A Vital Blockchain Use Case: Decentralized Rating Agency
Reclaiming the American Dream.
Learning Objectives:
- The cause behind the housing crash of 2008
- The purpose of Credit Rating Agencies, and their role in the 2008 subprime mortgage crisis
- Regulations set in place in response to the Great Financial Crisis
- DeFi and how it can replace certain aspects of our current financial system
- How a Decentralized Rating Agency can be beneficial to American society
Demise of the American Dream
You may have seen the box office hit ‘The Big Short’, which featured a number of Hollywood icons reenacting the events leading up to the financial crash of 2008. The film tells the real-life story of hedge fund owner, Michael Burry, who predicted the housing market collapse back in 2005. Burry shorted the housing market using his investor’s liquidity. Short selling in the traditional stock market is always riskier than longing a stock because, in theory, there is no limit to the amount of money that can be lost. Speculators such as Michael Burry capitalize on a decline, even at the risk of setting up his investors for an infinite loss. Burry created a new financial instrument, called a credit default swap, which allowed him to short the housing market on the assumption that the price of real estate would crash. He was scrutinized for this play for years. Other Wall Street bankers and opportunists soon discovered Burry’s findings to be true when they realized rating agencies were giving out high credit ratings to debts that turned out to be high-risk. The few who bet on home buyers defaulting on their subprime mortgages, collectively saw returns over a billion dollars. The collapse of the housing market during the Great Recession displaced close to 10 million Americans, and ruined the American Dream for many.
How could Credit Rating Agencies (CRAs) allow this to happen?
The concept of using rating agencies was formed in the early 20th century, with a purpose to evaluate the financial strength of a company, or a government entity’s ability to meet principal and interest payments on their debts. Each agency uses unique letter-based scores to indicate if a debt has a low or high default risk and the financial stability of its issuer. The debt issuers may be sovereign nations, local and state governments, companies, or non-profit organizations.
There are 3 Credit Rating Agencies (CRAs) that dominate the industry — Standard & Poor (S&P), Moody’s Investor Services, and Fitch Group. A number of factors are assessed for an institution’s rating, including the existing level of debt, financial liquidity, a historical demonstration of its ability to repay loans, and its current financial ability to repay debt. While no standard formulas exist consistently between the Big 3 rating agencies, their ratings tend to be highly subjective and inaccurate. The main fallacy, which also enabled the financial collapse of 2008, was significant conflicts of interest. Credit agencies can provide ratings at the request of the institution itself. Meaning, they have the ability to conduct unsolicited evaluations on companies, and sell those ratings to investors, and CRAs are usually paid by the very companies they are rating. Since CRAs are paid for ratings, they may be more inclined to give favorable ratings to a company in order to retain its business.
In the heat of the global financial crisis, the Big 3 came under major criticism for giving convenient ratings to failing institutions such as the Lehman Brothers. They were also investigated by the Department of Justice for their role in failing to identify risky mortgage-backed securities that led to the collapse of the real estate market. In 2010, Congress passed the Dodd-Frank Act in response to the collapse, enforcing stricter regulations on CRA’s and the financial sector as a whole. According to “The Fiscal Times”, one the greatest pitfalls of Dodd-Frank is allowing mortgage industry giants such as Fannie Mae and Freddie Mac to continue to dominate the housing finance market. The government guarantees or owns 90 percent of existing home loans. There is no consensus plan in place to return private investors into the market, and little bureaucratic interest to develop one.
A plausible solution? DeFi.
With blockchain technology gaining momentum in recent years, and Decentralized Finance (DeFi) locking in projects valued over $38 billion and an estimated $70 billion in total market capitalization of DeFi tokens, DeFi’s expansion has caught the attention of government regulators. We’re seeing more and more technical advances in the DeFi realm, with the opportunity for users to finance projects through decentralized lending, borrowing, staking, investing, betting, etc. Although DeFi is still in its early growth stages and has its own risks, it can be beneficial by establishing a Decentralized Credit Agency.
DeFi is still new and an enigma for many, but with our current financial ecosystem constantly under fire, decentralized finance could offer an alternative to the very institutions that failed us. DeFi protocols offer accessibility to individuals that have been set back due to their credit histories (or lack thereof) as a result of speculated, and inconsistent ratings from traditional CRAs. This doesn’t mean a use case of Decentralized Credit Rating Agencies (DCRAs) wouldn’t have its risks either. Many DeFi protocols require a certain level of knowledge to use safely, without this users can be exposed to risks unintentionally.
Instead of centralized custody and servers, participants have to trust that smart contracts do not have any vulnerabilities that put assets at risk. In a way, DeFi replaces custodial risk with smart contract risk, which has allowed attackers to steal funds escrowed in smart contracts. Since DeFi removes certain constraints while introducing others, raising awareness to educate borrowers will be key for it to move forward. On the other hand, having a DCRA backed by a blockchain ecosystem would allow data to be obtained from the blockchain directly. This way, the risk profile related to collateral free lending might become tangible, since addresses will have reputation, as we have with centralized credit scores. The Blockchain is a global, open and in real time available ledger of financial transactions, that can be analyzed using automated algorithms and prediction markets.
Overall, for a new wave of DeFi protocols to take appropriate steps to replace the void left by traditional banking, the ecosystem itself must first address its own shortcomings. To reconsider our current centralized financial system, and replace it with a globalized network with no custodian can feel out of reach. But with more and more delinquencies in subprime loan repayments since the global pandemic, considering DeFi as an alternative solution can address the malfeasance left by our current financial system. The vision for DCRAs, along with more blockchain use cases in the real estate market, will be discussed in further detail in Carthago’s ebook series.
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Sources:
- Amadeo, Kimberly. “The Causes of the Subprime Mortgage Crisis.” The Balance, 29 Jan. 2022, https://www.thebalance.com/what-caused-the-subprime-mortgage-crisis-3305696.
- Daniel, Will. “The Typical Homebuyer in 2022 Is Totally Different from 2008. It’s a Good Thing.” Fortune, Fortune, 13 May 2022, https://fortune.com/2022/05/13/housing-market-2022-homebuyers-better-financial-position-2008/.
- CFI Education Inc. “Rating Agency.” Corporate Finance Institute, 7 May 2022, https://corporatefinanceinstitute.com/resources/knowledge/finance/rating-agency/.
- Publisher Guest Contributors, “Are Credit Ratings Agencies Really Necessary Going into 2021?” Nasdaq, 16 Feb. 2021, https://www.nasdaq.com/articles/are-credit-ratings-agencies-really-necessary-going-into-2021-2021-02-16.
- Lewis, Katherine Reynolds. “The 5 Best and 5 Worst Regulations in Dodd-Frank.” The Fiscal Times, 11 July 2011, https://www.thefiscaltimes.com/Articles/2011/07/19/The-5-Best-and-5-Worst-Regulations-in-Dodd-Frank.
