THERE are two phenomena in China's financial market today: the lack of investment options and funding channels.

Investors are between a rock and a hard place. The Shanghai Composite Index has dropped by as much as 20 percent during the past year, banks' annual deposit rate is less than 1 percent, and property market is still expensive despite the government's effort in cooling down this sector.

As borrowers, banks are reluctant to lend money to persons with little creditworthiness, or to small- and medium-sized enterprises (as well as microenterprises) with no collateral. The export market continues to slow down, but borrowing demand does not. So what are the alternatives?

A new business model was introduced to the world in 2006 by Zopa, a British pioneer in online lending, or commonly known as peer-to-peer (P2P) lending. Simply put, through P2P, loans are arranged between borrowers and lenders without the middleman, which makes them cheaper to the borrower and more lucrative to the investor.

With today's technology, all of the transactions can be executed online, through internet. That is, borrowers and investors don't even need to meet face to face and have their business completed. Ever since Zopa made its debut, this new growth engine is widely accepted and adopted elsewhere, including China.

The beauty of online lending (and investment) is its simplicity. There are no complicated procedures and long waiting time like borrowing from banks, or complex investment instruments that investors find difficult to understand. The key factors that need to be known to both borrowers and lenders are: the price - a mutually agreed interest rate; the risk - the creditworthiness of the borrower; and the tenure - the duration of loan. There is no official figure for the number of online lending operators in the country, but an estimate of active lenders are over 100, with the leading top five operators already making profits.

Unregulated segment

Since this market segment is unregulated, these companies are in general startup, formed as an IT, consultant or investment entity. Similar to other countries, personal lending and borrowing is legal in China, which is what makes growth possible in this lending segment in the first place. Although non-bank operators such as microcredit and guarantee companies do cover this lending market which traditional banks have neglected, for example, individuals and enterprises without credit history or collateral. The P2P lending market provides an arena that matches funding supply and demand, with a convenience unmatched by other operators.

Similar to financial organizations, the success of online lenders depends on how well they manage risks, both internally and externally. Almost all of the P2P operators review the loans, through assessment of individual borrowers and subsequently provide a risk rating that matches the respective credentials, credit history, household income and other factors. Naturally, too many dishonest borrowers who don't pay back will certainly damage the lending site's reputation. Through word of mouth via internet, it won't take long before the poorly performing operators lose business credibility.

With an increasingly competitive environment in this new market, it is becoming a common practice that loan guarantee is part of the service. For example, the principal and interests are guaranteed by the P2P lending site as insurance for investors.

There is obviously a need for such service since the risk of the borrower who defaults on the loan still exists. Hence with the guarantee service that may be charged by the operators. As such, operators need to retain their reserved pool to cover default loans, like banks. This alternative lending (and investment) market should not be underestimated. Although the 2012 projection for this market is only 18 billion yuan (US$2.9 billion) in outstanding loans, which is less than 1 percent of China's consumer lending market, the annual growth rate of this segment is over 200 percent.

So it's easy to understand that many of the leading players such as RenRenDai, and ShengRong already have disbursed loans of over 100 million yuan. However, CreditEase stands out from the crowd, with estimated disbursed loans of 10 billion yuan, even though their offline operating model differs from the rest. Instead of providing an online platform, CreditEase have offices with sales teams that target investors with wealth management plan and borrowers with loan products.

Attractive feature

In the P2P market, the minimum investment can be as low as 50 yuan, with a maximum investor yield of over 20 percent. It is certainly appealing to many investors. Another attractive feature of this kind of online investment is that investment can spread across different loans. For example, the total investment of 1,000 yuan can be broken into 10 transactions (loans) of 100 yuan each.

This is a strategy to mitigate risk, just like fund managers managing their investment portfolio with different asset classes, across different industries and countries.

The US Congress has passed a new regulation in April 2012 called The Crowdfunding Bill, which is the first of its kind since the birth of P2P more than 6 years ago. One of the bill's highlights is that all P2P platforms need to be registered with the regulator, the US Securities and Exchange Commission, in addition to other investment guidelines. Well, it's a start. In China, there is not yet any law that governs online lending. However, in terms of investment risks, China's banking regulator, the China Banking Regulatory Commission has provided risk guidelines to the general public even though the P2P market is not yet regulated. The guidelines cover areas including illegal deposits, fraud, money laundering, credit risks, and poor quality of loans. In addition, the "interest rate" charged to borrowers cannot exceed four times the official bank benchmark interest rate, or it will be considered usury, which is illegal.

Although the online market is still small, it will be a different landscape in five to ten years time. Observers compare the P2P industry with the payment industry, which the central government finally regulated last year, when it reached nearly 2.2 trillion yuan, after years in the wilderness. Now there are 101 licensed payment companies in operation. So it is only a matter of time before this virgin territory too will be regulated.

Risk management

Since P2P lending involves financial transactions, risk management should be part of the governance structure, which exercises diligence over operation control, information security, and credit risks, and provides a certain level of assurance to clients. Prior to the industry being regulated, it would be sensible to form a self-regulated association that unites the industry, promotes best practice, and minimizes bad conduct in the trade.

Some banks do not entirely ignore the development of the P2P market and its potential. China Merchant Bank's charismatic CEO, Ma Weihua, conceded that with the proliferation of technology, P2P lending will become the trend, along with internet and mobile banking. Ping An Group, one of the leading financial conglomerates in China, under the leadership of Ma Mingzhe (unrelated to CMB's Ma) took it one step further by launching its P2P website, Lufax, early this year, as a pioneer of P2P in the mainland financial industry. In August alone, the site has generated 60 million yuan in new loans.

In the P2P world, China is in a level playing field with other nations. The marriage of business and technology has created a new model of financial intermediary for consumers. Although it is not considered mainstream "banking", it is nevertheless a disruptive innovation that can one day redraw the map in the financial industry. The concept also allows new competitors to enter the financial market at warp speed, without the traditional entry barrier. As for consumers, this is a lifeline for borrowers, and an alternative avenue for investors. And this revolution has just begun.

Gregory Au-Yeung is currently chief information officer at VantAsia Finance, a foreign-owned financial institution that specializes in consumer finance in China. He is part of the senior management committee in building and expanding VantAsia's retail (personal loan and wealth management) footprint. Prior to joining VantAsia, Au-Yeung held senior positions at Morgan Stanley and State Street Bank in China and other Asian locations, and has been based in China since 2005, covering China for more than a decade. He is also a visiting professor at Fudan and Zhejiang University. His email address is gauyeung@hotmail.com and the opinions are his own.