If digital disruptors like crowd-sourced equity funding and peer-to-peer lending platforms are going to transform the finance sector, they need to be regulated. If they are going to create permanent positive change, they need to be regulated intelligently.
But so far, the ability of regulators and industry to agree on the rules has been hampered by a significant knowledge gap: there is no accurate, up-to-date information about the size, scale and scope of the rapidly growing online alternative finance sector in our region.
The University of Sydney Business School has joined forces with the United Kingdom’s University of Cambridge and Tsinghua University in China, to conduct the first comprehensive survey of the rapidly expanding alternative finance sector in China and across the rest of the Asia-Pacific.
Building on a successful 2015 benchmarking survey of the UK and Europe, the Asia-Pacific survey will run through to mid December 2015. By early 2016, we will have aggregate information about the various types of online platforms, the overall size and recent growth of the alternative finance sectors in Australia, New Zealand, Singapore, China and other Asia-Pacific neighbours.
Why is aggregate data on crowd-sourced and peer-to-peer finance so critical? Uninformed regulation can indeed be harmful — so why regulate at all? Direct connection between lenders and borrowers, or donors and causes, is part of the attraction of alternative finance, and that’s all between consenting adults after all. But it’s the “peer-to-peer” feature of these markets that calls for intelligent regulation.
Naïve ideology sees all regulation as anathema to free markets. In reality, most markets can’t function without it. Efficient markets depend on reliable information about product quality being shared between buyers and sellers, as Nobel prize winner George Akerlof demonstrated in his analysis of the used car market – his famous work on the “market for lemons”.
If buyers can’t tell whether they are buying a good car or a lemon they will never pay what a good car is worth. Owners of good cars will not offer their cars for sale and eventually only lemons will be left. Markets with this unequal information problem are likely to collapse without minimum quality guarantees.
In crowd-funded and peer-to-peer finance markets, the borrower knows much more about their ability to repay than the lender does. Minimum credit worthiness standards for borrowers, some limitations on risk exposure for unsophisticated lenders, and effective disclosures are needed for the survival of these platforms.
Take peer-to-peer lending for example. In conventional lending markets an intermediary like a bank transforms the deposits of lenders into loans for borrowers. Intermediation turns one person’s bank deposit into another person’s loan but no individual depositor cops a direct hit if a particular borrower defaults; the intermediary bears this risk. Of course, banks charge for the service of disconnecting lenders from the risk of individual borrowers.
This charge partly accounts for the (at least 10 percentage points) difference between term deposit rates and personal loan rates.
Peer-to-peer lending uses a direct connection between lenders and borrowers. This allows the platform to shrink the difference between lending and borrowing rates. Someone wanting a $5,000 loan for a holiday might register with a peer to peer platform. If they default on their repayments, whoever lent them the money bears the loss. While the average default rate across all loans on a peer-to-peer lending platform in normal times might be low – say less than 3% – the actual outcome for each lender depends on the specific borrowers they lend to and economic conditions at the time.
Without some minimum guarantees and lender protections, interest rates and charges are likely to rise as poor quality borrowers (lemons) drive out good quality borrowers, and the market will collapse. Similarly, the crowd-sourced equity platforms that can enable brilliant and highly profitable new ideas (so-called “unicorns”) to find capital depend on regulatory protection for unsophisticated investors. Stability, sustainability and trust are needed so we can all benefit from the accessibility and efficiency of this digital disruption.
Most alternative finance providers now operating in Australia are well aware of the need for sustainable business practice. Peer-to-peer lenders, for example, check the credit worthiness of borrowers in conventional ways, using credit history, capacity to pay, and sometimes secured assets. The platforms usually spread lenders’ funds across a range of borrowers, and facilitate payments and repayments.
However minimum regulatory guidelines ensuring good practice will protect the sector from “fly-by-night” entrants with lower standards. Setting those minimum standards well can only be done with comprehensive data on the alternative finance sector.
We don’t want to lose or delay the benefits of digital disruption in finance simply because not enough is known about the structures and participants.
Author: , Professor of Finance, University of Sydney
