Online or Offline?

The Rise of Peer to Peer

Lending in Microfinance
Susan Johnson
Center for Development Studies, University of Bath, UK
Arvind Ashta
Burgundy School of Business (Groupe ESC Dijon-Bourgogne), Francei
Djamchid Assadi
Burgundy School of Business (Groupe ESC Dijon-Bourgogne), France

ABSTRACT

Over the past five years, so-called “peer-to-peer” lending websites have become a new approach to
mobilizing funds for on-lending to poor people in developing countries (microfinance) and in
domestic markets. This paper reviews these developments. It uses the analytical lens of asymmetric
information and the transactions costs to explain the characteristics of the different models in
operation. We find that “peer-to-peer” lending is more of an aspiration than a reality. Although web
2.0 technologies have offered new means of mobilizing funds, the borrowing mechanisms at work
follow mainstream conventional approaches to the management of lending.

INTRODUCTION

The internet has reduced transactions costs dramatically in a wide range of contexts, either through
the ease of searching for information on the web, or communicating via email. From an economic
perspective, the key feature of ‘Web 2.0’ tools compared to ‘Web 1.0’ are the reduced costs in terms
of time and skills needed in making information available for a much wider range of users. No longer
is it necessary to bear the costs of setting up a website to disseminate information in a “one-to many”
fashion. These technologies offer much easier access to platforms through which information can be
made available about the firm or the individual, and devices for interaction that reduce the costs of
finding peer groups with similar interests.

For institutional economists, reducing transactions costs is a key means through which economic
development takes place (North 1990), as this results in improvements in market efficiency and hence
also in the allocation of resources in the economy. In economic theory, transactions costs arise in a
number of ways. First , they may arise from the simple fact of geography and distance: for example,
the time and costs incurred for going to the bank to deposit savings or seek a loan. Second, they arise
from the need to search for information: to find out where a particular product or service is available,
or what is the most reliable and appropriate bank account to deposit the savings in. Third, they may
relate to the particular product or service involved, in that the bank will charge for example to
undertake certain checks e.g. a credit check if you want to take a loan. In this latter case the cost may
be included in the interest rate instead of an upfront fee and is effectively the bank charging for its own
need to find out about the customer before it lends.

One of the key problems of lending to poor people is the transactions costs incurred in making very
small loans. The rise of microfinance in the past two decades is, in part, due to reducing the
transactions costs of lending to poor people. The internet offers the possibility that transactions costs
can be reduced over greater distances – even across national boundaries – and that lenders in

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developed countries can lend small amounts directly to poor people in developing countries. Online
lending firms have entered the market to seek to achieve this.

The purpose of this paper is to review the nature and characteristics of seven such companies in order
to better understand the role of the internet in this approach. This peer-to-peer lending industry is
evolving rapidly having about $650 million in outstanding debt in 2007 (Lee-St. John 2008) to which
can be added another $100 million to $150 million for 15 online microfinance platforms, according to
a spokesman from Babyloan. A rising number of individuals are now looking towards networks of
friends or even strangers on the Internet to finance purchases, pay for one-time events (such as
weddings or vacations), consolidate debt, finance their small business or pay off a mortgage. The
paper proceeds as follows. In the Background section, we discuss transaction costs web 2.0 and the
rise of online lending. We then proceed to examine the operational models of each of these companies
in greater depth. Finally, we draw conclusions about the models and their characteristics using the
insights offered by transactions costs analysis.

BACKGROUND
This section aims to scrutinize the impacts of Web 2.0 tools on transaction costs. Theories and
applications will be discussed.

The Nature of the Problem: Transactions Costs in Microfinance

We outlined in the introduction three types of transactions costs involved in lending: the physical
costs of travel and time incurred; the costs of searching out products or services and the costs of
checking the quality of the customer or client. It is the latter two of these that we will focus on here as
both of these arise from the problem of asymmetric information.
The information asymmetry between the borrower and lender produces two particular
problems:adverse selection (Akerlof 1970) and moral hazard (Stiglitz and Weiss 1981). The problem
of adverse selection is, for example, that the borrower may give the lender information about the
potential returns to the project being higher than they actually will be. Moral hazard, on the other
hand, is the case where after the loan is given, the lender cannot be sure that the borrower’s interests in
the project are aligned with his own and hence that she will act to ensure the project is effectively
carried out; rather she may prefer to default.

