Direct: The Rise of the Middleman Economy and the Power of Going to the Source by Kathryn Judge

Direct: The Rise of the Middleman Economy and the Power of Going to the Source

Kathryn Judge

304 pages, Harper Business, 2022

Walmart and Amazon are the two biggest companies in the country. Many of us have become so accustomed to relying on Amazon or Walmart that we take their size and omnipresence for granted. But there is much more to the rise of these giant middlemen, and the supply chains behind them, than meets the eye. They are just the most vivid examples of a much broader transformation in how the economy works, whom it works for, and where the real power now lies.

In my book, Direct: The Rise of the Middleman Economy and the Power of Going to the Source, I explain the rise of the “middleman economy”—characterized by powerful middlemen and long supply chains. The book weaves together data, stories, and theory to show how the middleman economy took hold, the benefits it brings, and the dangers it poses. By comparing today’s middleman economy with the very different ecosystem that grows out of direct exchange—between makers and consumers, investors and entrepreneurs—the book shows how much is at stake in the threshold issue of “through whom” we buy, invest, and even give. It demonstrates how increasing direct exchange and more modest shifts in that direction can help us lead richer lives and contribute to a more resilient, connected, and just economy.

Direct exchange and its kin are proliferating, for reasons both profound and practical. As the drawbacks of trying to navigate the middleman economy grow, so too do the benefits of finding a way around it. There has been an increase in true direct exchange, embodied in farmers’ markets, creators selling homemade goods via their own websites, and comic cons replete with small-production graphic novelists hawking their wares. There has also been a proliferation of close cousins, including digital platforms such as GoFundMe, Etsy, and Kickstarter, and producers that bypass traditional middlemen, such as Warby Parker, Allbirds, and other direct-to-consumer companies. In providing consumers, investors, workers, entrepreneurs, and all of us as humans, an outside option, the rise of direct exchange can go a long way in shifting the balance of power even in a world still full of middlemen. Middlemen are not the enemy. The middleman economy is.

But not everything that claims to be direct really is. Nor is direct a one-size-fits-all solution. The benefits of going direct vary depending on the setting. There are many domains where one or more middlemen are helpful, if not downright necessary. Entrepreneurs and other innovators are most likely to succeed when they understand the challenges a particular middleman arose to solve, how else those can be solved, and how going direct can unlock new types of value that cannot be readily provided in an intermediated exchange.

In this excerpt, I explore why one attempt at seemingly direct exchange—peer-to-peer lending, or P2P, a movement that sought to use technology and the wisdom of crowds to cut out banks—failed to live up to its promise. Comparing the shortcomings of P2P with the success enjoyed by the financing platform Kickstarter reveals lessons about where direct is most likely to succeed and the conditions required for direct exchange to live up to its potential.—Kathryn Judge

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In the mid-2000s, Silicon Valley got into the business of displacing banks. Their aim was to harness technology to cut out the middleman and facilitate more direct investment and exchange. One prominent example was P2P, lending. As a newspaper explained in 2007, the then-leading P2P lender, Prosper, “aspires to do for money what eBay did for your grandmother’s teapot collection—create a person-to-person marketplace for consumer loans, and in the process, turn average people into bankers.” Prosper and others did this by creating platforms that allowed would-be borrowers to tell their story and explain why they needed the funds and enabled would-be lenders to select which borrowers to trust with their money. By harnessing the “wisdom of crowds,” these platforms aspired to make loans available to more people, on better terms, while also creating a new type of investment.

Many embraced the innovation and the hope that P2P could offer a more personal and connected experience. An early account of P2P in Times Trenton opened with the story of Colin Nash, a thirty-five-year-old “struggling with $12,000 in credit card debt,” and Michael Fisher, who, at twenty-four, “was looking for a new investment.” Although the two never met, each helped the other get what they wanted when “Fisher loaned Nash $200” through Prosper.com. For both, the appeal of Prosper went “beyond the bottom line.” “Photos and personal narratives” and other personalizing touches meaningfully enhanced the experience for Colin, Michael, and other users.

