from the lenders. Since the platform now owns the loan, the borrower will make repayments to the platform, which will transfer these on to the lenders. In this situation, both the platform and the bank become intermediaries without credit risk, meaning that the platform has no obligation to compensate investors in the case of losses.
P2P Lending Business Model 4: Balance Sheet Lending
Balance sheet lending is the business model in the peer-to-peer lending sphere that bear the closest resemblance to traditional bank lending. In traditional bank lending, funds are listed as liabilities and loans are listed as assets on the balance sheet of the bank. This means that banks take on credit risk, while customers’ deposits are usually insured up to a certain amount. In the same way, P2P platforms involved with balance sheet lending will both originate the loan and keep it on the balance sheet. By doing this, the platform assumes credit risk, but it will also profit from both fees and interest payments accruing on the loan. Just like other types of peer-to-peer lending, balance sheet lending can be both consumer and business lending.
Is P2P Lending Shadow Banking?
A shadow bank is a financial intermediary that provide credit services comparable to that of traditional banks but without being subject to the same banking regulations or only loosely linked to these.
Both banks and P2P lending platforms are connecting people with excessive capital and borrowers. However, there are two great differences between traditional bank lending and P2P lending. These differences also reveal that some types of P2P lending are very close to shadow banking, while others belong to a category that could be coined as pure peer-to-peer lending.
First, when you deposit money in a traditional bank, you hardly have any visibility regarding how the money is used, whereas lenders on pure peer-to-peer lending platforms are free to choose the projects, businesses or consumers they want to lend money. Second, pure P2P lending platforms remove the need for balance sheet intermediation, which means that the lenders – and not the platform – are exposed to credit and liquidity risk.
According to the OECD, this means that P2P lending platforms where funding does not have deposit-like characteristics, lenders bear all risks and platforms do not perform risk transformation cannot be considered shadow banks. Also, pure P2P lending platforms do not use direct or indirect leverage, nor will they be prone to self-fulfilling bank runs by guaranteeing maturity transformation and/or liquidity transformation.
Given the description of the different business models within the P2P lending universe, it is, therefore, important to keep an eye on hybrid business models that might express some of these characteristics. This could be both peer-to-peer lending with loan originators (business model 2), bank-funded P2P lending (business model 3) and balance sheet lending (business model 4). However, especially platforms using balance sheet lending have a business model similar to banks as they rely on leverage and retain credit risk by keeping the loans on their balance sheet
The Market of P2P Lending: Statistics and Developments
The global P2P lending market has shown extraordinary growth rates since 2013, where systematic data collection in all regions of the world began. Below we will present data collected by the Cambridge Center for Alternative Financing that we have processed to highlight the development of P2P lending worldwide and regionally. Because the data is collected using surveys there is a time lack, which means that the latest data available is from 2017. If you are looking for updated data on both P2P lending and equity crowdfunding, you can find this by visiting our data-section or our collection of the top P2P platforms by funding amount.
In 2017, the global P2P lending market funded loans for than $400 billion, but an important observation is that this loan volume is very much concentrated on a few large countries/regions. According to the data from the Cambridge Center for Alternative Financing, P2P lending is absolutely dominated by China and the Americas region (mainly the United States). Below is a depiction of each region’s market share of the global P2P lending volume in 2017, which shows that China accounted for 87.0% of the overall market followed by the Americas region with 10.2%.
However, the Chinese P2P lending industry has experienced massive turmoil in recent years with even more frauds and scandals surfacing since the 2017-data was collected. Lately, regulators have intensified their crackdown on Chinese P2P platforms making the future of P2P lending in China even more uncertain. It is therefore important to keep in mind that the numbers from China are especially prone to misrepresentations. To provide you with an idea of how the regional distribution of the market share would look like without China, a similar pie chart but excluding China can be found below:
Looking at the global P2P lending market volume we find a market that has developed rapidly in recent years. It is again important to keep in mind that insecurities in the numbers used can have a great impact on the actual market size. However, the numbers presented here are the best estimate we have. Data collection started in 2011 in the UK and in 2012 the European market was included as well. In 2013, all regions of the world were covered for the first time. To have the best possible basis for making a prediction for the global P2P lending market and for making a comparison between regions, we will, therefore, focus on the numbers from 2013.
