Credit rating processes could get better with blockchain tech
Make way for disruptions in the credit rating industry!
Following the subprime mortgage crisis of 2008, one of the issues that particularly stood out was how inefficient and prone to manipulation the credit rating process is. Several reports show that the three largest credit rating agencies in the world contributed to the financial crisis by giving toxic financial products good ratings despite having evidence that they were misleading investors.
Fast forward to today and the same three rating agencies still dominate the global market despite the post-crisis recommendations that they should be regulated and opened up for competition. Even if these recommendations are followed, the conventional credit rating process will remain unreliable given that it’s highly dependent on trust.
In other words, the rating agencies lack toolsto determine the accuracy of the data they collect about borrowers and investors cannot see the exact criteria used to rate various financial products. It is no wonder that a 2014 survey by the CFA Institute shows that traditional credit rating agencies lack transparency and are marred by conflicts of interest. In the 2008 subprime mortgage crisis, credit rating agencies are said to have conspired with the behemoths of Wall Street to market the toxic products to unsuspecting investors.
However, with blockchain, these challenges could be a thing of the past. The distributed ledger technology (DLT) has the power to bring transparency to the credit rating process while ensuring data privacy and safety. The technology aims to decentralize the credit rating process by moving the power over the data from credit rating agencies to the people. This will eliminate overdependence on government-controlled agencies such as FICO which are not only prone to corruption but which also use outdated rating models and so, locking out many qualified borrowers.
Bloom, a decentralised credit scoring system powered by Ethereum and IPFS, is one of the blockchain solutions seeking to address these challenges. The project aims to put the borrower’s entire transactional history in an openly accessible public ledger thus ensuring transparency. According to Bloom, with the blockchain based rating system, the lenders will be able to evaluate the borrowers better than in the traditional manual systems which are based on a single score.
Another benefit of moving credit scoring systems onto the blockchain is that with a decentralised credit rating agency, the credit rating process is transparent to all parties including the regulators and would leave no room for manipulation. In the 2008 global financial crisis, lending institutions are said to have manipulated their credit rating systems in order to accommodate unqualified borrowers so they could increase their profits on mortgage-backed securities (MBS). The end result was catastrophic for everyone including the borrowers and the investors.
If the rating agencies were using a blockchain-based rating agency at the time, the reckless lending would never have happened in the first place. This is because the blockchain system is immutable and transparent which means that lenders would not have been able to alter it and the regulators and investors would have been able to determine the risks by themselves. Blockchain solutions such as those that track supply chains can be beneficial in assessing the risks involved in sophisticated financial products such as MBS.
With the blockchain-based system in place, the borrowers’ creditworthiness evaluation not only becomes highly accurate but is also faster and cheaper. Traditionally, lending institutions rely on due diligence underwriters to manually evaluate loan applicants’ data and make recommendations. This process, aside from being prone to error, is tedious, time-consuming, and expensive. With IoT, big data analytics, and blockchain, the whole process can be made more efficient.
Another attractive aspect of blockchain tech is that borrowers have an assurance that their data is safe from hackers. In the past, credit rating agencies have been a top target for cybercriminals with the latest incident involving Equifax, the US largest consumer credit reporting agency. In September of 2017, the company reported a hacking incident that impacted credit histories of up to 143 million Americans (which is over 50% of the US’s population).
With the robust growth of the blockchain technology in the recent years, there is no doubt that more disruptions for the credit rating industry are yet to come. The application of the technology in the industry will not only benefit the industry players but will open up opportunities for entrepreneurs and investors worldwide.
By Reuben Jackson, our editorial contributor in New York
