Crowdfunding Needs Regulation to Scale Up

By

Lars Kroijer

The young and rapidly evolving field of crowdfunding is democratizing investing like never before, making finance — donations, debt, equity — available where it wasn’t previously. It is cutting the cost of financing, offering higher risk-adjusted returns than traditional channels, and making a positive economic impact on people’s lives. While technological developments are helping crowdfunding grow, what is needed to scale up is enabling regulation.

These were the views expressed at the European Investment Conference by Lars Kroijer, a hedge fund manager, who, driven by a desire to help eradicate poverty, has embraced crowdfunding. Kroijer is the founder and managing director of AlliedCrowds, a data and analytics firm for crowdfunding in developing countries.

Donations Dominate in Developing Countries

Crowdfunding in the developing world is largely fueled by donations or soft loans, Kroijer explained. This is quite different from the situation in the developed world, where crowdfunding is more investment focused. Excluding China, there are about 180 platforms that make up AlliedCrowds’ universe in the developing world, Kroijer said. The largest is Kiva, a lending-based platform that has an 28% estimated market share and uses social underwriting to manage credit risk. Other platforms include donation sites, such as gofundmeYouCaring, and Razoo, and the equity-based Fundacity. Setting up a crowdfunding platform is neither very difficult nor very costly, said Kroijer, who recently established greencrowds.org in Ecuador. The developing world, excluding China, is expected to raise about $500 million in crowdfunding in 2015, a mere fraction of the $34 billion raised globally. The biggest markets are Brazil, Nepal, India, the Philippines, and Mexico.

Growth Is Mind-Boggling

In the aftermath of the Nepal earthquake in 2015, Kroijer said, over $23 million was donated to relief efforts through crowdfunding channels. AlliedCrowds drew more than 800,000 visitors to a simple Facebook page listing the existing Nepal crowdfunding and general relief efforts. The example from Nepal offers further evidence of crowdfunding’s huge potential as well as its startling growth. A number of factors are driving that growth, according to Kroijer, such as rising internet penetration rates, mobile technology adoption, and financial inclusion. Currently, crowdfunding is growing at a rate in excess of 100% per year. Kroijer believes that if crowdfunding in developing countries could transition from predominantly donations to more for-profit investments, the sky is the limit for the amount of capital that could be raised.

A Harder Road in Developing Countries

Much of the gap in crowdfunding levels between developing and industrialized countries is explained by the financier’s ability to perform due diligence on the client, Kroijer said. Take the example of Lending Club, a US peer-to-peer lending company, the largest of its kind, which has a diversified loan portfolio and an established track record of cutting costs for borrowers and offering higher risk-adjusted returns for investors. Lending Club can perform due diligence on a borrower’s ability and willingness to pay because of the systems and legal institutions regarding retail credit and default in place in the United States.“We leverage online data and technology to quickly assess risk, determine a credit rating and assign appropriate interest rates,” Lending Club reports. Such systems and institutions do not exist in developing countries, however, thus holding back crowdfunding. While social underwriting is a possible solution, it is not a perfect substitute for online credit scoring, and Kiva has been criticized for telling an oversimplified narrative as to how it works.

Some entrepreneurs are trying to find new models to help address the due diligence question. One proposal is to ask borrowers to hand over control of their social media accounts or provide track records of their mobile phone, with the idea that the fear of reputational damage or the loss of a prized mobile phone number will help deter defaults. Such new and untested solutions raise a variety of concerns, both ethical and otherwise. The hope is that by experimenting, someone will find models that work.

Equity Is More Challenging, Even in the Developed World

Most global crowdfunding takes the form of debt. Equity financing for start-ups is a tougher ball game, and that’s just in the developed world. Here investors assume a bigger risk in exchange for (hopefully) a bigger return. A core idea driving equity stakes in start-ups is that even if just 1 project in 10 succeed, if it is a wild success, the return is well worth the risk. The past data on equity investing are much thinner compared with debt, which makes the task harder. Speaking from personal experience, Kroijer told the audience how he invested £250 in a South African start-up using his credit card when he happened to be at the launch party — effectively making a small bet he could afford.

The fear of deception, if not outright fraud, and the need for due diligence are heightened in the equity financing of start-ups. A key challenge is when a high-profile project collapses. Rightly or wrongly, the credibility of crowdfunding itself often takes a hit. Critics start to question if equity crowdfunding platforms are merely selling the dreams of naive entrepreneurs to naive investors. Interestingly, this kind of criticism is not very different from the chatter heard after the collapse of the over £2 million Zano mini-drone project in Europe on Kickstarter. Given such examples, it’s no wonder equity composes such a small portion of crowdfunding in the developing world.

Diasporas Offer Opportunity

Diasporas are other areas of potential for crowdfunding in developing countries, Kroijer said. In the Philippines, for example, a significant portion of the economy relies on money sent home by Filipinos living abroad. These expatriates are “getting ripped” by the traditional transfer channels, which often charge more than 7% on the transaction, according to Kroijer. When industrialized nations finance projects in the developing world, the inefficiencies are even worse, he said. For every dollar of investment, only about a quarter actually ends up being used in the intended project.

But imagine there is an initiative to build a bridge in Bangladesh. There are an estimated half a million people of Bangladesh heritage living the United Kingdom. Some of them would no doubt be interested in financing such a project. The World Bank Group, the UK Department for International Development, the Gates Foundation, and the government of Bangladesh could all collaborate on constructing the bridge, offering first-rate due diligence and credibility. By crowdfunding the project rather than going through the traditional developmental finance channels, large amounts of capital could be mobilized quickly and cheaply, earning higher risk-adjusted returns for the investors than are available elsewhere and otherwise making a positive impact.

The Next Step? Regulation

Crowdfunding needs enabling regulation, Kroijer said. In general, regulations are weak in industrialized nations and largely nonexistent in developing ones. Even major achievements in developed countries lack the regulation they need. Consider Lending Club, for instance. Though perhaps crowdfunding’s most successful platform, Lending Club cannot operate in a third of the United States. Regulation is also needed to build trust. Without winning public support, crowdfunding will be hard, if not impossible, to scale up, Kroijer said. He is not alone in this assessment. In a recent article on crowdfunding regulation in the United States, the economist Robert Shiller noted, “Regulators need to get the rules right (and it would help if they hurried up about it).

In the “super-exciting” field of crowdfunding, as Kroijer describes it, there is vast potential to build economies and transform lives in both the developing and industrialized world. Why regulation has yet to be adopted to help facilitate such advances remains a critical but unanswered question.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: Harry Richards

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