Regulating unanticipated behavior: the example of peer-to-peer lending

A few months ago I got an account at, a peer-to-peer microlending site. Prosper matches up individuals who want personal loans with other individuals who are interested in lending. Lenders “bid” on prospective borrowers, telling the site how much money they’d be willing to lend and the minimum interest rate they’d be comfortable with. Once enough lenders have bid on a borrower to fully fund the borrower’s loan, Prosper issues a loan to the borrower and issues promissory notes to each lender reflecting the amount of money each of them put into the loan.

Peer-to-peer microlending like this is pretty new, although there are a few other sites that do about the same thing (such as, a site that issues small loans to people in developing countries, and It’s been hailed as a “Web 2.0” take on savings-and-loan institutions. Web sites like Prosper are a real advantage over both traditional banks and traditional person-to-person lending. Because the loans are person-to-person, the interest rates are more favorable to borrowers than bank loans, and lenders get more in interest than they would on many other investments. At the same time, the loans are simpler, more “legal,” and easier to arrange than regular person-to-person loans: the site allows people to search through large numbers of loan listings, checks borrowers’ credit scores, writes the loan contract, and arranges all of the collection activity, and because the site is actually the issuer of the loan, borrowers don’t have to juggle multiple creditors.

When the economy started crashing this Fall, I decided to get an account at Prosper. I had a vision of individual Americans easing the blow of the credit crisis by reaching out to each other by giving each other loans when banks were too scared to give them out. Because Prosper had lower interest rates and much clearer terms than most loan contracts, the market was a lot more consumer-friendly than the credit markets that are currently in crisis, which, following Elizabeth Warren’s reasoning, meant the peer-to-peer lending market was far less likely to implode like the other credit markets (although lenders have complained about high default rates nonetheless). Supporting peer-to-peer lending was starting to look like not only a good idea, but also a civic duty.

Sadly, I’d only successfully bid on two loans before Prosper, without warning, halted all lending activity while the Securities and Exchange Commission evaluated its regulatory filings. Their statement touted the move as an important step toward creating a secondary market for their loans, allowing lenders to sell their promissory notes to other people. Reporters have suggested, however, that the primary reason the site shut down temporarily was fear that the SEC, which until then had not decided how to classify peer-to-peer loans, would decided that these loans were securities and fine Prosper for not having registered with the SEC earlier.

While peer-to-peer lending sites have now existed for a couple of years, another site,, experienced a similar problem in April. Like Prosper, it had filed with the SEC so that it could create a secondary market. The SEC, which had apparently not spent much time thinking about peer-to-peer lending sites until just then, suggested that perhaps LendingClub should have registered with them before setting up shop in the first place. LendingClub, spooked, stopped issuing loans for months while its filings were reviewed. After LendingClub came back online, apparently due to the legal reclassification of its loans, only residents of a small number of states were allowed to bid on loans.

During an economic slowdown, shutting down potentially promising ways to revitalize the credit market seems like a bad idea. Although I can’t blame the SEC for wanting to take a look at peer-to-peer microlending before giving it the green light, I do blame the SEC for not taking a look at it a bit earlier, before the economic crisis scared it out of its general regulatory complacency.

Peer-to-peer borrowers or lenders are not exactly the kind of politically invisible or marginalized group that this blog is meant to focus on. Their problem is probably not that they’re too unsympathetic or invisible to influence the legislative process, but that they are a relatively new phenomenon and regulatory agencies like the SEC are rarely proactive in determining how new behaviors fit into old regulatory schemes. Still, Prosper’s situation is a good illustration of what can happen when people make laws as if a potentially affected group doesn’t exist: at some point, how the law applies to the group will actually matter (if only to the group itself), and there’s no guarantee that the result will be favorable for anyone involved.


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