Social Lending
Social Lending is another name for the trend of people lending/borrowing money to each other without the intermediary of a bank.
It is also covered under our entries of P2P Finance and P2P Lending
Definition
"The basic idea with social lending is that when you need money, others will pool their funds together and lend them to you at x% interest rate. Prosper uses your credit score to determine your risk rate and then based on that risk rate you bid for the loan with your terms. What makes Zopa & Prosper popular is the "social" aspect; that is you can post your story about why you need the money." (http://www.centernetworks.com/social-lending-web-2-0)
Description
Sander Van Damme:
"Very basically we can say that social lending (or peer to peer lending, both are actually synonyms) is the grouping of small amounts of money from many lenders to fund a project without (traditional) intermediaries. When trying to define peer to peer lending one cannot omit to talk about the recent impact of the internet and how this profoundly changed the way we handle borrowing and lending today. Peer to peer lending has actually always existed; it is the practice of people lending to each other without the intermediary of a bank. As such it is actually older than banks themselves. Rather than being a one-to-one service such as banks and other traditional forms of credit, it is a many-to-one service where many people fund a small piece of the eventual loan to the one borrower. Therefore it is inscribed in the crowdsourcing movement where individuals turn to the general public for ideas, work, feedback, etc. (Garcia, 2010). In the case of social lending this means using the 'crowd' to obtain financing for any project you have in mind. Although close to crowdfunding and microfinance, it needs to be differentiated from both. First, rather than trying to get funded through credit, crowdfunding tries to have many people buy some form of equity and thus make an investment in a yet-to-be-proven idea (Lambert & Schwienbacher, 2010). Second, it is also related to microfinance in the sense that it funds small entrepreneurial projects for people who lack access to formal finance. Nevertheless, unlike social lending's peers supporting each other, the funds for these microfinance loans usually come from institutions rather than the 'crowd'.
Klafft (2008) defines peer to peer lending as “online platforms where borrowers place requests for loans online and private lenders bid to fund these in an auction-like process.” Clearly in this definition we can see how 'online' and 'internet' are key terms in explaining the way it works. Many different websites exist and each of them has its own variation and therefore constitutes a different system. We will come back to this later on in this chapter when we evaluate some examples (see section 2.3) Nevertheless, the basics of it are as follows: a borrower needs to get funded for some reason and either does not want to go to the bank, or cannot receive a loan from it. He then has a few options left: he can try to borrow it from his friends or family (the well-known 3F: Friends-Family-Fools); he can go to a so.
called moneylender which offers him money 'without questions asked' at a very high interest rate; or he can go to one of the online lending platforms and apply for a loan. If he does the latter and fills out an application form on one of the social lending websites, it will subsequently be evaluated in some way; either by a local institution (e.g. a microfinance institution), the organization behind website itself, or fellow members on the platform. Once the request is accepted and published online, members prepared to lend to him express their willingness to do so. When at the expiration date of the loan request enough financiers are found, the amount requested is wired to the applicant. In order to minimize their risk, lenders normally only lend small portions of the requested loan and usually interact with many different borrowers as a means of diversification. After being funded, the borrower gradually repays the loan plus interest over time. At the end of the loan, lenders usually have some system to evaluate the borrower and give feedback on his repayment performance. This way, borrowers build up credibility and credit history on the online platform and future lenders base their funding decisions on this feedback (much like feedback mechanisms on eBay or Amazon.com). This system exists both in developed and developing countries, in the case of peer to peer microfinance we are talking about peer to peer lending on a microfinance scale. It means lending to disadvantaged borrowers from developing countries who ask for the loans to start a business in order to supplement their small income with its proceeds.
