Writer: Mert Özdal Artwork: Numa Oliveira, “Ruins of Japanese banks reforested, under a blue sky” 2022, Dreaming on Machine via Pollinations.AI

With the changes in the predominant global political-economic paradigm in the 1980s, commonly known as neoliberalism, the three major credit rating agencies, Moody’s Investors Service, Standard & Poor’s (S&P), and Fitch, began to dominate the credit rating market and gain unprecedented power.

These three agencies account for 95% of the market for credit rating agencies (1), which gives them immense power to alter the course of the global economy. Their opinions on creditworthiness have become much more significant as financial capital has grown as a means of credit financing, and they can alter the course of a nation’s development, trade deficit / surplus, and more.

On the other hand, over the last 10 years the ascendance of digitally distributed ledger technologies such as blockchains have enabled coordination mechanisms that incentivize communities to participate in, contribute to, market-make, and make decisions around everything from options pricing to flash loan creditworthiness. Prime Rating has emerged in this space as a financial primitive that integrates systematic evaluation of security, governance, tokenomics, and more with the decentralized wisdom of a crowd of expert raters.

Traditional institutions face a crisis of public distrust, and distrust leads to loss of legitimacy. Everything from banks, governments, administrative bureaucracies, public health institutions down to colleges and institutions of higher learning are slowly having their territory threatened by play-to-learn projects, peer-to-peer finance, and smart contracts. We’ll now see how this revolution threatens credit rating agencies as well, by taking a deeper look at Prime Rating.

A Brief Overview of Credit Rating Agencies

Today, three credit rating agencies heavily dominate the credit rating market: S&P, Moody’s, and Fitch. All these three agencies are private entities based in the US. According to S&P, credit rating agencies aim to provide investors and the public with an objective and independent analysis regarding the credit trustability of different entities. They analyze an entity’s prospects for failing to “pay a material sum of interest or principal on a debt instrument on its due date or within applicable principal or interest grace periods, as stipulated in the governing debt structure; or to reschedule and to exchange a debt instrument conducted in a manner deemed to be coercive, involuntary, and distressed, as determined on a case-by-case basis by each agency” (Bhatia, 2002). To analyze these prospects, rating agencies examine a wide range of quantitative and qualitative variables, including economic, political and institutional qualities. For instance, S&P (S&P, 2011) evaluates five different groups of variables:

1. A political score analyzing institutional effectiveness and political risk.
2. An economic score expressing the economic structure and growth expectation of the economy.
3. An external score reflecting external liquidity and the international investment position.
4. A fiscal score analyzing fiscal performance and flexibility.
5. A monetary score

As a result of the assessment, they attach letter scores to the entities to denote credit quality.

According to the neoliberal understanding of rating agencies, rating agencies serve the public by reducing the information asymmetry between borrowers and lenders. As expected, the information available to borrowers about their own internal activities and financial status is much more comprehensive than that of a lender (2). For example, the state has more information on its financial position than an ordinary person due to documents inaccessible to the public while selling government bonds. Since it is very costly and time-demanding for a person to study the state’s internal financial metrics, rating agencies offer that service. This is profitable for rating agencies by applying economies of scale and specialization. Rating agencies collect information, monitor borrowers and provide qualitative assessments at a much lower cost than the individual investor would incur (3). As a result, investors would invest more confidently by looking at the agency ratings. This would help raise more liquidity for borrowers because rating agencies increase the investors’ confidence. Ratings are also beneficial for investors as they help minimize their risks due to the high quality assessment provided. However, in the next chapter I will argue that with the increasing power held by rating agencies starting with the neoliberal era, these agencies play a political role in shaping the political-economic environment according to their own vision, rather than helping the public by diminishing the information gap.

How did credit rating agencies shape the political environment?