The means by which lenders seek to overcome these problems are threefold: screening of the
borrower and the investment project; ongoing monitoring of the project and loan repayment; and
finding means to enforce repayment in the event of default. It is the costs of carrying out these
functions that contribute to the costs of borrowing in the form of the interest rate. The interest rate in
turn has four key components: (i) the cost of funds i.e., what must be paid to depositors or investors
offering the funds for on lending (including inflation rate coverage); (ii) the cost of actually lending in
terms of these transactions costs of screening, monitoring and follow up enforcement; (iii) the costs of
default when funds are not repaid and (iv) the profits that the lender expects to earn as a result of
carrying out this business (return to equity).

Lending a $50 loan to a poor person differs little in terms of the transactions costs involved than a
$5000 loan since the checks involved still have to be carried out. Hence lending to poorer people has
in the past incurred losses and been a market which banks were unwilling to enter. The growth of
microfinance can in part be understood in relation to how it has addressed the central problems of
screening, monitoring and enforcement for lenders. The use of groups as a conduit for lending to
individuals has been a key feature discussed in the analytical literature (Besley 1995). This makes use
of information that local people have of each other without the lender needing to find out more about
an applicant's creditworthiness. Second, close monitoring of borrower behaviour is undertaken
through weekly meetings and weekly repayments. This also makes repayments manageable and able
to be paid from other sources of income if the project is not being successful. Third, enforcement can
operate either through the pressure the lender puts for repayment on a regular basis; as well as using

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other members of the group to put pressure on someone who is not making the repayments. The
regular visits of the loan officer become more affordable since lending to the group produces
economies of scale in the operation.

While group lending technology may have helped address the transactions costs of delivering small
loans, controversy has simmered over the level of interest rates charged which remain high by
developed country standards. On a declining balance basis they may range from 15% at the low end
to well over 100%ii once compulsory savings, fees and other costs are included. A recent study by
CGAP (Rosenberg, Gonsaez & Narain, 2009) estimated that the average interest rates of MFIs to final
borrowers in 2006 were 28.3% (median interest rates reduced from 32% in 2003 to 26% in 2006). The
average cost of funds for MFIs was 8.3%, the loan loss reserve 2.3%, while operating expenses are a
median of 11.4% and profits are about 12.5% (Rosenberg, Gonzalez et al. 2009) (figures reported are a
mix of means and medians and do not add up to the total).

The question arises whether web 2.0 technologies serve to improve access to information, reduce
transaction costs and increase outreach.

The Role of Web 2.0

The term Web 2.0 stands for a generation of social media that allows users to jointly create and
manipulate content.

For solving problems, collaboration and aggregation of information in groups is considered to be

better than the enlightenment of an elite few, no matter how brilliant (Surowiecki 2004).Web 2.0 tools
can enhance collaborative environments by making the practices of knowledge work more visible and
accessible (McAfee 2006). These tools enhance meaningful in-house dialogue and facilitate mass
virtual collaboration to solve a problem or to improve an operation (Tapscott and Williams 2006).
Collaborating through Web 2.0 technologies is also referred to as “crowd sourcing” (Tapscott and
Williams 2006).

Through Web 2.0 technologies, information can flow between virtually any points rather than in the
more linear fashion of the past and, thus, may proximate a more spherical model (see figure 1).
Furthermore, Web 2.0 open standards applications such as tagging, bookmarking, and user-generated
content enable new forms of collaboration and new forms of information. An illustration of such a
network is provided in the right hand of figure 1 as a potential spherical web2.0 based model, where
people network with each other using the website as a platform to create content compared to past
models which have been linear in the production and distribution of data.

