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Credit scoring and pricing security tokens

Security tokens represent shares, bonds, fund units and other mostly private, unlisted financial assets. How do we value them ?

The focus so far in the decentralized finance (Defi) and digital assets space has been on issuing and trading of collateralized crypto assets. While that is new and interesting, tokenization of financial assets is the big opportunity.

Billions in Defi today and the Trillions in traditional financial assets that can potentially get tokenized

Tokenization of privately held, unlisted financial assets will enable distribution of tokenized assets to a larger investor base and will help investors access liquidity by trading tokenized assets. However, the success of tokenizing assets is based on the ability to price them and pricing is based on credit scoring tokenized assets.

This article explains how we can profile assets and is a result of our work on the Verified Network which is a Layer 2 Ethereum network of financial service providers that enable tokenization of private financial assets, investments in and trading of tokenized assets.

High level architecture

The Layer 2 network does most of the transaction processing and heavy lifting without incurring Ethereum gas fees and validators on the L2 network stake their share of fee from transactions on the network. Asset balances and credit scores are rolled up to the Layer 1 Ethereum main net which reinforces security and the ability to interface with individual users on the main net.

Export of a company’s credit score summary

Businesses wishing to raise capital or let their investors access liquidity create a profile on Dapps that connect to the Verified Network where smart contracts for credit scoring are deployed. A business profile would include business registration details, and optionally an approval for accessing income and sales tax data, and banking data. The screenshot above is for a business in India where CIN refers to the business registration for companies (or the Company Identification Number), PAN refers to the income tax registration (or the Permanent Account Number) and GST refers to the sales tax number (or the Goods and Services tax). The terms and sources of data vary across countries. For example, in Europe, PSD2 based open banking standards enable approval based access to data from hundreds of financial institutions. Companies registry data is usually public and offers data on financials, shareholdings and more.

The credit scoring contracts are different for businesses and financial institutions such as non bank lenders. In the case of businesses, the assessments take — computed financial ratios, the track record of ability to raise financing, management and ownership risks, debt servicing track record, liquidity and cash flows, capital efficiency, business stability based on customer and supplier analysis, fraud and compliance checks — into consideration for credit scoring. In all, the credit scoring contracts for businesses on the Verified Network use 174 metrics computed out of thousands of data points on every business every month. For financial institutions, additional metrics related to capital adequacy and provisioning are taken into consideration.

Revenue analysis based on sales tax (GST or VAT) records
Cash flow analysis based on bank statements that also report cash withdrawals, payment defaults, etc
Profit and Loss metrics based on financial statements filed with tax and companies registries
Asset — Liability analysis and performance metrics based on filed balance sheets

While data used for credit scoring and assessments are viewable by businesses that provide them, credit scores and reporting on a large number of events of interest such as change of directors and auditors, new shareholders, litigation, ratings by credit rating agencies, debt repayment defaults, record of charges and mortgages, and many more corporate actions are recorded in security tokens. As security tokens are issued to investors, credit scores and corporate actions are available to investors in addition to balances of such assets they hold on security token issuing contracts.

For trading of tokenized assets, the credit scoring tools also provide a guidance on pricing and valuation of assets. Valuation of shares is done by providing analysis of financial multiples and comparing them to competing businesses in the industry the business operates in. Pricing of bonds take face values, discounts, accrued interest income, cash flows and analysis of any options that bond holders have into consideration.

We will cover the issuing and trading of tokenized assets in the another article. Where security tokens are traded, prices at which trades are settled are recorded on the issuing contracts that provide pricing guidance to new investors.

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Kallol Borah

Kallol Borah

Entrepreneur, Technologist, Explorer. Tweets@BorahKallol