Shadow Market: What It Is, How It Works, Example

What Is a Shadow Market?

A shadow market is an unregulated (or less regulated) private market where goods and services are exchanged with little or no oversight.    

Understanding the Shadow Market

The purpose of a shadow market is to shield participants from the oversight and transparency of conventional marketplaces, which often include significant documentation. Because activity and transactions on a shadow market have little or no oversight, it offers participants the opportunity for strategies or schemes otherwise unavailable in public markets.

A shadow market may describe a simple transaction between two individuals, such as one party agreeing to purchase an asset without the burden of standard methods. Alternatively, a shadow market can be much larger, such as a private mortgage lender who doesn't qualify or fall under the regulations of a bank but supplies people with credit across the country anyway. A significant number of companies fall into this category.

The expression "shadow market" conjures up images of illegal or otherwise shady business arrangements, but not all shadow markets are nefarious in nature. A robust shadow banking system of non-bank financial intermediaries provides similar services to traditional banks but with the added benefit of convenience and often less paperwork. Such institutions can include payday loan companies, private mortgage or loan lenders, hedge funds, insurance companies, and private equity funds.

Many financiers in this space take issue with the expression "shadow banking," as if they're back alley loan sharks. The behavior of some operating this way hasn’t helped their reputation, though— the shadow market for mortgages played a primary role leading up to the subprime mortgage crisis of 2007 to 2008 and the global recession that followed.

When times are good, these types of legal shadow markets or systems generally operate without much scrutiny. When the economy tanks, they're a usual suspect. This often leads to certain types of businesses having to deal with more regulation or increased oversight.

Shadow Market vs. Black Market

The shadow market should not be confused with a black market. This is the market for illegal goods, and goods and services that should be taxed but go unreported.

There are various types of black markets. Examples include a black market for undocumented work and pay under the table, as well as a black market for illegal drugs and legal drugs that are being bought or sold illegally.

Example of a Shadow Market

Traditionally, if you wanted a loan you went to the bank, or possibly facilitated a loan agreement with family or friends. In recent years, technology has allowed for the rapid expansion of another form of lending: lending between peers.

Online peer-to-peer lending platforms allow people with money to connect with someone needing money. The platform handles the exchange and repayment of funds in exchange for taking a small cut.

In the banking system, all loans are tracked for reserve requirement purposes. Since peer-to-peer lenders fall outside the banking system, there is less regulatory oversight and the size of the market is largely unknown. The size of the market can be estimated based on the advertised numbers of peer-to-peer lending firms. Or in some cases, these firms are publicly traded and their accounting records show the types of business volumes they are doing.

According to Allied Market Research, the global peer-to-peer lending market was valued at $68 billion in 2019 and is expected to grow to $559 billion by 2027, which reflects a compound annual growth rate (CAGR) of almost 30%.