Intermediation Is Not a Necessary Evil, It’s a Desirable Good

It was called Peer-to-Peer Lending.

The idea was to circumvent banks, the inefficient too-big-to-fail organizations that grew fat after centuries of undeserved profits, and create a market without any intermediates, where borrowers would be matched directly with lenders. Of course, such a market would be, by itself, an intermediary. But at least there was hope that the Internet, that great crusher of incumbent businesses, would eliminate as many middlemen as possible.

Peer-to-peer lending appeared on US shores in the form of Prosper Marketplace in 2006, followed by Lending Club one year later. Prosper started as a flexible market, allowing people with not-so-stellar credit to borrow at interest rates determined by the lenders themselves. It turned out to be a disaster: people simply don’t know at which rate they should lend their own money, especially to risky borrowers.

Lending Club focused on the social aspect, building a platform to lend through Facebook. The results were also disastrous: as those of us who have ever lent money to a friend in need painfully know, lending works better between strangers and when following strict rules.

In response, these marketplaces took on a necessary larger role: determining interest rates, distributing loans, and attracting borrowers and lenders. It turns out that lending money also requires tons of extra work for regulatory and technical reasons.: credit score agencies to determine the risk of a given borrower, collection agencies to try to recover funds when a borrower walks away, a qualified custodian to hold assets and cash, and even a bank to issue the loan itself.

From the investor point of view, lending money is by itself complex and time-consuming, which means investment advisors are also needed, sooner or later. So much for building a credit market without intermediaries.

While this newer system was being built, Wall Street smelled money. The bankers and financiers and hedge fund managers came in, bringing along tons of funding that fueled amazing growth and increased obfuscation. Gone were the days of ‘Napster for finance’, it was now ‘marketplace lending’, and most of the loans were no longer funded by ordinary people but from institutional deals made behind closed doors.

Eager to make another pretty dime, institutions brought ‘securitization’ to the table. For those unaware of what securitization is, it is the art of putting a lot of small stuff in an opaque bag, then convincing potential buyers that everything inside is good and it’s not worth opening the bag to check. Unfortunately, sooner or later someone realizes that profits can be increased by sneaking in a few rotten potatoes. And then a few more,… until ultimately there’s not one single good vegetable left in the bag. Hello 2008.

At the root of all financial evil is opacity. It allows unscrupulous people to disguise Ponzi scheme as wondrous investments, and money managers to discreetly sweep away unsavory results. In most cases, it simply entices decent people to be a tad more lax than they should be. Opacity used to be a by-product of all transactions happening with the same institution, usually a bank. Lending money is a risky endeavor, and banks are here to make it theoretically safer through careful diversification and crafty financial setups. In the process, banks hide the risk from ordinary people’s eyes.

But the increasing digitization has driven down transaction costs to the point where they are essentially free and instantaneous. It is no longer necessary to opaquely keep the entire loan process in house, since splitting work between different entities doesn’t cost additional time or money. This makes the whole operation more more trustworthy and resilient.
More trustworthy, because the more participants, the harder it is to keep anything a secret.

More resilient, because even if one piece fails, the system as a whole can keep working.

Here’s how Peer Lending 2.0 could work: a company functions as a marketplace to attract borrowers and capture their personal information. The marketplace is also responsible for scoring borrowers through credit scoring agencies and listing the loans. A custodian would be responsible for holding investors’ money. Investment Advisors are delegated by investors, individual or institutions, to decide which loans to fund. When enough money is committed, the custodian asks a bank to issue the loans, wire the money from the investors, then pays the marketplace for ‘origination fees’. The loan itself would stay at the bank during its duration, which is needed in the process anyhow, and would be services by the usual loan services. The marketplace and the custodian would not be able to package loans and sell them wholesale to a third party. At no time would the advisor be able to talk directly to the marketplace, or withdraw money from the custodian, except for its management fees. At last, each transaction between all these entities would require a time-stamped signature, blockchain-like, to prevent any further tampering, and signature ledgers would be made publicly available at all time (privacy would be maintained through anonymous IDs)

Such a system would be more transparent and safer for investors. It would not cost marginally more to operate, and would be easier to regulate. Maybe we should call it ‘Super-Intermediated Lending’.