Inside Morningstar’s New York offices, where chief operating officer Michael Brawer is building a … [+]
Michael del Castillo
Credit ratings giant Morningstar is making a number of previously unknown moves into the burgeoning industry of assets issued on a blockchain. The rating agency that made its name rating mutual funds from the likes of Prudential, Morgan Stanley and TDAmeritrade is on the verge of rating a number of investment opportunities similar to bitcoin but backed by real-world assets tracked on a blockchain.
Traditionally, the ratings giant, which is valued at $6.4 billion, uses grades of one to five stars to rate a wide range of bonds based on their past returns to investors relative to the risk of the investment. In spite of only receiving permission to rate corporate debt in 2016, the upstart ratings agency last year passed $1 billion in revenue for the first time, putting it within spitting distance of the veteran Fitch Ratings, which generated $1.7 billion revenue that year.
Now the Chicago-based company is challenging Fitch and the other “Big Three” ratings agencies, Moody’s and Standard & Poor’s, for pole position in the race to bring credibility to assets issued on a blockchain, also known as cryptoassets. While Morningstar’s ratings services extend to government and corporate bonds, its blockchain work so far is limited to debt instruments that pay out fixed interest and are backed by a wide range of short-term loans.
With a diverse set of partnerships, including a company that securitizes short-term small business loans on the ethereum blockchain, a home equity securities startup that uses a custom blockchain, and another that helps companies raise capital selling blockchain securities, the multiple blockchain efforts under way amount to the largest bridge being built between the mostly uncharted world of blockchain, the technology first made popular by bitcoin, and the global debt securities industry, which had $117 trillion outstanding as of March 2019, according to the Bank for International Settlements.
As these startups, some of which have been working in obscurity for years to bring institutional investors to the world of blockchain, slowly emerge from stealth and enterprises long afraid to even mention bitcoin in public are increasingly finding ways to explore the underlying technology, Morningstar’s entrance into the space could unlock billions of dollars waiting for the moment when cryptoassets assets finally become credible.
“We’re working very closely with a number of blockchain-oriented firms who are looking to issue debt instruments on a blockchain,” says Morningstar Credit Ratings chief operating officer Michael Brawer, 58, who oversees new business development. “We’re looking to see how we can also provide credit opinions, whether it’s a credit rating or different types of credit data and credit analytics that accompany those debt instruments, and we’re also looking to provide our services on a blockchain.”
Morningstar began its work with blockchain in June 2018, when associate director Jim Sinegal published a three-part series exploring how companies like Bank of America, Apple, and Walmart are using blockchain and how the technology might affect credit ratings agencies’ coverage. Then, in September, Brawer was approached for the first time by a blockchain startup looking to do business, San Francisco-based Figure, which wanted to issue home equity loans on a blockchain.
While S&P, Moody’s and Fitch have all come out in support of the potential savings and transparency that moving debt issuances to a blockchain could create, none have revealed projects with Morningstar’s breadth and depth. In May, the company said in a newsletter to investors that it was in conversations with as many as nine blockchain startups interested in doing everything from originating assets on a blockchain that could later be securitized to facilitating debt issuances to selling products to financial institutions that want to issue debt on a blockchain.
Importantly, the newsletter also laid out a business rationale for getting into blockchain, explaining how a shared, distributed ledger of transactions could directly connect lenders and borrowers without the need of custodians or trustees. Brawer calls these activities “rent seeking,” in that they charge a fee for a service increasingly being made redundant. Custodians charge between 25 and 500 basis points depending on the complexity of the assets. Trustees charge an additional one-time acceptance fee, an annual trusteeship fee and transaction fees, resulting in an average of between $50,000 and $150,000 in fees annually per deal.
“I don’t think blockchain startups are at the point where they would say they can eliminate the custodian, but they would like to start to chip away at some of the custodian’s responsibilities,” says Brawer. “I don’t think anyone is pretending at this stage that they can eliminate the role of the trustee either. But they’re starting to chip away at that too.”