Usual linear model Potential spherical web 2.0-based model

Figure 1: Models of peer-to-peer micro-lending distribution channels on the Internet

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A McKinsey survey by Bughin & Manyika (2007) includes the following nine web 2.0 tools, ranked
in order of respondents' interest and importance attached: web services, peer-to-peer networks,
collective intelligence, social networks, podcasts, Blogs, RSS (Really Simple Syndication), Wikis and
Mash-ups. Web services are defined as "information systems to make it easier for different systems to
communicate with one another automatically in order to pass information or conduct transactions"
(Bughin & Manyika, 2007), and they give an example of a supplier and retailer updating each other's
inventory. While this was the most used service across the board, the survey points out that different
industries make use of different tools. For example, communications and media industries use RSS,
Blogs and Podcasts more than the average user. Similarly, knowledge-focused industries (such as
high-tech) use mash-ups, peer-to-peer networking, social networking, collective intelligence and wikis
more that average users.

Our question is therefore, to what extent Web 2.0 tools are being used in peer-to-peer (P2P) online
lending websites to reduce information asymmetry and, hence, transaction costs in microfinance.
Schematically, the question is whether the online lender's system resembles a linear intermediation
chain as in the left hand side of figure 1 or a spherical model as in the right hand side of figure 1.

The Rise of Online Lending

A new category of lending companies has emerged on the Internet, which have been termed "peer to
peer lending". From the outset there are differences between them in terms of their approaches and
objectives. Four types stand out. First, there are those specifically engaged in microfinance by raising
funds from individual donors (philanthropic lenders) mostly in developing countries for investment
with poor entrepreneurs in the developing world – such as Kiva and Babyloan. Second, while also
belonging to the microfinance category, MicroPlace (owned by e-Bay) raises funds from the public
with the promise of a return, to invest with specialist investors who then invest in microfinance
institutions. Third, there are three that operate by raising funds from investors and matching these to
the needs of borrowers within the UK or US : these call themselves “social lenders” and include
Prosper, Zopa and Lending Club. Fourth, a site facilitating lending between friends and family
members in the US, for example, Virgin Money.

TRANSACTIONS COSTS AND THE ROLE OF THE INTERNET IN PEER TO PEER

LENDING
We first describe the different online lending models. Then we look at the role of web 2.0 in these
models. We complete this section with an analysis from the asymmetric information and transaction
costs viewpoint.

Different Online Lending Models

This sections reviews the business models of various lending sites to understand the underlying
structure of their operations and the extent to which the aspiration of creating direct relationships
between lenders and borrowers is achieved. We do this by reviewing each of the four main models of
operation.

The online microcredit model (Kiva, Babyloan)

For both Kiva and Babyloan, their objective is developmental in terms of mobilizing lower cost funds
for MFIs in contrast to other sources of finance available to them. On their websites, individuals can
choose to invest in one of the entrepreneurs who are profiled there. The course of a loan is usually
between 6-12 months and its amount can be as little as $25 at a time (20 Euros for Babyloan). The
individual sends the funds she wishes to lend to Kiva who then on-lends them to the microfinance
institution (called field partners) of which the entrepreneur is a client. In the case of Babyloan, it
facilitates a contract between the lender and the MFI. The borrower repays the MFI which in turn

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repays Kiva (in the case of Babyloan, repayment is made via their system). Individual investors do
not receive interest on their loans but may be repaid or roll the funds over into another loan. Hence,
these are effectively “donations” which rotate and offer better value than a donation to other charities
which might be spent directly.
Kiva is an NGO whose running costs are paid by donors (including lenders who donate a small
percentage of their loan (15% sugested by the system at the time of each laon for Kiva, 2,5%
mandatory for Babyloan)), sponsors, as well as the interest on the float (money received but not yet
lent or not yet reimbursed to lender). It also mobilizes volunteer labour to assist with its operations. In
contrast to Kiva, Babyloan charges a service fee to the MFIs to cover its own transactions costs as it is
looking for a financially sustainable model of microfinance lending. This quarterly management fee is
charged at 2.5% on net outstanding loans provided to the MFI. Babyloan operates through fees
because under French law, interest can only be charged by banks.

