Monday, 7 October 2019

Morningstar Move into Cryptocurrency Ratings, but is it too soon?

It has been reported recently that Morningstar, a credit rating agency, is attempting to move into the rating market for digital assets. Whilst the article breaking this news contains a number of issues, it does raise an interesting point regarding a. the rating of digital assets, and b. whether the credit rating industry is ready to move into that particular marketplace. In this post we will assess the lead article, and discuss some other elements within this particular field.

The article in Brave New Bitcoin starts off on a worrying footing right out of the gate, announcing that ‘Morningstar Credit Ratings launched in 2016… despite only being in the market for three years the financial services company managed to generate over $1 billion revenue in 2018’. We can dismiss this error as we know that, in 1984 Joe Mansueto founded the agency in Chicago. The article has mistaken Morningstar’s receiving of permission to rate corporate bonds in 2016 as the beginning of it as an agency. Nevertheless, the points the article raise are of interest. In Forbes an article discusses how Morningstar are pushing to become the first formal agency to get involved in the rating of ‘cryptoassets’. COO Michael Brawer said recently that ‘we’re working closely with a number of blockchain-oriented firms who are looking to issue debt instruments on a blockchain… we’re looking to see how we can also provide credit opinions, whether it’s a credit rating or different types of credit data and credit analytics that accompany those debt instruments, and we’re also looking to provide our services on a blockchain’. Whilst there have been suggestions and small advances into this marketplace, Morningstar are attempting to be ambitious to steal a march on their larger rivals. This movement was apparently initiated by an approach from a blockchain start-up looking to issue home equity loans on a blockchain, and who were in need of some third-party verification process. The article discusses how the Big Three agencies have acknowledged that moving debt issuances into blockchains could create potential savings and increased transparency, but that Morningstar is leading the way on a system that may eventually result in assets being originated in a blockchain and then securitised, at which point financial institutions that want to partake in the technology would join the fold.

Morningstar are apparently developing two particular routes. The first is via a system called an oracle. This essentially means that Morningstar’s ratings could be attached to a given asset or product, and it could not be doctored – this means that it could be utilised securely and, potentially, as part of ‘smart contracts’. Interestingly, Brawer discusses how no new people are being hired for this effort, but that this year’s takeover of DBRS means there are skilled people within DBRS who can assist with the effort. The second route is particularly interesting. Morningstar, under this particular plan, would make their quantitative model available for users who would pay for the privilege, so that investors could test the creditworthiness of a product for themselves. There are natural limitations to this, like slow settlement times, but the plan is extremely ambitious. Morningstar already develops bespoke models for some clients, but the scope of this plan is much larger than anything they run at the moment. This market is developing at a pace, with Figure and Cadence amongst a number of firms who are engaging with credit rating agencies for the purposes of securitising within a blockchain, and who are having early successes in doing so.

However, there are concerns. There already exists a crypto-rating agency, and it is being massively criticised. Weiss Crypto Ratings began operations in 1971, but has been attempting to make its place in the crypto world. Proudly operating the subscriber-pays remuneration system, the firm suggest it provides crypto-ratings and that there ‘are the first by a financial rating agency’. To do that, it combines ‘robust, intelligent computer models built by our team of analysts and software developers, analysis of vast amounts of data, and, above all, independence’. This process results in letter-graded ratings for digital products. However, its ratings have been labelled ‘laughably bad’, based on a number of issues. Their rating of Bitcoin, as the standard-bearer, is much lower than much newer and more unknown offerings, which has raised red flags. It has also been suggested that, apart from the massive rating divergence within the crypto world, the process of rating within this realm is actively operating against the ethos of cryptocurrencies, which are designed (through distributive ledger technologies) to be essentially trustless and transparent – it has been argued that unless Weiss Ratings offers a rating system that is fundamentally transparent, then it should not exist within the technology. However, Moody’s has warned against the inherent risks of trading within environments with no formal structures, which seems to put the two worlds at fundamental odds.

Ultimately, it appears that Morningstar’s potential offering of opening their quantitative models for consumers, within a blockchain, could be advantageous. However, this is only the case if they can sort out the time-lags that accompany credit ratings, which is no small feat. Also, there is a more philosophical question as to why ratings are needed in a blockchain – the whole point is to remove informational walls so that everybody can see everything. Perhaps the issue, again on a philosophical footing, is that blockchain technology cannot cure the informational asymmetry that keeps the rating agencies in business. Whether it is through an inability, an inefficiency, or something else, people often do not understand financial-based data. This is where rating agencies, with their letter-based rating systems, exist. Efforts after the Crisis to reduce the position of the rating industry have not only been ignored, but the industry has become more prevalent – this is because they are, fundamentally, required. This is not, arguably, for their informational value, but for their signalling value – and that value is required in a blockchain. Whilst crypto-believers may believe that a trustless system can be developed, it is extraordinarily unlikely, and whilst that is so the credit rating system will be alive and well.

Keywords – business, cryptocurrency, bitcoin, credit rating, Morningstar, @finregmatters

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