Evolution of Credit and Lending Practices

Digital Financing

• Digital financing delivers financial services through digital channels
• Its goal is enhanced accessibility, convenience, and affordability
• PayPal is an example, initially a digital payment platform, now a global financial solution
• Peer-to-peer (P2P) lending is a significant innovation
• Large sums of money have flowed into P2P lending over the past decade
• Data analytics improve credit scoring and eligibility for lending

Evolution of Financing

• Pawnbrokers were early financial lenders using collateral to secure loans
• In the Middle Ages, Christians were prohibited from charging interest, while Jews could, paving the way for lending practices
• The word "bank" originated from the Italian word "banca," referring to benches where money lenders sat. A broken bench, "banca rupta," could lead to "bankrupt."
• The Rothschild family built an 18th-century international banking network, becoming incredibly wealthy.
• Building Societies emerged in 18th-century UK taverns, pooling funds for housing. Ketley's Building Society was a notable early example (1775).
• The Philadelphia Savings Fund Society was formed in the early 1800s to provide savings and loans
• The Federal Home Loan Bank System, created in 1932, established a framework for U.S. residential mortgage lending.
• The Diners Club Card (1950), invented by Frank McNamara, addressed the need to pay at multiple establishments without carrying a wallet.
• BankAmericard (now Visa) and American Express followed shortly after, in 1958.
• The MasterChargecard (later MasterCard), emerged in 1967.
• FICO credit scores were adopted in 1959 to assess creditworthiness

Peer-to-Peer (P2P) Financing

• P2P financing is direct lending between individuals, facilitated by online platforms, without intermediaries
• The concept originated in computer networking
• P2P financing addresses the lack of access to financial services and aims for financial inclusion
• It pairs those seeking funds at lower interest rates with investors desiring above-average returns
• P2P platforms allow capital to be channeled effectively, efficiently, and transparently, at a lower rate than traditional banks
• Effective credit scoring is crucial to manage risk in P2P financing

Financing Appeal of P2P

• Compared to standard savings accounts, P2P financing potentially offers higher profit potential for investors—a higher return on investment.
• P2P financing in the financial community is generally viewed as having better social value than traditional banking systems.
• While P2P financing offers more potential profits, it does involve a higher risk factor than traditional savings

Introduction to Peer-to-Peer (P2P) Financing

• Zopa (UK) and Prosper (US) launched as the first P2P platforms in 2005
• Borrowers apply, and platforms assess risk levels to determine interest rates
• Loans are funded by private investors
• The process generally offers better rates for both borrowers and investors

Key Metrics and Growth of P2P

• Prosper had 2 million members and 6billioninloansin2016,exceeding6 billion in loans in 2016, exceeding 6billioninloansin2016,exceeding21 billion in 2023
• Zopa had £1.4 billion in loans and 114,000 members in 2016
• Zopa's customer base surpassed 1 million in 2023
• Zopa's total loan balance reached £2.7 billion in 2023
• P2P lending has shown rapid growth, with expected continued expansion

Other Key Players of P2P Platforms

• Lending Club was founded in 2006 and raised $10.26 million
• It became a P2P lending company in 2007, completing a major IPO (900million)in2015andcollaboratingtoprovidefundstosmallbusinessesinCalifornia(900 million) in 2015 and collaborating to provide funds to small businesses in California (900million)in2015andcollaboratingtoprovidefundstosmallbusinessesinCalifornia(10 million) in 2016
• RateSetter, established in London in 2010, boasts at least 33,000 active lenders with well over $2.7 billion in assets, along with a default rate of 0.71%.
• Lufax has a Shanghai headquarters and is known as the Shanghai Lujiazui International Financial Asset Exchange Co. It was founded in 2011, raising almost $500 million in 2015.
• It is owned 49% by Ping An, China's largest insurer, with a CEO, Gregg Gibb. Lufax has partnerships with Saxo Bank and etoro.
• LendingRobot is a loan comparison engine that applies algorithms to help lenders find the most profitable loans.
• Capsphere is Malaysia's first P2P asset-based financing platform, registered with Securities Commission Malaysia

P2P Financing in Malaysia

• P2P enables Malaysian businesses to borrow capital from investors through platforms registered with the Malaysian Securities Commission (SC)
• The P2P Framework was launched in May 2016
• As of December 2022, about RM3.87 billion in P2P financing had been raised
• More than half (49%) of the investors were aged below 35, with 89% of investments coming from retail investors.
• In 2022, about RM140.38 million was raised by 65 issuers

Eligibility Criteria for P2P Platform Providers

• Anyone seeking to create a P2P financing platform must register with the Malaysian Securities Commission (SC) as a P2P operator through the Recognised Markets (or RMO) guidelines.
• All P2P operators must have a minimum paid-up capital of RM5 million to operate in the Malaysian market.
• P2P operators need to adhere to comprehensive criteria, including risk-scoring system efficiency, a robust risk assessment process, and compliance with all relevant guidelines and regulations.