To become a Kiva or Babyloan "field partner", the prospective microfinance institution must currently
serve at least 1,000 active microfinance borrowers; have a history (at least 2-3 years) of lending to
poor, excluded or vulnerable people for the purpose of alleviating poverty or reducing vulnerability; be
registered as a legal entity in its country of operation; be able to show at least one year of financial
audits; and preferably be registered on the MIX Market (www.mixmarket.org). Moreover, field visits
by volunteer workers (in the case of Kiva) verify the existence and operations of the MFI, and are an
expense borne by the supporters of KIVA in terms of volunteer time and donations. For Babyloan, the
MFI’s are supported by European technical assistance organizations and “Babyloan’s Professional
Network (BPN)”iii.

Lenders periodically hear back from their sponsored entrepreneur and remain informed on the progress
of the enterprise, via email and online journal updates, usually written by MFI representatives or loan
officers. Neither site facilitates direct interaction and communication between lending and borrowing
individuals.

This system therefore involves two intermediaries between the initial lender and the ultimate borrower.
First, Kiva as recipient aggregates funds from small-scale donors, or in the case of Babyloan,
aggregates them as a facilitator. These are then on-lent or transferred to a field partner (a microfinance
organization), who on-lends to the final borrower.

Online social investing (MicroPlace)

MicroPlace distinguishes itself from Kiva and the other entities and specifically refers to its lenders as
"investors" rather than donors. It offers a return on the investment of 1 to 3%, but because of this, it
can take only funds from USA-based retail investors and the USA Securities and Exchange
Commission does not allow MicroPlace to give loans to MFIs directly. Instead MicroPlace invests in
market notes of security issuers. These security issuers then provide the funds to microfinance
institutions who on-lend to the poor. Microplace earns a commission from the security issuer.

Once loan repayments are received by the MFI from its clients, the institutional investors receive their
principal (plus interest) and can then pay back their own investors, i.e., people who purchased those
original securities – in this case MicroPlace and its investors. As a result of this model, profiles of
entrepreneurs are only included as sample borrowers of the MFIs involved. This also reduces the costs
to it and the MFI of managing and updating such profiles.

In MicroPlace's case, their website suggests that they would like to view themselves as a platform
where at the very least investors, security issuers and MFIs are present. But a Microplace official
commented that "MFI's are simply not sophisticated enough themselves to be able to create a security
to offer to US investors. As you can appreciate, it's an expensive and complex process even for the
largest organizations like Calvert or Oikocredit." As the same spokesman comments: "We have many
security issuers in the pipeline, but bringing a retail investment to market in the US involves many
regulatory, cost and other hurdles. We try to lead security issues down the path and make it easy, but
the fact is it just takes time and perseverance to get through all the necessary details and MicroPlace

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may be one of many competing distribution channels for them. As we have more issuers on the site,
raise more capital, and develop more of a standard "toolkit" for completing the process, it will be
easier- we're just enduring a few expected growing pains now".

By contrast to Kiva and Babyloan, the MicroPlace model involves three links in the chain between
initial investor and final borrower. The individual investor lends to MicroPlace, which aggregates the
funds and invests in the security issuer, who in turn negotiates and lends to the microfinance
institution and then on-lends to the final borrower.

Online social lending (Zopa, Prosper and Lending Club)

Zopa, Prosper and Lending Club are for-profit companies which provide a marketplace for loans
between investors and borrowers in the same country. Borrowers post a profile of themselves and
submit their requests for funds on the site and investors can choose to take on a whole loan or portions
of loans to a number of borrowers, depending on the risk and return profile they are looking for.
According to the websites, this process helps borrowers to get lower rates than commercial credit and
offer lenders higher rates than bank deposits. The websites indicate that many borrowers would
otherwise be unable to get any loans from banks: for example, new companies who have no financial
history seem to have difficulty in getting loans from banks during the first two years because they do
not have financial information to provide (Farrell 2008). However, borrowers are vetted for their credit
records and, according to Lending Club, only the top 14% of candidates are accepted, and these are in
turn allocated a credit rating by the site. While investors can choose which borrower's projects they
invest in, all personal details remain confidential even though they may disclose information about
themselves or their project, so that neither the lender nor the borrower can fully trace the other party.
Borrowers can use the site to build up a credit rating. An auction mechanism is used to allow
borrowers to get the lowest rates for their credit rating.