At first glance, P2P lending seems to be precisely the type of direct exchange that I call for in my book Direct, and that the book suggests is vital for a better future. It cuts out an established and costly middleman, facilitates a type of connection, and could provide a social good by creating a lending regime less reliant on imperfect standardized metrics, such as credit scores.

The subsequent reality of P2P, however, bears little resemblance to these early, idealistic accounts. It turns out that individuals are very bad at determining whether a stranger is creditworthy, so early P2P loans performed miserably. Additionally, research examining which borrowers got P2P loans and on what terms revealed significant bias. If you were Black, it was held against you. Old or overweight? Not as significant, but also a negative. By contrast, mention military service and your odds of getting funded go up relative to other prospective borrowers with similar credit profiles.

Moreover, P2P platforms have not proven any more willing and able to help people when they really need it than banks. For example, when the pandemic hit and many people lost jobs and needed cash, loan applications at P2P lenders went up. But rather than meeting this heightened need, Prosper and other P2P platforms pulled up the ladder. They started making fewer loans, and making those loans only to borrowers with high credit scores and verifiable income—the same people who could also get a loan from a bank.

P2P platforms were able to quickly tighten lending standards because they had long ago abandoned a true peer-to-peer structure in favor of a “marketplace lending” or “digital lending” model. They still provide a nonbank alternative, but they increasingly rely largely on objective, verifiable data, just like banks. And, to gain scale, they have eschewed money from people like Fisher in favor of funding from private equity funds, hedge funds, and banks, sometimes via securitization. Adding to the complexity, regulators forbade the original structure in which funds flowed directly from individuals to borrowers. As a result, rather than being “direct,” these loans now entail multiple layers of middlemen. More recently, Lending Club decided that the best way for it to thrive is to become regulated like a bank or to buy a bank. The direct alternative thus became the very middleman it once sought to displace.

P2P vs. Kickstarter

To better understand why P2P as a true peer-to-peer exchange failed, and what lessons that failure may hold, it’s helpful to compare it to a successful financing platform, Kickstarter. Kickstarter holds itself out as “a new way to fund creative projects.” It enables filmmakers, musicians, video game designers, and other creatives and entrepreneurs to seek funding for “projects, big and small.” It has helped them finance projects ranging from theatrical productions to innovative bike racks and new lines of yoga clothing, and has often helped them garner valuable press, customers, and other connections in the process. A typical proposal features information about the proposed project, the creatives behind it, and an array of other material—such as pictures, videos, and stories—intended to capture the spirit of the proposal and engage with would-be funders.

Like the original paradigm for P2P lending, Kickstarter uses an Internet-based platform to enable people to raise and give funds; and, on both, a project must hit a minimum threshold level of support to be funded, thus harnessing the wisdom of a crowd. Yet, there are important differences between the two. The P2P exchange is at core financial and obligatory: Money flows one way today in exchange for an obligation that it flow back, with interest, in the future. As the performance of early loans showed, most people are not experts in credit risk.

On Kickstarter, by contrast, creators may offer goodies, including tickets to the show, early models of the good to be produced, or other paraphernalia in exchange for support, but promises of financial re- wards are prohibited. Explicitly prohibiting loans, equity stakes, and other common financing devices changes the nature of the exchange, and, therefore, who is coming to the table and why. People do not back products on Kickstarter planning to get rich. They do so because they think an inventor has a good idea and they want what he has to offer or are inspired by an artistic project. They are, in short, harnessing more parts of who they are and providing information about what people want and what moves them in conjunction with providing financing.

This shapes who seeks funding via Kickstarter and why. Borrowers seeking funding via P2P just wanted a loan, ideally on better terms than they could get elsewhere. Creatives and entrepreneurs, by contrast, often use Kickstarter to test out ideas and cultivate connections with the very people they hope are interested in their good or other offering. Bob Frantz, a creator in Ohio, sees his Kickstarter campaigns as, in part, pre-sales of his graphic novels, allowing him to gauge interest and build a customer base in addition to raising the funds he needs to execute on an idea.

