A man was honored for 50 years of loyal service to a Virginia bank. At the party celebrating his long service, he was asked what he thought had been 'the most important change that he had seen in banking in his half century of service?' The man paused for a few minutes, then went to the microphone and said: 'air conditioning'.
Financial experts put enormous effort into making their work look like rocket science. It pays off by keeping their club closed. However, the basic financial concepts are simple enough to explain them in ten minutes. Understanding how banks work leads to understanding how alternatives to banks work, what their advantages and disadvantages are and if we can trust them.
Peer-to-Peer lending is one of such alternatives. The Internet provides people with an option to permanently abandon the large and cumbersome centralized mediator that makes decisions for issuing loans or sets interest for deposits. Now, the Internet allows people to lend money to each other. All they need is a suitable platform.
How the Banks with Conditioners Work
The main purpose of any bank, from the very beginning (I mean from around the 17th - 18th centuries) is to receive money from depositors who have no idea where to put their money, and loan that money to the borrowers who do know how to use it.
The depositors get a reward called interest, while the borrowers get a punishment called a loan rate. A depositor can lend his money to the bank for safekeeping with a 1% interest rate (nice terms for him), while the borrower gets a loan with a 15% rate (nice terms, too). The difference between what the borrower has to give and what the depositor receives is huge!
This difference is used for covering the risks (as the borrower might never return the loan), operational expenses, insurance, taxes, and, of course, they form the profit of the bank owners.
This system has been working for hundreds of years, but today it seems a bit outdated. Why? Because the operational costs can be dramatically reduced by using IT, and risk analysis can be improved by using Big Data. As for the owners' profits... they are too high, are they not?
FinTech works on reducing the difference between the interest rates. If a traditional bank takes money at a 1% rate and loans it at a 15% rate, then a modern bank can afford taking money at a 5% rate and lending it at a 10% rate, with the majority of the money the bank receives being used for covering the risks. Banks with IT turn out to be more profitable than the banks with air conditioning.
One of the approaches implies that the banks should be dropped in this chain, and we can work directly with the borrowers... Anyway, we still need a mediator.
Peer-to-Peer Lending: The Essence
A bank with air conditioning is a black box for any external observer. There are input channels for depositors' money and output channels used by borrowers. An outside observer cannot say why the rates are what they are, and which intrinsic factors lie behind the fact that they are so different.
The P2P approach turns the black box into a transparent one. The Peer-to-Peer lending service itself is not a formal bank; it is a simple platform that establishes a connection between investors (they are not depositors anymore) on the one side, and the borrowers on the other.
In order to average the risks, the investor is not offered to lend money to only one or a few people. In order to average the risks, he should lend to hundreds. The platform allows for receiving an amount from investors and distributing it between the borrowers.
In this case, an investor has more freedom compared to a depositor. The P2P platform provides data concerning the potential borrower complete with his purposes, credit score, etc. to the investor. The investor, in turn, decides if he wants to lend money to a particular person or not, basing his decision on the data and recommendations he received from the platform.
This approach heads towards the reduction of the difference between the rates. It attracts both investors and borrowers. A load of operational expenses is dropped, for instance supporting a chain of offices, salaries of the employees, etc. Due to the process automation, the platform owners can get good profits while reducing the costs of revenue for servicing the clients, not by increasing the rates.
Therefore, owners of the P2P lending services are able to reduce the rate difference and offer a higher investment rate (and higher risk) with a lower loan rate.
Investors are attracted by the fact that the interest might be as high as 5%, which is substantially higher than 1% offered by banks. The borrowers, in general, have different reasons. But we can distinguish two large groups.
The first group is millennials. While the older generation can be impressed with air conditioning, comfortable leather chairs in the office, a water cooler, a glass ceiling and a modern-style design, the millennials are impressed by an option NOT to visit the office and NOT to talk to the bank officers.
Therefore, P2P lending has two advantages for the millennials: it is convenient and offers lower loan rates.
The second group consists of small and medium-sized businesses. For the owners of such enterprises, every basic point in the loan is critical. In addition, the bank beltline can simply refuse to lend money to a businessman. 33% of pollees noted that P2P lending is the only option to get loans for them.
Zopa: First Successful User Case. But hold your horses...
Zopa checks the borrower's credit score and requires a high credit level for receiving a loan. This is a good sign for the investors, as it increases the probability of the loan being returned. However, Zopa acts as traditional banks in this part and cannot solve the following issue: how can we help people with a poor credit score? Both traditional banks and innovative Zopa basically help the people who already have the money.
Zopa has a Safeguard fund used for repaying the loans not returned by borrowers. Again, this seems to be very good for the investors, but investment protection leads to lower interest rates and higher loan rates. Again, traditional banks act the same way by insuring the deposits. In case of delayed payments, Zopa fines its borrowers; and in case a loan cannot be paid, it hands the loan to a debt collection agency. Once again, there is no difference between Zopa and a bank. However, the status of the company does not allow it to work with the borrowers the same hard way the banks do it. Non-payment of a loan worsens one's credit score, but it seems that Zopa cannot go any further.
A significant difference between a bank and Zopa lies in a higher degree of freedom and transparency of the latter. Investors are offered to divide their investments into small parts of 10 pounds each, which are used for forming loans. Therefore, each investment and each loan consists of a great number of small parts, which leads to averaging the risks. The investor can track which part of his money has been lent, and observe how the payments for it are coming to his account.