It is evident that the company stands in between the lender and the borrower, collecting and vetting the
information submitted by the borrower and through the site offering investors a choice of investments
while also carrying out collections and enforcement. Hence there is one link in the chain in this case.
Much of the lending is for consumer lending: cars, weddings and other such major purchases.

Facilitating Social Lending (Virgin Money)

Virgin Money (USA) differs from the previous social lending model because it focuses on loans
between people who already know each other. The site offers the means of formalizing the loan in
terms of loan documents, payment processing, reminder emails, and year-end statements. This is
offered on a fee for service basis rather than taking a cut of the interest rate. It enables people who
might be willing to lend to each other but may feel that they do not have the ability to ensure
repayment and do not want to damage a friendship or family relationship as a result. Thus they are a
facilitator of direct peer-to-peer lending.

The role of Web 2.0 tools in online lending

Having described the models, we turn to examine our a priori hypothesis which was that by enabling
individuals to interact, online lending sites would find Web 2.0 tools useful in furthering their
objectives. Of the nine web 2.0 tools outlined above, we review five, first webservices; and then four
social tools: blogs; interactivity; peers' reviews and comments; peers' communities and chats - as
these are visible and relevant to the potential to build up direct interaction between lenders and
borrowers. While all sites use webservices, we find that five sites use blogs, two sites have other
means of interactivity, one site is using wikis and three sites are offering peer community and chat
services, as shown below in Table 1.

First, it was indicated above that "web services" are the most used tool across all websites and indeed,
that is also the case here. This is the type of tool that makes these sites operable as they offer the
means for the company to interact directly with the donors and investors on the one hand and, in the

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case of social lending, with the borrowers. Investors use them to pay into their accounts and manage
their portfolios and, in the cases of Zopa, Prosper and Lending Club, these are the means through
which borrowers upload their profiles and requests for funds.

Table 1 - Web 2.0 social tools used by lending websites

Blog Interactivity between Peers' reviews and Peers Communities

lenders and buyers comments and chats
Kiva Journals of entrepreneurs with None, but members Comments on the Communities only for
photo, message. Possible link may request for journals of the lenders (since August
to the lenders’ blogs. Kiva Blog, visiting their entrepreneurs. No 2009)
"Inside Kiva", an info letter beneficiaries. interactivity
with links. No interactivity with
readers.
Babyloan The blog is interactive. None, but members None Friends community
Babyloan members receive a sometimes request system allowing
monthly news letter. visits to their lenders to invite and
beneficiaries, as create friends
indicated in blog. network inside the
web site

Lending General blog for all members , No direct contact or Possible comments None
Club allows comments and exchange on the site on borrowers or
discussion by authorized Possible exchange lenders in the out-of-
people (we see the same via common out-of- site affiliations
person writing all the time). site affiliations like websites. None on
FaceBook, MySpace. their website.

MicroPlace Institutional blog, personalized Listing of borrowers. General information None

with pictures. Can comment No interactivity on borrowers. No
but not initiate. peer comment

Prosper There are two types of blog on "Questions & None Prosper Groups,
prosper.com : institutional Answers" on created by lenders
blogs and affiliated and linked borrower’s listing. and borrowers,
to blogs. The institutional blogs Rated on repayment
are not personalized. Still, they performance
allow comments even if users
cannot initiative new topics.

Virgin None None None None

Money
Zopa Institutional blog for all The discussion board Not on the site. Discussion board for
members. Can comment. is interactive Possible via the members
personal borrowers’
blogs (if linked to the
site’s listing)

Total using 5 3 1 3
tool
As on September 25th, 2008, incorporated Babyloan reviewer updates March 2010 for Babyloan.

However, some of these blogs are less interactive than others. Some are only one-way communication
channels used by the company which permit comments and allow the initiation of new topics.

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Similarly communities may be open only to lenders; only to borrowers; or to both lenders and
borrowers. The fact that the members of our sample use web 2.0 in a rather limited way seems
surprising because these tools have the potential of promoting connections between peers, and one
might expect that social lending websites wish to increase these interactions.