Morningstar is working on two efforts designed to change the way debt securities are rated on a blockchain. The first will put Morningstar’s system for rating funds directly on the ethereum blockchain and eventually on other blockchains, through technology called an oracle. Oracles move trusted data, like a Morningstar rating or the London Interbank Offered Rate (LIBOR) for example, onto a blockchain in a secure way that ensures the rating isn’t doctored, allowing it to be used as a term in a smart contract. Oracles are important, because once such data is admitted to the blockchain it’s immutable, and any agreement that uses it can’t be changed.
In Morningstar’s case, the company is building its smart contract oracle, or “smart oracle,” as Brawer calls it, using a small team of existing employees. The oracle relies on third-party providers to convert business debt—say from a group of merchants looking to meet payroll—into tokens similar to bitcoin. The securitized tokens are then dispersed to investors via a smart contract, with the terms of the investment, the public addresses of the investors and the Morningstar rating all “living together” on the blockchain, as Brawer puts it. As of now, no new staff is being hired for the project, but Brawer says employees at DBRS, which Morningstar purchased this year for $669 million, have also been approached by prospective blockchain debt issuers and will likely be joining the Morningstar effort soon.
“We don’t have it fully built out yet, but we are in fact creating technology to be able to disseminate a credit rating on-chain,” says Brawer. “We refer to it as an oracle of ratings that would be able to come directly from a third party, such as us, and tell interested parties our opinion of the creditworthiness of a particular debt issuance.”
The second blockchain product is also for debt securities, but involves Morningstar making available the quantitative rating models it uses internally on a blockchain. Morningstar and other credit agencies use these models to determine the creditworthiness of debt securities. While the models themselves won’t likely run on a blockchain anytime soon due to slow settlement times, the inputs and outputs of the model could be logged on the public blockchain, making it easier for investors to test the quality of an investment on their own, but still for a fee. “The objective would ultimately be to allow investors in a digital debt security to be able to run an independent, third-party model and see the results of that model on the blockchain,” says Brawer.
Of the two blockchain efforts currently under way, only the commercialization of Morningstar’s models will generate new revenue for the company. To give an idea of the growth opportunity here, Morningstar generated $21 billion in revenue last year by building custom models for its clients. On the other hand, the smart contract oracle will result in publicly available ratings similar to those already published for free on the company’s website. Taken together, Brawer believes the savings from the reduced reliance on custodians and trustees will let debt issuers build smaller, more affordable products without sacrificing profit.
“If you can make it more efficient, you may need less scale to issue a debt issuance in a profitable manner,” says Brawer. “So you can perhaps issue smaller securitizations that meet your profitability requirements.” But there’s a long way to go before that happens. Brawer estimates that the smart oracles project could be ready as soon as the end of this year but that the blockchain modelling project might not be ready for action until the end of 2020.
Along the way, Morningstar analysts on the other side of a locked door from Brawer’s New York desk are now preparing to sit down with regulators at the U.S. Securities and Exchange Commission (SEC) to see whether the ratings agency’s existing methodology is sufficient to be adapted point by point, or whether an “enhanced” blockchain methodology will need to be developed. If the SEC decides a new methodology is required, it will have to be submitted for public comment, the comments will have to be evaluated, and a number of committees, as well as Morningstar’s board of directors, would have to approve it. “There’s a very elaborate and intricate governance process which is all based on Dodd-Frank law and SEC regulations,” says Brawer.
One of Morningstar’s earliest partners is Figure, the blockchain home equity line of credit startup founded by Mike Cagney, former CEO of personal finance giant Sofi. After their first meeting at the ABS East conference on structured finance in 2018, the companies partnered with the Kroll Bond Rating Agency to write a paper on the impact of blockchain on credit ratings, concluding that tracking investment products on a blockchain would make data more reliable and increase transparency while reducing the actual costs to rating agencies. A white paper published by Figure earlier this year estimates that moving the securitization process to a blockchain could save investors $90 billion annually in lower origination costs, lower deal costs, improved liquidity and more efficient ratings.
In addition to co-publishing the report with Morningstar in May, Figure secured a $1 billion line of credit from financial services company Jefferies and WSFS Bank, raised $115 million venture capital from DST Global and others, and an additional $20 million by selling its HASH token to investors and potential early adopters.
