Rating Providers and the Future of Blockchain Recommendations
Recommendations have always been and continue to be the most important thing we need to make the right choices. On the Internet, which is nowadays becoming even closer to us, these rules are becoming even more significant. The web is full of offers, information and allurements. Now, it is becoming even truer than ever that great things are rated as great by a larger number of people and vice versa. Impartiality is the important thing that we will be discussing in this article.
Nowadays, all value from the “off-line world” is gradually moved to online networks. Banknotes are becoming mere numbers and codes. Enterprises and projects as we know them are becoming values defined by numbers, often without any clear connection with what they represent. It is therefore wise to take a thorough look at who will be those commenting, rating and recommending these values. Also, it is necessary to know the rules of this process.
Rating, Rating, Rating!
In this article, you will learn about the future of rating providers and what this term even means. You will also find out to what extent we need these providers and how they might affect our future. We will take a look at specific examples of how such agencies may collaborate and how their collaboration will transform the perception of a seemingly simple thing such as payment for services, management or investing. At the end of the article, we will see that currently, in the beginnings of RA, we can invest a lot in the quality of information so that we can sit down in a few years and count the capital in multiples.
First, let’s see the general definition of rating:
Rating is an independent scoring of various subjects classifying them into several categories, allowing an approximate comparison or even ranking.
In the field of finances, the term credit rating is often used. It represents the credibility of debtors (issuers) or bonds. Credit rating is provided by rating agencies, so-called Rating Providers.
Generally speaking, a rating provider is any entity offering one or more rating features.
Simply put, a rating provider transforms an input information into an output information:
- If the rated input is an address, a specific user is rated.
- If the rated input is a transaction output, a product is rated (produced by a user). A product can be a product as well as a receivable, share in a company, or a cryptocurrency.
- The output of the rating is a number (e.g. a real number between 0 and 10). This number may be complemented by a verbal rating.
Rating, therefore, basically represents trust, or, more accurately, a value which is necessary for almost every relationship we make. While the original definition had been linked primarily to financial markets, currently, it is connected to everything – from shopping online to an appointment at the hairdresser. This value has swiftly moved from the classic, old world to the new, digital world, the world of social media. Let’s take a look at the beginning so that we are able to see what we might face in a new, decentralized, purely digital world which is the Blockchain.
The History of Rating
The history of rating as a service (in the new world, we use SaaS – software as a service) is closely related to the development of the financial market in the United States of America. The beginnings of rating can be traced back to 1909 when John Moody started rating bonds of railroad companies (which was a major industry at the time). Shortly after, this type of rating was used for bonds of public service enterprises and industrial companies. Poor‘s Publishing Company was one of the first providers, it made its first ratings in 1916. Standard Statistics Company and Fitch Publishing Company ratings followed in 1922.
The rating market has gradually developed to the extent that we now have three global rating providers and other local and specialized providers.
Although these are purely American providers, their rating system has been adopted by the whole world. The current “cartel” arrangement has been allowed mainly by the American federal regulation, which identified the selected rating providers as nationally recognized statistical rating organizations (NRSRO) decades ago. SEC, an American financial regulation authority, requires other organizations to keep their assets in accordance with the rating provided by NRSROs. This caused a major concentration of power as the market of rating providers became effectively closed.
The failure of this system manifested itself during the mortgage crisis in 2007 when institutions holding “safe” instruments with high-interest rates started to go bankrupt. The rating providers failed as they rated derivatives based on subprime mortgages as high-quality instruments (AA rating or higher).
Most of us remember this period very well. Based on this context, we are thus able to understand how important rating providers are to us and how powerful their rating is. Therefore, independence is the most important factor we need to observe. First, let’s see the general definition of rating and the used criteria.
Types of Rating
Generally, we may classify types of rating as a rating of an issue (a bond) and a rating of an issuer (a company or a state) which is in most cases also directly related. Another very important criterion is time. We use the time to classify rating as short-term (rating of liabilities with a due date within 1 year) and long-term (liabilities due after 1 year).
Simply said, a rating of an issue = product, a rating of an issuer = user. In other words, bonds may be understood as the product and the issuer of the bonds may be understood as the producer.
Rating of an Issue
Most ratings are related to a specific issue of a certain instrument (bond). They rate the probability of full repayment of this issue in the given time. It is, therefore, possible that a single issuer will hold several issues with the various rating. Such a situation occurs when the conditions of individual issues differ and are taken into account by the rating.
In the contemporary world, it is, for example, one manufacturer producing various types of products. Each product can have a different rating.