Interestingly, of all the sites, Virgin Money does not use any web 2.0 social tools. But, it must be
remembered that the people using Virgin Money already know each other and therefore do not need
such tools. Overall, compared to the McKinsey survey (Bughin and Manyika 2007), we find that
online lending sites use more blogs than most websites, however their use of other tools is little
different.

Analysis and discussion

The above review has demonstrated that the reality of so-called “peer-to-peer” lending seems
somewhat at odds with its rhetoric. We have shown how the four models can be seen as offering
different lengths of chain – one, two or three links, and operate in a linear manner. The fourth, Virgin
Money is actually the only one which involves direct lending from peer to peer, and in this case it
operates as a facilitator – with zero links! This helps highlight the issues that force the other sites to
operate in the way that they do and the reasons for it are readily understood through the theoretical
lens of asymmetric information and transactions costs introduced earlier.

First, the expectation that peer-to-peer lending could offer the means to lend directly to poor people in
developing countries is clearly unrealistic. In all lending, there is a need to make an assessment of the
borrower and rather than making this easier, the internet actually makes it more difficult. The costs of
verifying the information submitted by a potential borrower in India for example, from the USA are
clearly much higher than for a local lender. This was discovered by Matt Flannery as he started Kiva.
The initial channeling of funds to apparent enterprises in Uganda, were found to be fraudulent as
Kiva’s contact there was posting fabricated stories and this was only discovered when a Kiva
volunteer visited (Flannery 2009). In addition, poor people may be illiterate and unlikely to have
access to the internet so in any case being inaccessible. Moreover, even if they were literate and had
access to the internet, the legal safeguards around the information they submit are unlikely to be
adequate across national boundaries. So, the transactions costs of screening, monitoring and enforcing
loan repayment at such great distance are in fact extremely high and prohibitive for very small loans.
Clearly, these sites have therefore solved this problem by lending to existing microfinance institutions
who in turn undertake the task of screening the borrower, monitoring repayment and enforcing where
necessary, often reinforced by technical assistance partners. The online lender then has the more
limited and achievable task of undertaking due diligence checks with respect to the MFI and provides
it with a much larger loan (or re-financing facility). As Flannery (2007:38) notes, Kiva was
concentrated on the ultimate borrowers experience and had no background in due diligence and it has
taken a “cultural shift” in the organization to “get good at it”.

The case of MicroPlace stands slightly separate from the first two microfinance sites because it offers
a return on the funds involved. This contrasts to Kiva and Babyloan because in those cases the
‘investor’ is operating as a donor who does not receive a return. This is due to the requirements of the
Securities and Exchange Commission and Central Banks surrounding the ability of an investment
company to offer a return and the nature of the investments it can make in order to offer this to its
investors. Such regulations cannot simply be viewed as an obstruction to successful cross-border
operations because they exist to safeguard the interests of investors and to help address the asymmetric
information problems they face in handing their funds over to another institution (whether a bank or an
investment company). The device of investing these in MFIs via security issuers is then a means of
operating within the law where expertise in risk assessment is appropriately organized.

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By contrast, the fact that Zopa, Prosper and Lending Club offer a model with one link in the chain is
precisely because their transactions costs are structured differently, in part because they operate within
the same legal jurisdiction. In these contexts, borrowers uploading their information must comply
with statements regarding the integrity of the data submitted and can be sued if this is erroneous.
Moreover, the sites can reduce their costs of checking loans in the same way a bank would, by making
use of available third-party information in the form of identity and credit checks of the loan applicant.
They do this before the borrower is posted as a potential borrower on the website.

For microfinance lending sites the intention of the interaction on their websites is about building a
community of people who are interested in addressing poverty – i.e., it is a marketing tool and a means
to mobilize ‘social’ investors who wish to engage in an alternative model of giving. This has created
an additional and alternative source of funding for MFIs that did not previously exist. It is the use of
web 2.0 webservices tools that is the most effective in enabling this model to develop and web 2.0
social tools only act to support this in some limited ways. The model of donor mobilization takes its
inspiration from previous child-sponsorship types of mechanisms used in the past (Roodman 2009).

