How Big Three ratings agency S&P aims to ‘institutionalize’ DeFi

The fight to stabilize, legitimize and normalize cryptocurrency markets continues to rage — and ratings agency S&P Global is the latest giant of traditional finance to enter the ring.

The company’s dash into crypto follows similar moves by fellow “Big Three” ratings agencies Moody's and Fitch. In May, the firm behind the S&P 500 index and the Dow Jones Industrial Average installed its first chief DeFi officer, Charles “Chuck” Mounts. 

Mounts, a former Wall Street analyst and multi-national bank examiner at the Fed, said he became interested in crypto while working as the chief index officer at S&P’s Dow Jones index.

“It immediately hit me how this new technological capability is going to fundamentally transform how markets work,” he said. “So I started having discussions with our executive leadership and said, ‘Hey guys, we’ve got to be paying attention to this.’”

In his new role, Mounts will team up with crypto enthusiast Charles Jansen, who was previously the head of cognitive automation at the firm and is now the head of DeFi transformation, another new role.

The duo’s mandate: support traditional finance clients as they integrate crypto into their business models and help crypto-native clients “institutionalize.” 

The Block recently caught up with Jansen and Mounts to learn about the specific opportunity that S&P sees in DeFi — and where its new DeFi team sees crypto going from here.

The 'institutionalization' of DeFi

While S&P may be best known publicly for its indices, a mainstay of its business involves arming investors with insights about how likely it is that a government or corporate debt issuer will be able to meet their obligations in a timely fashion.

S&P scores issuers with ratings that range from D, commonly understood as a “junk” rating, to AAA — a standard held by corporate monoliths like Johnson and Johnson and countries like Canada.

In May, S&P made headlines when it gave out its first rating to a crypto-native issuer: lender Compound Prime, which nabbed a B-. The score, according to S&P, is shared by countries such as Angola, Belize and El Salvador — and indicates that an issuer is “more vulnerable to adverse business, financial and economic conditions, but has the capacity to meet financial commitments.” 

Though grades in this range are often seen by insiders as a junk rating, Compound’s founder Robert Leshner didn’t seem concerned, telling The Block at the time that the rating represented “a watershed moment for our industry.” 

This is just the start, said Mounts. Despite the current bear market, S&P plans to delve much further into DeFi, betting that it’s going to play an important role in the evolution of financial markets. 

“You can look at President Biden's executive order as kind of like a shot over the bow that this is coming,” Mounts said. “The institutionalization of the market, although it's happening … it hasn't really happened to the full extent that we think is going to be likely.” 

His expectation is that as DeFi capabilities increase, there will be a shift in the way financial markets work from a purely centralized system to one that is a blend of centralized finance and DeFi.

In practice, this could mean a variety of things — from protocols funding real-world assets using crypto rails to portfolio managers experimenting with alternative asset allocations. Investors will be playing a “3D chess game” with portfolios that include traditional assets, tokenized real-world assets and crypto native assets, said Mounts. 

But before that is possible, investors need better information about the risks associated with specific protocols, according to Mounts.

He told The Block:

“Our expectation is that as the market matures, and as institutional players look to get more involved in the credit intermediation framework that DeFi offers, there's going to have to be an introduction of risk assessments.”

Mounts isn’t the first to make this argument. In May, a so-called algorithmic stablecoin called TerraUSD collapsed, knocking out $40 billion of the company’s value in the process, leading many to question the way risk is calculated within the sector. And DeFi protocols have drawn scrutiny from policymakers due to frequent hacks, million-dollar thefts and other failures.

“There may be some other protocol or blockchain that could be the next Terra,” Jansen said. “And right now there's no real risk assessment to help the market see who they potentially are.” 

Mounts thinks S&P can help provide a “holistic” view of risk in the system by conducting both “systematic” and “idiosyncratic” analyses — a framework common in traditional financial markets. Systematic risk analysis means studying the potential for knock-on effects in a system, and idiosyncratic analysis involves studying risk on a case-by-case basis. This type of oversight is missing right now, said Mounts.

According to Mounts, such oversight could also help decentralized lenders avoid over-collateralization. Such platforms typically require borrowers to post more than the amount borrowed in collateral as a way to reduce risk. For instance, on a $1 million loan, a borrower might have to post $1.3 million in collateral. Some market analysts say this requirement slows the growth of the industry and leads to inefficient capital allocations. 

Still, there are reasons to be skeptical.

While ratings agencies theoretically play an important role in financial ecosystems, their ability to make or break public perception can create conflicts of interest. In 2015, for example, S&P was charged with fraud and ordered to pay $1.37 billion for providing AAA ratings on bundles of toxic mortgages leading up to the 2008 financial crisis. Some have likened the ratings business model as akin to a movie studio hiring its own film reviewers.

Nonetheless, the DeFi group has been “extremely well-received” by many major DeFi protocols, said Jansen. Although S&P declined to specify the firms it is working with, Mounts said that the firm is especially interested in protocols that provide financing for real-world assets like commercial loans, trade receivables, or real estate.

According to Jansen, some of the firms S&P has worked with have even suggested that ratings could bring greater decentralization to the market by externalizing some parts of risk management.

That’s a significant change in tone compared to when DeFi first emerged, Jansen said. “Initially DeFi was like, we're going to kill you all,” referring to traditional financial institutions like S&P. Now it appears a partnership is in the works.