Alternative Finance Terminology

Finance beyond the banks

Any financial services provided outside the traditional banking systems fall into the category of “alternative”. Although the alternative finance sector is still dwarfed by mainstream banking, it is growing rapidly: it’s predicted that by 2025, alternative finance will have as much as 37% of the addressable SME lending market.

Because “alternative finance” is defined simply as everything that’s outside of the banks, there are many products and services that this definition could include. Things like pawn shops and payday loans have historically been included in the category. However “alternative finance” is increasingly used to refer to a specific group of services, enabled by innovative financial technologies (fintech). This includes peer-to-peer lending, invoice trading and various types of crowdfunding.

Alternative finance is sometimes known as disruptive finance because of its potential to disrupt the traditional bank-based systems of borrowing and lending.

Crowdfunding

Crowdfunding is a way of sourcing small amounts of money from a large number of sources– a “crowd” of hundreds or even thousands of individuals, brought together by an online platform.

There are three main types of crowdfunding, based on what the funders expect to get in return: donation-based, reward-based and equity-based.

Charitable causes

Donation-based crowdfunding looks for altruistic funders to contribute money for good causes without expectation of any return, for example for charities or community projects. An example is JustGiving, who claim to have helped raise over $3.3 billion for charitable causes. Donors can give via debit or credit card or via text message.  You can also fund creative projects, sports teams and trips and well as more serious things like medical bills.

Cool stuff

Reward-based crowdfunding raises money in exchange for something from the fundraiser. Examples might include tickets, pre-orders of product or memorabilia. Gadgets and new products are particularly popular, with a notable example being the Oculus virtual reality headset. As well as raising funds for product development or manufacture you can also use crowdfunding to test an idea, build customer loyalty or as part of a marketing strategy.

Crowdfunding as an investment

Equity-based crowdfundingor “investment-based crowdfunding”, is a modern form of venture capital, where funds are raised in exchange for shares. If the company is a success, investors can make a profit by selling up. However the majority of startups fail (around 80% within the first 5 years) so potential investors should approach this cautiously.

Alongside typical equity-style investments, where investors buy a portion of the company, equity crowdfunders are increasingly offering “mini-bonds”. These are similar to normal bonds in that they have a predetermined duration over which they pay out interest. Unlike normal bonds, it’s generally difficult to trade mini-bonds so investors are locked in for the full duration.

Equity crowdfunding is regulated by the FCA, with notable UK examples including GrowthDeck and SyndicateRoom.

Loans provided by the crowd

The fourth version of crowdfunding has many names. It’s sometimes called “loan-based crowdfunding” or “debt-based crowdfunding”; in the USA, it’s increasingly called “marketplace lending”. But internationally and in the UK it is more commonly known as “peer-to-peer lending” or “crowdlending”.

Crowdlending draws money from the crowd to provide a loan. Like loans from banks or other sources this money has to be repaid, usually with interest.

Crowdlending started life with a crowd of individual peoples providing loans to consumers. It’s now much more diverse, providing business loans, community loans and property development finance. Crowds often include institutions and professional wealth managers alongside ordinary individuals.

Safeguarding investments

Whether it’s personal loans or business finance, peer-to-peer loans have an element of risk. Some platforms have set up provision funds or safeguard funds to minimise the money lost. If a borrower defaults, the money is made up from the platform’s fund.

It’s not insurance – if multiple loans go bad at the same time the fund could be exhausted. However it does provide an extra layer of reassurance for particularly risk-averse investors.

Short term business cash

Invoice trading is a way for businesses to get hold of cash quickly, by auctioning their unpaid invoices online. Once the invoice has been paid the seller can buy the invoice back again. Invoices can be broken up and sold to multiple buyers in a way that is similar to crowdlending.

Invoice trading is different from traditional invoice finance in that it’s generally less restrictive – individual invoices can be traded on a case-by-case basis, and there’s no long-term contracts.

Low income finance

Microfinance is the provision of very small amounts of finance to low-income individuals who do not have access to banks, because they are too poor to have a good credit rating or because their community is not monetized. Microfinance platforms can include various funding mechanisms including interest-free crowdlending or donation-based crowdfunding.

Lending money to low-income individuals and businesses might seem risky, but it needn’t be – non-profit platform Kiva has loaned over $825 million in microfinance, with a 98% repayment rate.

Modern technology

The common element between all these different products is the technology. Financial technology has been around for decades, but the explosion of innovative new businesses in the last decade has resulted in the word fintech being redefined. Like alternative finance, it has taken on a disruptive edge, referring to smaller, younger companies that are challenging the incumbent financial models.

Fintech isn’t just for providing loans. There are fintech businesses in every area that banks operate including payments processing, currency exchange, credit assessment, data handling and banking itself. Instead of simply using technology to streamline an existing process, fintechs are built differently from the ground up, meaning they can provide services in genuinely new and innovative ways.

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