The last point is a huge drawback: minimum loan amount is 1000 pounds, with a minimum loan period of one year. For Zopa it is a reduction of operational expenses; but for the users, such terms are far worse than the bank terms. Credit cards allow for borrowing small amounts for small periods. So, can we say that Zopa is a disruptive innovation business? No. We can say that Zopa is simply a bank in an Internet cover. More transparent, more risky, with lower rate difference... but still a bank. Another UK competitor of Zopa, Ratesetter, does not differ much from a bank either.
Despite the success of Zopa, Ratesetter and many other companies like them, this approach to P2P lending development does not create any new entities. It means that we can expect a real breakthrough in this field. The question is, where?
Is Funding Circle a Breakthrough?
Another approach offered by P2P-lending is shown best by Funding Circle, a company that appeared in the UK in 2010.
This company aims solely at offering loans to businesses. Despite this fact, all basic principles of P2P lending are preserved: on the one hand, a very good credit score is required from businesses and on the other hand, investors divide their investments into small pieces to spread the risks.
Until September of 2015, Funding Circle utilized the flexible free-market approach, when the investors established their own loan rates for businesses during an auction bidding. However, starting September, Funding Circle started to move towards traditional financial institutions and, for the investors' protection, removed the free market. Now, experts of the company establish loan rates.
Both Funding Circle and Zopa started as free market-oriented companies and ended as advanced versions of banks. Neither managed to solve the problem of reliable and cost-efficient risk analysis. Zopa introduced an insurance fund, and Funding Circle went even further: it buried self-organizing and free market.
What we have now are companies that use credit score to let a borrower in and then split the raised money for averaging the risks.
I would like to note that it still is a significant step forward in the banking field, which already helped millions of people around the world. But it is only the tip of the iceberg for now.
The real revolution in the credits field will happen only after a revolution in risk analysis.
Disruptive Effect of Blockchain: Decentralized Risk Management
Can we reduce the risks even more? There are many credit bureaus and scoring companies that devote their very existence to collecting data about the borrowers.
There is no doubt that credit bureaus, in the years they have existed, have solved not only the air conditioning issues, but other issues as well, and have learned to make conclusions about people based on a number of criteria. Still, there are restrictions on their operation posed by legislature and incompleteness of the data sources...
Walmart would be the best forecast company. The program for evaluating and forecasting the consumers' behavior allows one to receive highly accurate data like age, education, income level, sex, race, etc., based on one's purchases.
The reverse is also true. Presented with data about a person, Walmart can predict what a person would buy, and offer the things he or she needs.
daily consumer behavior.
Analyzing the purchasing history of people allows for dividing them into groups that have common behavior patterns. This is why a new father is offered diapers at a discount, and a health-conscious student gets a discount on fresh fruits, and not the other way around.
Storing information concerning the changing ownership of money is not the only function of a blockchain of any cryptocurrency. For instance, the Emercoin blockchain is capable of storing one's Internet address, and the Bytecoin's blockchain can be used (in the future) for emitting private bonds and shares.
In addition, the Bytecoin Blockchain will be able to store data concerning Smart Contracts.
We have already discussed the ways the Smart Contracts help people organize an efficient business strategy or formalize some common agreements. Now, we want to point out the fact that Smart Contracts are stored in the Blockchain and we can find out how responsible certain people are.
Some companies already make use of additional information about users. For example, Zopa checks the rating of a client on Ebay or how regularly the clients pay their rent.
Big Data makes it possible to not only acquire information about how the client uses his credit card, but also to find out their credibility on some trading services, get data from Blockchain and many other sources as well.
Does Cryptocurrency make the difference?
Blockchain of a proper Cryptocurrency can hold information about a user's behavior if the said user ever entered Smart Contracts. But the role of cryptocurrencies is not limited to being just another channel for the Big Data Analysis.
Different cryptocurrencies possess different features, but all of them are essentially platforms for building different services (mostly financial). Including the peer-to-peer lending.
The benefits of the services built upon a cryptocurrency come from the fact that the services themselves inherit all the features of the underlying platform. Naturally, with all the shortcomings as well.
I will only point out a few of the benefits one could get by using the Bytecoin Platform to run a P2P service. With some amendments, these can be applied to almost any cryptocurrency.
International origin of the cryptocurrency. The owners of the business itself can choose to operate within one country due to legislative issues, but the platform provides them with an international arena.
Low operating costs, which lead to reduced fees. Basically, all the operating costs for a cryptocurrency are already included in the reward paid to the miners. This amount is quite a bit lower than the one that should be spent for keeping an office and paying salaries to a large staff. Businessmen can concentrate on developing their service without paying so much attention to how the platform works.
Large scale. It is similar to Facebook. People come there to be able to do different things. Therefore, a platform with a wide range of functions that attracts users is fit for building a new service, which, in its turn, attracts more users to the platform.
Cryptocurrencies are based on the principles completely different from those that form the basis of traditional financial institutions. Therefore, a service developed with a cryptocurrency as its foundation has a greater chance of growing into a new disruptive business compared to any traditional approaches, which eventually end up as regular banks but with new wrappings.