Peer-to-peer exchanges are growing rapidly in terms of membership and loans funded, defaults are miniscule, and now there's talk of a secondary market for these loans. Of course, P2P is no threat to banks-yet-but the rise of these exchanges, which cut out banks and allow people to lend directly to each other is a phenomenon worth studying. Are P2P exchanges the credit unions of the Internet age? Will they ultimately rewrite the rules of lending and borrowing? Will they turn conventional marketing on its head by allowing customers to segment themselves? In every case the answer may well be 'Yes.'
To the financial services industry at large, peer-to-peer lending might still seem little more than a novelty act-a venue for a tiny fraction of lenders and borrowers to deal directly with each other. But for the people running these lending marketplaces, which include Lending Club, Prosper Marketplace, Virgin Money USA and Zopa, as well as analysts following the development of this market, P2P holds valuable clues to the nature of lending and borrowing and the future of marketing.
Make no mistake, for the immediate future P2P in no way jeopardizes the banks' lending model. But the growth of P2P is impressive and worth studying. Consider Lending Club, which launched on the Facebook platform in May. By early November loan volume was growing 25 to 30 percent per week and had reached $2 million. CEO Ranaud Laplanche predicted volume will hit $8 million by year end, $220 million by the end of 2008 and $1 billion by the end of 2009. Or consider Prosper, the largest P2P marketplace in the U.S., which launched in February 2006, has 440,000 members and has funded more than $100 million in loans. In the first nine months of 2007, the average number of borrower listings per day totaled 2,213 loans, and the average loan size funded was nearly $7,000.
The basic idea behind these P2P exchanges is simple: allow users to borrow and lend money directly among each other, bypass the banks, and get better rates. Lenders get higher returns than stashing their money in a savings account, and borrowers get a better rate than had they borrowed directly from a bank. "Consumer lending is one of the few areas not disintermediated by the Internet and we thought we could make it more efficient," Laplanche says. "There's a gigantic spread between savings-account rates and what the bank charges for unsecured personal loans, and when there's such a large spread, there's a large opportunity for disintermediation."
P2P often involves a connection or "affinity" between the borrower and lender. At Virgin Money the marketplace is for friends and family. For Lending Club the connection can be a hometown, college, or occupation, to name a few. Prosper describes its model as akin to the credit union of the Internet age, "a leap back to a time when people formed credit communities to help themselves live better lives and earn a fair return on their money. Prosper's founding principle is that people from close communities act more responsibly towards each other." Edward Woods, a senior analyst at Celent, describes P2P as "a new investment capability that ties into an emerging demographic around social networking and around aspects of community."
The knee-jerk reaction of some bankers is to dismiss P2P marketplaces as places people go who can't get a bank loan. Since it's not business worth having, they reason, it's not a business model worth studying. That's a self-serving, dangerously short-sighted view, say analysts. It fails to acknowledge the growing importance of social networking, a phenomenon only beginning to work its way through the fabric of society but sure to transform many aspects of it. Moreover, to dismiss P2P marketplaces as serving only those whose credit is poor and business not worth having ignores that many of these borrowers have high credit scores and overall defaults on P2P loans-including subprime loans-are miniscule. At Zopa, a U.K.-based marketplace launched in May 2005 that has attracted more than 170,000 members, bad debt is a mere 0.2 percent. Lending Club did not have a single default by November, and plays in a prime crowd: it requires a minimum 640 FICO credit score and only approves about 10 percent of prospective borrowers. Having an affinity, like a hometown or college, helps keep the default rate down, as does requiring an automated debit, says Laplanche, though he reckons that a zero default rate can't be sustained.
And it should not go unnoticed by banks that the growth of P2P volume and continued low defaults are occurring at the same time that more conventional lenders are tightening their underwriting standards and issuing fewer loans. Jim Eckenrode, banking research fellow and executive lead for financial services strategies and IT investments at TowerGroup, says there are three main P2P models. U.K.-based Zopa assigns its own ratings to borrowers; CircleLending, recently acquired by Virgin mogul Richard Branson and rebranded Virgin Money USA, is geared toward lending between friends and family (it has facilitated $200 million of loans and mortgages); finally, Lending Club and Prosper are similar in that they use standard credit scores and then attempt to match up borrowers and lenders. However, while Lending Club has preset interest rates based on a borrower's credit score, Prosper uses an online auction method of setting interest rates.
At Zopa, the company examines credit scores of people looking to borrow and then works out whether they're an A, B, or C-rated borrower. If they're none of these, Zopa doesn't accept them, which is about half of all applicants. Approved borrowers are allowed to peruse the loan offers. A lender might make an offer to lend X amount of money to, say, an A-rated borrower for X amount of time at X interest rate. Borrowers size up these rates, accept if they want, or come back the next day to see if rates have changed. When a loan offer is accepted, borrowers enter into a legally binding contract with lenders and agree to pay monthly by direct debit. To reduce risk to lenders, someone lending 500 pounds or more has their money spread across at least 50 borrowers. Zopa earns money by charging borrowers a 0.5 percent transaction fee and lenders a 0.5 percent annual servicing fee. (Zopa got its start with backing from Benchmark Capital and Bessemer Venture Partners.)
