Peer-to-peer (P2P) lending may be the biggest innovation in financial services since the invention of the ATM. The advent of the Internet and lack of funding options for small businesses from most banks meant an alternative lending option was needed to fill the gap. This is where P2P lenders come in. P2P lenders offer what is often referred to as a marketplace platform that matches borrowers with lenders who get access to a new asset class: small business or consumer credit.
Although prevalent in the United States, Britain, Europe, and Australia, P2P lending is still an emerging concept in Canada with great potential that could really change the small business lending landscape in the country. The largest player, Lending Club, went public in the U.S. in the fall of 2014 and has a market capitalization of $5 billion, yet is widely unknown to Canadians.
25 Hours Of Legwork
Prior to the emergence of online P2P lending platforms, it took almost 25 hours of legwork to fill out the paperwork required to apply for a small business loan, according to a recent U.S. Federal Reserve study. This also applies to businesses in Canada and worldwide. Small business owners would often have to wait several weeks, or sometimes even months, before getting an approval or rejection on the application. Also, the transaction costs associated with a bank processing a $100,000 loan were similar to those of a $1 million loan; making it significantly less profitable for banks to process smaller loans. Therefore, banks slowly stopped making loans under $250,000 and often attempted to turn business loans into personal loans through the use of personal guarantees, collateral mortgages, or a push toward credit cards.
The coming of age of the Internet, and improved access to data has enabled the online P2P lending industry to emerge and fill the void for small business loans that are not adequately serviced through traditional means. Today, small business owners can go online any time of the day or night, conduct a quick search, apply and get funded by lenders without leaving their home or office or using snail mail to send paperwork. By using online connections to accounting software, Canada Revenue Agency, bank accounts, and supplier portals, lenders have the tools they need to make decisions in real time and fund in less time than it took before through traditional loan application methods. It is easy to understand why online P2P lenders are gaining traction globally.
How Does Peer To Peer Lending Work?
Once lenders have created and obtained funding through their account on the P2P lender’s website, they get access to all the available loans. Lenders can choose which loans they want to fund based on their preferred risk/return criteria or they can select to be automatically diversified across all the available loans on the platform. The P2P platform manages the small business owners’ loans and makes payments to the lender.
What Are The Benefits To Lenders?
Lenders earn a return greater than their bank savings account. Borrowers get access to capital quickly at a risk appropriate rate.
Depending on the jurisdiction, lenders may need to be accredited investors, although in the U.S., UK, and elsewhere in Europe, retail investors with idle money earning close to zero per cent in their savings accounts can also participate.
Why Is Peer to Peer Lending A Game Changer?
Marketplace platforms make the Canadian economy more stable. They eliminate the ‘too big to fail” risk associated with traditional banks. These platforms have no leverage and no balance sheets. They simply facilitate borrowers and lenders coming together. P2P lending provides a new option to both investors and small businesses, making the economy more liquid and fair. P2P lenders increase borrowing capacity by providing a broad range of investors to fund loans, meaning no one institution or individual takes all the risk. Investors can diversify across multiple loans and multiple borrowers, also spreading the risk for their investments. By facilitating a broader range of investors, these platforms improve the availability of credit for high quality borrowers. For example, many investors whom are immigrants over-index in small business ownership, yet under-index in loans from traditional banks. Through marketplace platforms, they can now access the capital they need to grow.
Marketplace lenders have proven to be more efficient than traditional financial institutions. Why is it that a small business owner who sells to Wal-Mart or other similarly high quality companies often cannot get working capital funding at reasonable rates (if at all) from traditional financial institutions? The lender in this case focuses on the quality of the borrower and may require two to three years of financial statements and specific financial ratios in order to lend. All the while, investors are earning almost nothing in their savings accounts. P2P platforms are able to price loans more efficiently and, therefore, more appropriately for borrowers.
P2P lending platforms have and will continue to change the way small businesses access capital. They put the power back in the hands in the borrower to access funds on their terms when they need it. These platforms will also offer investors a new and attractive investable asset class that complements traditional fixed income investments.
Steven Uster is co-founder and CEO at FundThrough (www.fundthrough.com).