Lenders
Digital Lending: Trends, Consumer Benefits and Regulatory Implications
Dec 2, 2023
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InnReg
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9 min read
Contents
The use of digital technology and the Covid-19 pandemic have significantly transformed the lending industry in recent years. We see more financial institutions shift towards digital transformation and adopt advanced and innovative technologies like artificial intelligence (AI) and machine learning. The quest for better customer experience, quicker service, and improved profitability has led to the emergence of digital lending.
This article covers the post-pandemic emergence of digital lending and the main alternative lending channels, the digital lending trends we see and the regulatory implications they bring, as well as how InnReg can support your digital lending business.
Our experienced lender compliance advisors created this overview, not freelancers, third-party agencies, or AI-based tools. We are global regulatory compliance and operations experts.
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What is Digital Lending?
Digital lending is a technology that enables automated process management of customer acquisition, credit scoring, decision-making, electronic signature, disbursement, loan administration, and ongoing customer support. By incorporating cloud technologies and analytics, borrowers can apply for any consumer or business loan product over the internet or via any mobile device globally.
For too long, traditional banks have had a complete monopoly on and sole discretion over lending through lengthy, bureaucratic, and inefficient processes. Often, these also lacked oversight of consumer protection. Nowadays, fintechs are leveraging technology and innovation to overtake traditional banks.
At the same time, we see that more and more traditional banks are exploring ways to digitize their lending processes. Interestingly, “hybrid” models have also become common in the industry, such as direct investment or acquisition, outsourcing services, or, for example, allowing a fintech to work with a bank to offer lending and account issuance services.
What are the Main Digital Lending Trends?
The coronavirus pandemic significantly disrupted the entire banking industry by introducing major digital lending trends. The pandemic educated consumers on how digital technology can simplify their day-to-day life, which, in turn, led to a major shift in their borrowing needs. This unprecedented crisis increased the demand for digital lending platforms and efficient processes more than ever before. At the same time, it also served as a catalyst to improve financial inclusion.
According to the 2021 National Survey conducted by the Federal Deposit Insurance Corporation (FDIC), an estimated 4.5 percent of U.S. households (approximately 5.9 million) were unbanked in 2021, and an estimated 14.1 percent of U.S. households (approximately 18.7 million) were underbanked. An older survey conducted by the Consumer Financial Protection Bureau (CFPB) found that about 26 million consumers are what the CFPB calls “credit invisible,” with no credit history and score, and as such at the risk of complete exclusion from basic financial services. Even the underbanked consumers with access to bank accounts frequently experience challenges in accessing other financial services like loans.
The emergence of alternative lending channels in recent years has shown that digital lending has the potential to reach people who have, so far, been excluded from basic financial services.
The Emergence of Alternative Lending Channels
This section focuses on the digital trends of three main alternative lending channels, as well as the consumer benefits they offer.
1. Buy-now-pay-later (BNPL)
The most globally used and popular form of digital lending is the so-called “buy-now-pay-later” product, which allows splitting payments into equal installments over time. This kind of loan is typically interest-free as long as the consumer makes full payments on time.
BNPL differs from a traditional credit card that typically charges interest on unpaid balances . In addition, compared to credit cards, it is easier to access BNPLs, as most BNPL providers do not require a credit score.
The global BNPL market size was valued at USD 15.91 billion in 2021. The market is projected to grow from USD 22.86 billion in 2022 to USD 90.51 billion by 2029 at a compound annual growth rate (CAGR) of 21.7%. Digital lending trends are rapidly growing as more and more consumers take advantage of online shopping, favoring BNPL as the preferred alternative lending channel. The global BNPL market is segmented into five major regions: North America, Europe, Asia Pacific, the Middle East & Africa, and South America. North America is expected to hold the largest BNPL market share, whileAsia Pacific is expected to grow with the highest GACR during the forecast period.
According to the Global Buy Now Pay Later Top Market Players 2022, the top three market players are Klarna (Sweden), Afterpay (Australia), and 2 (U.S.).
2. Peer-to-peer lending (P2P)
Peer-to-peer lending is a form of alternative lending that enables individuals and legal entities to lend or borrow money from one another without going through a credit institution. The service is also known as “social lending” or “crowdfunding.”
In general, P2P lending platforms operate with lower operating costs than traditional credit institutions, enabling them to offer attractive terms for both borrowers and lenders. Thus, in the best-case scenario, lenders gain attractive returns, and borrowers gain simplified access to capital, better interest rates, and an overall smoother process.
There are four general P2P business models, namely:
Standard P2P Lending - involves only one middleman (the P2P platform) between the borrower and the lender;
P2P Lending with Loan Originators - involves an extra party - a loan originator, which makes the lending process a bit more complicated;
Bank-funded P2P Lending - a bank originates a loan that is then sold to the P2P platform, which buys it with money raised from the lender(s). The borrower makes repayments directly to the platform, which then transfers them to the lenders;
Balance Sheet Lending - P2P platforms that originate the loan and keep it on the balance sheet. This way, they assume credit risk but also profit from the fees and interest accrued on the loan.
The last two models are sometimes regarded as “shadow banking.”
Nowadays, P2P platforms are among the fastest-growing sectors of the financial industry. According to a recent report, the global P2P lending market was valued at USD 83.79 billion in 2021 and it is expected to hit over USD 705.81 billion by 2030, with a registered CAGR of 26.7% from 2022 to 2030. North America dominated the P2P lending market in 2021 and is expected to continue doing so during the forecast period. As with the BNPL market data, the Asia-Pacific P2P lending market is expected to develop at the fastest rate during the forecast period.
