Peer to Peer debt refers to data sharing between users directly, without a third party such as a central server. So what exactly is P2P and how does it work?
What is Peer to Peer (P2P)?
Peer to Peer (P2P) lending networks consist of two or more computers interacting to communicate, share data, and provide lending services without the need for a central server. P2P lending networks are starting to integrate with blockchain-based smart contracts, contributing to decentralized finance (DeFi) development. The resulting networks facilitate reliable transactions that reduce costs and save time by eliminating middlemen. Peer to Peer credit has become an important subset of the DeFi ecosystem and its growth is accelerating.
If you’ve spent any time online, you’ve likely experienced Peer to Peer (P2P) technology in action. Long before the emergence of Peer to Peer lending websites in 2005, popular platforms like Napster were built on a decentralized network infrastructure. Looking back even further, many would consider the 1969 Advanced Research Projects Agency Network (ARPANET), the precursor to the modern internet, as the earliest iteration of P2P technology. But despite this extensive history, P2P technology continues to be overshadowed by central giants in the modern internet landscape. This leaves many people 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 larger network, and each holds a copy of the same information. In contrast, client-server networks connect multiple clients to a server that acts as a central repository. As noted, this centralized approach to data collection and storage dominates most institutions that are still in effect today.
In finance, the centralized nature of client-server networks is representative of banks and other financial service providers operating with sole authority over your money. By contrast, Peer to Peer decentralized finance (DeFi) alternatives represent a departure from this paradigm.
Traditional Peer to Peer Lending
Peer to Peer lending allows you to borrow directly from others without the need for an intermediary such as a bank. Because of this dynamic, P2P lending is also known as “social credit” or “crowd credit” and has seen tremendous growth in recent years as an alternative form of financing.
Traditional P2P lending occurs when funds in fiat currencies such as dollars are exchanged outside of the traditional banking system. Companies like Prosper, Lending Club, Peerform, Upstart, and StreetShares are competing to make big impact in this digital-heavy space. Traditional P2P lending has provided small and medium-sized businesses with an alternative source of capital when faced with increasingly stringent bank regulations. The volume of business and consumer Peer to Peer loans has seen a 30% increase since 2017, according to The Paypers, a respected financial technology (FinTech) news and analysis publication. Business P2P loan projections show P2P loan values to reach $219 billion.
Crypto Based Peer to Peer Lending
With the advent of cryptocurrency, the P2P market continues to evolve as decentralized networks and smart contracts offer new ways to access financial services outside of traditional banking infrastructure. Using blockchain technology, borrowers and lenders can conclude a loan agreement without the need for an intermediary. Instead, self-executing smart contracts enable trusted transactions. According to DeFi Pulse, a DeFi analytics and ranking publication, $2.29 billion in value is locked in the DeFi loan market as of September 2020.
The term “crypto-backed loan” is another way of expressing the concept of a P2P loan expressed in cryptocurrency and executed on a blockchain network. On-chain loans require collateral in fiat or cryptocurrency. This dynamic is similar to traditional banks that require 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 rate. In exchange for providing these funds, lenders receive interest from the borrower and sometimes, but not always, principal repayments within a specified time frame. Smart contracts automatically execute the loan and fulfill its terms.
Crypto-backed loans are breathing new life into the Peer to Peer loan market. By removing middlemen from the process, costs were reduced, settlement time was made faster, and a more diverse and potentially fair market emerged.
Centralized and Decentralized Crypto Credit
While some may naturally associate the use of cryptocurrencies with the idea of decentralization, this is not always the case. You can think of centralized P2P lending platforms as FinTech companies using cryptocurrencies. For example, these companies such as SALT, Celsius and BlockFi operate similarly to traditional banks and financial services companies and have minimal P2P elements, if any.
Lending platforms follow Know Your Customer (KYC) protocols, take custody of users’ cryptocurrency, and act as intermediaries between fiat and crypto ecosystems. Most of the time, the platform is the lender itself. Also, lender interest rates are usually set by the company, not by the smart contracts that manage the decentralized platforms. Centralized crypto lending platforms take a tried-and-true approach to loans, but do so with digital assets.
Popular Projects in Decentralized Credit
- 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 where users enter a Collateralized Debt Position (CDP) to receive DAI tokens, a stablecoin on the Ethereum blockchain. Users can then lend DAI tokens to earn interest from borrowers.
- dYdX: A decentralized borrowing and lending protocol built on the Ethereum blockchain. dYdX enables borrowing and lending as well as supports margin trading (trading with borrowed funds to increase returns).
All of these decentralized platforms provide anyone with 24/7 lending access without the need for KYC protocol or a central custodian as 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 floating interest rates that result from the supply and demand of platform-specific assets. This dynamic can cause significant interest rate fluctuations for lenders, resulting in financial losses.
The availability of Peer to Peer lending alternatives and their blockchain-based counterparts has had a significant impact on how borrowers and lenders come together. As cryptocurrency and blockchain technology continues to mature, crypto P2P lending platforms point the way to a more inclusive and accessible financial future than ever before.
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