Solving Information Asymmetry Problem in Crowdfunding
Crowdfunding has seen rapid growth in recent years, with $2.5 Billion raised in equity crowdfunding globally during 2015. This amount is expected to grow further, as new regulations make it easier for entrepreneurs to raise money through crowdfunding. In theory, crowdfunding provides great benefits to both the seekers and providers of capital; allowing entrepreneurs to raise funds easily, and providing small investors with fresh avenues for investment.
In practicality, however, the situation may not be as rosy. It is seen that the general public is not as fit as traditional lenders to evaluate the risks and rewards of the investment. According to a recent study published in the Journal of Entrepreneurial Finance this February, information asymmetry seems to be a significant challenge for crowd-funding. It is seen that investors are likely to fall into the trap of false signals sent by entrepreneurs, fraudulent schemes, or may simply be unable to read the signals sent by the entrepreneurs correctly.
The trap of information asymmetry is closely linked to financial literacy. According to the S&P Global FinLit survey, only one in three adults globally can be described as financially literate. This means that the rest lack a basic understanding of concepts such as risk diversification, interest, and inflation. How can the public then be expected to make wise investment decisions when it comes to crowd-funding?
While this number varies greatly from developed nations to developing economies, at least one-third of the adults in even the most developed nations are financially illiterate. If we look at the US for example, we see that only 57% of the population is financially literate. These scores are lower for women, the poor, and those in the younger age brackets. An American study recently showed that when asked 5 simple questions regarding financial concepts, those in the 55 plus age bracket scored a 3.3, compared to a 2.3 for those between 18 and 34. At the same time, it is this age group of 18-34 year olds which we see investing more through crowdfunding.
The success of crowdfunding and an improvement in financial literacy thus go hand in hand. In order for crowdfunding to be successful, steps must be taken for the education of the public so they may make well informed decisions when it comes to investing. With financial literacy in place, there is also a need for stronger regulation of the area for the protection of investors.
With the digitization of finance in today’s world, financial literacy can be spread faster than ever before. Rather than focusing on services that allow users to spend and transfer money easily, FinTech is also responsible to help individuals save money and meet their financial goals. Stash, an investment advisory app, allows you to make investments as small as $5, buying fractional shares and providing personalized investment guidance and definitions of financial terms. Moneythink, a financial literacy startup uses technology to teach teenagers financial concepts through their own language – emojis, hash-tags, and social media. In fact, it calls itself a “gamified Instagram for finances”. Services such as these can help bridge the gaps in financial literacy among the general public.
With the public beginning to understand the information signals sent by entrepreneurs looking to raise capital, there is also a need for greater regulation regarding the level of information disclosed. The Financial Conduct Authority of the UK has been calling for further regulation in the market, as in the current situation it is ‘difficult for investors to compare platforms or to compare crowd-funding with other asset classes because product offerings were ‘complex and often unclear’.
It is only a combination of the two above factors that will allow crowdfunding to successfully grow to the next level, creating economic prosperity for both the users and providers of capital.