Most of these platforms however, although they call themselves social lending platforms are not actually the pure form of social lending where peers lend money amongst each other and the power to do so is with them. Usually the platforms act as intermediaries who screen the applicants and collect the funds in order to then channel them through to the borrower. As such they replace the banking institution which collects the public's funds in savings accounts and then lends them to loan applicants. Only very few sites exist where money travels directly from the lender to the borrower and the website is only the portal through which contacts are made." (https://www.zidisha.org/editables/news_docs/Louvain.pdf)
Typology
By Sander Van Damme in his Master's Thesis on Peer to Peer Microfinance:
National, For-Profit Platforms
First, we have the national, for-profit platforms as they have appeared in developed countries.
One of the oldest is Prosper, a US based firm which does basic peer to peer or social lending: it connects lenders and borrowers. It lets the latter apply for loans online which will or will not be funded by the investors. As is implied in the title, this is true for the national market, meaning that if a German lender would want to invest his money in an American loan, for legal reasons this would not be possible. To find out which interest rate the borrower will have to pay, this website uses a 'Dutch Auction'. It means that everyone can bid on an individual loan request and set the interest rate they want to achieve. At the end of the bidding period, the lowest rates bid win the right to fund the loan at their proposed rate. After funding the loan, monthly installments are automatically deducted from the borrower's account and sent back to the lender. People can hold their loans either until they are paid back in full, or trade them on the websites' Folio Investing Notes Trader.
A very similar approach is seen in UK based Zopa. But whereas Prosper uses an auctioning
system to set the loan's interest rate for pre-specified loans, Zopa preferred a different
approach: a lender first sets some desired parameters (rate, level of risk and time period in
which he/she wants to be repaid), after which the platform itself tries to link these to existing
borrower demands. Once this is done, the money is dispersed to the borrowers. After lending
out the full amount, monthly repayments are made and after 36 to 50 months the lender is
repaid in full including interest. Recently Zopa also moved more in the Propser direction by
allowing people to also bid on what they call 'listings'.
A similar interesting player is RateSetter, a UK platform launched in October 2010. This
platform differentiates itself in two ways: there is no auctioning of funds through lowering
interest rates but rather queuing of borrowers and lenders at rates they set themselves.
Secondly, given that an investor cannot choose himself the actual person he is lending to, the
website also has some form of insurance by ways of a 'Provision Fund'. This covers borrower
default and late payments, thereby sharing this risk amongst all lenders.
A final example is
Lending Club, an American platform offering fixed rates to borrowers and lenders which are
calculated based on credit score, debt-to-income ratio and other measures of credibility.
We could continue for quite a while mentioning all platforms that exist today (adding Smava,
Communitae, Fairplace, etc.), but we would be sure to miss quite a few of them, and the list
would quickly become outdated in this emerging market. We therefore prefer to limit us to
these proven recipes and draw some conclusions on these kinds of platforms, after which we
can move on to peer to peer microfinance platforms.
Generally speaking, what we see in all of the above platforms is that they offer loans to individuals at what they claim to be 'better rates than the market' and do so anonymously, meaning that you as a lender have no idea about the identity of the person who's borrowing from you, let alone have any feedback from them on the way the loan has impacted their lives. In order to offer their lenders additional certainty that they will get paid back, all these platforms do a screening of the potential clients and demand some minimum standards of credit rating and history. These ratings are of such a kind that only people with fairly good credit are able to get such 'cheaper loans' and so they clearly do not target the very poor. However, this is also not the way these websites try to market themselves; rather, they speak of themselves as 'diversification tools for investors' portfolios' and as a way of 'cutting out the middle man', thereby offering better rates to everyone. Finally, the business model behind these platforms is to charge small fees on money transactions, as well as some kind of borrower registration fee; their financial sustainability comes from their large turnover and networking effects which help them to grow continuously." (https://www.zidisha.org/editables/news_docs/Louvain.pdf)