The enormous increase in the importance of credit rating agencies during the neoliberal period goes hand in hand with financialization, which is characterized by the increasing power of finance in the determination of the investment flows of the state (4). Starting from the 1970s, two vital historical changes strengthened finance’s position significantly: First a change in the approach to control debt; second, capital flows between nation-states. Before the neoliberal period, the policies of central banks were more borrower-friendly. At the time, through financial repression policies, states’ unpaid debts tended to be inflated and postponed, and there were barriers to financial circulation. For example, during Mexico’s debt settlement in the 1940s, the Roosevelt administration of the United States pressured oil companies and the International Committee of Bankers to accept a major reduction in their claims (5). Consequently, U.S. bondholders have accepted losses of 90 percent on the nominal value of their claims. On the contrary, core central banks have followed more creditor-friendly policies under neoliberalism. States are strictly obligated to pay all their debts and ensure free capital flow (6). German scholar Jerome Roos (2019) argues this is partly because in the post-war era capital was largely controlled under the strict financial regulations of the Bretton Woods agreement, which limited investors’ ability to freely invest capital outside of national borders. Consequently, the volume of international money lending was very low compared to that of the neoliberal period. However, starting with the collapse of Bretton Woods, big banks, especially Wall Street banks, started to lend significantly outside their borders. That meant a rapid change in the composition of creditors. Once they consisted of hundreds of thousands of small bondholders, now a few powerful banks. For example, in 1982 Mexico had an $82 billion debt load, $53 billion of which was owed to the nine largest Wall Street banks alone (7). This represented an important shift in the international balance of power. This is because now the owners of huge capital gain unprecedented power to affect the financial system both indirectly (by investing or not investing in national economies; in other words, they can move capital out if they are not pleased enough) and directly (by financing or not financing the state debt itself) (8). Another variable that strengthened the creditor’s hand was the unusually high demand for private credit in the early 1990s due to the very high public indebtedness caused by a series of global strategic monetary policy choices, starting with the 1970 stagflation crisis (see Wolfgang Streeck, 2012).

Through that increasing power, creditors forced states to change their approach to debt management (now, borrowers have to pay and cannot use excuses to avoid paying or pay less than they agreed to pay) and movement of capital (now, capital moves freely) to be more creditor friendly. The new approach to debt management was expressed by the US Treasury Secretary Donald Regan; he stated that “I don’t think we should let a country off the hook just because they are having difficulties as debtors, I think they should be made to pay as much as they can bear without breaking them. You just can’t let your heart rule your head in these situations (cited in Quirk, 1983,p.10).”  Also, along with the abolishment of Bretton Woods, many policies that supported free capital flow, such as GATT (The General Agreements on Tariffs and Trade) have been adopted by many states.

It is evident that the creditors force states to pursue policies that benefit investors more than ever with the enormous bargaining power they have (derived from the threat of capital flight and vital position in debt financing). This change leads to the reformation of the international state system towards one where the state aims to become a safe harbor for capital by complying with the policy dictates of international (IMF, etc.) and private (credit rating agencies) regulatory institutions that represent the interests of capital. According to Wolfgang Streeck, these developments resulted in the state resembling “a collection agency on behalf of a new global haute finance.” (Streeck, 2012, p.16) Also, David Harvey noted this as an important difference between liberalism and neoliberalism:

“… under the former, lenders take the losses that arise from bad investment decisions, while under the latter the borrowers are forced by state and international powers to take on board the cost of debt repayment no matter what the consequences for the livelihood and well-being of the local population.” (Harvey, 2005, p.29)

However, in this respect, the position of credit rating agencies as regulatory institutions is more problematic position than that of supranational organizations. Even though the objectivity of the supranational organizations has been criticized by various scholars from different schools of thought, they are still organizations that still encompass different perspectives on policy issues. However, credit rating agencies are private enterprises that are part of the capitalistic system pursuing their own interests. They tend to work in the interests of private companies as they are one of them themselves. They are not just employing policies which are favourable to capital, like the IMF, but they are part of capital themselves. According to Sinclair, this unique position and increasing power of the credit rating agencies in the neoliberal era allows them to help the creation of the neoliberal world by imposing certain standards on sovereigns (9). Also, when a state’s action is misaligned with their agenda they also employ soft power to further continue with their agenda.

