After an exciting, disruptive, and challenging year 2020, it is time for us to recap the rise of digital lending. How did 2020 shape the nascent industry, and where is it headed? Let’s have a look.
The Origins – Building on the Crowd
Digital lending emerged in line with the expansion of digital financial services. Its origins are thereby largely based in Crowdfinancing.
Crowdfinancing is a concept that describes the opportunity for individuals, entrepreneurs, and companies to raise funds online by applying to a pool of investors, typically in the form of a campaign. Crowdfinancing platforms lower the threshold for borrowers and investors to partake in a transaction alike, by enabling direct and more fragmented interactions. The use of technology allows for improvements in speed, transparency, and costs. Various technologies are deployed to automate the entire credit process, from online-only applications, to data-driven risk assessments and automized matchmaking and allocation processes. Furthermore, borrowers can directly test the market value of their endeavor by being directly exposed to potential financiers.
Common Crowdfinancing models include Equity-based Crowdfunding or “Crowdinvesting”, Reward-based Crowdfunding, Donation-based Crowdfunding, and ultimately Lending-based Crowdfunding or “Crowdlending”. Crowdinvesting thereby describes a form of equity financing, while Crowdlending is a debt-based financing solution.
In Equity-based Crowdfunding, the loan is granted in the form of shares or mezzanine financing instruments. Accordingly, the investor acquires a share in the company and participates in its success, i.e., in the profits.
In Reward- and Donation-based Crowdfunding, the borrower may provide a material consideration to his investors for contributing their capital, although the reward is not necessarily of financial nature, but may be idealistic. With donation-based Crowdfunding, the investor does not receive any financial or material consideration for his investment, but donations are made for ideological reasons only.
Lastly, lending-based Crowdfunding describes a concept akin to a bank loan. As with any debt security, every investor that financially participates in the corresponding crowdlending project receives a fixed interest rate in return for his investment for a certain period of time and is repaid the principal.
The latter is what is also commonly referred to as Digital Lending.
The Rise – Redefining the Lending Value Proposition and Driving Financial Inclusion
Lending is traditionally banking business. In more established credit markets, efficiency concerns drive digitization in the credit process, enabled by technological advancements and changing business requirements. Speeding up the lending process by means of automation is a significant advantage of Digital Lending over traditional lending products. It enables players to cater to changing consumer preferences for speedy and flexible financial services. Through automation, Digital Lending has extensively reduced the amount of time needed to obtain a loan from a couple of months to just a few hours. Furthermore, procedures from application to risk assessment and disbursement are becoming more transparent. Meanwhile, a lot of waste linked to cumbersome, manual processes is reduced by paperless and largely data-driven systems.
In developing markets, the lack of traditional credit options has led to an enhanced proliferation of digital financial services. Globally, millions of people still lack access to traditional financing institutions due to structural barriers or simply because they do not fulfill conventional customer requirements. The result of an insufficient financial infrastructure is that a suboptimal amount of capital finds its way into these economies. By offering digitized solutions, digital lending platforms can also contribute to financial inclusion and make credit more widely accessible by reaching previously excluded borrower segments. Since credit is the backbone of economic growth, improved lending services are widely regarded as a key element in financial and capital systems. The potential value of Digital Lending for the real economy is largest in emerging economies that are characterized by a flawed banking system, high demand for credit and a young, and tech-savvy population.
Digital Lending also opens a new segment for investors, leading to a broader, more diverse investable ecosystem. Compared to traditional asset classes, Digital Lending thereby offers an attractive new investment opportunity characterized by steady income generation, short duration and competitive returns. It can be accessed by technology-enabled players who can exploit process efficiencies using standardized default predictions based on qualifiable data and applied machine learning techniques.
Current Situation – New Regulation and Institutional Capital Needed
Digital alternatives thrive, where traditional services and products fail or become outdated. As of now, only a small fraction of lending activities is truly digitized. Of the trillion-dollar global lending market, a few hundred billion in transaction volumes are covered by digital lending platform activities every year – although at rapidly increasing growth.
We count more than 1,500 digital lenders globally, facilitating around 300bn USD in digital credit on an annual basis. At the same time, we observe that, on average, less than 20% of approved credit applications ultimately receive financing with the existing (mostly retail-based) investor basis. The fact that the demand for digital credit widely exceeds available funding volumes is a worldwide phenomenon. Now that the pandemic and subsequent economic scrutiny has forced many private investors to retreat their capital off digital lending investments, this problem is likely to persist.
The findings are critical, given the already existing financing gap of more than 5bn USD annually, which hinders in particular SMEs in developing countries to receive appropriate funding via traditional channels.
With these considerations in mind, several regulators in emerging economies have adopted progressive Fintech frameworks to incorporate digital financial services – and digital credit – into their conceptualizations for new, inclusive, and sustainable economic systems. With the groundwork of Fintech regulations almost done, in Southeast Asia, it is assumed that by 2025 around 8% of the local lending market will become digitized, representing more than 100bn USD in aggregated loanbook values across the region (Google, Bain & Temasek, 2020).
A significant development this year has also been the proposal for a new European crowdfunding regulation by the European commission. The regulation, which is aimed to come into force in November 2021, acknowledges not only the importance of a Pan-European, harmonized regulatory framework for digital lending activities, but also the difficulties for the necessary institutional capital to enter the market. Proposed measures should ease the entry of institutional money.
In line with these developments, few prominent players are opting for institutional capital as their only source of funding in the future, as the AltFi team reports in their alternative lending predictions for 2021.
While these are favorable outlooks, one may put the careful caveat that the necessary technology for standardized, large-scale institutional investments in digital credit is yet to be implemented. Nonetheless, the introduction of large-scale institutional capital is certainly what Digital Lending needs to transform successfully into a full-fledged digital financial market.
Outlook 2021 – Great Fundamentals & Key Year Ahead
Overall, 2020 has been a stress-test for the industry, highlighting the advantages and challenges with Digital Lending activities. Regulators all around the world, established financial institutions and governments locked their focus on digital lending platforms, closely eying their ability to distribute capital and process loan request rapidly and efficiently without personal contact over the past months of the pandemic.
We have seen businesses being driven out of the market as their investor base crumbles. Other players have mobilized to adopt and conquer the challenges of 2020 successfully by means of new collaborations and improved risk management.
Digital lending is still relatively young, but its sound fundamentals and far-reaching value proposition indicate, that the credit platform economy will continue to shape lending as we know it.
At Exaloan, we look forward to an exciting new year for digital lending and welcome the unique challenges and opportunities of 2021!
PS: Which topics would you like to read about in 2021? Let us know, which aspects of the digital lending investment ecosystem you would be interested in learning more about by submitting your feedback via firstname.lastname@example.org.