What Is Peer-to-Peer Lending?

If you’ve spent any time online, chances are you’ve experienced peer-to-peer (P2P) technology in action. Long before the arrival of peer-to-peer lending websites in 2005, popular platforms like Napster were building on a decentralized network infrastructure. Looking even further back, many would consider the 1969 Advanced Research Projects Agency Network (ARPANET), a precursor to the modern internet, to be the earliest iteration of P2P technology. But despite this extensive history, P2P technology remains overshadowed by centralized goliaths in the modern internet landscape. This leaves many still wondering what P2P technology is, where it lives, and why it’s relevant.

P2P networks consist of two or more computers interacting to communicate or share data without the need for a central server. That is, each computer acts as a node within the broader network, each keeping a copy of the same information. In contrast, client-server networks connect multiple clients to one server that acts as a central repository. As mentioned, this centralized approach to data collection and storage still dominates many of the institutions in place today.

In the realm of finance, the centralized nature of client-server networks is representative of banks and other financial service providers that operate with sole authority over your money. By contrast, peer-to-peer decentralized finance (DeFi) alternatives represent a departure from that paradigm. Considering these differences, let’s take a closer look at the evolution of P2P lending.

Traditional Peer-to-Peer Lending

Peer-to-peer lending allows you to source loans directly from others, without the need for an intermediary like a bank. Because of this dynamic, P2P lending is also known as “social lending” or “crowdlending,” and has seen immense growth as an alternative form of financing in recent years.

Traditional P2P lending results when funds denominated in fiat currency like dollars are exchanged outside of the conventional banking system. Companies such as Prosper, Lending Club, Peerform, Upstart, and StreetShares compete in this digital-heavy space to great effect. Traditional P2P lending has given small and medium-sized businesses an alternative source of capital when faced with increasingly stringent bank regulations. According to The Paypers, a respected financial technology (FinTech)news and analysis publication, the volume of business and consumer peer-to-peer loans has seen a 30% increase since 2017. Business P2P lending forecasts suggest P2P loan values will reach $219 billion in 2020 and $290 billion by 2023.

Crypto-Based Peer-to-Peer Lending

With the advent of cryptocurrency, the P2P market continues to evolve as decentralized networks and smart contracts present new avenues for accessing financial services outside of the traditional banking infrastructure. Utilizing blockchain technology, borrowers and lenders are able to enter a loan agreement without the need for an intermediary. Instead, self-executing smart contracts enable trustless transactions. According to DeFi Pulse, a DeFi analytics and rankings publication, $2.29 billion of value was locked in the DeFi lending market as of September 2020.

The term “crypto-backed loan” is another way of expressing the concept of a P2P loan denominated in cryptocurrency and executed on a blockchain network. Loans occurring on-chain require collateral, either in fiat or cryptocurrency. This dynamic is similar to conventional banks requiring collateral, such as a car or house to facilitate a loan agreement.

The maximum amount a user can borrow is determined by the amount of collateral provided, also known as the collateral factor or collateral ratio. In exchange for providing these funds, lenders receive interest from the borrower and repayment of their principle sometimes, but not always, within a set timeframe. Smart contracts automatically execute the loan and uphold its terms.

Crypto-backed loans are breathing new life into the peer-to-peer lending market. By removing intermediaries from the process, costs have been lowered, the settlement period is faster, and a more diverse and potentially equitable market is emerging.

Centralized vs. Decentralized Crypto Lending 

Although some may naturally associate the use of cryptocurrency with the idea of decentralization, this isn’t always the case. You may think of centralized P2P lending platforms as FinTech companies that utilize cryptocurrency. These companies — like SALT, Celsius, and BlockFi, for example — operate similarly to conventional banks and financial services companies and have minimal P2P elements, if any.

Lending platforms follow Know You Customer (KYC) protocols, assume custody of users’ cryptocurrency, and act as intermediaries between the fiat and crypto ecosystems. Often, the platform is the lender itself. Furthermore, lender interest rates are often set by the company, not by the smart contracts that govern decentralized platforms. Centralized crypto loan platforms take a tried-and-true approach to loans, but do so with digital assets.

  • Compound: An algorithmic decentralized protocol built on the Ethereum blockchain that allows users to earn interest or borrow assets against collateral.
  • MakerDAO: A decentralized autonomous organization (DAO) where users enter into a Collateralized Debt Position (CDP) to obtain DAI tokens, a stablecoin on the Ethereum blockchain. Users can then loan their DAI tokens to earn interest from borrowers.
  • dYdX: A decentralized borrowing and lending protocol built on the Ethereum blockchain. Although dYdX enables borrowing and lending, it also supports margin trading (trading with borrowed funds with the intent of amplifying returns).

All of these decentralized platforms provide lending access to anyone, 24/7, without the need for KYC protocol or a centralized custodial intermediary because they use automated smart contracts. While Maker relies on a decentralized governance system to set interest rates for lenders, many other platforms in this space have variable interest rates resulting from the supply of and demand for platform-specific assets. This dynamic can result in substantial interest rate swings for lenders, which in turn could result in financial losses.

The availability of peer-to-peer lending alternatives and their blockchain-based counterparts has made a considerable impact on how borrowers and lenders come together. As cryptocurrency and blockchain technology continue to mature, crypto P2P lending platforms are pointing the way to a financial future that’s more inclusive and accessible than ever.