Peer-to-peer lending (crowdfunding) is an alternative financial system, the essence of which is to provide individual lenders and borrowers with a way of lending money to unrelated persons, or equal parties, without involving a traditional financial intermediary.
What is traditional P2P lending?
This method of private lending has a long history and is even culturally traditional in some areas of the world. But in modern manifestations, it is usually found in the form of specialized online platforms that bring together those willing to lend with those who would like to borrow. Since such websites operate exclusively online, they have fewer and lower fixed costs, and can, therefore, provide their services cheaper than traditional financial institutions.
As a result, borrowers can earn more than interest on deposits and other investment products offered by banks, and borrowers can get a loan with lower interest rates. That’s even taking into account the commission of the P2P lending provider itself, which it charges for its services of bringing together borrowers with lenders, as well as the function of checking the creditworthiness of a borrower.
It is expected that by the year 2050, the global P2P lending industry will reach an annual turnover of 1 trillion USD.
This is also a great moment to create decentralized P2P lending platforms, as more and more countries are now beginning to regulate their P2P lending industries.
In countries such as the USA, Canada, Australia, and Germany (where the industry is already regulated), it’s already become a popular alternative financing model. Across these countries, about 25 percent of the population is already using decentralized P2P lending to borrow funds.
China (where P2P is mostly unregulated) and India (where P2P has until recently been primarily self-regulated) also have a potentially substantial P2P market. As more and more countries recognize P2P as a mainstream financing option, startups in this area will only look better.
A decentralized credit system is a beautiful idea, especially when compared to conventional systems tied to large credit institutions. However, it also has its own innate problems.
In particular, the creditor’s investments in P2P lending are usually not protected by any government guarantee. In some services, lenders may try to reduce the overall risk by diversifying their investments among different borrowers, and to reduce the risk of bad debts, having the ability to choose the borrowers to which they provide loans.
But then the question arises: what information forms the basis for making this choice? Some P2P lending services use external Know-Your-Customer (KYC) solutions as well as solutions for determining the credit rating of potential borrowers. In other words, one must arbitrarily rely on the decisions of trusted third parties.
Other problems include the limited scalability of local P2P lending services on an international scale.
This ties in with the problems mentioned above of loan repayment guarantees, as well as with regulatory issues (rules and regulations vary from country to country). There is also work to be done on accelerating the process of granting loans, etc.
Also, despite the supposed decentralization of P2P lending platforms, they still retain a certain degree of centralization. In particular, all records and identification data are stored and maintained by the central party, leaving room for human error or manipulation.
This point may also impede the growth and coverage of a platform since centralization makes a system more vulnerable to regulations at the regional level. These regulations may differ significantly from country to country, which makes things even harder.
And this is only a small sampler of the problems that traditional P2P lending services face; which, by the way, are in one way or another characteristic of all conventional financial institutions. Taken as a whole, they not only slow the business down but also reduce the possibility of scaling.
However, there is hope that blockchain technology will solve most of these problems.
First of all, the property of decentralization, already inherent in the P2P industry, makes it the blockchain’s natural use case. Also, transparency, equality of interest rates, and improved due diligence analysis make the use of blockchain technology in the P2P lending industry a good fit for both lenders and borrowers.
Decentralized Credit Services
Unsurprisingly, we’ve already witnessed the first P2P lending services beginning to appear on the blockchain. We will divide them into several groups.
First of all, these are cryptocurrency-to-fiat P2P lendings, that include:
Overall, cryptocurrency-to-fiat lending solutions are more like traditional semi-centralized P2P lending services, with nearly all the associated problems and disadvantages.
They act as a third party and escrow in the lending transactions between their clients. The only difference from regular P2P lending services is that they don’t limit users to working with fiat, but facilitate the use of cryptocurrencies, and also use their own token for various services and additional incentives for customers. On the other hand, the ability to get cash for cryptocurrency collateral is a desirable option, which is currently more in demand in real life than pure cryptocurrency loans.
Secondly, these are purely cryptocurrency P2P lendings, for example:
- Maker DAO
As we see, the market for decentralized P2P lending solutions is gradually being filled by projects based on blockchain technologies. However, all these solutions have some impossible or difficult to overcome limitations.
As we see, the market for decentralized P2P lending solutions is gradually filling with projects based on blockchain technologies. However, all these solutions have a number of impossible (or at least difficult-to-overcome) limitations.
One of the main limitations is that most of these solutions are “closed” within a single cryptocurrency/blockchain ecosystem (Ethereum, in particular).
But even when some of these lending services work with several different crypto-assets, their variety is often limited to a couple of the most popular ones. Also, most of the services are trying to tie their users to their native token – that contributes to the exclusiveness of these systems, rather than to their openness. So, in these cases, we can leave out any network effect, serious scalability, or possibility to build a more or less global network.
In other words, blockchain-based decentralized P2P lending solutions inherit all the same problems from the primary Layer 1 blockchain projects (Bitcoin, Ethereum, etc.). These problems also include the lack of transaction atomicity (in cases where cross-chain transactions are involved, or there are fiat-to-crypto transactions).
And finally, these are decentralized credit networks, which we will discuss in more detail.
Decentralized Credit Network
Unlike decentralized credit services, the decentralized credit networks can not only overcome the disadvantages as mentioned above of blockchain-based services but also significantly expand the opportunities offered to existing and potential users (including businesses).
The principal difference between decentralized credit services and decentralized credit networks is that the latter, in addition to ensuring greater scalability and interoperability, also provide the transitivity of trust. The services must rely on third parties (in particular, to assess the creditworthiness of borrowers).