Virgin Money USA launched in October after acquiring a majority stake in CircleLending. It manages loans and mortgages between relatives and friends, with interest rates typically two to three percentage points lower than what a bank charges and with flexible repayment schedules. The company makes money by charging borrowers $9 per payment and upfront charges ranging from $99 to $2,000 for large mortgages.
In the lead up to the launch, Virgin Money noted that Branson, Virgin Group's flamboyant chairman, borrowed money from his own mother to launch his billion-dollar empire. In a statement he said, "We are literally changing the face of money by empowering people to realize their hopes and dreams, all the while keeping money within the family." Just to drive the point home about "changing the face of money," partygoers at the launch received red dollar bills with a picture of Branson and his mother.
Meanwhile, the Prosper marketplace is set up a bit differently. Prosper lenders bid for loans in an online auction environment akin to eBay. In addition to considering criteria commonly used by traditional lenders, such as credit scores and credit histories, lenders can also consider group affiliations. Here's how it works: People who want to borrow on Prosper create a loan listing for up to $25,000 and set the maximum rate they are willing to pay; then an auction begins in which Prosper lenders bid down the interest rates. Once the auction ends, Prosper takes the bids with the lowest rates and combines them into one simple loan and then handles all on-going loan administration tasks.
Interestingly, the lenders on Prosper are quickly showing their sophistication. In his October commentary, CEO Chris Larsen (who also founded E-Loan) studied the question of whether the Prosper marketplace anticipated or reacted to the Federal Reserve Board rate cut. "Many might assume that the Prosper marketplace would act less like the mortgage markets and more like the credit card and savings rate markets given that the latter compete with Prosper. Nevertheless, the month-over-month drop in average borrower rates indicates that the Prosper marketplace may have anticipated the Fed cut," dropping 0.37 percent and 0.28 percent, respectively, for prime and near prime loans funded from August to September. Average borrower rates in September ranged from 9.98 percent for prime select loans to 24.86 percent for sub prime select loans.
Of all the P2P platforms, Lending Club is the one that has tapped most directly into the social networking phenomenon. Its proprietary technology called LendingMatch helps lenders identify loans based on pre-set criteria such as being Facebook friends, or being in the same network, group (such as college or religion) or geography. LendingMatch then presents lenders with a diversified loan portfolio, composed of ten to thirty borrowers, reflecting their relationships as well as the lenders' individual risk preferences.
Borrowers on Lending Club can apply for loans of $1,000 to $25,000, and Lending Club handles user authentication, bank account verification, credit checking, credit reporting, funds transfer and collection. Like the other P2P platforms, Lending Club makes money from processing fees (from 0.75 percent to two percent for borrowers and one percent from lenders). In September Lending Club announced its Web availability outside FaceBook.
For mainstream lenders, what lessons does P2P lending offer? For starters, it shows there are clearly "holes in [bank] offerings," according to Woods of Celent, that banks either can't profitably plug or haven't realized need filling. Perhaps the loans are too small, or too short in duration to be worthwhile.
But more important than showing what niche products might be possible today, P2P exchanges "offer an opportunity to see how markets will change over the next 10 years, since the sites likely involve younger people who are the future target of banks," says TowerGroup's Eckenrode. He says the first lesson banks should take from the P2P phenomenon is that customers want to dictate the terms and conditions of their financial relationships. P2P gives banks a chance to see what customers want in terms of product and pricing; longer term, he predicts, banks will need to incorporate some aspects of customization and individualized product design that is the hallmark of these marketplaces. "People want to determine their own destinies," he says.
The second lesson may have even more significance for banks. The affinity aspect of P2P at Prosper and Lending Club literally turns conventional marketing on its head by allowing customers to segment themselves, instead of banks deciding how to segment customers. With P2P, segmentation is not inferred; instead, it's observed behavior. That has enormous implications for banks' marketing strategies. P2P "may show how wrong the current marketing approach is," Eckenrode says.
For banks that want to get an early taste of the P2P market, Woods of Celent suggests two ways. The first is to invest through a venture fund. For instance, Lending Club secured $10 million from Canaan Partners and Norwest Venture Partners. Another route could be through a secondary market, which would give banks a way to study the long-term performance of these loans. No such market exists today, but Prosper filed with the Securities and Exchange Commission in October to establish one. Prosper executives declined to comment on the filing on the advice of their lawyers due to the filing's pending nature. But Laplanche of Lending Club says Prosper's move is a smart one and he expects Lending Club will follow suit in a few months, perhaps launching a secondary market several quarters from now.
P2P clearly has a lot of momentum, but Eckenrode offers a warning as the exchanges ramp up volume and executives talk up a secondary loan market. Given this year's subprime mortgage implosion and the woes being suffered by millions of voters, politicians are highly focused on consumer lending. We're going into an election year, and the mood has swung decidedly toward stepped-up oversight. "It wouldn't surprise me if regulators suddenly decide to step in and say [to the P2P exchanges], 'Guess what? You're a bank.'"
