Peer-to-peer lending has arrived in Canada, marking the birth of a niche financial service for consumers.

IOU Central Inc. , a Montreal-based online lending service, launched in mid-February. CommunityLend Inc. of Toronto intends to follow in the spring.

Although they’re both funded by angel investors and venture capital, the firms have taken different approaches to the business, underscoring the regulatory challenges the industry faces.

Peer-to-peer online lending services compete against the retail credit card market for low-range consumer credit. In “P2P” lending, as it’s called, consumers post borrowing needs online and let a community of anonymous Web-based lenders bid for the loan at competitive interest rates. After all, the average consumer can pay 19% and upward in interest on his or her credit card balance.

Borrowers can build up their creditworthiness and borrow at better rates than they might with traditional lenders. The site’s host, meanwhile, takes a percentage on either side: a service fee from the lender and closing fee from the borrower.

One week after its launch, IOU says hundreds of borrowers looking for more than $75,000 in total loans have posted on the site. But lenders are scarce so far. “It’s only been a week,” says IOU’s president Phil Marleau, a former equity research analyst for both Scotia Capital Inc. in Toronto and Merrill Lynch & Co. Inc. in New York. He also worked for a small investment counsellor in Montreal.

“We’re at the early stages,” he adds. “But most people are excited about the concept coming to Canada.”

P2P rides the industry’s high-minded spirit. Mohammed Yunus received the Nobel Prize for Peace in 2006 for pioneering social lending and micro-financing. He founded a bank in Grameen, a poor Bangladesh village in 1976, to lend small amounts to women to support their livelihoods. The model has been copied many times over in countries in which banks and secured capital won’t tread.

For European and North American consumers having trouble borrowing cash, the idea has been commercialized over the past two years by Zopa Ltd. in Britain, Prosper Inc. in the U.S. and the Netherland’s Boober BV. In 2007, Richard Branson joined the field, buying Circle Lending Inc. and rebranding it as Virgin Money USA.

Analysts who follow the nascent industry agree that there’s a place for P2P, although it barely registers against US$4 billion in outstanding consumer loans in the U.S. alone. Tower Group Inc. analyst Craig Forcardi estimates that together, Virgin, Prosper and Zopa (now with a U.S.-based service) have no more than 30,000 P2P loans outstanding; he estimates total volume since the industry’s inception is in the hundreds of millions of U.S. dollars.

A 2006 Forrester Research Inc. report on Prosper, the biggest player in the U.S., says the success of the industry will be tied to its ability to: attract clients who understand the risks and opportunities in the model; develop a large community of lenders and borrowers; and control fraud and default rates.

For advisors, the industry pitches itself as a new asset class. Want to diversify your client’s portfolio? Why not ask clients to consider a handful of investments in unsecured consumer debt? But while underlying interest rates might be tied to the overnight lending rates at the central banks, this is not fixed-income. A 2006 Tower Group report notes Zopa’s average rate of return is 7% for lenders and up to 10.5% for certain categories of lenders.

That report, authored by Theodore Iacobuzio, managing director at Tower Group, also notes the industry can benefit from the increasingly poor credit environment. P2P lending is simple and accessible compared to complex securities, and that could help the online firms become “significant players for consumers and businesses,” it says.

“One can argue that [P2P lenders] should always be able to compete very cost-effectively with traditional banks because of their low cost base,” the report continues, “and they may well attract a growing and loyal customer base willing to work that little bit harder and take more responsibility for managing its borrowing and lending.”

It seems no one knows his or her bank manager anymore. But, ironically, in social-lending theory, knowing your community of borrowers plays a part in the success of the model.

@page_break@Michael Garrity, president of CommunityLend, points to a 1993 Bank of Canada study on two micro-financing institutions, Calmeadow Metrofund in Toronto and Cal-meadow Nova Scotia in Halifax. The study shows that loan defaults are lower by half in lending environments in which social monitoring exists. About 24% of borrowers defaulted in a group environment in the study, whereas 41% failed to pay individual loans.

The structure of the study didn’t account for self-selection; maybe those likely to rip off friends wouldn’t borrow knowing they would be caught, for example. Nor does the study say anything about online environments.

Nevertheless, it’s this dynamic that Garrity says CommunityLend will aim to create with a proprietary calculation for generating a “community score,” a rating of borrower quality above and beyond credit scores such as Equifax Canada’s FICO, that members must agree to make public on the site.

“It’s displayed alongside the credit ranking that we show, and the idea is that a borrower can do something about it,” says Garrity. “It shows that people know you, they validate you and believe you’re a good bet for repaying a loan.”

Online auctioneers such as eBay Inc. operate with some of the same social mechanisms, but the risks attached to lending $1,000 of after-tax cash are higher than buying an old pair of ski boots — which underlines the need for regulation and recourse.

Apart from bad FICO scores and public shaming for bad borrowers, both IOU and CommunityLend are resorting to the time-tested solution of collection agencies to sort out bad loans. “We basically hire a collection agency on behalf of the lender,” says IOU’s Marleau. “And they report to the credit bureaus.”

Globally, regulators have taken different positions on how to oversee this industry. In Britain, the Financial Services Authority oversees Zopa and even offers some monetary recourse to lenders to the extent that they have bought Zopa’s creditor insurance. In the U.S., Prosper plans to register with the Securities and Exchange Commission, as it opens up a secondary trading exchange on contracts in its system. It already has several state licences.

Garrity says CommunityLend sought opinions from federal and provincial regulators about its business model, although, for competitive reasons, he’s coy about specifics. The company has made many submissions and answered the Ontario Securities Commission’s questions over the past eight months as the lender readies for launch.

“The fundamental question has been: ‘Is the underlying asset class a security?’” says Garrity. “The counsel we’ve received from our lawyers and regulators is that there’s no question that it is.”

Based on CommunityLend’s business model, the OSC has sought dealership registration from the firm, which will also apply for a number of exemptions. Garrity says the know-your-client rules and ensuring suitability can only help the industry. “Part of our submission to the OSC,” he says, “will be the set of activities that we will ensure are built into the system to disclose investor/lender risk and to protect investors.”

IOU’s legal counsel has advised against seeking regulatory registration, says Marleau. That follows a pattern set by predecessors that have tested laws and regulators as they launched in their vastly different environments.

Tower Group’s Forcardi says getting to market can weigh heavier than sorting out regulatory issues with P2P firms. They develop “mindshare” while they work through the law with their business models, he says.

Looking ahead, depending on how well they’re capitalized, Forcardi adds that there’s room for P2P firms to carve out a market, operating over the long-term as stand-alone entities or getting bought out by banks.

“But it’s the large banks themselves that will respond as competitors,” he says, “and develop their own P2P models in time.” IE