CREDIT: <a href="">Reto Fetz</a> (<a href="">CC</a>).
CREDIT: Reto Fetz (CC).

Policy Innovations Digital Magazine (2006-2016): Innovations: Peer-to-Peer Finance: A Flight to Simplicity

Feb 25, 2009

Internet activist John Gilmore famously said, "The Internet interprets censorship as damage and routes around it." A key event of the Internet age was the invention of Napster, the direct online music-sharing program that helped erode the business model of the global music industry. This capability of the Internet to route around middlemen is becoming more apparent. A reader of the Financial Times in December won £10,000 for identifying peer-to-peer lending through the Internet as the "next big investment idea."

How such a directly connected financial system could work is a question that has interested me for almost a decade.

At a recent conference in Tehran on the current financial crisis, one of my fellow speakers observed that "it is not possible to solve 21st century problems with 20th century solutions." I agree. The emergent partnership-based enterprise model, however, has evolved in response to the challenges of this direct Internet connectivity.

Finance consists of three things: credit, which facilitates trade and enables the creation of productive assets; investment, which consists of financial claims over productive assets such as secured debt (e.g., mortgage loans); and equity, which is an ownership interest in a corporation, and typically exists in the form of shares.

Credit and investment may be achieved without the intermediation of banks. Since bank capital will be further depleted as the credit crunch spreads into the productive economy, peer-to-peer finance offers a solution from an entirely unexpected direction.

Direct Credit

Trade sellers have extended credit to trade buyers for thousands of years. As trade has developed nationally, regionally, and globally, one of the key enabling factors has been credit intermediation by banks. This intermediation protects sellers by taking on the credit risk of buyers and enables trade to flow by providing liquidity to sellers.

It is possible to dispense with a credit intermediary and provide such a framework of trust through the use of an agreement—a guarantee society—whereby sellers and buyers collectively provide a mutual guarantee. This mutual guarantee may then be supported by provisions made by both seller and buyer into a default fund in the hands of a neutral custodian.

A service provider could then set guarantee limits, operate the accounting system, and deal with defaults in return for a fee. The crucial advantage for banks of such a guarantee-society credit-enterprise model is that they would no longer have to put capital at risk by creating credit based upon it.

Direct Investment

When we distinguish the public sector from the private sector, we are actually distinguishing between enterprises and assets that are owned by the state and those which are owned by that specific enterprise model known as the joint stock limited liability corporation.

In recent years, media attention has focused on developments and events in the field of credit. The emergence of new generations of alternative investment vehicles—such as income trusts, real estate investment trusts, exchange traded funds, and hedge funds constituted as limited partnerships—has passed relatively unnoticed.

In particular, there has been an explosion in the United States of the use of the simple and flexible new partnership-based Limited Liability Company. In Britain and elsewhere, an even simpler form—the Limited Liability Partnership—is emerging at a phenomenal rate for purposes never intended by legislation introduced with the intention of limiting the liability of partners in professional partnerships.

Such partnership-based entities may be used as framework agreements—not organizations—which bring together investors with users of investment in a capital partnership. In this way, it is possible to create new revenue- and production-sharing mechanisms for direct investment in productive assets of all types, and particularly in real property and in energy assets through what I call "unitization."


Let's consider how this might be used to refinance a portfolio of distressed mortgages. The properties are transferred to a neutral custodian, and an affordable rental is agreed upon. That rental is then index-linked. The resulting Rental Pool is divided into proportional units which are allocated between investors and a suitable management consortium.

For the "co-owner" occupier, this is a new form of rent-to-buy, since any amount paid in excess of rental will buy units. For the "co-owner" investor, units provide a reasonable, index-linked, secure revenue stream, ideal for risk-averse long-term investors such as pension funds. For banks, this is an optimal form of refinancing through a "Debt/Equity Swap."

Similarly, we may finance a wind turbine simply by creating units redeemable in, say, 10 kilowatt hours of energy and selling these to investors. In the United Kingdom, the sale of between 30 and 40 percent of production finances the turbine, and with a few percent of production to a manager, the balance is pure surplus.

Direct peer-to-peer investment gives rise to shares, but not as we know them. Once again, we see a role for banks as service providers, appraising investments, advising investors, and providing liquidity—all classic investment banking roles. As with direct peer-to-peer credit there is again no need for banks to risk capital by creating credit based upon it.

The enabling factor for a new generation of peer-to-peer finance is a new generation of networked partnership-based framework agreements and entities. The work of visionaries like David Johnson of New York Law School and Oliver Goodenough at the Vermont Law School in creating the new Vermont Virtual LLC is a major advance in this direction.


A generic clearing-union network of direct financing will enable a simple but radical new approach to global economies. It could enable systemic fiscal reform based upon taxation of privilege rather than earned income, and it also offers new solutions for financing public assets. Most exciting of all, it enables a new networked generation of global markets, and even the potential for a "New Settlement"—a Bretton Woods II—establishing a new global architecture for world trade.

Chris Cook was formerly director of the International Petroleum Exchange, and is now a strategic market consultant, commentator, and enterprise architect. He is currently developing new partnership-based enterprise models and financial products based upon their application to Internet market networks.

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