Below, you will find the figure “Global P2P Lending Market Volume 2013-2017 in billion USD” that will give you an overview of both the regional development and the overall market size. The numbers show impressive yearly growth rates that nevertheless follow a pattern similar to many young markets, where we often see drops in growth rate as the volume goes up:
- 2013: Loan volume: $10.33bn
- 2014: Loan volume: $37.65bn – Growth rate: 264%
- 2015: Loan volume: $130,51bn – Growth rate: 247%
- 2016: Loan volume: $279.05bn – Growth rate: 114%
- 2017: Loan volume: $402.62bn – Growth rate: 44%
A growth rate of 44% is still very impressive, but as the numbers above show, it will be interesting to see whether the market can keep up the same level of growth going forward – especially as significantly lower numbers from China must be expected in the coming years. However, even if we might see a significant drop in the growth rate of the global market as a consequence of stricter regulation on Chinese P2P lending platforms, it is expected that all other regions will continue their growth.
To demonstrate the large impact a complete shut down on P2P lending in China would have on the overall market, below you can again find a similar figure to the one showed above, but now just without the Chinese loan volume:
The data presented on P2P lending in this section has been found by compiling regional funding volumes from P2P consumer lending, balance sheet consumer lending, P2P business lending, balance sheet business lending, P2P property lending and balance sheet property lending.
Explanations and Potentials for Growth in P2P Lending
In 2015, the first peer-to-peer lending platform, Zopa, was launched in the UK. As can be seen from the section above, the P2P lending market has grown substantially since then. From a theoretical perspective, this growth has, according to Serrano-Cinca, Gutierrez-Nieto & López-Palacios (2015), been explained through the market equilibrium theory and the financial intermediation hypothesis.
The market equilibrium theory states that efficient markets are characterized by a state of equilibrium between supply and demand. Thus, advocates of the market equilibrium theory claim that peer-to-peer lending platforms bring the credit market towards equilibrium by solving a credit rationing problem that exists because there are borrowers, especially in economic downturns, who do not receive loans even if they are willing to pay higher interest rates. On the other hand, the financial intermediation hypothesis focuses on the fact that peer-to-peer lending platforms are more cost-efficient and have lower intermediation cost than banks, which makes them more attractive to both borrowers and lenders as competition forces platforms to share these lower cost with both sides.
From a more practical perspective, a research report on financial technologies from the International Organizations of Securities Commissions (IOSCO) pinpoints four supply and demand factors that have supported the growth of P2P lending: 1) Reduced technology costs; 2) Underserved market segments; 3) Low interest rates; 4) Risk diversification.
1 Reduced Technology Costs
The operating costs of P2P platforms are minimised because of the online nature of the business models, which reduces the cost of attracting both borrowers and lenders. At the same time, algorithms can be utilised to automate processes like credit scoring and diversification of investments by lenders. Also, because P2P platforms normally do not participate in lending decisions or collect deposits as in traditional bank lending, their intermediation and transaction costs are kept low.
2 Underserved Market Segments
In many countries, the demand for capital is lower than the available supply of capital because startups and SMEs (small and medium-sized enterprises) are underserved by traditional banks. This is especially true in China where the large public banks have mostly played the role of serving large corporations. At the same time, P2P lending has been a place for small scale investors to invest even small sums.
3 Low Interest Rates
Low interest rates (in periods even negative) have been the norm since the global financial crisis of 2007-2008. The same is true for yields on sovereign bonds, which has forced investors to look elsewhere in the search for higher yields. Here, P2P lending represents an alternative investment that offers potentially higher returns. However, as is always true with investments offering high returns, investors must also be willing to accept a higher risk.
4 Risk Diversification
Following the above, P2P lending offers individual investors the possibility to invest in loans, something that was previously only possible for mainly institutional investors.
How to Make Money with Peer-to-Peer Lending – a Step-by-Step Guide to How P2P Lending Works
In this section, you will find a thorough step-by-step guide to the P2P lending process. The figure below illustrates every step – from picking out a loan if you are an investor or making a loan application if you are a borrower to the final payment.
Please note that these are general guidelines and that there might be slight differences in the exact process you will encounter with some steps being more or less straightforward depending on the project and the platform.
Step 1: Loan Application and Loan Picking
Before the actual P2P lending process begins, potential borrowers make an application for the desired loan on the peer-to-peer platform. Depending on the platform, this application must contain certain information and data enabling the platform to assess the borrowing capacity and creditworthiness of the borrower. In some cases, the platform can choose to outsource this process to a rating agency or loan originator that reviews and denies/accepts the loan takers. If the borrower is a private individual this is commonly referred to as consumer or personal P2P lending, while a company borrowing from the crowd will fall into the category of business P2P lending.
