Conflicts of interest in the credit rating agency (CRA) business model were revealed during the 2008 financial crisis.
Investors and issue sponsors (banks) rely on ratings from the Big Three (Fitch, Moody’s Investor Services, and Standard & Poor’s) to determine the likelihood that a bond issuer will repay its money on time.
The credit rating of a borrower (usually a company, government or multilateral institution) affects the price of its debt, especially bonds traded in the market. Triple-A lenders like Apple have lower borrowing costs than the lowest investment-grade companies, and much cheaper than companies issuing junk bonds, which are high-yield bonds.
That sounds good, but the problem with the model is that it depends on who is paying for the evaluation. In an ideal world, investors would pay a fee for an independent valuation so that CRAs would be free to give their honest opinions. However, the asset management industry has decided to save on fees in exchange for potentially damaging credit ratings (larger firms can do their own due diligence). So the CRA industry charges issuers a fee, and issuers are incentivized to pay for ratings if they are good.
In theory, this means that only sound companies buy the ratings, but the 2008 subprime debt crisis made it clear that the CRA was happy to assign triple-A ratings to bundled real estate loans that turned out to be toxic.
A new model for DeFi
Because “everyone was doing it,” no one was severely punished and the model remained the same. And since only very large companies can give ratings, this is mostly okay. Approximately 10% of listed companies have credit ratings, and these are very well-known and well-researched companies.
The disruptive power of blockchain is slowly spreading through more areas of financial services. As more lending protocols emerge and eventually real-world tokenization takes root, more businesses will look to borrow in the form of digital assets.
Fintechs are emerging to provide credit ratings within the DeFi space. The first wave of technology-based businesses attempted to create ratings in the form of NFTs. But now a team based in Dubai and Hong Kong is taking the problems from TradFi’s starting point and transforming this model into one suitable for DeFi. In the process, they are reconfiguring different sets of incentives to make credit ratings different and better.
“We will provide forward-looking default probabilities that are more accurate than traditional CRAs,” said Robert Alcorn, co-founder and CEO of Dubai.
Synnax has raised $1 million in a pre-seed funding round to launch DeFi CRA, which is currently in beta testing mode and has a live launch scheduled for the summer.
Alcorn said the idea originated from his previous startup, Clearpool, a DeFi protocol for unsecured lending. He launched Synnax in collaboration with Dario Capodici and Alessio Quaglini of Hong Kong-based Hex Trust, a digital asset manager. The founders have a pre-cryptocurrency background in the fixed income space of international banking.
Encryption vs. Transparency
Capodici, who also serves as COO, said Synnax’s models take encrypted data from the companies being evaluated and allow a network of independent data scientists to make a variety of ratings using their own machine learning models. The companies being evaluated provide APIs to display real-time updates on data such as profitability and utilization, but data scientists can also integrate their own data sources, such as macro information or social media sentiment, into the model.
A network of data scientists can generate dozens or hundreds of different scores to determine the likelihood that an assessee will repay its debt on time. Synnax consolidates these into a single credit rating and publishes them. However, data on companies subject to primary evaluation will remain private.
“We aggregate the data and evaluate analysts’ assessments based on whose models are most accurate,” Capodici said. “It provides a single view, but is based on hundreds of algorithms with real-time updates. This differs from traditional CRAs, where ratings are assessed through the lens of a single analyst or model and only change when the company releases its latest financial statements.”
Not only does this tilt more weight in the final tally, but weights also play a role in the fee model.
revenue stream
Synnax is building three revenue streams: First, the companies being evaluated pay on a quarterly subscription basis. Second, users (hedge funds, brokers) pay a subscription fee to get a look under the hood. There are many nuances to the models behind the ratings themselves. Third, banks, underwriters, lenders or fintech companies can purchase the data to run their own models and help price DeFi debt for their customers.
Money also flows to data scientists. They are rewarded based on weights based on how predictive the model is, default rates, and other metrics such as spreads or volume forecasts.
Because it is a cryptocurrency, data scientists will be paid in Synai, the yet-to-be-issued Synnax governance token. The customer also pays for this form of service. Synnax will operate a treasury with a discount window for trading Synai on virtual asset exchanges. Synnax will also reward users with Synais by answering surveys or participating in competitions to build new AI models.
Synnax, and the DeFi world in general, will not impact the traditional CRA model, which is designed to serve large public companies. The founders said they are targeting private companies interested in blockchain-based finance.
However, the two worlds can influence each other.
How DeFi Impacts TradFi
Alcorn says he hopes traditional CRAs will become customers that use Synnax data to power their own practices. Synnax plans to release ratings for about 2,000 companies, including large public companies. This provides an alternative rating even if the company is not in the DeFi space.
To keep things simple, Synnax has decided to stick with the TradFi rating system (triple A and below), but it will be interesting to see how the ratings differ or adhere to those issued by traditional CRAs over time.
DeFi ratings also change regularly. Rated companies will see their scores improve with increased transparency. This means providing more data while ensuring that the data is API-ready and doesn’t have to be uploaded manually. This too will create a new way of looking at a company’s creditworthiness.
If there really is a hidden bias in the status quo business model, there are hybrid pricing models that can impact the final rating.
This model for CRA will also impact how investment banks and lenders approach debt issuance. This comes from how we handle data and how we handle capital.
At TradFi, the acquiring bank has staff in its Debt Capital Markets team who work with clients through financial engineering and the company’s tax and account reporting methods to improve their credit ratings. That kind of thing is not effective in a DeFi environment. Because a banker cannot (theoretically) influence every decentralized data scientist.
“Data scientists will not take fabricated data submissions at face value,” Alcorn said.
Capodici added that TradFi ratings are designed to minimize a bank’s cost of capital. Under Bank of International Settlement rules, banks prefer fee-based businesses that do not incur capital costs. But loans are like that. The same goes for share acquisitions (since the shares are on the bank’s balance sheet for a while).
Banks therefore only want to acquire for their largest clients who are expected to generate significant fee-based revenue through other means (transaction banking, FX, wealth management, etc.). This is one of the reasons why only large corporations have credit ratings. Small and private companies do not have access to traditional capital markets.
private capital market
However, it is possible for such companies to borrow in the DeFi market and obtain cheap credit ratings to meet their financial needs.
“We expect to see a migration of private credit moving on-chain because it is much more efficient, while at the same time we think digital asset capital will sometimes want to transact off-chain when there is a yield differential,” Alcorn said.
Pre-seed funding was led by No Limits Holdings. Other investors include Edessa Capital, Kenetic Capital, Bitscale, Ryze Capital, MH Ventures, Hex Trust, Moonvault, GameFi Ventures, Typhon Ventures, Ausvic Capital, Drops Ventures, and Everstake Ventures.