In late January, Wells Fargo (NYSE:WFC) cautioned its employees against lending personal funds in the peer-to-peer space, saying that “peer-to-peer lending is a competitive activity that poses a conflict of interest!” But what is peer-to-peer (P2P) lending and why is one of the world’s leading banks worried about it? Has the lender foreseen something that most people have yet to see?
Let’s begin with a definition. Peer-to-peer lending (P2PL) is a type of debt financing that allows unrelated individuals to lend each other money without involving a financial institution as an intermediary. The borrower and the lender meet online in a credit marketplace and agree on the terms of the loan before completing the transaction. In P2PL, the lender is called the investor, because he puts in his money and expects returns, while the borrower becomes a debtor.
The P2PL onslaught on the financial sector is aided by Bitcoin, a type of digital currency and the first decentralized peer-to-peer consensus payment network. The conventional banking industry is still grappling with legislative and regulatory issues globally surrounding this digital currency and similar forms of payment.
According to a forecast by Goldman Sachs, the innovative financial technology industry is threatening to swindle conventional Wall Street firms out of over $4.7 trillion in revenue and $470 billion in profit. Alternative lenders are becoming popular among small-business owners, who find it difficult to borrow from banks.
Leading this revolution are LendingClub Corporation (NYSE: LC), currently valued at $5.42 billion, and On Deck Capital Inc (NYSE: ONDK), which is currently valued at $791 million. These two companies were listed last December and garnered much attention from investors and borrowers alike as they were viewed as better alternative financing models and reliable sources of capital for future ventures. Nonetheless, the share prices of both LendingClub and On Deck Capital are down significantly since their initial public offerings.
Why P2PL has continued to flourish
The borrower’s perspective
It has now been seven years since the 2007-2008 financial meltdown, but the banking industry is still undergoing radical surgery to tighten up and prevent repetition of a similar scenario. Some of the changes have only helped tighten the lending conditions surrounding the business of banking.
P2PL platforms use very different but efficient credit-checking tools, and annihilate most of the uncalled-for lending obstacles that are common in the traditional banking sphere. These not only help reduce the loan processing period, but also cut the cost of borrowing.
Small business enterprises (SMEs) and startups are the greatest beneficiaries of this new phenomenon. Referring to Goldman’s report regarding the impact of emerging technologies on the financial services industry, in the month of January banks gave out merely 21% of all small-business loans, compared to P2P’s whopping 62%. In the same report, it was estimated that the banking industry could lose $84 billion to new payments systems, headed by Bitcoin. These systems, it said, are faster and less expensive than banks. A great number of SMEs who get their loan requests rejected in the traditional banking system get their loan approved in P2P lending with requests processed in a short time, albeit at higher interest rates. Startups and SMEs therefore have easy access to an alternative source of capital.
The lender’s perspective
During the financial crisis, investors in the financial sector of the economy suffered huge losses. What’s more, the misconducts and stream of scandals, which have continued to surface after the crisis, have only helped worsen the situation. The entire industry has since become less appealing to quite a number of investors, who opt for other alternatives. Peer-to-peer lending offers such an alternative, because of the potentially higher investment returns and convenience.
While P2P investments are highly risky ventures, investors are willing to trade that risk for the rate of return on some investments, which is often more than 9%. In comparing these returns to those offered by other types of investments such as bonds and treasury bills, peer-to-peer lending stands out as a viable investment option to a growing number of investors. Some higher-yielding bonds might pay just over 6% interest, while the safest debt investments with maturity of less than three years can yield less than 1%.
Technology
Peer-to-peer lending started as a group funding phenomenon but now enjoys the backing of digital currencies, which has made the transfer of money even easier. As aforementioned, this is not the case with our brick-and-mortar banks. In fact, some countries like China have completely banned banks from trading in digital currency. This has given P2PL a big opportunity to exploit the advantages that come with cryptocurrencies, such as accessibility, convenience and innovative solutions.
The Bottom Line
A bank is a financial intermediary known to make money by borrowing money from its depositors (investors), to whom it pays relatively small interest, and lending the money to creditors at a higher interest rate. Therefore, it makes sense for Wells Fargo to feel threatened by peer-to-peer lending that cuts the banks out, shaking the banking industry at its very foundation.
We have witnessed some of the world’s greatest industrial disruptions caused by digitization: the fall of Kodak in the face of digital photography, the birth of MP3 music in the music industry, Amazon’s onslaught in the retail industry, and how the internet revolutionized communication. In all these and other similar cases, large corporations that adapted quickly survived, but those that remained conservative were wiped out.
With the backing of Bitcoin and other altcoins, P2P is a force that the financial sector has to accept and work with, or perish. While most industry players are still living in denial, Wall Street firms have realized the kind of disruption the financial industry may be headed to, and they are not taking any chances. To mitigate the competitive threats, large banks will no doubt be looking to acquire or partner with these innovative financial technology startups.