Tuesday, December 4, 2007

Revisiting Group Rewards

After my initial reaction to Prosper removing group rewards, I spent some time understanding the (near) collective wisdom that group rewards needed to go. I've hit acceptance. The positive group leaders could not overcome the market-distorting effects of the pump and dump and the community payment.

Here's how the pump and dump worked. A group leader would take smaller loans with high interest rates and bid a large sum (25% - 50%) at the initial interest rate. Other lenders, noticing a loan about to fund, would bid. As more lenders bid, the group leader's bid would be pushed off the loan, leaving the group leader with a funded loan to his group and no skin in the game. Why did lenders pile onto the loan? It was because the group had a 5 star rating.

But why did the group have a 5 start rating? It was because of community payments. The community payments were originally intended to allow a friend to help out a borrower, but were used for statistics manipulation. The group leader would prop up his group's rating by making community payments for those loans that ran late. The group rewards provided sufficient income to the group leader to maintain this system for several months. Those familiar with pyramid schemes will recognize that eventually the pyramid will fall apart - the community payments cannot be maintained with the group rewards as defaults increase as more loans are funded. When everything falls apart, however, the group leader still gets group rewards on those loans that didn't go belly up, usually with little or no money lost on their part.

At some level, the system was perpetuated because Prosper did not account for community payments in the star rating system and community payments were difficult to observe for lenders. But, even if existing lenders could learn to navigate the dangerous waters, a constant stream of new lenders were entering the marketplace. The current system was damaging to the marketplace and had to change. I still believe that it was painful to lose the good group leaders who made working with borrowers their full time job, but Prosper made the right choice to preserve the integrity of the marketplace.

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