Rating of an Issuer
Rating of an issuer does not necessarily have to be a result of the overall rating of the given subject. It is often based on ratings given to individual issues, while taking into account factors that have not been considered during the rating of an issue. Rating of an issue, therefore, estimates the issuer’s ability to fulfil their liabilities and often greatly influences the interest rate used for the specific issue.
In other words, if Apple users are satisfied with the offered product (iPhone for instance) the product rating (iPhone) will affect the producer rating (Apple) as well.
During the rating, both factors inside the rated subject and the external factors must be taken into consideration. For the classification purposes, we also differentiate between quantitative and qualitative factors.
Quantitative factors focus mostly on economic conditions and are often a result of a mathematical-statistical method. These may include ratings based on accounting indicators such as profit, capital structure, liquidity, development of the capital, etc. For state ratings, economic growth, inflation rate, debt rate, etc. are included.
Qualitative factors are those that are difficult to assess objectively. This includes, for example, company management, relations with business partners, risk management, company strategies, government policies and competition. In the case of states, this is, for example, a history of payment and budget discipline or political stability.
Rating in the New World of Cryptocurrencies
In the field of cryptocurrencies, a rating system as we know it from stocks and bonds has not yet been established. There are certain attempts that are however being mocked by the community (Weiss Ratings, the Ministry of IT of the PRC) as these are issued by institutions of “the Old World”. With respect to the above-mentioned cases, there are doubts regarding their impartiality and competence. Most cryptocurrency ratings are now descriptive (in words) rather than evaluating (CoinMarketCap, CryptoCompare).
Nevertheless, it can be assumed that with the increasing number of projects/firms issuing their cryptocurrencies in the new world, a transparent rating institution will have to be established, this time in the true competitive market environment.
There is one field, however, where the rating has already begun operating satisfactorily: the ICO projects quality rating (projects exchanging shares for capital). Many specialized sites were created for this purpose – ICOindex, ICObench, etc. However, the disadvantage of these providers is that
a) their credit and reputation is immeasurable
b) can be used only with already defined projects
Ad a) There are attempts for quantification with ICObench – individual rating entities gain a score which increases the significance of the rated projects. However, this score is given by ICObench, a central authority, not independent users.
Ad b) Also, there are planned products utilizing the analytical services of a provider for the purpose of the token specification. These, however, are problematic due to the superficial knowledge of the rating entity which is unable to assess whether a project is possible to implement.
Due to the massive amount of ICO projects (ICObench reports nearly 3,700 planned, ongoing and finished projects), the users have no other option but to use the ratings, even though they only represent the opinion of the authority.
If we imagine that every individual project brings a unique solution for a specific field of business, it is virtually impossible to think that a centralist organization (limited by capacity and human resources) would be able to rate each project in an independent and relevant manner.
Considering the fact that the number of projects/firms joining ICO is growing exponentially, this finding is truly alarming. Let’s have a look at how this increasing need could be satisfied while maintaining the qualitative and quantitative rating criteria. Also, let’s see the possibilities and methods for maintaining a healthy and neutral rating environment.
Optional Transparent Blockchain Rating
A decentralized shared database (Blockchain) allows for an optionally transparent rating process. If you never encountered this term, imagine it as a transparent data available to anyone. A rating provider gives a rating in form of a score to a rating recipient. The number of rating providers may be hundreds of thousands, even millions. Each rating provider focuses on a specific field, a specialization which increases their own rating.
The rating has a scale of numbers from 0 to 10. The nominal score is transparent and a part of the public layer of a blockchain. The content of the rating is optionally transparent. Rating Provider rates upon request or from own initiative. The rating provider provides ratings based on various factors:
KYC inputs, blockchain analysis, personal meeting, online communication, etc. The rating of the address/product/project is then published in form of a score and a specification of the rated field (KYC/AML/CFT, project credibility, credit score, ecological footprint, etc.).
The rating is issued through a blockchain transaction. The transaction consists of two parts: unencrypted and encrypted. The unencrypted part contains the nominal score and the rated field. The encrypted part contains detailed factors taken into account for that particular rating. The transaction is encrypted with a public key of the rating recipient.
The rating received by the rating recipient (whether requested or not) contains full information regarding all accounted factors. The rating content itself is not public but is possible to unlock using a key available to the rating recipient (provided in exchange for a fee). The recipient may decide whether they will publish the rating content and under what conditions. The transparency of each rating is optional and depends on the recipient. Recipients may publish the rating content selectively (to selected parties) or fully (to the entire blockchain).
- If the provider publishes an unqualified rating damaging the recipient, the recipient can publish the rating content and show everyone that the provider is unqualified/bases their rating on irrelevant data.