Bob is a stay-at-home father and a creator of podcasts and graphic novels. For him, Kickstarter has been a creative lifeline. He doesn’t have the means to hire the artists and others needed to produce high-quality graphic novels on his own and he has yet to find a commercial publisher for his work. On Kickstarter, he and his co-creator have had two campaigns that brought in a little over $25,000, along with some smaller successes. They don’t tend to make money after paying for the project and the various goods promised, but they raise enough to continue to create, to hire the experts needed to bring their visions to life, and to provide them a finished project that they can continue to sell at comic cons and elsewhere. Funding projects via Kickstarter also provides less tangible benefits. As Bob explained to me, “every one of your backers is validation, like someone believes in your project.”

And just as with true direct exchange, there are often positive spillover effects from the connections people forge on Kickstarter, even beyond the goodwill it can engender. Wharton professor Ethan Mollick surveyed all 61,654 Kickstarter projects that got funding in excess of $1,000 before May 2015. Based on responses from more than 10,000 of those creatives, he found that each dollar a creator raised on Kickstarter was correlated with $2.46 in additional revenue outside of Kickstarter. His work suggests that by 2015, Kickstarter had already played a role in the creation of more than 5,000 full-time jobs, 160,000 temporary positions, and more than 2,600 patent applications.

Like all platforms, Kickstarter is a middleman, and much of its success can be attributed to the way it helps creators and supporters forge connections that would not have been possible twenty years ago. Yet the nature of the connections it helps to forge and the design decisions it has made about which connections to encourage situate it toward the middleman-lite end of the spectrum. This allows it to provide more of the benefits associated with going to the source— and means it also has some of the challenges, like fewer middleman assurances of quality of performance.

The contrasting fates of P2P and Kickstarter serve as a reminder that the benefits that direct exchange and shifts in that direction can offer are not equally helpful across all types of settings. One important difference between more direct and more intermediated forms of exchange is that direct makes it so much easier for people to come to the table as multidimensional beings seeking a multidimensional exchange. This is what lies at the core of Kickstarter. People who provide money are also revealing something about what they like, what excites them, and what leaves them cold, and that information provides value to creators apart from the sums transferred.

The same was never true for P2P, despite the nice stories. The exchange is at its core financial and little more, and there are some distinctly good reasons for intermediation in financing. The ability to get a lump of cash has a long history of motivating less-than-honest claims, enhancing the importance of intermediaries’ expertise in weeding out fraud and assessing the probability someone will repay a loan. The process of collecting money when it is owed has never been a pleasant one, and is unlikely to foster intimacy or goodwill, which are often key benefits of going direct. And the value of diversification to investors means that the individuals providing funds are often better served by going broad rather than deep. P2P platforms recognized this, but efforts to ensure that lenders were exposed to lots of borrowers and that borrowers got funding from lots of lenders had the effect of further depersonalizing the exchange. At least for now, financing may well be a domain where a middleman, or even two, will often be helpful.

Similar dynamics also arise in other domains. It is not by chance that many of the stories of direct at its best involve farmers’ markets, crafts, and other goods that require relatively minimal processing. In many ways, this could be a distinct benefit of going direct: Less processed foods, for example, are often healthier than more processed ones. When buying a car or computer, however, a multi-stage production process is almost inevitable. As Michael Dell made clear with computing, even in these domains, there can be a lot of value unlocked by cutting out a layer of middlemen. But there will be a lot of domains where putting the book’s lessons into practice will entail looking for ways to shorten supply chains and reduce layers of middlemen rather than eliminating them altogether.

One reason that my book devotes so much effort to explaining what middlemen do is that it is very hard to disrupt an established class of middlemen without first appreciating the value they bring to the table. Today’s intermediation schemes may be ridden with inefficiencies, but most arose for good reason. Understanding why middlemen exist in a domain is key to identifying the hurdles that must be overcome for a direct or almost-direct option to be viable. Only by understanding middlemen and the benefits of intermediation can we begin to identify the domains most ripe for change, and the conditions required for a more direct alternative to take hold.