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Monday, July 10, 2006

Eliminating Friction in Financial Services

By William Trent, CFA of Stock Market Beat

As much attention as is given to high-flying Internet stocks, people often forget that the biggest impact from the Internet has been the disruption to traditional industries that results from removing friction from everyday transactions. Many businesses were built around the friction, and they are in the most danger from its removal.

Financial services constitute a huge industry that is ripe for removal of some of these frictions. The profit margin banks earn from the spread between the interest rate they give savers and that which they charge borrowers could easily be divided among the borrowers and lenders themselves.

There are many hurdles, including the heavy regulation to which banks must adhere and the desire of law enforcement agencies to monitor money flows. Is online peer-to-peer lending simply a loan between two people (which happens all the time and is not regulated) or a banking transaction that requires regulation? One company aims to find out, and the impact on the banking world could be significant:

Would you lend cash to a stranger? - Money - Times Online

You may think the idea sounds crazy, but a growing number of people are lending their own money over the internet — and they are receiving market-beating rates in the process. In fact, the idea has proved so popular that the British internet company that came up with the concept has decided to expand into the United States.

The website has been described as the eBay of personal finance and has attracted more than 78,000 members, who have loaned or borrowed more than £2 million since its launch in March last year.

James Alexander, the co-founder and chief operating officer of Zopa, which stands for “zone of possible agreement”, says that the service is for people who would rather lend and borrow directly than deal with faceless corporations. He says: “Lending through Zopa gives people a better, fairer and more transparent rate of return than they could expect from a bank — and the chance to help others to get a better deal. It is a more connected and personal way of dealing with money.”

The average rate of return for lenders on Zopa is 7 per cent, before tax and defaults, and the average loan rate is similar. Mr Alexander says that it would be difficult for a Zopa member to obtain a better deal on the open market.

Since the launch, the default rate on loans has been only 0.05 per cent, although Zopa warns its lenders to expect a default rate of between 1.3 per cent and 3 per cent.

Mr Alexander says that Zopa has a rigorous credit-checking procedure and accepts only the top 50 per cent of borrowers as members.

The website works by ranking accepted borrowers into two categories: type A and type B. Lenders can offer their savings to either type of borrower at any rate of interest for a set period of between six months and five years. Every loan offer goes into one of 12 marketplaces that reflect the six different loan lengths for type A and type B borrowers. Members can borrow up to £15,000 and are matched automatically with the deals in their marketplace that meet their criteria. If a lender’s loan rate is too high, there will be no takers and the money will simply sit there earning the 3.5 per cent paid by Zopa.

Lenders can offer up to £25,000, but from Monday this cap is being abolished. Deposits of more than £500 are always distributed between at least 50 borrowers to minimise the risk of bad debt. Deposits of less than £500 are distributed in £10 chunks. At present Zopa is offering a 2 per cent bonus to lenders.

Lenders and borrowers enter a legally binding contract with each other and Zopa manages the collection of monthly repayments. If a repayment is late, Zopa levels a fine. It also uses the same recovery processes that banks use. Zopa says that lenders who fall victim to fraud will have losses refunded.

The website makes its money by charging borrowers a 0.5 per cent fee and taking a 0.5 per cent annual charge from lenders. It also sells payment protection insurance (PPI) and introduces unsuccessful applicants to other loan companies. However, Ms Owens says that anyone borrowing on Zopa should shop around if they want PPI.

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