A Case Study: Japan’s Credit Rating Crisis

In the 1990s, Japan’s creditworthiness in the eyes of the rating agencies diminished gradually, unlike the general trend of increases in the rating scores of OECD states. The gradual decline started due to growing government debt and rating agencies’ dissatisfaction with the Japanese government’s approach to its agenda for financial deregulation, which was referred to as The Japanese Financial Big Bang initiated in 1996. The Japanese Financial Big Bang aimed to create a Japanese financial market that was ‘free, fair and global’ in line with “global standards” (10). The deregulation roadmap had five main actionables: i) the liberalization of transaction fees, ii) the lifting of the ban on financial holding companies to pave the way for ‘financial conglomerates’, iii) the termination of the convoy regulation to let less competitive firms go out of business, iv) a reduction in administrative guidance by enhancing regulative transparency, and v) yen internationalization (Malcolm, 2001, p.109–10).

The initial signs of decline in rating were observed in July 1998 when Moody’s stated that the Japanese government had been suffering from structural problems and there was “an apparent lack of consensus among policymakers on a medium-term strategy.” Moody’s statement led to three-day yen depreciation on the currency exchanges. Moody’s followed this warning with a downgrade in November 1998 (11). It was the first downgrade of a G7 member since Canada’s downgrade in 1995. Many Japanese scholars perceived this downgrade as a biased decision against Japan by Moody’s. For example, a Japanese scholar, Kurosawa Yoshitaka, stated that the US agencies rate countries “on the basis of their home standards” and do not consider an appropriate monetary policy for the Japanese economy (12). However, these criticisms did not prevent the second downgrade by Moody’s in September 2000. Also, Moody’s was not alone in downgrades; S&P downgradedJapan’s rating in February 2001. S&P pointed to debt levels and the ‘protracted approach’ of the government to reform. S&P posited the reason for the downgrade as ‘political reluctance to address rigidities in the economy”(13). For many scholars, the rigidities here refer to policies that neoliberal theory does not adhere to, such as tariffs, price controls, national enterprises, etc. (14)

After the S&P’s downgrade, in one of his speeches, Finance minister Masajuro Shiokawa stated: ‘We will have to work to regain trust in government bonds’; however, downgrades did not slow down. S&P again downgraded the rating note in November 2001, and after three months in February 2002, Moody’s announced that they were considering lowering Japan’s rating again (15). As The Financial Times put it at the time, that downgrade from Moody’s would put Japan below the rating of Botswana, the African state where almost more than one-third of the population was tackling AIDS (16). Also, in 2002 the GDP per capita of Japan was 4.183 trillion dollars, whereas Botswana’s was almost 770 times lower at 5.439 billion (17). Following its warning, in March 2002, Moody’s downgraded Japan’s rating in the national debt category. This series of downgrades again received serious criticism from the Japanese government. On 26 April, Vice Finance minister Haruhiko Kuroda criticized credit rating agencies and stated that their qualitative explanation of Japan’s rating lacked objectivity (18).

Nevertheless, this rating downgrade sequence which started in 1998 resulted in the Japanese government’s failure to sell 1.8 trillion-yen worth of 10-year government bonds issued in late September 2002 due to low confidence in Japanese finances (19). As one can see from the Japanese experience, credit rating agencies have the power and intention to impose a certain worldview on countries and undermine their sovereignty. Ironically, this power and intention have been misconstrued by New York Times columnist Thomas Friedman to glorify these organizations by saying that Moody’s and S&P are ‘imposing on democracies economic and political decisions that the democracies, left to their own devices, simply cannot take’ (20).

Prime Rating: An Alternative to Centralized Agencies

Unsurprisingly, centralized rating agencies are engaging in patronage relationships and do not serve the public as much as they purport to. What, then, is the alternative?

In April 2021, PrimeDAO announced the beta of its new product Prime Rating. The article stated that “The Decentralized Finance industry has seen exceptional growth in 2020, growing from a mere $1B to over $20B of total value currently locked in DeFi applications. The potential of a permissionless and composable financial system is becoming increasingly clear, but this fast growth trajectory also comes at a cost: high knowledge asymmetry, increasing complexity, and coordination friction. It has become almost impossible to track all developments and understand the associated risks (and qualities) of the different DeFi protocols. To help users, builders and investors better understand the quality and risk of each protocol, PrimeDAO decided to create Prime Rating!” I argue that in contrast to credit rating agencies, Prime Rating has the potential to provide public benefit as a rating protocol through its permissionlessness, open source and decentralized structure.

