The basic idea behind peer-to-peer lending is simple. People lacking funds find others with excess funds on the internet and lend to each other. In itself it’s not a new phenomenon. In many Middle Eastern and Asian countries this type of practice has been going on for a long time based on the principles of a ‘lending circle’. A lending circle is run by a trusted person in the neighbourhood who keeps control of the money. Each of the participants pays a set amount per month, and each month one of them borrows the whole amount from the circle. They have a very low default rate which could have something to do with the fact that they have a predominantly female membership. In addition, there is significant peer pressure since the lending circle is based in the local community.

In a peer-to-peer lending environment, however, people are relatively anonymous, and thus the advantage of peer pressure is significantly reduced. Instead, borrowers receive a credit rating which is determined by the facilitator’s process, after which they advertise their requirements including the reason for wanting to borrow, and the interest rate they are willing to pay. In some cases this is accompanied by a description of how they are expecting to repay and some detail surrounding life style. Borrowers do not divulge their real name, and the majority of outstanding loan requests appear to be for credit card and other debt consolidation, or to buy a car. Not all borrowers will e successful in raising the funds they require.

Lenders can ‘bid’ on borrowers they will support either for the whole or part of the amount requested. The lender faces the challenge on how to choose between similar borrowers, which requires a significant amount of trust in the underlying process. The majority of peer-to-peer lending offerings are relatively young without a track record and do not qualify for deposit protection schemes. The lender will look to be compensated for these additional risks in the form of a higher required return, although some of the risk is reduced by diversifying the funds over a range of borrowers.

Whether it appeals to an individual is strongly dependent on their individual risk appetite, but it does provide an alternative means of borrowing and lending particularly at a time when banks are not lending, and returns on current and savings accounts are at an all time low.

Dr Natalie Schoon, CFA