Crowdfunding is the word we use to describe the act of small amounts of money being obtained from a large number of individuals or organisations to fund a project, business, loan, or something else.

There are four types of crowdfunding:

Donation crowdfunding
Reward crowdfunding
Peer-to-peer lending
Equity crowdfunding

Peer-to-peer lending and equity crowdfunding are forms of market-based finance that are referred to together as 'financial return crowdfunding' (FR crowdfunding). The other two are not of great concern since they are essentially gifts and the giver willingly relinquishes complete control over the money once it leaves their possession. (They may complain about its uses afterward, but that is the nature of the game.)

Crowdfunding is done online and investment size tend to be small. This makes FR crowdfunding different from other types of similar - and larger - investments.

The short history of crowdfunding

Crowdfunding has grown at a good clip over the past five years. Some reports have suggested that the peer-to-peer lending market is doubling every year and accounts for US$6.4bn outstanding globally - this is immense. The FR crowdfunding market has a USA, UK and Chinese market of over US$1bn, with uptake increasing everywhere.

FR crowdfunding business models

There are three overarching business models when it comes to FR crowdfunding:

Client segregated account model
Notary model
Equity crowdfunding model

The first two are peer-to-peer lending models, with the notary model having banks fund the loans, whereby the client segregated model is funded by the platform. Equity crowdfunding is substantially different to the first two models because stock equity is allocated to investors, with the financial return being dividends and/or capital growth.

Why FR crowdfunding is great

Anyone with a business idea can raise capital with the offer in response being a small parcel of equity interest. This means start-ups and entrepreneurs can get the funds they need and spread the risk across many investors. Institutional investors are also starting to pay attention, so this individual-investor scenario may change, and quickly - institutions are dipping their toes in with small investments, and seeing where this will all lead. In the meantime individual investors are riding the exciting wave of small, frequent investments.

This method of sourcing capital and obtaining returns is inexpensive for the seeker and the investor, which is simply appealing for everyone with the possible exception of regular sources of these funds, in many cases banks.

It is also more difficult to get venture and seed capital than ever before, so crowdfunding provides a feasible alternative to being said 'no' to repeatedly.

How crowdfunding supports economic recovery

FR crowdfunding helps fuel economic recovery by offering small and medium businesses a golden ticket to growth. Expansion, development and the subsequent job creation contribute in a realistic and positive way to economic growth and sustainability, which is why governments and regulatory bodies are very supportive of crowdfunding. (We discuss this further in Crowdfunding Part II.)

Where crowdfunding falls down

The stakes are high - according to some reports, the risk of default or investment failure is sitting at about half. Default rates are coming down in peer-to-peer lending due to a concerted effort to make it so, since defaults don't do the industry any good. Giving money away isn't anyone's idea of a good time unless you're in the charity business, so the 2009 stats for defaults sitting at 30 per cent is good news.

While these are the official numbers, it is believed that the rate of default isn't actually known since most platforms are new (less than three years old), and loans have only just begun to mature.

There has been one case so far of complete platform failure with no trace left of any contracts, with everyone (except the platform, presumably) experiencing a 100 per cent loss. The platform falling to pieces under investors' feet is one possibility, but another is fraud - peer-to-peer lending and equity crowdfunding support anonymity and that creates a situation where secrets can be kept. Fraud is a very real risk on all sides - the lender/investor relationship and the borrower/issuer relationship are both susceptible.

Any liquidity issues can be kept from investors and borrowers alike, and investors are unable to sell their participations since there is no second market. You can't sell your bit and get out because there is nowhere to go. This is a potential risk that investors could be tripped up on.

The other major risk is one based in technology - if it can happen to Ashley Madison, it can happen to a FR crowdfunding platform.

Regulation of crowdfunding

There are five different ways to regulate peer-to-peer lending:

Exemptions or unrelated due to a lack of definition
Platforms are regulated as an intermediary
Platforms are regulated as a bank
In the US, there are two regulatory levels - A) Federal regulation via the SEC* and B) at state level, where each platform must get state approval
Prohibition

There are three main ways to regulate equity crowdfunding:

The prohibition of equity crowdfunding completely
Legal equity crowdfunding, but barriers to entry are high due to regulations
Regulations allow industry, but with very strict limits

Some areas approach the FR crowdfunding industry regulation by issuing exemptions or lightening restrictions of share issuances to promote SME growth. The view of regulatory bodies thus far is that FR crowdfunding platforms do not pose a risk to the financial system or create any great investor protection concerns, but that a close eye needs to be kept, because the growth is so rapid.

Potential problem areas

Lack of liquidity
No secondary market to sell loan portfolios to
Investors can't liquidate their positions
Cross-border complexities may arise including legal issues
Interconnections via bank and securitisation practices
Loans are mostly unsecured
Fraud
Collapse

Crowdfunding Part II - Crowdfunding trends and regulatory approaches globally

Crowdfunding Part III - Australian regulations on crowdfunding

To view the full report, visit IOSCO's website.

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*Securities and Exchange Commission

MI Articles

Crowdfunding Part I - An overview from a regulatory perspective