FUTURE RESEARCH DIRECTIONS

Rather than the direct interaction of donors/ investors and borrowers, it is the web services aspect of
the sites that allows interaction between the organization and its donor/investors, and in the case of
social lending with borrowers, and it is this that has provided the key value added in this field. While
social lending sites claim to reduce the costs of borrowing and increase the returns to investing, this
paper has not investigated this claim. However, given that their investors do not demand a return,
these funds are being on-lent to MFIs at lower rates than other investors, however their actual
transactions costs of operations could be investigated and compared to other donors. .

As we have said, the question of whether these companies in national markets are offering more
competitive prices to both investors and borrowers than the banks has not been reviewed. There is
certainly scope for this if they can use Web 2.0 to raise and on-lend funds in more streamlined and
cost-effective ways than banks. However, they are not competing in the same markets at present
because they do not offer guaranteed returns because these are investments (risk capital) rather than
deposits and hence are not subject to deposit protection laws. These laws are, in turn, a means of
addressing the asymmetric information problems that depositors face.

The rise of the microfinance sites suggests that they are responding to an interest on the part of donor
or investors to better know where their money is going. More research needs to be done on the nature
and motivation of such funders. The organization of a number of off-line events such as conferences
by these organizations and field visits indicates that human interaction may necessitate some physical
community and that virtual communities are not sufficient.

CONCLUSION

This paper has investigated the rise of peer-to-peer lending sites through the lens of transactions costs
analysis. Asymmetric information problems characterize the nature of the problem of lending funds
and to overcome these requires borrowers to be screened through the collection and assessment of
information about them, and - once the loan is made - ongoing monitoring and enforcement of the
borrowing agreement. We have argued that - contrary to first impressions - web 2.0 technologies do
not provide an easy solution to these problems. Rather, they have the potential to exacerbate them.
As people may interact at greater distances - both geographically and socially - it raises the costs of
one individual actually being able to check the information provided by another before entering into a
loan agreementiv.

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We have shown how this problem affects the nature of the operations of the various peer-to-peer
lending sites currently operating on the internet. The sites have to undertake this function on behalf of
their donors and investors. The exception, which highlights the issue, is the case of Virgin Money
which operates as a facilitator to formalize an agreement between a borrower and lender who already
know each other.

We have argued that the number of links in the chain can be understood as arising from this problem
and its interaction with national boundaries. While laws governing the integrity of information given
in one country can enable interaction between borrowers and lenders at just one step removed via
‘social lending’ sites, this does not extend across national boundaries. This explains the fact that many
of the microfinance sites operate with donors not receiving a return, while these are differentiated from
MicroPlace which, because it is offering a return, is regulated by the SEC and must allow for proper
risk assessment for investment in overseas MFIs.

It is evident that in the long run, as the potential for interaction over the internet develops, the key
issue is the verifiability of information provided. This offers scope for the further expansion of
supplementary services related to credit checks and so on, but fundamentally hinges on what societies
agree to be the necessary safeguards around personal information collection and dissemination. As the
internet and the tools of Web 2.0 develop it will be these issues that are at the center of whether peer-
to-peer lending ever becomes a reality.

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KEY TERMS & DEFINITIONS

Peer to peer, p2p, social lending, online lending, microcredit, microfinance, technology, web
2.0, trust, innovation

ENDNOTES
i
Arvind Ashta would like to thank Banque Populaire for financing the Microfinance Chair he is
holding that partially finances his time.
ii
The interest rates also vary from author to author: For Example Dieckmann (Dieckmann, R. (2007).
Microfinance: An emergin Investment opportunity: Uniting social investment and financial returns.
Frankfurt, Deutsche Bank Research: 20. ) suggests a range of 15% to 70%. However, with
Compartamos, Mexico having charged 100% the range is increased to 100% in line with Ashta Ashta,
A. (2009). "Microcredit Capital Flows and Interest Rates: An Alternative Explanation." Journal of
Economic Issues (M.E. Sharpe Inc.) 43(3): 661-683.
iii
Information provided by above-mentioned Babyloan reviewers.
iv
A problem most obviously evident from concerns people have about interaction in chat rooms and
dating sites and whether information given can be trusted.

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