Will Crowdfunding Help Financial Inclusion of Unserved Crowds?
“Crowdfunding” refers to a range of technology-enabled financial innovations that hold great promise to reach the unserved and underserved masses. The term describes market-based financing where small amounts of funds are raised from large numbers of individual sources, typically using online platforms to match supply with demand, thus bypassing traditional financial intermediaries. While crowdfunding has the potential to become the next big thing for financial inclusion, it brings along risks for both borrowers and lenders, which need to be better understood and timely addressed.
Two things are sure about crowdfunding: It is evolving, and it is growing at a very fast pace, not just in developed markets but in countries across the income spectrum. Emerging from notions of shared economy and social investment, crowdfunding has evolved into four main categories, distinguished by the promise made to the funder:
- Donations-based crowdfunding, in which funders do not expect any financial return.
- Rewards-based crowdfunding, where funders pre-buy the product or receive special perks as a reward.
- Debt-based crowdfunding, where funders lend money to other individuals or companies in return for interest payments.
- Equity-based crowdfunding, which allows funders to purchase equity in a company and earn a financial return if the company makes an exit through an initial public offering or acquisition.
We see lines blurring among these categories, however, with the creation of many hybrid models, some of which rely mostly on institutional investors rather than appealing directly to “the crowd.”
Though growth is uneven by category, overall the volume of funds raised is climbing at a staggering rate, from US$2.7 billion in 2012 to an estimated US$34 billion in 2015 globally. The fast growth is driven by high demand for credit and high supply of savings resulting from a mix of phenomena, including credit shortage in the aftermath of the global financial crisis, low interest yields and technological advancements.
As crowdfunding has become a global phenomenon and is no longer confined exclusively in developed countries, its potential to promote financial inclusion has attracted the attention of the international development community. The G20 Global Partnership for Financial Inclusion’s (GPFI’s) recently published white paper says that crowdfunding can deepen financial inclusion: “It can be a quick way to raise funds with potentially few regulatory requirements; it can be cost-efficient and can produce a good return for the lender; and its potential market reach is limited only by access barriers to the platform and regulatory restrictions where applicable.”
Moreover, crowdfunding has the potential to adapt and incorporate country-specific traditions, reflecting local sociocultural patterns (e.g., M-Changa, a donation-based platform that digitize the practice of “Harambee” – community fundraising) or leveraging development programs (e.g., Cheetah fund – a now-closed experiment combining a donor-based matching fund and locally focused debt crowdfunding).
Policy makers now face a key question: How do you regulate crowdfunding so that it can achieve its market-building potential, while appropriately managing the risks that come with it? And there are many potential risks indeed: lack of transparency, fraud, default of the platform, and cyber-attack to name a few.
A number of countries have tried to answer this question by passing laws and regulations establishing a specific regime for crowdfunding (e.g., France, Germany, Israel, Korea, Malaysia, UK, USA), while others are expected to follow soon (e.g., Australia, Brazil, China, India, Indonesia, Mexico, Vietnam). Although widely diverse, the rules generally aim to balance investor protection and related market conduct concerns against the positive role crowdfunding can play in promoting economic growth. However, thus far they focus predominantly on the risks faced by the supply side (investors, lenders and other suppliers of funds). As crowdfunding reaches scale in lower income countries and begins reaching poorer market segments, more attention will need to be focused on the demand side as well.
In such market contexts, it is worth reflecting that often the platform is the only “professional” in the crowdfunding game – and not a disinterested one – while both the investor and the borrower often are equally vulnerable and inexperienced individuals or small businesses. On the investor’s side, because of its social nature and high advertised returns, crowdfunding may attract consumers who lack experience with these types of financial offerings, and for whom crowdfunding is not suitable. Similarly, inexperienced borrowers may underestimate the rules they need to comply with (e.g., disclosure and reporting), and they may not fully appreciate the legal implications of equity distribution and future repercussions of “managing the crowd” of creditors or stockholders. In the case of debt crowdfunding, borrowers may be steered into borrowing beyond their financial means without appreciating the risk of over-indebtedness, credit bureau blacklisting and a range of possible penalties.
