Digital financial assets: rating and areas of development

The law defines digital financial assets (hereinafter, DFAs) as digital rights, including monetary claims, the ability to exercise rights under equity securities, rights to participate in the capital of non-public joint-stock companies, and the right to demand the transfer of equity securities, which are stipulated by the decision to issues DFAs. At the same time, additional rights related to the receipt of material values may be included in the issuance of DFAs. Accordingly, DFAs should be considered as a fairly wide class of financial instruments that combines obligations of issuers or third parties that are different in economic essence, but similar in form.

Rating analysis of DFAs

DFAs can be classified based on the type of rights or claims underlying them, or, in other words, based on the type of underlying asset. This allows the possible varieties of these instruments to be compared to more familiar, traditional securities. In particular, the following DFA groups can be highlighted:

1.    Equivalents of standard debt obligations in the form of bonds that certify monetary claims directly to DFA issuers. This also includes so-called tokenized metals, i.e., DFAs denominated in precious metals, provided that the fulfillment of obligations for them does not depend on the market value of the underlying asset.

2.    Equivalents of structured (securitization) instruments and project financing. This includes DFAs whose underlying assets can be:

• Rights of claim under a single debt obligation or financial instrument;

• Rights of claim under a portfolio of debt obligations or financial instruments;

• Rights of claim under project finance debt, as well as project assets and the cash flows they generate;

• Future cash flows arising from contractual obligations

3.    Equivalents of structured bonds, the fulfillment of requirements for which depends, for example, on the performance of market indicators (inflation, key rate) or third-party events unrelated to the DFA issuer (third-party defaults, the occurrence of third-party events, or performance of market indicators).

4.    Equivalents of certificates of participation and financial derivatives. This group includes DFAs based on the rights of equity participation in the authorized capital of legal entities or possession of material assets, and on the requirements for the supply of material assets or securities.

5.    As a significant part of the types of DFAs is characterized by at least some debt obligation properties, it is difficult to imagine the full circulation of these instruments without credit ratings. However, given the breadth of the array of instruments included in the DFA concept, rating them is not always possible and depends on the fulfillment of a number of requirements, which are also typical for standard financial instruments:

• Debt nature of the obligation

A credit rating cannot be assigned to a DFA with a predominance of equity characteristics.

• Clear source of credit risk can be determined

A credit rating can be assigned to a DFA, the fulfillment of obligations for which depends on the creditworthiness of the issuer or the credit quality of the underlying asset. For example, a DFA issued to pay for part of authorized capital with the delivery of shares at the end of the maturity period cannot be assigned a credit rating if the deal does not include the obligation of a third party to buy back the securities transferred to the DFA holders at a predetermined price.

• Volume of obligations exposed to credit risk can be determined

DFAs must be linked to the unconditional obligation of full (and less often, partial) execution of payment requests.

• Impact of non-credit risks can be minimized or excluded

Certain types of DFAs, which, in particular, have the characteristics of derivative financial instruments, may be exposed to currency, market or other non-credit risks, which often makes it difficult or impossible to determine the size of credit risk, which is ultimately what a credit rating is aimed at. Accordingly, for lending purposes, any non-credit risks must be mitigated, for example through hedging. This of course imposes additional restrictions on credit assessment, since it involves the participation of third parties — providers of swaps, options or other hedging instruments.

The above classification of DFAs allows rating agencies to use methodological approaches already at their disposal to assign credit ratings to this new class of instruments, provided that the requirements necessary to ensure ratings are met.

Potential areas of development of the DFA market

Currently, the DFA market is at its inception, market participants are studying this new instrument and carrying out pilot emissions in the simplest form. There are a number of factors contributing to the growth of interest in this class of financial instruments. For example, the disclosure requirements for issuing DFA documentation are less formalized than those for traditional financial instruments. Thanks to this, the issuance of DFAs is less labor intensive and, consequently, more attractive to many issuers. However, in ACRA’s opinion, this situation will not last long. Another factor that, in the opinion of the Agency, will contribute to the popularity of DFAs is the possibility of including in the terms of an issue additional rights related to the ownership or receipt of material values, which, in addition to precious metals, may include minerals, market commodities, and even shares in properties (even including square meters in residential buildings under construction).

In the Agency’s opinion, one of the most promising areas of development for DFAs is structured finance. Issuers can be not only legal entities, such as banks or non-financial organizations, but also special purpose entities (hereinafter, SPVs) created as part of each individual transaction. Currently, the issue of DFAs by bankruptcy-remote SPVs, such as specialized financial institutions or mortgage agents, is not provided for by law, but the establishment of an independent company under external management is possible. This paves the way for broad opportunities for securitization. Similar to standard securitization transactions, the originator bank can assign or sell securitized loans to the issuer’s balance sheet, after which DFAs are issued that certify the rights of claim to the securitized loans. If this area is given due consideration, DFAs will be able to provide the possibility of securitization without using an SPV as an issuer and without decline in the credit quality of the issues, which will significantly simplify and reduce the cost of organizing structured finance transactions. However, to realize the potential of this area, it is necessary to address a number of legislative and regulatory issues:

• Ensure the possibility of dividing DFA issues into tranches of different priority of fulfillment of obligations;

• Clearly indicate in legislation the admissibility of using a portfolio of liabilities of third parties as the underlying asset for a DFA;

• Ensure the possibility of issuing DFAs secured by rights of claim against third parties by specialized companies — SFOs, SOPFs and mortgage agents;

• Ensure the possibility of separating assets that are collateral for DFAs on the balance sheet of the originator of such assets;

• Ensure the legislative possibility of the issuance of loans by SFOs that issue DFAs secured by obligations of third parties;

• Ensure that secured DFAs rated by Russian credit rating agencies on the structured finance rating scale can be purchased by various classes of investors.

Specific risks of DFAs

Despite the fact that debt DFAs are considered by the Agency as a type of traditional debt financial instruments, there may be specific risks that could affect the credit quality of DFAs. These risks include, for example:

• Infrastructure operator risks. Information system operators (hereinafter, ISOs) play a key role in ensuring the processes of issuance and circulation of DFAs. As the system for accounting DFAs is not centralized, and various legal entities can act as ISOs, the risk arises of the creditworthiness of ISOs influencing the fulfilment of obligations under DFAs. Mechanisms for ensuring the rights of DFA owners in the event of bankruptcy of ISOs require additional study and elaboration. One solution is making it possible to transfer the functionality for servicing and accounting of DFAs from one ISO to another. At present, such an option can probably be worked out on a contract-by-contract basis. However, relevant procedures must be drafted on a legislative level in order to fully exclude the influence of market infrastructure.

• Technological risks and cybersecurity. This group of risks is associated with the IT solutions used by ISOs, as well as with the ability of ISOs to ensure the uninterrupted operation of information systems on the basis of which the issuance and circulation of DFAs takes place, as well as the correctness and reliability of information entered into DFA registers.

• General risks related to the lack of an established practice of issuing DFAs. For example, tax and legal risks, risks related to the structuring of issues and interacting with different DFA issuer counterparties.

It should be noted that the infrastructure risks specific to ISOs, as well as the determination of requirements for ensuring their reliability and uninterrupted operation, are the responsibility of the Bank of Russia, which allows their impact on potential DFA ratings to be minimized. However, in ACRA’s opinion, since DFAs are a new instrument without an established practice of issuance, circulation and collection, these risks require additional study in order to completely exclude them from the rating analysis.