- Should the recipient provide an untruthful image of its high rating, the provider may publish the real rating content, decreasing the recipient’s credibility
What is this good for? (Model scenario)
Any blockchain platform can be used for various purposes, such as P2P lending, fund-raising, consumer/investment loans or tokenization of projects/firms. The issue here is trust, the credibility of the counterparty – how can a person send money to be sure about receiving the product promised by the project team?
The person cannot be sure (just like in the current world), but he can use quantification of probability in a form of a score. If anyone wants to obtain funds for their project, they have to secure a sufficient score from reliable rating providers (i.e. those who have themselves received a high score from credible rating providers – this circle will have to be started by a fully identified rating entity).
It is in the interest of every capital-seeking project to provide rating providers with adequate information and documents. Rating providers will then register a score in the blockchain. The project will gain credibility and first investors. However, investors are still unsure => the project thus selectively uncovers the rating content.
Investors become convinced that the project is growing and reaching the promised goals. The project gains money. A year passes, and the project is supposed to return the money + interest.
Two following scenarios are to be considered:
1) The project is honest, it remits finances to creditors and everyone is satisfied. The whole process occurred based on the idea of selective transparency: the transaction content was given on a “need to know” basis.
2) The project is dishonest and does not communicate. The creditors are contacting rating providers and request a disclosure of rating details so that everyone knows the details of the project. Since the rating providers do not want to be a part of a fraud and want to maintain their good score, they disclose the information. Now everyone knows the true rating of the project (other rating providers will no longer give it a high score) and the people behind the project may be prosecuted for fraud, as the evidence in the blockchain is clear.
Now let’s make a short summary of what we have learned until now. We know what a rating agency (a rating provider) is. We know how much we need them and how their rating may affect our lives, both personal and professional. We used an example to show how these agencies work. We know that these ratings are only beginning to develop.
What development can we expect?
The existing services are transforming under the new interface. Banks and various investment companies currently hold clients’ money. In the future, clients will hold all of their capital. Banks will transform and become rating providers, solely focusing on rating assets. The client will make purchases on his own based on their recommendations or the bank will purchase applications on behalf of the client based on such recommendations (due to the diversity of assets, banks will have loads of work).
Various NGOs trying to rate corruption, human rights, ecology, etc. will be able to comment on anything in a way that is visible on the blockchain (for example, in several cantons of China, people with negative rating are not admitted in restaurants). Whether to consider this rating as important depends entirely on each specific user (or the application used by the user). For example, the opinion of a regulator (such as the rating provider) will be in many aspects decisive for many projects.
Each rating provider will accumulate influence given by how many users trust him. Entities offering high-quality services will have many users and therefore high influence. If the entity exploits this influence, it will lose it. Users will use services of many rating providers. There will be mutual control. If a rating provider starts to differ from others, this will serve as a signal for loss of impartiality or quality. Its influence will drop.
The software will present the user with a simple yes/no result based on conflicting ratings of dozens of rating providers. Additionally, the user will be forced to select more than one dominant rating provider. Therefore, the rating is a continuous process which is entirely transparent due to the blockchain and allows fulfilling project plants in time.
And now comes the most interesting part:
Identifying a high-quality project in the current blockchain environment is quite difficult (and losing money is thus very easy). Therefore, if we find a tool that will allow for such identification today, we will be able to finance projects yielding multiple amounts of the invested capital. So how do we do it?
The answer is quite simple. Finding a team of people who understand the specific field will do the trick. For example, banks understand the parameters used to rate projects or firms that seek funding. There are also certain tools that have been used for many years by consulting companies. These tools are used for feasibility studies. Based on these parameters, a technology suitable for a specific solution can be recommended. In the case of the blockchain, an expert rating provider will then begin rating the suitability of the project implementation via the said technology. Knowledge of the specific field of the project is, therefore, the alpha and the omega of successful implementation of a given concept. Exactly as it has been up until now.
What should we focus on more?
Essentially, the changes are not that severe. The roles will change slightly and those who are now hidden behind the walls of centrally managed companies will be forced to uncover their real assets. The development will be gradual, but very distinct. Thanks to these changes, people who are really good at their job and give it 100% will become successful. Their influence will grow. The tools they’ll need will be available for free and their reward will be directly proportional to the number of people using it. People, companies and projects will only pay for what they use.
Therefore, we recommend observing the development of complex solutions on the blockchain, platforms that will allow users to pay for services in tokens or cryptocurrencies for user data. Simply put, search for solutions that make sense in the context of the formed cryptocurrency or token. On these platforms, application solutions will be formed. They will themselves become rating providers; thanks to the simplicity of the concept, this will enable the users to do everything they have done up until now.
A business that works.
© Richard Watzke, Josef Tětek, Jan Lánský