Crowdfunding and Peer to Peer Lending in the Digital Age
Crowdfunding and peer to peer lending (P2P) are two financial innovations that have gained immense popularity in recent years, reshaping the way individuals and businesses access capital. These concepts leverage the power of the Internet and social networks to democratize finance and connect borrowers with a diverse group of investors.
In an era marked by increasing digitalization and a shifting landscape in traditional financial services, in which the “combination of new telecommunications, big data analytics, cryptography and machine learning technologies has the potential to change the whole banking industry in faster and more disruptive ways than ever before” (ECB, 3rd annual conference on Fintech and Digital Innovation, 26 February 2019), these innovative platforms offer new opportunities for both those seeking funds and those looking to invest.
This article analyzes the mechanisms, the differences, the benefits and the risks associated with such financial innovations.
The Mechanisms of Crowdfunding and P2P Lending
The underlying idea between crowdfunding and P2P is to provide financial support to entrepreneurs or small and medium sized businesses that would not otherwise be able to raise capital through traditional means, such as bank loans or venture capital investments.
The mechanism that involves these innovations is rather similar.
Crowdfunding is a funding mechanism where individuals or organizations raise money for projects, products, or causes by seeking small contributions from a large number of people, through online platforms. The process typically involves the creation of a crowdfunding campaign detailing the project’s purpose and funding goals. People who are interested in supporting the project, known as backers, contribute money to help reach those goals. Depending on the type of crowdfunding (rewards-based, donation-based, equity-based, or debt-based), backers may receive different incentives or financial returns. If the campaign meets its funding target within a specified timeframe, the funds are collected and used to execute the project, product development, or the intended cause. Crowdfunding platforms facilitate this entire process, making it accessible to a wide audience of potential backers.
Similarly, the P2P lending mechanism works like a sort of debt-based crowdfunding in which borrowers create profiles and loan requests on P2P lending platforms, providing details about their borrowing needs and creditworthiness. Investors browse through borrower profiles and select loans to fund, based on their investment preferences and risk tolerance.
The P2P platform handles the entire lending process, including credit assessments, loan origination, and repayment collection, making it a streamlined and efficient way to connect borrowers with a diverse group of individual lenders.
Opportunities and risks of Crowdfunding and P2P investments
The main advantage associated with crowdfunding (and P2P) is the fact that it promotes the democratization of finance, the idea that financial opportunities and access to capital should not be limited to a select few or traditional financial institutions. Indeed, raising capital from a multitude of investors becomes much easier as crowdfunding and P2P lending harnesses the power of technology and online connectivity and exploits the fact that the multitude of investors share the risk associated with funding the project. In other words, those riskier projects that banks or venture capital firms would not fund because of their risk-averse nature can find support within the diverse and decentralized network of investors in crowdfunding and P2P lending.
Moreover, most of these projects offer some interesting risk-adjusted returns for investors and they provide an opportunity to diversify investor portfolios by participating in a wide range of projects or loans, reducing their exposure to any single investment and potentially increasing the resilience of their portfolios. This is because, oftentimes, both equity-based crowdfunding, which consists in trading money for shares of the company, and P2P lending, which consists in lending capital against the promise of future principal and interest repayments, are accessible to small retail investors as well.
Despite their growing popularity and the incredible opportunities that they offer, it is important to recognise that (equity)crowdfunding and peer to peer lending are not risk free investments.
In particular, the risks associated with equity based crowdfunding are the following:
- Limited liquidity. Investments made through online platforms are often illiquid, meaning that it may be difficult to sell or exit the investment before the project reaches its maturity or completion date. This risk is further exacerbated by the fact that, unlike publicly traded stocks or bonds, investments in crowdfunding and P2P lending
- Equity Dilution. In equity-based crowdfunding, early investors might face equity dilution if the company later raises more funds by issuing additional shares, reducing the value of existing shares.
- Business Failure. The possibility that the funded project does not succeed in achieving its intended goals, ultimately leading to its failure.
Similarly, peer to peer investors face risks associated with the either partial or total default on the loan and the low liquidity.
We notice that such risks are similar to those associated with buying stocks and bonds respectively, with the difference that publicly traded companies and rated bonds do offer investors more data and ratings to make more informed investment decisions and are, by nature, more liquid instruments.
The lack of available information in crowdfunding and P2P investments is often compensated with higher returns.
Finally, investors are exposed to the risk associated with the platform going bankrupt or facing financial difficulties.These platforms serve as intermediaries that connect investors with borrowers or projects, and their financial health is crucial for the proper functioning of the investment ecosystem.
In conclusion, crowdfunding and peer-to-peer lending represent dynamic and innovative ways for individuals and businesses to access capital and for investors to diversify their portfolios. As these platforms continue to evolve and mature, both investors and capital seekers will benefit from an ever-improving ecosystem that balances risk and opportunity in the pursuit of financial innovation.
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