Disruptive Lending, Disrupted

At Consumers’ Research we first examined Peer- to-Peer (P2P) lending in the Summer 2014 issue of our magazine. We explained how P2P lending gives modern consumers an interesting new opportunity to engage in borrowing or lending. While this is still true nearly two years later, the breadth of this opportunity has contracted as a result of misapplied regulation.

P2P lending is available through online platforms that allow lenders to connect directly to borrowers without the use of a traditional institutional intermediary, such as a bank. Two of the more popular platforms are Prosper and Lending Club. In these marketplaces, lenders can loan out as little as $25 at a time. The platforms bundle a number of small loans into a larger loan, ranging in size from $2,000 and $50,000, and lend the aggregated loan to borrowers at an interest rate typically between 5% and 15%.

As a lender myself, I scan the loan amounts and durations of borrower listings, looking for the option that best fits my needs. After receiving dividends for a couple of months, I set my “auto-invest” criteria, so whenever my cash on hand reaches $25, it is automatically lent to a new borrower. It’s a really fun and easy system to set up, and I enjoy checking it to watch my regular dividends stream in. For example, a $25 loan with a 36-month term and 6% interest rate pays a monthly dividend of 76 cents. I’ve been lending for the past 3 years and have earned an average of 7.31% on my loans at a time when the annual percentage yield offered by most savings accounts is negligible.

That is, until I updated my mailing address to New Jersey.

At that point, I was greeted with the friendly but ominous message from Prosper that read, “Unfortunately, at this time lenders in New Jersey are not able to invest or transfer money to Prosper. You may transfer money out of your Prosper account as funds become available from loan payments.”

What?!

See, back in 2008, the U.S. Securities and Exchange Commission determined that the loans these peer- to-peer lending platforms facilitated constituted unregistered securities. In an administrative opinion, the Commission reasoned that the loans should be classified as investments, because lenders expected to make a profit based on higher interest rates than those found at financial institutions. As a result, companies offering P2P lending platforms had to restructure their business models – a process that nearly destroyed Prosper – even though the final product still functioned like a loan to lenders and borrowers.

One effect of this regulation is that these companies need to register as providers of securities in every state from which they want to accept loans. As you can imagine, this is a costly and time-consuming endeavor. Consequently, lenders, now termed investors, cannot “invest” in peer-to- peer loans in every state. While Lending Club is available to investors in 43 states, Prosper is only available in 32.

One way to give the burgeoning industry of financial technology, known as “fintech,” the breathing room it needs to grow, while also protecting consumers, is to give the industry the chance to self-regulate. This would give the P2P market the opportunity to mature and the Commission the time to develop an appropriate regulatory framework based on case studies of Prosper and Lending Club – if still deemed necessary.

In August 2015, a group of P2P lending platforms, including Lending Club, revealed a list of best practices they called the Small Business Borrowers’ Bill of Rights. The list included a right to transparency in terms and pricing, a right to non-abusive products, a right to responsible underwriting (i.e. no predatory lending), a right to fair treatment by brokers, a right to inclusive credit practices (i.e. no discrimination), and a right to fair collection practices. The list, which was unveiled at a National Press Club Event, was met with a positive response among industry insiders, though it remains to be seen whether such efforts at self-regulation will stay the government.

Regulating the rapidly advancing fintech industry is a balancing act. American consumers are accustomed to being protected against bad actors and we shouldn’t assume that consumers will suddenly become responsible for assessing the security and fiduciary reliability of financial institutions. At the same time, overburdening startups with ill-fitting regulation threatens to stifle the very innovation these peer-to-peer lenders promise to bring to the lending and borrowing process.

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Joseph Colangelo is Executive Director of Consumers' Research, the nation's oldest consumer-focused organization. Joseph grew up in Northern New Jersey and attended U.C. Berkeley on a Naval ROTC scholarship where he graduated with a Bachelor’s of Arts with a concentration in Political Science.

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