If I want to lend my friend $5,000, governmental regulations don’t seem terribly necessary.  But what if I want to lend $5,000 to the small entrepreneur who I met on the internet?  How should that agreement be regulated?

This is the question currently facing the peer-to-peer (P2P) lending industry.  State law has governed the industry since its popular inception, but from 2008 onward, the Securities Exchange Commission (SEC) has taken control of the reins—a development that has rightfully upset many P2P lending companies.

P2P lending is not much more complex than the story related above.  Through websites such as Prosper, Lending Club, Kiva, Loanio, VirginMoney, and Zopa, borrowers interact with lenders and swap information before determining a flexible lending rate.  Owing to the low transaction costs, both lenders and borrowers usually walk away with better deals than could have been secured at a bank or with a credit card.  To date, Prosper has loaned $211 million.

But such innovative dynamism in the lending industry eventually fell under the regulatory eye of the federal government.  As chronicled by American Enterprise Institute fellow Alex Brill in this Washington Legal Foundation Legal Backgrounder, the SEC recently claimed that P2P loans can be classified as securities and therefore fall under the organization’s regulatory authority.  The stultifying effects of SEC regulation have been far-reaching and have even deterred some European P2P companies from entering the U.S. market.

It’s a well established fact that excessive regulation can cripple businesses.  But by restricting P2P lending, the SEC’s negative effects span beyond economics.  P2P lending has played a major role in allowing small entrepreneurs to form their dreams during a time of economic downturn, and the internet is replete with P2P lending stories enabling people to get money for weddings, diapers, or college degrees.  P2P sites like Kiva and GlobeFunder are already playing an important role in getting cash to developing countries.

The Coalition for New Credit Models—a consortium of P2P groups—is trying to avoid “suffocat[ion] by rigid regulations.” If federal regulation is necessary, the group claims, the industry should be regulated by the Consumer Financial Protection Bureau (CFPB), a bureau that deals with banks and other lending institutions.  The Dodd-Frank financial regulatory reform bill has commissioned a study to be completed in July, 2011 that will address the regulatory concerns.  We can only hope that this growing dynamic industry is left at least partially free to flourish.