Three years ago, the International Organization of Securities Commissions called crowdfunding a nascent industry, and this description still holds true despite the tremendous growth. Crowdfunding has not yet reached systemic dimensions in any market in terms of funds intermediated when compared with more traditional mechanisms. Yet recent developments remind us of the potential serious consequences of platform failure. The prominent case of Ezubao, where 900,000 investors lost more than $7 billion, is an extreme example, but it is likely that it will not remain an isolated case.
Policy makers around the globe will need to monitor closely and be prepared to intervene to close any existing regulatory gaps, to ensure crowdfunding continues to grow because of its innovative and attractive nature, and not because of regulatory arbitrage or lack of consumer protection.
Editor's note: This blog is available in Mandarin on the World Bank Voices blog.
Grateful for the opportunity to comment on this important issue.
Crowd funding is an innovative approach to raising funds thru the thrift system. It is traditional with most petty traders in rural and, even, the urban areas of my country, Nigeria.
The system is highly risky and unpredictable, not profitable to the contributors who are made to part with the first contributions in a month.
I studied the system and have done a good work which will combine this traditional "esusu" model with a modern, ICT-based Micro finance Network that can alleviate poverty and promote financial security and social impacts to millions of the poor masses in Africa.
Thank you for sharing your experience and information about your work. We would be interested to hear more about your work and discuss findings from our recent research as well. Please feel free to reach out to us through the contact form: www.cgap.org/content/media-inquiries-0.
Further guidance for policy makers may be found in the December 2015 Statement on Addressing Regulation of Crowdfunding by the Board of the International Organization of Securities Commissions (IOSCO Statement). In summary, the IOSCO Statement refers to the findings from a recent survey of 23 IOSCO members in the Crowdfunding 2015 Survey Responses Report. The IOSCO Statement lists crowdfunding risks to which regulators should pay attention (in addition to common investment risks), notes some of the approaches taken so far by regulators to address inherent investor risks and stresses the need to take account of cross border implications. However, given that “most regulatory regimes have only recently been implemented… IOSCO has not proposed a common international approach to the oversight or supervision of crowdfunding at this stage.”. Nevertheless, the IOSCO Statement is likely to be helpful for policy makers in addressing the important issues raised by this Blog.
Thank you for your comment. IOSCO’s work regarding crowdfunding including the Survey (which informed the Statement that you refer to) and 2013 paper Crowd-funding: An Infant Industry Growing Fast provides helpful input for policy makers concerned with developments of alternative market-based funding. There are two important points to emphasize (as mentioned in our blog): (i) crowdfunding is broader than investment-based crowdfunding, which is natural focus of IOSCO’s work, and concerns other policy makers (national and international) beyond regulators of capital markets, and (ii) the borrower/issuer protection deserves as much attention as the lender/investor protection, particularly in emerging and developing markets.
Thank you for the write up. I have been actively involved in microfinance since 2005 and I love Kiva has done since inception; it is a typical example of how crowdfunding can impact the world of finance. I have coveted the system used by Kiva and your publication has reinforced my resolve to go ahead. The major challenge I see in using crowd funding is the fear associated with doing business with Nigerians especially on the internet. But conventional methods used in Nigeria is such that a number of individuals pull funds and decide to give the cash to just one member without any interest. This is done weekly or monthly as the case may be till all members have benefitted from the crowdfunding. The risk associated with this method is the risk of default. The other type described by Mr. Ajayi is the conventional thrift system but it is different from crowdfunding.
Thank you for your contribution. The issue of trust is indeed one of the key challenges associated with crowdfunding, particularly in jurisdictions with a limited or nonexistent regulatory framework for crowdfunding. Therefore we argue for more attention to be paid by national and international policy makers to the need for a sound legal and regulatory framework that would allow the innovation to develop and grow safely.
As crowdfunding keeps evolving, we may see models different from Kiva that build on existing funding schemes similar to the ones you describe.