Five things you need to know about: crowdfunding

People are increasingly lending money to each other, investing in small businesses and seeding new ventures – but now they are excluding the usual middlemen.

  1. What is crowdfunding?
    Crowdfunding, or peer to peer (P2P) lending, describes groups of individuals lending to each other without banks or business angels. It is typically conducted with relatively small, unsecured loans (US$10 to US$10,000).Sites such as Seedrs offer small equity stakes in start-ups, while “reward” P2P businesses including Kickstarter typically offer cheaper or exclusive deals to early backers of the product or project. The most common, such as the UK’s Zopa, offer conventional consumer loans at set rates between borrowers and lenders. Borrowers with poor credit ratings pay higher interest rates and lenders’ loans are split between many individuals to cut the risk of losses. The lending networks charge borrowers a fee.
  2. What’s the potential for P2P lending?
    It is heading for the mainstream and the top two US networks, Prosper and Lending Club, have already lent more than US$2b. Google this year bought a US$125m stake in American P2P finance site Lending Club, valuing it at US$1.55b, and wealth management firms are exploring the sector. In the UK, P2P lending business is growing at 250% annually and could account for £12.3b of loans a year according to innovation body NESTA.The US currently leads in crowdfunding transactions (an estimated 72%, according to the 2013 Crowdfunding Industry Report), but Europe could catch up. P2P businesses there include Zopa (which has lent more than £330m), Rate Setter, Thin Cats and Funding Circle in the UK. There is also Auxmoney in Germany, Smartika in Italy, Pret d’Union in France and Communitae in Spain.
  3. What do the critics say?
    Beware. In many cases P2P lending lacks the tax advantages of mainstream investment and often lies outside the control of the financial regulators, leaving lenders at risk. With interest rates from banks currently low, the rates on offer look attractive but in a higher interest world its appeal may all but disappear. It is also, critics argue, a system open to abuse from foolhardy or cynical entrepreneurs seeking to part naive small investors from their money.
  4. How do advocates of crowdfunding respond to the criticism?
    Many lending schemes now have added reserve funds to guarantee that no investor will lose substantially. In the case of equity P2P networks such as the UK’s Crowdcube, investors are proving to be canny, working together to carry out thorough due diligence on investment pitches. P2P cheerleaders also point to the way it nurtures innovation by connecting inventors, developers and creatives in collaboration with their customers and fan bases. The most bullish say P2P lending will ultimately reshape the financial system, challenging bank business models.
  5. So will it remain niche “microfinance” or become the future of finance?
    There is little sign of things slowing down, and a host of new P2P lenders serving particular niches including property, foreign exchange, renewable energy generation schemes, farming and graduate loans are springing up. Even the regulators are taking note. The Bank of England’s director of financial stability recently noted the fast growth of P2P lending and its growing economic importance. There is plenty of innovation and growth yet to come.

The article was written by:

  • Andrew Stone

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