The Internet has spawned many regrettable things, such as dancing babies, sneezing pandas, and Star Trek porn, but peer-to-peer lending isn't one of them. The Web really has created some unique new situations and business opportunities that not even the omniscient Framers of the Constitution could have foreseen. Like electronically bringing together anonymous people who wish to lend their money to other anonymous people in a double-blind auction, facilitated by high tech-Web 2.0 technology of the sort eBay uses. That's precisely what sites like Prosper, Lending Club, and Loanio are trying to do: use the Web to create a network of regular people who wish to borrow and lend money to one another, at agreed upon terms that are a result of bidding and counterbidding. The Web sites even allow pools of people to fund loans partially in amounts that typically range from $1,000 up to $25,000, and to resell their loans to other members. It's like adultfriendfinder.com for financial hookups, minus the tawdry photos. And it's been working beautifully.

But in November 2008, when you might have thought the SEC had bigger fish to fry—like busting the world's biggest Ponzi scheme—they somehow found the time to slap a cease-and-desist order on little old Prosper. Until the San Francisco company registered with the SEC, they were ordered to facilitate no new loans. Oh, and they had to stand mute in the corner for a while, too—the usual mandated "quiet period"—which they are still doing today. Loanio voluntarily followed along without having to be told.

Why, in the depths of the Great Recession, would the federal government be stepping on the necks of John Dough and Joe Sixpack who just want to float a little cash to help each other get through the tough times?

They have shut down, for now, a powerful engine. Up until last fall, when the SEC white hats rode into town, Prosper had enabled 25,000 loans between its 750,000 members that averaged $6,000 each. That's about $150 million in serviced loans. The U.K. site Zopa, usually considered the granddaddy of P2P lending on the Web, reported that it had 200,000 members, and lenders were averaging 7.3 percent returns—better than twice the rate of a typical bank account and infinitely better than your average share of stock. Most impressively, perhaps, Zopa said the default rate of its members' loans was stable at an ultralow 0.02 percent.

But there were nagging questions. What if too many borrowers failed to pay? What if lenders charged criminal levels of interest or started whacking bad borrowers? What if the Web site went out of business? These questions were—as is so often the case on any frontier worth its tumbleweeds—pushed aside. As long as no one showed up at the saloon with a badge, everything was cool. At the heart of the matter was a question only a lawyer could love: Who could or should regulate this market? Traditional banking regulators? Or someone else? What, exactly, was this new thing: animal, vegetable, mineral, or complex three-party electronic transaction?

The crackdown appears to have begun with Lending Club; based in Sunnyvale, Calif., it is Prosper's main competitor in the United States. With venture capital money behind it and a high-powered team of former executives from American Express, Goldman Sachs, MasterCard, and E*Trade, the company decided to be proactive and hired lawyers who reached out to the SEC in early 2008. "We wanted to help define the space, to participate in the dialogue about how our industry would work, and how it would be regulated," CEO Renaud Laplanche says. "Because we really expect this business to grow huge in coming years, and we wanted to be sure everything was done right." Lending Club got in touch with the SEC's Office of Financial Services. Together, the lawyers parsed the business, and they came to see a peer-to-peer loan as a security. They reached this conclusion for a couple of reasons: P2P lending was, crucially, being marketed as an investment opportunity with an expectation of a return; P2P loans were offered to the general public; they enabled lenders to profit from someone else's labor; the Web sites actually issued a promissory note from a bank, which was then sold to the lender; and, most important from a regulator's point of view, there was no expertise required to participate, there were few protections, and there didn't appear to be any other agency or department actively engaging with the new industry.

In April of 2008, Lending Club registered with the SEC and accepted the somewhat daunting task of filing every single loan with the SEC as a security. Starting in October—just in time for the global economic meltdown—Lending Club went online with full federal approval and all paperwork duly filed. Laplanche told TBM that the process has now been mostly automated; the same technology that enables his company to replace a traditional bank or collection agency allows it to make regular automatic filings through the SEC's EDGAR filing system. While there was some initial pain and expense, he thinks they are far outweighed by the potential of the business.

So now Lending Club is quickly gaining ground on the hogtied Prosper and Loanio. While its main competitors twiddle their thumbs waiting to get back into business, the company has facilitated more than 3,000 loans for $30 million. For loans issued since October, only 0.35 percent have been delinquent, and there have been no defaults—though a spokeswoman admitted it's still too early to celebrate that particular data point. The average return for lenders has been 9.05 percent. With return and default rates like that, it's no surprise that business is booming. The company claims it has doubled its registrations from December to February.

The SEC registration and wrist-slapping may be the least of Prosper's worries. It has set the terms for countless additional headaches. Shortly after the SEC's cease-and-desist, a New York law firm filed a class-action lawsuit on behalf of Prosper lenders arguing they'd been hoodwinked into buying unregistered securities. That case goes to court on May 1. And in a separate case, Prosper has already paid $1 million to the North American Securities Administrators Association to try to head off state litigation.

This seems to be why Zopa declined to launch a planned U.S. expansion. In a late November blog post, CEO Giles Andrews said, "We always took the view that the SEC would likely view our platform, as operated in the UK and Italy, as requiring registration with them. ... That's the key reason why we didn't launch our UK model in the U.S. and watched with great interest when others did proceed with platforms that we felt carried regulatory risk." Just so, the global recession seems to have amped their business in the United Kingdom. While the company is stoic about releasing its numbers, spokeswoman Sarah Stocks-Wilson confided that "business in the U.K. is booming!"

For the SEC's part, a kindly spokesman there, John Heine, told me that even though times are crazy at the commission, he's confident that the laws that were written at the very founding of the SEC—the FDR-initiated Securities Act of 1933 and the Securities Exchange Act of 1934—were written broadly enough to handle anything technology could throw at them. "We had to deal with the telephone and the teletype," he laughed. "I think we'll be OK with the Internet." Of course, regular folks fooling around on the Internet had nothing to do with AIG's credit-default swaps, or Lehman's subprime tranches, or Bernie Madoff's prospectuses. So maybe P2P lending is, for the SEC, easy pickings. We can only hope their regulatory acuity trickles up.

(Photo of handcuffs by Getty Images)