I had a front row seat for the birth of peer-to-peer lending. In 2005 Omidyar Network invested in Prosper, arguably the first peer-to-peer lending platform. I didn’t work on the deal myself, so I don’t have any scuttlebutt on those early days, but I liked the founding team, I liked the concept and I’ve followed the field with interest ever since. In honor of the upcoming tenth anniversary of peer to peer lending companies (well, actually ninth, Prosper itself launched in early 2006, but that doesn't have the same ring to it.) I thought I would offer a few thoughts on what happened and why it might be time for those of us in impact investing to take another look at peer-to-peer lending.
I apologize ahead of time for the length of this ahead of time. It promises to be a rambler.
The pioneers of peer-to-peer lending were trying to completely disrupt the business of personal and small business credit. The (mostly correct) perception was that banks were incredibly conservative and rules-bound for whom they would extend credit to. Credit card companies and payday lenders would extend credit to almost anyone, but with high interest rates and confusing fee structures, it was rarely a good deal for borrowers. Finally, individual investors still smarting from the first dot com crash were looking for a reasonable, human-scale place to park their money. Enter peer to peer lending platforms like prosper. A borrower - a small business owner looking to expand, or a person with less than perfect credit starting to chip away at their credit card debt - would submit their request to the site. This would include not just standard financial information, but also their personal story. Why did they need the money? How would this change their current situation? They’d even upload a photo. This extra detail was important because on the other side of the platform would be an army of individual lenders, reading stories and contributing to loans a few hundred dollars at a time, not just because they were making a return on the investment but also because they felt a human connection to the people to whom they were lending.
This extra detail was important because the final piece of the model was a reverse dutch auction - lenders chose who they wanted to lend to and the rate at which they wanted to lend, so if a borrower had enough interested lenders (or a few who were happy to take a smaller return) there was a chance they would receive the loan at a very reasonable, if not surprisingly low, interest rate. In the same way, someone who couldn’t traditionally access credit might find that there were a group of people ready to lend to them because of some shared interest or piece of background. Prosper and platforms like it were trying to revolutionize finance. I know this because they would go on popular tech websites and say things like , “We’re going to revolutionize finance.” It’s been ten years. They have not yet revolutionized finance. They’re not even really peer to peer any more.
So What the Hell Happened?
Well, a few things happened:
Regulation - Much like companies in the new sharing economy, peer to peer lending platforms ran headlong into a thicket of regulation that had no interest in being disrupted. Lending, especially lending to individuals, is highly regulated, with federally and on a state by state basis. There’s good reason in theory for all this regulation - given the historic precedents of racial discrimination and good old fashioned fraud. Unfortunately, it means that a company trying to build a process that is genuinely unlike business as usual is going to face huge costs to negotiate state by state approvals. Additionally, they will have to abandon parts of their model to satisfy the sometimes valid concerns of regulator. Remember the photo of the borrower that helped you make a personal connection? What is that photo shows that she’s Latina? What if the borrower’s story includes that he is starting a business with his husband? Including this information in a lending process, even if the bulk of lenders would likely use it as an affirmative piece of information, is a pretty clear violation of fair lending practices. Even if in the long term everyone sees the value, a conscientious regulator’s first reaction is going to be “STOP!”
So that’s what happened. Peer to peer lending platforms spent years negotiating with regulators (and occasionally being shut down entirely) as they tried to negotiate this new paradigm. And when they came out the other side, the good news was they received the licenses they needed to stay in business making loans. In addition, they had built the infrastructure necessary to underwrite, process and service loans at scale. The bad news is, they unsurprisingly looked a lot more like standard lending practice. Gone were many of the personal details, replaced by credit scores and self reported income. Gone was the potentially revolutionary, potentially racist and definitely good for attractive people reverse auction, replaced by standardized rates based on credit quality. Not necessarily bad, but not revolutionary.
They dropped one of the two peers - It’s hard to overstate how difficult (and expensive) it is to attract and manage investors who are lending a few thousand dollars at a time. Once these platforms came back from their vision quest the regulatory wilderness and were ready to start scaling in earnest, the math was pretty simple. If you are ready to grow like crazy, it is a hell of a lot easier to raise $100 or $200 million in lending capital you’ll need from a single hedge fund than from a hundred thousand individuals. They kept calling themselves peer to peer lenders, but in actuality they became hedge fund to peer platforms. And hedge fund investors are, rationally, not interested in lowering your rate or taking a flier on you because you had some medical issues last year and are piecing your credit back together. Prosper still has a peer-to-peer lender window, but the vast majority of their loans are funded by hedge funds.
Lots and lots of venture capital and hedge fund investors got interested in these platforms - With the regulatory questions more or less solved, the business model and operational questions more or less answered by early companies, and a ready source of capital available, this has become a hot space for venture investors and hedge funds. There are now tens (probably soon to be hundreds) of online direct lending platforms (many of whom are incorrectly identified as peer to peer). Some are broad based, like Prosper or Lending Club, others are going after specific borrower niches
A lot of the impact investor interest moved away from peer to peer lending - Where’d they go? There’s a revolution happening in crowdfunded donations/patronage and another one brewing in equity crowdfunding. There’s a whole other blog post, but for now let’s say that most impact minded folks spend more time in the past couple years thinking about Kicstarter than Prosper.
So where does that leave us after eight years?
We have an established regulatory and operational model for how direct lending should happen online. We have more and more platforms coming online with real infrastructure for lending at scale. If you have good credit and are generally the sort of person who could get a loan in the past, you can now get that loan much more conveniently on line. Your interest rate looks generally the same, maybe a little lower. Hedge funds are making money hand over fist and have effectively “captured” individual lending platforms, making them inaccessible to individual lenders. And everything else is kind of same as it ever was.
So this was all for nothing?
Maybe not. I’m actually pretty hopeful. There are a bunch of people who now understand how to navigate the regulation, and there are regulators who have had almost ten years to wrap their head around the concept of peer to peer lending. The infrastructure now exists to do massive direct lending at scale and, at least for now, there is a ton of spare capacity in that system. Finally, there is tremendous innovation in adjacent fields, both in alternative financial services for unbanked and underbanked people and in crowdsourcing different types of funds. I think right now is a perfect time to think about ways we could recombine these more mature elements to build lending platforms that have all of the impact we wanted in the first place, only we can go to scale really, really fast.
And that will be the next post.
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.