The company is already lending on average $85 million a month via its custom Provenance blockchain, which requires the HASH token to operate. Figure, recently passed $500 million in net loans at an annual run rate of about $1 billion and is now in advanced talks with Morningstar about rating a HELOC securitization, according to Figure vice-president Mike Manning. “We expect the first Morningstar-rated securitization to take place by the end of the year,” said Manning. “Discussions and preparations are active and ongoing.”
Another likely candidate to launch Morningstar’s inaugural blockchain product is New York-based Cadence, which in March engaged the rating agency to help rate its securities on the ethereum blockchain. By then, Cadence had already proved its business model by raising $500,000 in structured notes backed by cash flows from short-term term loans and revenue advances to qualified Amazon merchants. E-commerce lender SellersFunding underwrote and serviced the underlying assets, selling stakes to a mix of accredited retail investors and institutional investors. In addition to a traditional debt security term sheet, investors in the note received a link to the underlying smart contract on the public ethereum blockchain showing the offering’s transaction identification number, the investor’s own wallet address and an anonymized list of other investors’ public ethereum addresses.
Since then, Morningstar and Cadence have been working together to nail down the right cost structure for blockchain securities ratings and to determine whether each individual investment should be rated, or the model as a whole. After “lengthy back and forth from the legal teams of both companies,” says Cadence founder and CEO Nelson Chu, 31, the companies focused on a traditional securitization and are now taking steps to sell shares of a debt offering for FAT Brands (FAT: Nasdaq), backed by cash flows paid by the company’s franchises, including Fatburger and Bonanza Steakhouse.
“It will also be our largest to date,” says Chu, “in the range of $30 million.” Cadence hopes to close the offering by this December. In total, Cadence has facilitated $17 million in debt securities on a blockchain, ranging from $20,000 to $4 million per fund, with $10.8 million still outstanding.
Another likely candidate to facilitate Morningstar’s first public blockchain rating is Barbados-based Polymath. Brawer first contacted the startup this Spring to learn more about its platform for helping companies raise capital by selling securities in the form of tokens cryptographically secured on a blockchain. Initially called initial coin offerings (ICOs), these capital-raises, dubbed security token offerings (STOs) when they are designed to comply with regulation, have so far raised $22.5 billion, according to CoinDesk numbers, but have also increasingly come under fire from the U.S. Securities and Exchange Commission (SEC).
On one side, many of the early organizers of initial coin offerings not only failed to provide the kind of transparency that using a shared, public ledger of transactions should have enabled, but didn’t even live up to basic levels of transparency required by the SEC, hampering institutional adoption. On the other side though, the actual movement of securities have proved too transparent for the comfort of more traditional entrepreneurs looking to raise capital, further restricting wide scale use of the potentially cost-saving technology.
To solve that problem, Polymath built software designed to merge the best of both traditional securities offerings and blockchain-based securities by letting entrepreneurs select trading restrictions, volume restrictions, create tokens, distribute tokens to investors and automate dividend payments on the ethereum blockchain. After curating a list of regulated exchanges, custodians, broker-dealers and anti-money laundering platforms to deliver an end-to-end securities solution for issuers, the company raised $57 million in exchange for POLY tokens, now valued at $0.025, with a market cap of circulating tokens valued at $13.2 million, according to price site Messari.
So far, Polymath has helped its clients launch five security token offerings STOs designed to be compliant with securities regulation. The most advanced of the Polymath STOs is a $14 million round for e-commerce site Buying.com, which is using its BUY token to streamline transactions between online stores, manufacturers and customers, and is preparing to list on the Open Finance Network for regulated secondary trading as soon as the second quarter of 2020. But so far, 287 tickers for possible future issuances having been assigned, according to Polymath numbers, leaving a big gap between interest in the technology and implementation. Enter Morningstar, according to Thomas Borrel, chief product officer of Polymath.
“As an issuer engages with us through our marketplace,” says Borrel, “they’re going to be able to elect to engage with Morningstar, get their product rated and get that rating attached to the token. So now anyone looking to invest into the token can see that rating from Morningstar and review it directly through the token.” Morningstar has signed an agreement to work with Polymath “if and when a project presents itself,” according to Brawer.