Now, if you find yourself in the blue circle and have money you want to invest in P2P lending, you start by picking out loans that you find attractive based on your risk profile. Besides picking a stable P2P lending platform for your investments this is, of course, the most important part on your way to success in the world of peer-to-peer investing.
Step 2: Loan Agreement
In the processes of due diligence and reviewing the loan applicant, the platform will estimate whether the specific loan is appropriate for them to place on their marketplace for the investors that trust their company to do a proper job of finding borrowers able to pay back the loan.
No matter if the risk is categorized as C- or A+, the essential part is that the borrower has a high probability of paying back the loan. When the platform has accepted an applicant and placed it on the platform for potential funding, it is up to the investors to decide whether the risk commensurate the potential reward. If enough investors validate and offer to finance a specific loan, the process is yet again validated by the platform and the loan agreement will be completed to validate the legality of assuring the money gets to the right person and the repayments are structured.
In the end, it is the goal of the investor/lender as well as the platform to facilitate loan agreements that returns both principal and interest to the lender.
Step 3: Loan Amount Transferred
Once the platform has done their due diligence and accepted the borrower to their platform, the loan terms are structured and agreed upon between the borrower and the platform. When and if the terms of the loan are acceptable to the platform, the platform will determine a time frame for funding the amount. They will then release the project and it becomes available for lenders to invest a minimum amount that varies from platform to platform.
The P2P lending campaign is now available for the public. Whenever a lender invests an amount the money is locked and in escrow with at the platform. If a company wants to borrow e.g. $1,000,000 from the crowd, it will typically only be completed if the total amount of $1,000,000 is met by the lenders on the platform within the time frame specified to fund the money. When this happens, the crowdfunding campaign has then been a success regarding the borrower, and the investors will not be able to cancel the commitment of lending the money. The platform will then collect the promised amount from the different investors and get the borrower to sign the agreement. The process is then ready to be finally settled and the amount to can be transferred to the borrower.
Step 4: Loan Amount Received (minus any platform fees)
When the loan amount has been transferred from the lenders to the platform, the platform will transfer it to the borrower. This transaction settles the loan agreement and the amount transferred is now owed to the lenders and is to be paid back according to the terms agreed upon in the loan contract – e.g. time frame (duration), interest rate, type of loan, securities, and rules on how to act if the borrower misses payments or do not pay back the loan on the terms agreed in the contract.
Step 5: Principal and Interest Payments (including any platform fees)
When the loan amount has been received and the agreement is settled, this becomes the principal, which is the total amount owed to the investors. The repayment amount to the investors is composed of two components: The interest and the instalment/principal payments.
The instalments reduce the amount due according to the loan contract and are usually paid evenly in instalments monthly (amortizing loan), quarterly (serial loan) or the total amount at the end of the loan (interest-only loan). This is specified by the type and duration of the loan.
The interest is usually paid at the same time as the principal payments and consists of the costs for borrowing the money. The P2P lending platform is keeping track of the payments specified in the loan agreement between the borrower and lender. The platform’s earnings/fees for facilitating the payments are usually tied to the interest. This creates a healthy incentive for the platform to secure the payment of interest to the lenders and makes sure that the platform does not only focus on facilitating as many loans as possible but also on fulfilling the loan to the last payment.
An example of this could be a platform fee of 1% on the remaining amount owed to the lender. This means that when the interest rate is 8.95% you as a lender will receive 7.95% upon each received payment along with the instalment that pays down the loan. For the investors/lenders this means that when the principal is transferred to their bank account at the platform, the amount received is minus any platform fees.
Below you will see an example of interest payments and instalments on a small loan of a million dollars, with interests of 6.95% and a duration of 24 months paid back in annuities:
Step 6 – Transaction Fulfilled and Payments Received
The last step in the process of P2P lending is the fulfilment of the transaction to investors who will receive the final instalments/payments. This means the transaction between lender and borrower has been successfully fulfilled with the lender receiving his or her payments according to the terms and everybody is satisfied.
This is the ideal scenario in peer-to-peer lending, but during the six steps is also the possibility of bankruptcy. This is the risk the investor must be willing to take to earn interest. If there were no risk, the investor would not be paid, and the interest hopefully reflects the risk associated with the loan invested subject for investing. In the traditional bond and stock markets, there is “no free lunch” – and the same should apply to P2P lending. High-risk loans with low or no security behind carry high interest (e.g. unsecured consumer loans with 12-18% interest and security of the single person), while low-risk loans with good security behind, carry low interest (e.g. a local authority such as Vags Kommuna, a local municipality in the Faroe Islands, with 0.45% interest and security of the 1350 taxpayers and in the end the government of Denmark).