In contrast, each network member in the transitive trust networks establishes his/her own trust lines with other users. And by doing go he/she evaluates and weighs all the risks. At the same time, other participants can use its trust lines (for example, when making multi-hop payments, etc.). A dishonest participant will have fewer trust lines with other network members or indeed have none at all. Thus self-regulation of the credit network will occur without the need for additional involvement of third parties.
All this is made possible by the unique technological solutions used in them.
Trustlines Network is an Ethereum-based P2P platform for creating IOU networks. Based on the original concept behind Ripple, introduced by Ryan Fugger in 2004, the Trustlines Network will allow users to generate money and make secure payments among themselves. The high-level idea is that individuals provide credit for the people they trust, and only for an amount they consider fair.
This provided credit is money that is valid for anyone who trusts the creditor. Thus, Trustlines Network is like the current credit-based monetary system, in a sense, but instead of just banks, anyone can become a creditor.
Since the system’s scalability depends on well-connected users, users are motivated to establish as many connections as possible. This is done by including a small capacity fee in every transaction, which is paid to users/nodes that work as middlemen connecting two end nodes.
In addition to the capacity fee, there is a relay fee (more on relays below), an imbalance fee (a fee for adding imbalance to a used trust line), and the Ethereum transaction fee. Optionally, users can also add an interest rate to any of their debtors.
There can be an arbitrary number of currency networks within the Trustlines Network ecosystem, using a related Currency Network Token Factory smart contract. Thus, there is no single “Trustlines token,” but instead an arbitrary number of coexisting currencies that share only the Trustlines Network platform, which are called Trustlines Money. From the point of view of Helsinki, this type of dynamic IOU network would necessarily mean that the city should act as a central bank of sorts.
The idea is quite promising, but TN is still tied exclusively to the Ethereum platform, which severely limits the versatility and scalability of this solution.
The GEO Protocol is a decentralized P2P protocol for value transfer. The basic idea is very similar to the idea of the Trustlines Network (or rather, Ryan Fugger’s original Ripple idea). But, unlike TN, the GEO has a more global approach to the problem – plus it is not tied to Ethereum or any other Layer 1 blockchain.
The GEO is a Layer 3 protocol solution, one of the main goals of which is to solve the interoperability problem of various cryptocurrency and blockchain ecosystems, as well as to interconnect them with traditional financial systems.
In other words, the developers of the GEO Protocol set themselves the task to provide the possibility of creating the so-called Internet of Value: a universal system that unites all possible carriers of value, as well as methods for its transfer, into a single global network of value exchange.
As you can see, this task is much broader than that considered in this article. However, the GEO Protocol also enables the creation of a number of use cases based on its technology, one of which is a decentralized P2P credit network: a network in which each user can define, create and maintain their own credit links.
Other benefits of the GEO Protocol technology include the following:
- Provides atomicity of all payments (including cross-chain payments).
- Automatically finds payment paths between nodes with no direct credit links, and also determines the maximum payment (maximum flow) capacity of these paths.
- Allows automatic clearing of convertible debt obligations (finding and closing debt cycles between several network participants – up to 6 hops).
- Off-chain and blockchain agnostic protocol.
- Local consensus between the nodes directly involved in a particular payment; a unique system for resolving possible conflicts, based on Observers.
- Increased privacy (all information about connections and payments is stored locally on the nodes themselves), plus the post-quantum cryptography is utilized in the protocol.
The Dharma Protocol is also a protocol solution, but with a view to debts’ tokenization in the broad sense. The project plans to achieve this by standardizing the process of issuing, certifying and administering tokenized debts.
Earlier, the Dharma development team tried to implement individual solutions for specific types of debt obligations but later realized the need to create a global and universal solution, which is what they started to do.
Possible use cases are building the following specialized solutions on the Dharma Protocol such as:
- Tokenized municipal bonds: municipalities often finance public infrastructure projects by issuing municipal bonds. Using the open debt standard, municipalities, large and small, can sell tokenized bonds directly to their citizens in a process similar to an ICO.
- Decentralized margin lending: a healthy financial system requires both speculators and skeptics, so buying and selling margins are fundamental components of any liquid financial market. Using the open debt standard, peer-to-peer margin lending schemes can be built using smart contracts and price-feed oracles.
- Tokenized SAFT: projects often raise staggering amounts of capital to finance their eventual token sales in vehicles known as SAFTs. With an open debt standard, SAFT agreements can be tokenized as generic debt tokens, where the expected repayment is defined in units of the soon-to-be-deployed protocol token.
So, the Dharma is an exciting project with an appropriate approach to a specific problem. But they are eager to solve precisely this particular problem, rather than dealing with broader goals. However, this project can contribute significantly to those more immense tasks.
The real power of decentralized P2P lending solutions will be recognized only if they manage to become not just services, but networks (or an integral part of more extensive global networks). Then, the original idea of these systems will be fully realized, and their utility for everyone will increase in proportion to the number of lenders and borrowers in the network (the network effect).
Any (largely or entirely) centralized service, or its binding to any of the existing ecosystems (or the creation of its own one, closed and unconnected to the rest) represents half measures only. That would be an attempt to limit and prioritize what should be open, borderless, and accessible to all.
At present, most of the existing solutions so far represent, to a greater or lesser extent, these same half measures we just mentioned. However, technologies such as the GEO Protocol are emerging, giving the opportunity to unleash the full potential of decentralized credit networks and more.