The three leading players dominating the global P2P lending market are Avant (U.S.), Social Finance (U.S.), and Zopa Bank (UK).
3. Blockchain-based digital lending platforms
Blockchain-based digital lending platforms, or simply “crypto lending,” is a growing market that started only a few years ago. It works similarly to peer-to-peer lending, where borrowers are connected with lenders via a crypto lending platform with cryptocurrency as the currency of trade instead of fiat money.
Crypto lending is essentially the process of depositing cryptocurrency that is lent out to borrowers in return for regular interest-rate payments. The interest payments are typically in the form of cryptocurrency deposited and compounded on a daily, weekly, or monthly basis. There are two main types of crypto lending platforms: decentralized and centralized.
Centralized platform - legal entities that handle the user's onboarding process, such as implementing KYC (Know-Your-Customer) and exchanging cryptocurrencies and fiat money with a custodial system in place to protect the assets. It is common for centralized crypto lenders to offer favorable interest rates and terms to lenders compared to decentralized crypto lending.
Decentralized (DeFi) platform - governed by protocols that rely on smart contracts that automate the distribution of crypto loans and interest-rate payments. Typically, DeFi platforms are non-custodial and do not perform KYC checks. The interest rates are generally lower than those offered by centralized platforms. However, DeFi is more transparent than centralized, as anyone can access the protocols and see the transactions recorded on the blockchain.
The possibility of blockchain technology to efficiently transfer documents with high integrity is expected to increase in importance among digital lending providers. Blockchain technology allows regulators and auditors to easily verify identities and track transactions. This transparency differentiates crypto lending from other alternative lending channels.
Some of the key crypto lenders are Crypto.com (Singapore), CoinLoan (Estonia) and Nexo (Switzerland).While these alternative lending channels offer numerous consumer benefits, given the regulatory climate they are expected to face more regulatory scrutiny than ever before.
What are the Main Regulatory Implications for Alternative Lending Channels?
The exploding use of alternative lending channels is drawing increased scrutiny from State and Federal regulators, who share concerns that these channels may require further regulation.
Early BNPL providers in the U.S. were non-bank fintech entities that provided services outside of Federal or State lending regimes. This gave them a significant advantage compared to banks and licensed lending institutions. However, an enforcement action issued by the California Department of Financial Protection and Innovation in 2020 brought a critical regulatory shift for digital lending licensing. The enforcement action emphasized the risks created by unregulated loans, such as accumulated late fees, potential harm to consumer credit profiles, and overall undermining of consumer protection.
Nowadays, the three alternative lending channels presented in the article are subject to Federal and State oversight to some extent. Their respective federal regulators are the Financial Crimes Enforcement Network (FinCen), Consumer Financial Protection Bureau, and the Federal Trade Commission (FTC). With regard to P2P lending, the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have the authority to regulate the lending-investing process.
Regarding BNPL regulation, the CFPB issued a 2022 Buy Now, Pay Later: Market trends and consumer impacts report that highlights the key characteristics of the BNPL industry and clearly states that the Commission is planning increased regulation of this alternative lending channel. Currently, BNPL is considered consumer credit in some states and requires state licensing and compliance with the applicable state consumer credit laws - California and New York, for instance. Most state licensing requirements, especially those in California and New York, may be considered quite burdensome and extensive by new entrants.
Similarly to BNPLs, P2P businesses with commercial and small business lending platforms also need to examine state licensing laws. Some states, like Delaware, do not require lending licenses for commercial loans. However, those that do have onerous licensing requirements. For instance, the California Finance Lenders License application requires the applicant to submit financial statements showing a minimum net worth of $25,000 to obtain a $25,000 surety bond and allow extensive background checks of its controllers.
Crypto lenders in the U.S. generally operate in a regulatory gray area. Depending on whether a given cryptocurrency is considered a security or a commodity, the respective Federal regulator will be either the SEC or the Commodities Futures Trading Commission (CFTC). Industry practice shows that crypto lenders providing services in the U.S. obtain traditional consumer lending licenses in some states without specific crypto lending license requirements.
In addition to state licensing requirements, alternative lending channels must comply with consumer compliance laws, especially in the areas of fair lending and unfair or deceptive acts or practices (UDAP). The FTC has recently published a BNPL FTC compliance check to serve as a starting point for alternative lending channels to comply with the FTC Act’s basic consumer protection ground rules.
At the same time, alternative lending channels must comply with global data protection laws and regulations to safeguard sensitive personal and financial data. This involves maintaining clear audit trails of customer data collection.
Last but not least, fintech lending providers should review their KYC and due diligence practices to build robust AML/CFT programs. Also, as fraudsters become more sophisticated day-by-day, it is becoming increasingly difficult to identify fraudulent activities and suspicious transactions without using artificial intelligence (AI) technology. Fintech lending providers should implement AI technology in their AML/CFT programs to safeguard their businesses from theft and reputational damage.
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Key Digital Lending Takeaways
As financial technologies and consumer demands continuously evolve, digital lending has become a game changer for consumers. In recent years, we’ve all witnessed tectonic shifts in the digital lending landscape. New alternative lending channels are improving the financial inclusion rate by enabling unbanked and underbanked customers to have access to basic financial services.
However, the rapid growth of digital lending means extensive regulation and new compliance requirements, which can burden alternative lending providers with increased compliance costs and challenges.
There is a clear expectation for increased regulation of alternative lending providers in 2023. Therefore, digital lenders must arm themselves with a well-considered strategic and compliance approach to overcome compliance hurdles, current market challenges, and economic uncertainty, to and emerge in a stronger position than before.
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Published on Jan 13, 2023
Last updated on Dec 2, 2023
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