Peer to Peer Microfinance Platforms
(see P2P Microfinance)
Sander Van Damme:
"In today's world a peer does not necessarily have to be your neighbor or someone living close by anymore; he does not even have to speak your language, have the same skin color or live in the same country, the internet has allowed us to explore a much bigger world than our grandparents could. This has also impacted our involvement with people from far away, and our willingness to support them where we can. This rationale has now been taken one step further by what we have chosen to call 'peer to peer microfinance platforms'. Instead of allowing you to lend money to John or Elisabeth to consolidate their credit or do some house improvements, these platforms let you lend money to Nkuyata and Sanou to buy cattle or car accessories. These websites try to empower entrepreneurs in developing countries by offering Western lenders the opportunity to supply them with the credit to invest in their businesses." (https://www.zidisha.org/editables/news_docs/Louvain.pdf)
P2P Lending to firms
"The same peer-to-peer model lies behind Funding Circle, another British start-up which launched in 2010 to facilitate lending to small businesses for periods of one to three years. Businesses go through an underwriting process before they get on to the company’s website, where lenders, predominantly individuals, can bid on the rate at which they are prepared to lend. The average loan is £40,000 ($63,000), the rates are competitive and firms get hold of the money within about two weeks. Samir Desai, a co-founder, dismisses the argument that lending to small firms requires bankers to make personal credit assessments: “SMEs want low costs, a quick process and a transparent fee structure, not a relationship.” Lenders are encouraged to spread their risk among at least 20 borrowers." (http://www.economist.com/node/21547994?fsrc=scn/tw/te/ar/onthesideoftheangels)
Examples
For example:
- Prosper (US)
- Wiseclerk (Prosper feeder) (US)
- Zopa (GB)
- Boober (Netherlands)
- Frooble (Netherlands - will re-open September 2007)
- CircleLending (US)
- Fygo (US)
- Duck9 (US)
- Paltrust (US)
- LoanBack (US)
- Community Lend (CAN)
- Ireloans (IE)
- La Tontine des Blogueurs (FR)
- Smava (DE)
- One2Money (DE)
- FairRates (DK)
- eLolly (DE)
- LendingClub (social lending service for facebook users)
Also:
- An updated directory is maintained here at
http://www.wikiservice.at/fractal/wikidev.cgi?EN/BarCampBank/BankAndFinanceWatch
The descriptions below are from http://www.money-rates.com/sociallending.htm
Prosper: Personal loans and online investing
"Prosper launched in 2006 out of downtown San Francisco. By 2011, the site had grown to more than one million members and funded more than $234 million in personal loans. On the site, borrowers start by setting the maximum rate of interest they are willing to pay, which then starts an open bidding process that can push down the rate of the loan. All loans are unsecured, three-year, fully amortized personal loans with no hidden fees. Loans can be paid off early with no penalty.
Lenders on Prosper can choose the individual loans that they will fund with a minimum investment of $25 for each loan. Because only a portion of each loan is funded, lenders have the ability to lower their default risk across a portfolio of loans. Prosper publishes the expected annual returns for loans based on historic loan and default rates. Prosper also publishes estimated annual loss rates for each loan grade, a powerful tool to help lenders assess risk and make informed investing decisions. Using the one-year time period from June 2010 to March 2011 as a data set, the expected annual returns for Prosper lenders was 5.7 percent for AA-rated loans, 6.3 percent for A-rated loans and 7.8 percent for B-rated loans. Actual returns can vary widely based on the performance of individual loans." (http://www.money-rates.com/sociallending.htm)
RateSetter: Social lending British-style
RateSetter is a new site from the United Kingdom on which you pick your borrowing or lending rate and then just sit back and wait for an approved match. Sounds easier than a bank loan, right? Another useful feature of RateSetter is that borrowers are screened for creditworthiness. Loans completed on RateSetter are paid in 36 equal monthly installments. Lending rates currently range from 4.0 percent to 7.8 percent, while borrowing rates vary from 7 percent to 13.1 percent.
SmartyPig: Reaching a savings goal with social networking
SmartyPig combines a high-yield online savings account with a social networking platform that can be used to raise funds for a financial goal. Social networking tools on SmartyPig can be used to encourage friends and family to contribute to a financial goal like a vacation, a wedding or college tuition. When a financial goal is achieved, cash rewards are available from participating retailers and travel companies.
