Alternative finance

What Is Alternative Finance?

Alternative finance encompasses financial channels and instruments that operate outside the traditional banking and capital markets system. It represents a growing segment of financial services, often leveraging digital platforms to connect those seeking capital with those providing it. As a category within Financial Innovation, alternative finance aims to address gaps left by conventional lending and investment models, particularly for individuals and Small and medium-sized enterprises (SMEs). This broad term includes various models such as crowdfunding, peer-to-peer lending, and invoice financing.

History and Origin

The concept of alternative finance, wherein non-traditional sources provide capital, has historical parallels predating modern banking systems, with early forms of peer-based finance and local credit cooperatives existing across Europe.³⁰ However, the contemporary alternative finance landscape largely emerged in the early 21st century. The modern era of alternative finance began in the United Kingdom in 2005 with the launch of the first peer-to-peer lending platform, followed by similar platforms in the United States in 2006.²⁹

A significant catalyst for the expansion of alternative finance was the global financial crisis of 2008–2009. As traditional banks tightened their lending criteria and public confidence in these institutions wavered, individuals and businesses, particularly SMEs, sought new avenues for funding., ²⁸T²⁷his period saw a surge in demand for non-traditional credit solutions and an increased willingness among investors to explore alternative options for higher returns. L²⁶egislative changes, such as the Jumpstart Our Business Startups (JOBS) Act enacted in the U.S. in April 2012, further facilitated the growth of alternative finance by easing securities regulations and enabling broader participation in private capital raising, notably through crowdfunding exemptions., ²⁵S²⁴pecifically, Title III of the JOBS Act, implemented by the U.S. Securities and Exchange Commission (SEC), opened crowdfunding to non-accredited investors, though with certain limitations on investment amounts.,
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22## Key Takeaways

• Alternative finance refers to funding methods outside conventional banks and capital markets.
• It often utilizes digital platforms for efficiency and broader access.
• Key models include peer-to-peer lending, crowdfunding, and invoice financing.
• The market expanded significantly after the 2008 financial crisis, addressing funding gaps.
• Growth is driven by technological advancements and evolving regulatory frameworks.

Formula and Calculation

Alternative finance itself is an umbrella term for various funding mechanisms, rather than a single financial product with a universal formula. However, individual alternative finance products, such as loans or equity investments, involve specific calculations. For instance, in peer-to-peer lending, the interest rate charged to a borrower is determined based on factors like creditworthiness, loan term, and the platform's algorithms, often expressed as:

Where:

• Principal represents the initial amount borrowed.
• Interest Rate is the annual percentage rate (APR) applied to the loan.
• Loan Term is the duration over which the loan is to be repaid, typically in years or months.

Similarly, in equity crowdfunding, the valuation of a company and the share price offered to investors would involve financial modeling, though there is no standardized formula universally applicable across all alternative finance instruments.

Interpreting Alternative Finance

Interpreting alternative finance involves understanding its role in the broader financial ecosystem and evaluating the specific mechanisms used. It represents a shift towards disintermediation, where traditional intermediaries like banks are bypassed, potentially leading to faster access to funds and more flexible terms for borrowers, and potentially higher returns for investors. F²¹or borrowers, alternative finance can be a lifeline when traditional bank loans are inaccessible due to stringent credit requirements or lack of collateral. F²⁰or investors, it offers diversification opportunities and access to asset classes or types of investments typically unavailable through conventional channels, such as early-stage company equity or consumer loans. T¹⁹he growth of the alternative finance market signifies an increasing demand for non-traditional credit solutions, driven by technological advancements and changing participant behaviors.

¹⁸## Hypothetical Example

Consider "TechSpark Innovations," a burgeoning startup needing $200,000 to develop a new software product. TechSpark has been turned down by traditional banks due to its lack of a long operating history and substantial tangible assets. Instead, TechSpark turns to an alternative finance platform specializing in equity crowdfunding.

On this platform, TechSpark offers 10% of its equity to investors, divided into 20,000 shares at $10 per share. The platform facilitates the offering, allowing individuals to invest small amounts. An individual investor, Sarah, who believes in TechSpark's potential, invests $1,000, acquiring 100 shares. Another 199 investors, collectively investing $199,000, join Sarah. This allows TechSpark to successfully raise the $200,000 needed, securing capital it could not obtain through conventional means. This scenario demonstrates how alternative finance can provide crucial capital for businesses that might otherwise face funding constraints.

