Credit Transparency and the Financial Merit Revolution
Introduction
Corporate ratings play a critical role in the global economy, providing an assessment of a company’s financial strength and reputation. However, in recent years, trust in traditional corporate ratings has diminished due to issues related to transparency, impartiality, and data manipulation. To address this challenge, blockchain technology emerges as a revolutionary solution in the business evaluation sector.
Blockchain, known for its decentralized, transparent, and secure nature, offers various solutions to traditional rating problems. By implementing this technology, we could witness a radical transformation in how we assess the creditworthiness of companies.
Limits of Traditional Corporate Ratings
In recent decades, the financial system has seen an exponential increase in the use of ratings to assess the financial strength of companies. However, the traditional rating assignment system has shown some critical issues that have undermined the trust of investors and market participants.
One major limitation concerns the transparency of evaluation methodologies. Often, the scoring process lacks transparency, making it difficult for investors and stakeholders to understand the methodologies used and the data sources involved. This leads to a lack of trust in the assigned rating and raises doubts about the reliability of the system.
Furthermore, potential and frequent conflicts of interest represent another obstacle to trust in traditional corporate ratings. Some agencies may be influenced by conflicts of interest, as they may be paid by the same companies they are evaluating. This raises concerns about the impartiality of evaluations and the possibility that ratings are influenced by external factors.
Finally, cases of fraud and data manipulation have undermined the integrity of corporate ratings. Incidents have been reported where data has been altered or manipulated to obtain more favorable ratings, leading to incorrect and misleading investment decisions.
Blockchain as a Solution
Blockchain technology offers several solutions to traditional rating problems. Firstly, thanks to its decentralized nature, blockchain eliminates the need for a central authority to manage and assign ratings. Financial and operational data can be recorded and verified by a distributed network of nodes, thus eliminating dependence on a single entity and ensuring greater security and reliability.
Another advantage of blockchain is the immutability of data. Once data is recorded, it becomes immutable and cannot be altered without the consensus of the majority of the network. This protects ratings from fraud and manipulation, ensuring that evaluations are accurate and truthful.
Blockchain offers greater transparency. All operations are visible to all participants in the network, providing a complete traceability of transactions and evaluation operations. This makes it possible to understand how ratings are assigned and on what data they are based, providing greater clarity and trust in the evaluation process.
Practical Implementation
A blockchain-based corporate rating system could work as follows:
- Data Registry: Companies record their financial, operational, and governance data on the blockchain securely and transparently. These data are verified and validated by network nodes, which play a role similar to agencies.
- Rating Assignment: Using transparent evaluation algorithms, ratings are assigned based on verified data. The numerical assessment represents the financial strength of the company and its ability to meet obligations.
- Real-time Updates: Since data is recorded in real-time, ratings will always reflect the current situation of the company. Any changes in financial or operational data are immediately reflected in the assigned score.
- Benchmark Comparison: Blockchain also allows comparing the assigned rating with the company’s benchmark. This enables evaluating the reliability of ratings and reinforcing the transparency of the process.
Advantages
The implementation of blockchain technology in the corporate rating process offers numerous advantages:
- Immutable and Verifiable Data: Blockchain ensures that data is accurate and cannot be altered without consensus.
- Accurate Evaluation: The blockchain-based rating system considers verified financial data, providing a more accurate assessment of companies.
- Increased Trust: Investors and financial institutions will have greater confidence in corporate ratings, as they are based on transparent and secure technology.
- Early Detection of Financial Issues: Data transparency allows for early detection of financial problems or data manipulations, providing timely warnings for
investors. - Discrepancy Detection: Companies and agencies entering data or evaluations will undergo a retrospective comparison, allowing an assessment of the accuracy and/or precision of the entered data.
Contribution to Point 5:
Think about Italian SMEs and how much they depend on the misguided judgment of insurance companies, often approximate evaluations by banks, and the number that associates a company’s evaluation. Think about how this estimation diminishes the true work/value of our entrepreneurial fabric.
Too often, I have faced absurd choices from insurance companies, too many times I have discussed the score associated with a company, penalizing it without concrete reason. It is unacceptable that this score should be subject to negotiation; it is unacceptable that an insurance company devalues a company without investigating, and above all, it is unacceptable that, after penalizing it, it realizes the error only if prompted. Most of oureconomic fabric does not have a CFO specialized in this, and often they silently suffer.
Imagine if the “decrease” or “increase” were recorded on a blockchain and checked retrospectively, imagine then associating a benchmark with those who release the judgment, and imagine being able to evaluate the evaluators for their accuracy, diligence, and thoroughness.
Structure of Italian SMEs: Capital and Ownership
Currently, Italy hosts a large number of VAT numbers, divided between capital companies (31%) and individual companies (69%). With a total of 5.38 million companies, the distribution highlights the prevalence of small family-owned businesses, with 3.70 million compared to 1.67 million capital companies. Classifying into five rating categories, based on financial reliability, it is interesting to note the strength of our companies. Singular is the predominance of companies with a good reliability rating.
Rating Trends
A temporal analysis of rating trends reveals important information about the financial dynamics of the business sector. In 2022, 70% of companies maintained or improved their rating, with a significant growth of 80% among individual companies. On the other hand, 23% recorded a deterioration, with capital companies likely facing more significant challenges than partnerships/sole proprietorships.
Details and sources: https://www.visidron.it/it/analisi-dell-andamento-dei-rating.html
Challenges
The implementation of a blockchain-based corporate rating system may encounter some obstacles:
- Adoption and Integration: Companies must adopt and integrate the technology into their management systems, which may take time and resources.
- Data Confidentiality: Some companies may hesitate to make all their data public, fearing being judged solely based on these values.
- Involvement of Rating Agencies: It will be necessary to involve rating agencies and financial information companies to make the blockchain-based rating system operational. With this system, they will be evaluated based on the accuracy of the judgment provided.
- Involvement of Insurance Companies: Insurance companies must be involved, and they will participate in forming the certain data based on their real experiences.
Conclusions
Blockchain technology offers a promising solution to improve the corporate rating system, ensuring transparency, security, and reliability. If adopted correctly, this technology could revolutionize how we assess the creditworthiness of companies, providing a fairer and more transparent environment for investors, financial institutions, and companies themselves.
However, challenges related to adoption and integration must be addressed to fully harness the potential of blockchain in the corporate rating sector. With blockchain, we will have certainty about the entered data and can verify them in the future. Companies will be evaluated based on their real value, and data transparency will improve confidence in the corporate rating system.
Below is a draft example of practical adoption.
Through software connected to business management systems or ERPs, payment data generating a solvency score will be obtained. This way, each transaction is recorded and linked to its payment. A value will be associated with the goodness of operations both for the customer and the company itself.
If the management system has mid-year financial situations (actual + forecast), they will be published and monitored with benchmarks. Therefore, the company that publishes the data will have a certain value that varies over time based on the accuracy of the predicted data with the actual ones (financial statement filing). A score/weight is assigned based on the deviation.
When a company asks rating agencies for an evaluation, it is published on the blockchain and compared with its benchmark to assign a score to the accuracy of the judgment. (agencies are also evaluated based on the accuracy of their judgments)
Insurance companies will have to publish any claims, and they will have the great advantage of accessing the data provided. In this way, they know the health status of a company in real time.
These are some steps that make the system transparent, decentralized, truthful, fast, usable, and hold all actors in the economic system accountable.
Sources:
https://www.visidron.it/it/analisi-dell-andamento-dei-rating.html
https://www.cribis.com/it/approfondimenti/chiusure-e-aperture-aziendali-italia/
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