Deposits in SmartyPig accounts are held at BBVA Compass Bank, a FDIC-insured institution. So is SmartyPig truly a social lending site? That depends on whether you consider the contributions made on SmartyPig as loans or donations. But either way, it is a very effective social networking tool that can help savers reach a financial goal. Lending Club: Removing the middle man
The Lending Club launched in 2007 to help borrowers find an alternative to traditional bank loans. Investors can also shop for a Lending Club Note with fixed monthly payments on terms of either three years or five years. The theory behind Lending Club is that both borrowers and investors can win by finding better rates without paying a bank their normal loan processing fees. As of 2011, Lending Club has funded more than $212 million in personal loans and has made more than $16 million in interest payments to investors. Lending Club also reported an average net annualized return of 9.65 percent for investors for the period from June 1, 2007 to April 5, 2011 -- a figure that easily beat the major stock-market indexes.
LendingKarma: Formalizing personal loans
"Lending money to a family member or friend can be tricky. On the one hand, you can eliminate a lot of service fees and secure a better rate when you borrow money from someone you know. Unfortunately, bad feelings can arise if there are late payments or misunderstanding about the terms of the loan. LendingKarma is a site dedicated to formalizing and tracking personal loans to prevent these types of problems. There you can purchase loan packages that track all loan payments, create legally binding documents and provide online payment tracking. A professional loan arrangement, such as those provided by LendingKarma, can help take some of the headaches and heartaches associated with personal loans out of the picture." (http://www.money-rates.com/sociallending.htm)
Discussion
Research findings:
"Abstracts from the paper “Open Business featuring the Finance and Insurance field” conducted by E. Ezeani, S. Kizil, V. Kostakis, H. Kroezen and T. van der Schoot for the Msc course: ICT and Organisation, instructor: Anna Snel, University of Amsterdam, 2007.
(…)In the traditional model for lending there are used the 6 Cs as a metaphor to develop a framework for analyzing lending to individuals or organizations. These are capacity, character, credit, collateral cash flow and community. Apart from these, the decision-making process is hierarchical, with intermediaries also playing important roles. There is also the idea of credit evaluation. In the traditional lending system that is now being challenged by P2P financial model, before a credit is approved, it must fulfill the fore mentioned criteria known as the 6 Cs. Furthermore, because of this evaluation process and the often-difficult additional processes one has to go through, it has been uneconomical as well as time and energy consuming to borrow money through the traditional lending model. P2P finance model aims to overcome these difficulties and bureaucracy, thereby making lending more open and transparent, through disintermediation through the Internet and flattened intermediaries of decision making, financial democracy, and provision of technologies whereby people in a community of like minds can lend money direct to each other. (…)
(…)Moreover, Michael Hulme did an empirical research (2006, Internet Based Social Lending: Past, Present and Future, Collette Wright B.A. M.A.) based on 20 qualitative interviews and 1000 quantitative responses and divided into 2 questionnaires. Strangely enough, whilst 61% of respondents in his survey of general bankers felt that the main aim of their principle bank was to make money for themselves, 63% said they were very satisfied with the overall service they received from their bank. Similarly, whilst 44% felt that banks were very trustworthy, 49% felt that banks did not have their best interests at heart. (…) people have a diversity of positive and negative feelings towards banks. (…)
Prominently, P2P lending is encouraging a coalition among values and finance, in which finance moves beyond the transactional towards relationship and authentic emotional value, based on transparency and authenticity. “Modern day Social Lending has various ideological antecedents in friendly societies by focusing on a study of aspects of community and individualism” (Hulme, 2006).
In addition, Hulme (2006) has argued in his paper that the concepts of the individual within community, transparency and ethicality are fundamental to social lending schemes, providing the ideological foundations of the financial exchange. More concretely he asserts that “our research has suggested that Social Lending attracts a particular type of person who demonstrates a need for financial services founded on ‘good faith’, ethicality and a varying desire to participate in communities or networks of individuals where financial exchanges are based on principles of personal social responsibility, philanthropy, altruism and transparency”.