Practical Applications

Alternative finance manifests in various forms across different segments of the economy:

• Business Financing: Many alternative finance platforms specifically target Small and medium-sized enterprises (SMEs) that struggle to secure loans from large banks. This includes platforms offering peer-to-peer business loans, invoice financing, or merchant cash advances.
  *¹⁷ Consumer Lending: Peer-to-peer lending originated primarily as a way for individuals to borrow and lend money for personal needs, bypassing traditional consumer credit products.
  *¹⁶ Real Estate Financing: Crowdfunding and peer-to-peer models are increasingly used for real estate projects, allowing multiple investors to pool funds for property acquisition, development, or refinancing.
  *¹⁵ Venture Capital Alternatives: For startups seeking seed or early-stage funding, equity crowdfunding platforms offer an alternative to traditional venture capital or angel investors.
• Social and Community Projects: Donation-based and reward-based crowdfunding are widely used to fund creative projects, charitable causes, and community initiatives that may not have a traditional financial return model.
• Regulatory Sandboxes: Many jurisdictions have introduced "regulatory sandboxes" to foster Financial technology (FinTech) and alternative finance innovation, allowing new models to operate under lighter scrutiny while authorities monitor their impact. T¹⁴he global online alternative finance market is projected to continue its significant growth, driven by increasing adoption of these platforms.

¹³## Limitations and Criticisms

While alternative finance offers numerous benefits, it also carries inherent limitations and criticisms. A primary concern is the increased risk for both borrowers and investors. For borrowers, particularly businesses with higher credit risk, the costs of alternative finance, such as interest rates or platform fees, can be higher than traditional options.

¹²For investors, the primary risks include a lack of liquidity in some investments, potential for default, and sometimes a lack of transparency or limited information about the underlying assets or borrowers., ¹¹U¹⁰nlike publicly traded securities, many alternative finance investments are illiquid, meaning they cannot be easily sold or converted to cash. A⁹dditionally, the relatively nascent nature of some alternative finance models means there is a more limited track record for historical performance analysis compared to traditional asset classes. C⁸oncerns about fraud and investor protection have also led regulatory bodies, such as the SEC in the U.S., to establish specific rules and oversight for certain alternative finance activities like crowdfunding. D⁷espite rapid growth, consumer surveys have indicated concerns about perceived risks and a lack of information when using alternative finance platforms.

⁶## Alternative Finance vs. Traditional Finance

Alternative finance and traditional finance represent distinct approaches to capital allocation. Traditional finance, predominantly represented by banks, large financial institutions, and established capital markets, typically operates under extensive regulatory frameworks and adheres to stringent lending and investment criteria. It often involves longer approval processes, significant collateral requirements, and may not cater effectively to niche or early-stage funding needs.

In contrast, alternative finance emerged to address these gaps, leveraging technology to disintermediate the financial process. It typically offers more flexible terms, quicker access to funds, and caters to a broader spectrum of borrowers and projects, including those deemed too risky or too small by traditional lenders. While traditional finance emphasizes stability, scale, and established credit histories, alternative finance prioritizes accessibility, innovation, and often, the direct connection between capital providers and seekers. The rise of alternative finance is partly a response to the traditional banking sector's retrenchment from certain lending segments and increased regulatory costs following financial crises.

⁵## FAQs

What types of businesses typically use alternative finance?

Many small and medium-sized enterprises (SMEs) and startups turn to alternative finance when they face challenges securing funding from traditional banks, often due to a limited operating history or insufficient collateral.

⁴### Is alternative finance regulated?
Yes, alternative finance is increasingly subject to regulation, though the specific rules vary by jurisdiction and the type of financial instrument. For example, in the United States, crowdfunding offerings are regulated by the Securities and Exchange Commission (SEC) under the JOBS Act.

³### What are the main benefits of alternative finance for borrowers?
For borrowers, key benefits include faster access to capital, more flexible lending criteria compared to traditional banks, and access to funding for innovative projects or businesses that might not meet conventional lending standards. It can also support financial inclusion for underserved segments.

What are the risks for investors in alternative finance?

Investors face risks such as the potential for default by borrowers, illiquidity of investments, and in some cases, less transparency compared to publicly traded securities. D²ue diligence and understanding the specific risk assessment of each platform and investment are crucial.

How does financial technology (FinTech) relate to alternative finance?

Financial technology (FinTech) is a crucial enabler of modern alternative finance. Digital platforms, data analytics, and online payment systems powered by FinTech allow alternative finance models like peer-to-peer lending and crowdfunding to operate efficiently, connecting borrowers and investors directly.¹