About 7-10 years ago everyone bet big on crowdfunding, regarding it as a long-awaited instrument that would exclude banks as useless intermediaries receiving commission for moving money from one pocket to another. However, as the hype abated with time, it became clear that it is not all that simple.
Most of the widely marketed international platforms that enjoyed popularity some time ago seem to have had their glory days past them. Many high-profile projects have been outright shut down. China’s market has been forcibly cooled by the regulator to restore investor confidence after having faced extreme overheating and massive bankruptcies caused partly by fraudulent activities.
At the same time, crowdfunding means different things in different countries: from traditional loans from individuals to individuals to complex lending-based models for funding projects with social impact and multiple effects by raising money from a large number of people. Crowdfunders often have a share in the results of a project: for example, they can get profit shares, books from promising authors, albums released by famous or rising bands, or certificates of appreciation for helping children.
So, what are the challenges facing crowdfunding? I will try to name those which seem the most important.
Firstly, as obvious as it sounds, credit risk assessment is not easy. Banks do not get their percent for nothing. Their risk assessment systems in retail lending are based on deep mathematical analysis, client scrutiny, and complex evaluation of borrowing capacity. Neither P2P nor P2B platforms (peer-to-peer and person-to-business lending means lending from individuals directly to other individuals or businesses through platforms, without bank participation) are yet able to achieve the same quality of credit risk assessment, partly because, unlike large banks, they do not have extensive client data.
Secondly, even without in-depth credit risk assessment, Р2Р/B platforms can presumably operate successfully in markets where customer loyalty is high. In these markets credit supply is poor but the demand for it is high, which makes borrowers cherish their relations with creditors. An example is small enterprise lending in the 1990s-early 2000s when small business development loans were extremely difficult to get in Russia and other economies in transition. Of course, banks at that time did not have credit assessment models as comprehensive as they now do. Customers showed tremendous loyalty deciding between borrowing from official suppliers at relatively low rates and partner or market loans, which were issued at higher rates and could cause certain troubles in the event of late payment.
However, a lot has changed since then: in most of the world, loan accessibility has become much less of a problem for the solvent (and I stress this word) part of the population and small enterprises. There are both state and non-government credit programs serving these types of borrowers. That is why customer loyalty to a single supplier has decreased and lost its significant positive impact on default risks (though, it still plays a crucial role in some African and Latin American countries).
And, finally, the third issue I consider important is the risk of fraud. I should say that it is not rocket science to carry out a fraudulent scheme in crowdfunding. Investors do not know or see to whom they lend and rely on the platforms to act as intermediaries. In any jurisdiction, there are some investors that are ready to give their money in exchange for the promise of higher returns than bank deposits can offer. The promised returns can be complemented by social cause messages. For example, investors may be told that the money will be given to farmers in developing countries as financial support. In this case, investors believe that not only will they gain money but also help farmers move forward. Unfortunately, if used with skill, these messages are enough to build Ponzi schemes without much effort, as recent history has proven multiple times.
Conditions and prospects
Does this mean that the P2P business—or crowdfunding in a broader sense—has no future? I do not think so. This market does have bright prospects, which I see in several domains.
The first is donation or reward-based platforms, where charity is rewarded with goods or services. These platforms are quite viable in the long run and, what is more, have high potential. Those who take part in such projects are motivated primarily by the urge to help rather than a financial gain; and as we know now, altruism plays an important role in any society improving its survival in a holistic way. The key is an effective project selection pipeline, fraud prevention, and proper control of cash flow.
P2P (P2B) models, too, have some prospects, but to benefit from them they need effective outsourcing of credit risk assessment.
If current neobanking forecasts are correct, and emerging ecosystems will be able to make reasonably precise credit risk assessments based on an array of circumstantial characteristics, and the results of these assessments will be available to third parties subject to fulfilling some requirements (most probably, paying fees), this model is likely to lay the foundation for high-profile P2P business.
There may be another promising opportunity, which we are thoroughly considering: this opportunity involves the use of crowdfunding platforms to promote structured loans, namely bonds. We are now seeing the rise of bond lending to small enterprises through both exchange-traded and commercial bonds. There is a growing demand for these instruments on behalf of various categories of investors. At the same time, unlike the conventional P2P business, where lenders deal with more or less non-transparent projects, these crowdfunding platforms provide clear procedures of access management, listing or company evaluation, and create or should create ratings for such projects. All this combined should keep the credit risks of such projects in check. Intermediation by platforms will reduce the costs associated with issuing and trading of securities.
However, even then, the risks will hardly ever match those of prime projects financed by banks or (speaking of the stock exchange) of first and second-level securities, which is no surprise. Because investing in crowdfunding projects is by default risky investing. It is crucial that retail investors keep this in mind and the market access management and surveillance system should properly control the transparency and integrity of these platforms.
Such crowdfunding 2.0 platforms have every chance of finding their niche in the array of investment models offered in the Russian and global markets.
I would like to note that my view, just like any expert opinion, is subjective; the future may, of course, prove any of the presented views wrong by enacting the least probable crowdfunding market scenario. Alternatively, it may vindicate opinions sooner than expected: I believe that the crowdfunding business will need 3-5 years to get rolling provided the above-mentioned conditions are fulfilled. For now, it looks to be an experiment with some chance of success, which makes it worth studying, regulating, and supporting to a reasonable extent.