While P2P lending is unlikely to substitute mainstream banking, not least because it does not compete with the range of services they offer, according to Hulme (2006), we would expect that it will significantly increase its appeal to a mass but niche market.(…)"
Why Social Lending Drives Down Interest Rates
Sander Van Damme:
"We notice how in social lending, relationships actually drive down interest rates, rather than resulting in a higher rate than transactional banking. This stems from the fact that even when lending is based on relationships and inside information, insider bidding itself is valuable information which is quickly disseminated to a highly competitive environment of lenders. Therefore everyone who wishes to fund a small part of the loan knows whether insiders are or are not bidding on the loan. In case a bank would possess inside information, it could try to extract a higher interest rate while lending the loan. In the case of social lending, an individual that has inside information will be willing to fund part of the loan but by not funding it all there can be no rent extraction. The act of funding a fellow member's loan leads to a clear signal for other lenders that this inside – and therefore better informed - party trusts this borrower and causes a bidding spree on the loan, eventually driving down the interest rate. This effect is even more important in the case of group leaders' inside bidding (Berger & Gleisner, 2009). By doing so, peer to peer systems actually put the cost of investigation on debtors, rather than creditors, allowing them to cut out the cost of the banking intermediary." (https://www.zidisha.org/editables/news_docs/Louvain.pdf)
The Big Players (banks) are taking over
By AMY CORTESE:
"as the industry matures, a new class of investors is storming the P2P gates, and they include the very institutions that P2P had set out to bypass. Today, big financial firms, not small investors, dominate lending on the two platforms. At Prosper, which has been courting institutional lenders over the past year, more than 80 percent of the loans issued in March went to those firms. More than a dozen investment funds have been formed with the sole purpose of investing in peer-to-peer loans. P2P sites are also attracting some of Wall Street’s biggest names as board members and investors, and investment banks are vying to manage Lending Club’s hotly anticipated initial public offering.
The influx of institutional money has supercharged the sector, allowing Prosper and Lending Club and a host of newcomers to extend more loans to more borrowers. Lending Club figures that it has saved borrowers $250 million in interest charges. The two platforms say they have made more than $5 billion in loans to date and have been doubling in growth every year.
But investor demand is now outstripping the loan supply, spurring fierce competition among investors to snatch the best loans first. And the original P2P investors — the dentists, dabblers and stay-at-home moms who helped establish the market — are finding themselves outgunned by the cash-rich, algorithm-wielding arrivistes.
P2P insiders say the new institutional investors benefit the industry. “It will drive competition, drive down rates and allow us to serve customers better,” says Alex Tonelli, a founder and managing director at Funding Circle, a San Francisco-based P2P market for small-business loans.
Still, the Wall Street makeover — some would say takeover — of P2P lending is raising concerns as the new players begin securitizing loans and clamoring for more. Insiders predict a day when the loans are regularly sliced, diced and securitized, hedged, traded on secondary markets and tracked by exchange-traded funds.
At the very least, the big players’ entry runs counter to the original notion of P2P lending as a populist alternative to the high stakes world of Wall Street. The term “peer to peer” has become something of a misnomer. Some of the latest lending platforms are ditching individual investors altogether to focus on big lenders.
Acknowledging the growing role of institutions, Ron Suber, the president of Prosper, says the industry as a whole is better described as “Online Consumer Finance.”
Jeremiah Owyang, the founder of Crowd Companies, an organization that helps corporations navigate the so-called sharing economy to which P2P belongs, was more blunt. “It won’t be P2P for long,” he said." (http://www.nytimes.com/2014/05/04/business/loans-that-avoid-banks-maybe-not.html)
The Algorithmit Protocol Wars in the Social Lending space
Amy Cortese:
"Lending Club and Prosper focus on prime and near-prime borrowers, that is, consumers with FICO scores higher than 640. The platforms apply their own credit models and assign borrowers to categories reflecting their level of risk. In the case of traditional loans, banks pocket the profit. On P2P sites, the individual lenders do. “The difference is who’s benefiting from it,” says Renaud Laplanche, the founder and chief executive of Lending Club. Prosper and Lending Club take a small origination fee from the borrower and 1 percent of interest payments to the lenders.
