ON THE RIGHT: A financial option with risks
Is there a need for alternative funding options?
Crowdfunding refers to debt and equity funding by large numbers of individuals and/or legal entities in small amounts transferred via mobile phones and online web-based platforms to a person or legal entity, whether to fund a business, a specific project, or other needs.
Crowdfunding pioneer of microlending, Kiva, was launched in 2005 to connect people through lending to alleviate poverty, and the number of online lending and investment platforms focusing on microfinance has been growing since. More recently, several microlending platforms have emerged using a peer to peer (P2P) approach.
Crowdfunding targeting a mass market and not specifically aimed at financing microentrepreneurs started in the United Kingdom in 2006, spread to the United States in 2007, and took off in China in 2009.
Since then, there has been rapid growth in crowdfunding in markets across the income spectrum, with high demand at both ends of the transaction.
According to The International Organisation of Securities Commissions research, crowdfunding accounted for US$6.4 billion in outstanding debt and equity globally in 2013.
Crowdfunding potentially holds promise for several reasons: it can be a quick way to raise funds; it can be cost-efficient, as the sales and marketing costs of the platform are close to zero (although these costs may increase, potentially significantly, if securities regulation applies); and its potential market reach is limited only by access barriers to the platform and regulatory limits where applicable.
With the increasing penetration of smartphones, this last barrier is also coming down, making the approach increasingly relevant to financially excluded and underserved market segments.
At the same time, the retail investors whose funds are being lent – especially small, potentially unsophisticated, individual lenders – face a number of risks, including lack of transparency and information on the borrower, fraud, borrower default resulting in loss of the investors, failure of the platform, failure or closure of the platform, and cyber-attack stemming from inadequate security of the online platform or the number of parties involved.
While the identified crowdfunding risks may also be relevant to institutional investors, they may have better means of assessing and mitigating some of the risks, including the risk of default, fraud, and technology failure.
In the context of the rapid growth of crowdfunding and the potentially increasing complexity (such as securitisation of crowdfunded loans), the challenge before financial regulators in the financial inclusion context is to put into place regulation that encourages the development of new financing techniques while protecting both retail investors providing the loan funds and potentially also the borrowers making use of them, while bolstering consumer confidence and trust overall.
In considering an appropriate regulatory framework for crowdfunding, policymakers will need to address certain fundamental market level questions. While bearing in mind that investor protection triggers many market-level regulatory questions (for example, what due diligence responsibilities should platform providers be obliged to conduct?) in the financial inclusion context consumer-level issues are particularly important.
Moreover, the concerns relate potentially to both the individual retail investors whose funds are lent and to the borrowers, as both sides of the transaction may be inexperienced financial consumers.
Financial consumer protection measures relevant to crowdfunding need to take into consideration all the investor risks outlined above. Issues will include lender and borrower education, transparency of product terms (to both borrower and lender) and borrower informed consent, consent for use of customer data for other purposes, recourse, and resolution of technical issues when using a third-party disbursement channel.
The Global Partnership for Financial Inclusion is an inclusive platform for all G20 countries.