Published on Tech in Asia.

Photo credit: Jon Collirt.
Photo credit: John Collirt.

If you want a loan without having to deal with the hassle of a bank, your best bet is to use a P2P (peer-to-peer) lending startup. There, you can connect with individuals who want to lend you money so they can earn off the interest you pay.

It’s a business model that’s been gaining interest in India. According to the Reserve Bank of India (RBI), twenty P2P lenders entered the scene last year, bringing the country’s grand total to thirty.

The excitement is with reason: this is the first time that millions of Indians without financial histories have the opportunity to take out loans.

And yet, it’s important to take the excitement with a grain of salt.

In China, where P2P lending companies are mostly unregulated by the government, a major industry player was indicted for cheating over 900,000 investors out of US$7.6 billion. It promised high interest rates to attract investors to the platform. When it couldn’t deliver, it made up investment products so it could take money from new investors to repay old ones.

In the United States, where P2P lending startups are banned in some states and have to go through two levels of regulations in others, the US$392 million-funded Lending Club is facing its own issues. It lost its CEO and P2P lending kingpin Renaud Laplanche and was accused of major inconsistencies soon after. Those included a US$22 million irregularity toward a single borrower and an employee working on a portfolio that would personally benefit them.

The question is: how can India tap into the full potential of P2P lending while avoiding the dangers that come with it?

Too many details

My friend had a bit of extra cash lying around, so he decided to try out Faircent, an Indian P2P lending site backed by ex-Infosys CEO Mohandas Pai and JM Financial.

When he signed up with the site, he was met with a list of borrowers, ranked by how risky it would be to lend to them. “These numbers were calculated by things like their account balance, or their credit scores, or loan histories,” he recounts. “The lower the risk, the lower the interest rates – something like 16 to 18 for really low, and 24 to 25 for mid-tier.”

It’s not that we don’t have the technology… we’re just waiting for regulators to catch up.

He was also prompted to place the amount of money that he would want to transfer into a virtual currency wallet as a placeholder. The money would not be taken from his bank account until after the procedure was over, he explained to me.

He decided to choose a medium-risk borrower who resided in Pune. The borrower had the option to choose multiple lenders for the same loan, so my friend had to bid on how much money he wanted to put in.

That’s when my friend began to feel a little uncomfortable.

“A woman who worked at Faircent emailed me and asked me to submit copies of documents to her – identity proof, passport, PAN cards,” he recollects. “They then created a dashboard for me where I could see my different investments.”

In turn, the woman on the email sent him the bank account details of the borrower, something that my friend dismissed as a risky and slow procedure.

If he said no, the borrower would have to waste time finding a new lender to cover that part of the loan. In that case, the rest of the lenders would also be held up.

“What if 20 people are all bidding for the same loan?,” he asks. “Won’t they all have to wait for approval? This girl emailed and called me for about a week – it was all unprofessional.”

This isn’t news to Faircent’s co-founder, Rajat Gandhi. He admits that the process isn’t nearly as seamless as it could be. “You’re right, it is a bit broken,” he says. “But that’s because we don’t have the right type of permissions right now. Intermediaries can’t hold money and it has to go directly between the borrower and the lender – which is why you get things like bank account details sent via email.”

“It’s not that we don’t have the technology,” he adds. “We do, but we’re just waiting for regulators to catch up.”

An OK future

Last month, the RBI put out a discussion paper on proposed regulations for P2P lending startups.

It suggested that all such sites will need to have a minimum capital of INR 20,000,000 (US$296,000). This would stop those who have run out of money from operating and digging into alternate pockets. It also creates a barrier of entry for startups that want to facilitate loans.

In order to prevent a meltdown if a site shuts down or fails, startups will be required to have a business protection plan that will act as a plan B. They will also have to submit regular reports to the RBI.

And yet, not everything has been resolved. One important detail in the proposal is that money will have to move directly between lender and borrower bank accounts. That means that Faircent still can’t hold money in a separate third-party account – known as an escrow account – and movement between borrowers and lenders will continue to be slow.

Some say there are ways around this. “There’s also the possibility of using a nodal account,” says Varun Bhalla of impact-oriented VC fund Khosla Impact. The nodal account is a separate entity – like an e-wallet – that can store money until it’s ready to be disbursed.

It’s his belief that it’s a good time for P2P lenders in India to raise their heads.

For example, in China, fraud and interest rates were high for a long time because startups weren’t given access to the country’s internal credit database. New ways to establish credit are now being proposed across the world – but they’re entering the scene at the same time as P2P lenders in India. “Startups like Finomena that scrape data to get credit are coming up in India,” Varun says. “They will help ease the unbanked along.”

Another is CreditVidya, a startup that claims to scrape 10,000 data points, from social media networks to phone top-up behavior. It raised US$2 million earlier this month.

And with the entrance of institutional investors – companies that want to lend money – Varun explains that the P2P lending landscape might evolve into a more secure one. At its peak, only 15 percent of investors in Lending Club were individuals, which might mean corporate interest, but also a much stronger guarantee for borrowers to get their money back.

Murky waters

There are also many arguments to be made for leaving the sector mostly unregulated. In China, the crash and burn of multiple P2P lending startups helped the quality ones stand out. One, Yirendai, even IPOed on the New York Stock Exchange as a sign of transparency.

Some believe that strict regulations may put a damper on the sector’s growth. “We expect the final rules to be those that wouldn’t take away the edge of disruptive force that P2P lending brings to the lending business,” Ekmeet Singh, CEO of Lendbox, explained in an interview with Bloomberg.

Rajat also takes a moderate approach to regulations. “There has to be some method to the madness,” he says. “We think that with a little bit of regulation, startups in the financial services industry flower. The prime example of this is what happened to e-wallets in India.”

At the end of the day, it’s up to India’s regulatory powers to decide what’s best. Are these freeform mistakes something that the country’s fragile startup ecosystem can afford? Or should it tread these waters carefully? As of now, it seems to be leaning toward the latter.