The sites’ business model relies on scale: Lending Club, the market leader, earned $7 million on revenue of $98 million in 2013, its first full year of profitability after seven years. That was on loan volume of $2 billion.
The fastest, and some say only, way to reach the kind of scale needed is to turn to institutions with boatloads of money to lend. Attracted by peer-to-peer’s relatively high and predictable yields in a low-interest environment, big investors have jumped at the opportunity.
The first in were hedge funds, like Eaglewood Capital Management and Arcadia Funds, which borrow money to amplify their returns and use their own algorithms to increase yields into the midteens or more. Soon, pension funds, asset managers, community banks and even sovereign wealth funds joined in. Santander Consumer USA, the United States arm of the Spanish bank, has an agreement to buy up to 25 percent of Lending Club’s loans.
Today, P2P loans that once took days or weeks to finance are snapped up in minutes, particularly those with higher yields. “There is at least twice as much demand as there is supply today,” says Matt Burton, the C.E.O. of Orchard, a firm that helps institutions invest in peer-to-peer loans. Lending Club and Prosper now set aside a randomly selected pool of loans for institutions, which prefer to swallow up whole loans rather than finance a piece of them. To eke out better returns, many fund managers then use their own credit algorithms to identify loans that may be underpriced or overpriced, and cherry-pick the ones they want.
Continue reading the main story For example, the Ranger Capital Group, a Dallas-based investment group that raised a $15 million P2P fund last fall, deploys a proprietary algorithm it calls TruSight to exploit variances in credit models. “Everyone’s got their own secret sauce on how they evaluate loans,” says Bill Kassul, a partner in the Ranger Specialty Income fund.
The loans not taken by these sophisticated investors go back to a fractional lending pool that is open to both individual investors and institutions. That doesn’t sit well with some. “The institutional investors are snapping up all the worthwhile loans,” one investor wrote on Prosper’s blog, echoing many comments.
“By cherry-picking, almost by definition what they leave behind is not as good,” says Giles Andrews, founder and chief executive of Zopa, a British peer-to-peer lender that so far has dealt only with individual lenders.
Like high-frequency trading, P2P lending has become a game of speed. Much of the investing done by institutions these days is automated, and some hedge funds have installed computer servers close to Lending Club and Prosper to gain an edge. “The fastest computer right now is getting the most loans,” says Peter Renton, the founder of Lend Academy, a site that follows the P2P market and co-hosts the annual LendIt conference, which runs through Tuesday in San Francisco.
Prosper and Lending Club have created speed limits, known as governors, to counter these moves, and they have instituted purchase limits to ensure that big buyers don’t hog all the loans. “It’s kind of an arms race,” Mr. Kassul says. “They put a governor on, but then everyone tries to trick the governor.”
Lending Club and Prosper say they are trying to balance their lender mix among individuals, institutions and active fund managers. “We want to be extremely careful and not let a handful of investors drive our expansion,” Mr. Laplanche of Lending Club says.
And Mr. Suber of Prosper says, “We’re making sure we stay true to our original business of P2P finance.”
Still, to meet demand, P2P executives are pushing into new, higher-yield markets." (http://www.nytimes.com/2014/05/04/business/loans-that-avoid-banks-maybe-not.html)
More Information
- 3-part article on social lending starts here at http://www.centernetworks.com/social-lending-web-2-0
- 115 page report on the history of social lending, with case study of Zopa, at http://www.socialfuturesobservatory.co.uk/pdf_download/internetbasedsociallending.pdf
- Blog: http://www.p2p-banking.com/
- P2P XML, open standard for p2p lending data