Campaign Sizes

• 70% of issuers raise less than RM50,000
• 26% raise between RM50,000 and RM200,000
• 4% of lenders seek more than RM200,000

Types of Investors

• Non-technology issuers make up 98% of all issuers
• Technology issuers make up 2% of all issuers

Who Can Raise Funds Through P2P?

• Locally incorporated or registered entities are permitted
• Sole proprietors
• Partnerships
• Limited-liability partnerships
• Private companies
• Unlisted public companies
• All others are prohibited, for example, investment funds or publicly traded companies

Who Can Invest in ECF

• Retail investors: Max RM5000 per company, with a 12-month limit of RM50,000 in investment across all companies.
• Angel investors: Max RM500,000 in 12 months
• Sophisticated Investors: No restrictions

Eligibility Criteria for ECF Platform Providers

• Applicants must be a legally recognized corporate body.
• Must meet criteria within the Recognised Market Operator (RMO) guidelines
• Due diligence on prospective issuers is required
• Platforms must ensure investors have access to comprehensive, verifiable information
• Platforms must ensure investor protection by ensuring that funding and investment limits aren't breached by issuers
• Issuers are prohibited from performing activities such as mergers or acquisitions to protect investors

Benefits of P2P for Borrowers

• P2P provides easier access to funds, often with less stringent credit requirements than traditional banks.
• Borrowers can apply online with a simplified application process, reducing paperwork and time.
• P2P platforms typically offer lower interest rates than traditional banks and credit cards
• Borrowers can choose various loan terms and repayment options
• Quick disbursement of funds is often a feature

Benefits of P2P for Lenders

• Possible higher returns on investment than traditional savings accounts
• Offers risk-adjusted returns, giving investors options to balance risk with potential rewards
• Diversification options allow investors to spread funds across multiple loans, reducing the impact of any single borrower default.
• P2P platforms are transparent and provide detailed information on borrowers

Credit Risk in P2P Lending

• Defaults occur when borrowers are unable to repay their loans, resulting in losses for lenders
• P2P lending is riskier for lenders than traditional banks because of the absence of collateral and government protections.
• Default rates vary based on different factors, including loan type, borrower creditworthiness, and platform practices. A higher risk loan potentially has higher default rates from 5-10% or more
• Variables that affect creditworthiness include financial history, credit scores, economic conditions of borrowers, and the type of loan

Mitigation Strategies in P2P Lending

• Risk grading systems categorize loans from lowest (A) to highest (E) risk.
• Investors can manage their risk by diversifying their portfolio across loans in the different categories.
• Encouraging investors to diversify their investments helps spread risk

Diversification in P2P Lending

• P2P platforms encourage investors to spread their funds across various loans
• This diversification approach helps to reduce the impact of borrower default on overall portfolio returns

Technological Solutions in P2P Lending

• P2P platforms employ algorithms and data analytics to accurately evaluate borrower profiles
• Al-driven models, such as those used by Upstart, incorporate traditional credit data with additional insight like education and employment information
• Some platforms have established provision funds to manage potential losses resulting from borrower defaults or account for higher-risk loans
• Examples include RateSetter in the UK offering a provision fund for such cases which provides peace of mind for lenders

Platform Risk

• Reliance on platform stability is a key concern in peer-to-peer lending, as lenders and borrowers depend on the operational and financial stability of the platform they utilize–a potentially significant risk unlike with traditional banks.
• P2P platforms are often newer ventures, lacking the financial backing or regulatory safeguards often found in traditional banks
• This increased vulnerability to market fluctuations, liquidity issues, and management challenges can place investment risk on lenders if a platform becomes insolvent or pauses repayments to investors.
• Liquidity issues, weak internal controls, inadequate compliance with regulations, poor oversight can impact platform performance

Regulatory and Market Risks

• Regulatory frameworks for P2P lending vary by region, impacting how platforms do business. Sudden changes to existing laws or new regulations can lead to challenges, costs, or outright closure
• Example: Chinese authorities enforced strict regulations in response to widespread issues and fraud within the marketplace; many platforms collapsed as a result
• Market risk relates to economic fluctuations (interest rates, unemployment) affecting borrowers and their ability to repay loans
• Vulnerability during recessions (economically difficult time periods) often shows a rise in default rates, disproportionately impacting lenders

