Peer-To-Peer Finance Connects Borrowers And Lenders

Peer-to-peer finance sounds like a concept born to be ridiculed. Finance demands oversight and networking through peers rather than a central authority, suggests a fundamental rejection of institutional scrutiny.

Call it a cautious rebellion. In February, Prosper opened what it calls "America's first people-to-people lending marketplace." It's a site that helps users borrow and lend money among themselves without the involvement of banks. Though the company says it hasn't been around long enough to disclose its user base, it claims to host over 1,000 active loan listings and 800 active groups.

This summer, a company called Zopa will bring its British brand of peer-to-peer finance across the pond and offer it to residents of California. Zopa began operating in the U.K. in March 2005 and currently counts over 60,000 members.

Both companies are flush with venture funding. Prosper has raised about $20 million from Accel Partners, Benchmark Capital, Fidelity Ventures, and Omidyar Network. Zopa has raised about $23 million from Benchmark Capital, Bessemer Venture Partners, and Wellington Partners.

Chris Larsen, CEO and co-founder of Prosper, likens his company to eBay, except that instead of providing a forum for listing and bidding on products, Prosper lets users list and bid on loans.

"The tools and technology that are in place now for the first time allow for this sort of direct person-to-person marketplace," says Larsen.

This goes back to the way things used to be, Larsen explains, when one neighbor supported the business of another neighbor. It's a model that, he believes, has a lot to recommend it. "There was a really strong sense of obligation and accountability and reputation within a small community," he says, "which actually made repayment of debts more reliable and less risky."

Forrester analyst Cathy Graeber says bringing finance to social computing represents a promising reinvention of a commoditized financial service.

The idea advanced by these companies is that by eliminating the middleman--banks--individual lenders, or groups of them, earn a higher rate of interest than conservative investment options such as certificates of deposit, and borrowers get a lower rate of interest than would typically be available from traditional financial institutions.

Users of these sites may have ideas of their own. Many of the participants in Zopa's online forums say they're early adopters who want to participate in something new and fun. "I am fascinated by the concept, [and] hate big corporate banks..." writes one user. Such sentiment baffles the more commerce-minded forum participants, who have posted complaints about Zopa's "uncompetitive" returns to lenders.

The ardently capitalistic appear to be better represented on Prosper, which offers lenders a wider range of risk and return. Interest rates for loans funded through Prosper range from 7.32% (low risk, low amount) to 24.04% (high risk, high amount)--the sort of rate that earns credit card companies criticism for being excessive.

At the moment, Zopa offers less risk and less return, claiming an average gross return of 7%. It reduces risk by automatically spreading lenders' money across 50 different borrowers. On Prosper, lenders can form groups, but they have to manage the process themselves.

By way of comparison, home equity loans listed at BankRate.com on May 15, 2006, ranged from 6.97% to 8.14%, and certificates of deposit ranged from 3.45% to 4.72%.

Prosper makes money from fees. It charges a 1% closing cost for loans, so securing a $5,000 loan nets the borrower $4,950. It charges lenders a 0.5% annual loan-servicing fee, so a $5,000 loan maintained at 10% interest for 3 years could cost $40.40. There are also delinquency and late fees. Zopa, too, relies on fees to make a profit. Borrowers pay a 0.5% fee on top of their loan. Taking out a $1,000 loan results in liability for $1,005. Lenders pay an annual 0.5% on the amount they're lending, which declines monthly as payments come in, so a $1,000 loan at 7% interest for one year would cost $2.69.

Greater sensitivity to risk is one way that Zopa CEO Richard Duvall differentiates his company from Prosper. "We appreciate it's people's money, and they don't want to lose it," he says, noting that the dissimilarities between Zopa and Wells Fargo are more instructive than subtle differences between Zopa and Prosper because large banks aren't trying to build social networks.

Zopa says it isn't offering exactly what a bank is, so comparison is difficult. It estimates that a committed lender could make 6% to 7% annually using its service, assuming a 96% repayment rate and full reinvestment. The company claims this is 1% to 2% higher than the best savings account currently and just below long-term annual stock market returns of about 8%.

But Zopa will soon be much more competitive in terms of rates with its American counterpart. Duvall says the company has surveyed its user base extensively, and when Zopa 2.0 arrives this summer in California and in the U.K., there will be higher risk, higher reward markets.

Both companies are planning to roll out APIs so that programmers can integrate social finance with social networking sites. The idea is to allow members of Yahoo Groups or MySpace, for example, to participate in peer-to-peer finance and to view financial data on other sites.

The charge-off rate--the percentage of loans written off as uncollectible--for consumer loans, including credit cards, hovered between 2.3% and 3.2% in 2005, according to the Federal Reserve. Though Zopa assumes a bad debt rate of 3.4% for its higher risk borrowers and a 1.3% rate on average, its actual bad debt rate to date is 0.05%.

Duvall says that low number validates Zopa's approach. Prosper hasn't been operating for long enough to offer such figures, says Larsen.

Prosper and Zopa provide the online infrastructure that connects lenders and borrowers. The most critical function they provide is security, without which no sensible person would risk a cent.

Prosper says it conducts anti-fraud and identity checks using data from credit reporting agencies and other sources. Users must provide their name, date of birth, Social Security number, address, telephone number, and a U.S. bank account number.

Zopa says it has a number of online and offline methods to keep dishonest people off its system. The company states it accepts liability for losses in the event of an online security breach not brought about by user negligence.

Despite such measures, there are risks, both in terms of loan defaults and fraud. Discussions in the Prosper online forum indicate that several dubious loan requests have been made by people characterized, fairly or not, as convicted criminals.

But the online communities growing at both Prosper and Zopa, at least in theory, should function as a sort of immune system against such risks. Because the personal identifying information required for financial transactions isn't infinitely changeable like an E-mail address, scammers can't conceal themselves as easily as they can elsewhere.

While the value of social financing as a stable investment vehicle remains unproven, the ability for community-oriented groups to offer discount loans to members of their respective communities has obvious advantages over the impersonal, institutional lending practiced by banks. Community-directed lending gives groups the financial muscle to advance their goals.

Prosper, for example, hosts a group called Christian Opportunities, which says it's "dedicated to helping borrowers and lenders of any denomination invest in their future." There's also the more cult-oriented Apple User Group, which bills itself as "a lending group for those wishing to purchase either a Macintosh or Apple iPod."

For these online communities, the real test will be how they respond to bad debt and fraud. It won't take much rancor to turn a social network into an anti-social one.