Peer-To-Peer Lending: The Free Market In Action

The internet is a beautiful thing, it creates opportunities to streamline so many things in our lives. It creates a marketplace where people can reach each other so easily. It has the power to decentralize authority and break down barriers. We have information sharing at an insane rate that people just 20 years ago couldn’t imagine, but I think we have yet to see the real power of the internet.

As the financial crisis rages on, a fairly new form of decentralized lending and borrowing is emerging through online sharing of money. According to a study by Grail Research, person-to-person lending (P2P) is a fast emerging trend that could seriously reduce dependence on banks. P2P lending is a form of micro-lending where an individual or a group lends money to a person in need without any intermediary or central authority like a bank.

Many people in third world counties could have their lives changed with less than $100 dollars. They can use that money to buy goods that could allow them to build a business and make more money. For example, someone in Africa could buy a small generator and use it to power a small refrigerator and sell cold drinks. A man in India could buy new carpentry tools to build houses. And those small loans make those things possible.

Borrowers put up a profile online, usually on the site that facilitates this whole process, sites like Kiva.org, dhanaX, or Lending Club, and lenders can browse through the site looking for someone they think is worthy of their loan. The market for these loans is huge. In India, for instance, the size of informal lending market is estimated to be $90-100 billion, with rural areas accounting for bulk of the market. Of this, just 30-35 percent is supposed to be managed through friends and family networks including the emerging new platform of person-to-person lending.

“P2P lending is one of Web 2.0′s less-appreciated applications. By eliminating intermediaries such as banks, it creates better outcomes for both borrowers and lenders. We expect it to be a key threat for traditional lenders such as banks in the long term,” Grail Research Country Head Amit Kumar said.

Groups of the poorest in any given society are the ones that traditional banks won’t help, which is why P2P works so well, it has access to the long tail

Call me an econ-geek, but I’m incredibly excited about the concept of P2P lending. Decentralized solutions to social problems are generally much more elegant and workable. With P2P lending, for example, each individual lender negotiates the interest rate with the borrower, this creates a system where competition increases greatly. Instead of a few banks capable of lending money, the number of lenders is only limited with the number of individuals willing to lend. More competition, of course, means lowered costs and raised quality of the service. It’s a perfect example of how the free market solutions are superior to centrally planned solutions.

Imagine if a government or some other central authority were to take over Kiva.org, or get involved in the micro-lending business. If government were the central authority controlling the microloans, the money would first come from taxes levied on the citizens, whether they want to participate in the program or not. Then, since some members of society may not agree with where the money is going, politicians would propose new legislation requiring borrowers to meet certain qualifications, and setting limits on the amount of money able to be borrowed. Each loan would be controlled by a government employee instead of by the prospective lender, and those government employees need to be paid out of the pool of tax money, lessening the amount that can go to borrowers.

Since everyone is paying, everyone wants a say in how the money is spent. Government officials and special interests, who have more power than individuals, start diverting this pool of money to their own ends. Large corporations start building projects in third world countries under the guise of helping needy so that they can gain access to the pool of micro-loan money, and politicians push that legislation through because they’re getting endorsements and donations from those corporations. All this happens when you move from a decentralized system to a centralized one.

In the decentralized system, since the loans are spread out among thousands of lenders making decisions about their own individual loans, the system is insulated from corruption. There is no need to pay loan counselors or financial consultants because each lender negotiates the rate of interest with the borrower, so less money is used overall and everything is more efficient.

Taking all these things into account, P2P lending is one of the most powerful real world examples of how the free market works better than a regulated system with a central authority. It’s just Common Sense.