Digital Lending for Students

• A specialized lending category often outside the norms of other consumer lending, student loans are treated as a unique market
• Countries with robust support systems frequently subsidize such loans to make funding accessible
• However, large sums of student loan debt are common (for example, in the U.S., greater than $1.5 trillion as of 2018) and may not be paid off
• Digital lending platforms facilitate online lending to students and are often more accessible than traditional options

Alternative Financing

• Methods outside of traditional banking to provide capital, particularly beneficial for small and medium-sized enterprises (SMEs) who might not qualify for classic bank lending
• Asset-based lending uses existing assets (inventory, accounts receivable, or equipment) as collateral for loans
• Invoice financing enables companies to generate funds by utilizing future invoice payments
• Revenue-based financing provides funding in exchange for a portion of the business's future revenue

Invoice Financing

• Provides funds for unpaid invoices via factoring, trading, or discounting—Essentially, a 3rd party (factor) preemptively pays the seller a percentage of the value of an invoice awaiting customer payment, receiving payment from the customer directly
• Allows businesses to access short-term operating capital
• Factors often assess a business’ creditworthiness and the customer’s payment history before granting invoice financing

Asset-Based Lending

• Loans secured by assets such as inventory, accounts receivable, or equipment
• Offers an advantage as it enables businesses to leverage existing assets, without dilution of ownership.

Revenue-Based Financing

• Businesses receive funds in exchange for a percentage of future revenue that is then scaled according to business revenue

Blockchain in Alternative Financing

• Blockchain technology enhances transparency and the integrity and security of transactions, often making digital transactions more secure by mitigating fraud
• Loan origination processes are often more efficient and faster, in part because of the transparency and security aspects

Embedded Finance

• Financial services incorporated directly within non-financial platforms
• Simplifies funding processes by eliminating the need for separate applications or outside funding sources

Pros of Alternative Financing for SMEs

• Faster access to capital
• Flexible terms tailored to specific business needs—often quick approval and turnaround times
• Examples include using a third-party service to manage collection practices for quick cash flow

Challenges in Alternative Financing

• Higher fees or interest than traditional bank loans
• Risk of asset seizure in case of default
• Impacts on customer relations by requiring contact with a 3rd party financing company

Crowdfunding

• Enables raising small amounts of money from many people, typically on online platforms, by individuals, startups, or companies for various initiatives
• Donation-based crowdfunding often involves charitable causes without expectation of repayment.
• Reward-based crowdfunding offers products or services in exchange for financial contributions.
• Equity crowdfunding offers financial backers ownership in a company or project.
• Debt crowdfunding enables backers to lend money for return in interest payments and repayment

Case Study: Oculus Rift

• Oculus Rift was a virtual reality headset that launched and succeeded via a Kickstarter crowdfunding campaign
• The company sought funding to create a VR technology project—a smartwatch
• Kickstarter funding surpassed the initial goal, and its success attracted attention and acquisition by Facebook for over $2 billion

Comparison to Other Funding Options

• Crowdfunding is generally less formal than bank-based loans and often doesn't require strict credit checks or collateral. It is less structured and offers flexibility in the terms for the business owners.
• Funding goal flexibility and a more flexible timeline are key features of crowdfunding. This is often not the case with traditional bank-based loans, which typically have set repayment schedules.
• Crowdfunding is an excellent option for startups, creative projects, and innovative products because it allows them to test the market without taking on debt
• Crowdfunding can serve as a form of market validation because of the interest shown in an idea, product, or concept

Popular Crowdfunding Platforms

• Kickstarter
• Indiegogo
• GoFundMe

Equity Crowdfunding (ECF) in Malaysia

• A novel form of alternative fundraising designed for small businesses to raise capital from the public
• Online platforms registered with the Malaysian Securities Commission (SC) serve as a key component
• ECF enables small businesses to offer equity to investors who invest in the venture being proposed
• The SC launched the secondary trading framework in 2020—which allows investors participating in crowdfunding to exit their investment
• Malaysian ECF platforms have generally been experiencing impressive growth starting in 2016, along with increased call for capital market systems to adopt more technology- and investor-friendly methods

Limits on Funds Raised from ECF Platform

• Malaysian sole proprietors, partnerships, corporations, and certain forms of limited-liability partnerships are eligible to receive funds through the ECF platform.
• Issuers are limited to a maximum of RM3,000,000 within a 12-month period
• Issuers are limited to RM20 million in total funding from all crowdfunding campaigns

Conclusion

• Digital financing continues to redefine the financial landscape by introducing innovative solutions for businesses and consumers.
• The digital alternative creates more accessible, transparent, and diverse funding options

End of Topic 3

Explore the key milestones in the evolution of credit and lending practices in the United States. This quiz covers significant innovations and foundational systems that shaped mortgage lending, credit cards, and peer-to-peer financing. Test your knowledge on important dates and concepts that emerged through these financial transformations.