From a token holder perspective, Prime Rating aims to evaluate quality and risk of DeFi protocols, stable coins, and metaverse tokens. The platform utilizes the wisdom of the crowd in combination with a learn-to-earn approach, to ensure resilient and up-to-date rating scores. Projects are evaluated in terms of both their technical and fundamental quality according to Prime Ratings open-source methodology.

“By being permissionless, Prime Rating is more resilient, neutral, and able to leverage the wisdom of the crowd. All Prime Ratings and documents are publicly available and can be accessed non exclusively by anyone with an internet connection, making Prime Rating a public good for the benefit of the systemic advancement of open finance.”

Announcing the Prime Rating Beta- PrimeDAO(2021)

The Prime rating process starkly contrasts with the e.g. Moody’s process:

1. The rater will choose an eligible project for rating from a list that is usually provided by Prime Rating.
2. The rater will analyze the protocol in terms of its qualities in line with the methodology provided by Prime Rating.
3. After completing the report, the rater will ask for feedback and a peer-review by fellow raters will ensure expected quality.
4. Once the report is ready, the rater will submit it for the voting process.
5. After the submission, Prime Stewards will review the report (quality, relevance, etc.; not analysis) and open a Snapshot vote to be voted by the Prime Governors (RXP Holders). The only way to earn RXP and become a Prime Governor is writing rating reports and gaining experience. The more you rate, the more you earn.
6. If a governance vote accepts the report, the Prime Rater would be rewarded.

With the community-driven and permissionless nature, the Prime Rating can be an alternative to centralized institutions that engage in murky patronage relationships. This is because Prime Rating allows different perspectives to be represented in the rating result. Prime Rating scores are calculated as an average of all submitted reports per protocol. If a rater does not believe a certain rating is justified, they can write their own report and if it gets accepted, the rating score is updated taking the new evaluation into account.

Another major difference between Prime Rating and traditional CRA’s is that Prime Rating’s methodology is open to critique and re-evaluation. If the DAO members collectively agree on revision or change, it would be implemented. That way biases in methodology can be minimized over time. This is vital for the objectivity of the rating because the structure of the methodology can help certain entities/protocols more than others.

For example, as I have discussed in the Japan case for the 2001 downgrade, the Japanese finance minister argued that evaluating Japan with a methodology that is prepared for the American fiscal structure led to lower grades for Japan. Allowing its methodology to be democratically changeable, Prime Rating will also reduce methodology related biases. Further, by allowing multiple report templates, Prime Rating accommodates for different use cases and ensures apples are compared with apples. Starting with a dedicated report template for DeFi protocols, the community already established a separate template for metaverse protocols (gaming, media, NFT marketplaces, etc.) and is working on a framework to evaluate stablecoins as well.

Also, one of the critical differences between traditional finance and web3 finance, which by nature reflects rating systems, is transparency. In the former, the acquisition of certain data is confined to a limited group of people and even the accuracy of data for that little group is sometimes suspicious; however in the latter thanks to on-chain data availability and the open-source nature of the web3 community, anyone who wants to reach technical data can access data without data manipulation. As a result, Prime’s raters can analyze on-chain data within their report.

Last but not least, another big differentiating factor is governance. While at traditional centralized agencies it’s the top management, shareholders and other influential entities that make decisions, at Prime Rating it’s the community of raters. Anyone successfully submitting a report gets issued Rating Experience Points (RXP), which is a non-transferable token (ERC-1151) issued and redeemed by the Prime Rating treasury. RXP is used to govern all things related to the rating scores (e.g. accepting/rejecting new reports, allowing updates to templates, accepting new templates, etc.). Since RXP cannot be transferred or bought but only earned through contributing, it eliminates the attack vector of transferable tokens to influence rating scores (e.g. through bribes and the borrowing of voting power).

Conclusion

Prime Rating can be an important alternative to credit rating agencies that historically benefited a limited group of people. Through its permissionless, decentralized and community driven approach Prime Rating can democratize the rating business. That way it would prevent the moral hazard that central rating agencies engage in. So, if you want to be part of that movement towards public benefit, come and rate with us in Prime Rating Season 2 ! To read more on Season 2: Here !