The Australian Securities Exchange (ASX) is exploring implementing a new clearing and settlement system based on Blockchain technology and has purchased a minority stake in Digital Asset, a Blockchain start-up based in the US.
The ASX is seeking to overhaul its clearing and settlement system – CHESS – for the first time in nearly 20 years and Blockchain is one potential solution to this overhaul. Blockchain is a distributed database based on technology used by crypto-currency Bitcoin.
If the ASX developed a system based on distributed ledger technology – the alternate name for Blockchain that the ASX prefers to use – it would be the first exchange in the world to do so.
ASX is looking at distributed ledger technology after announcing in February 2015 that it would replace or upgrade all of its major trading and post-trade systems, including CHESS.
ASX said that, if implemented, distributed ledger technology may be able to simplify and speed up post-trade cash equity clearing and settlement to near real-time, reducing costs and removing potential risks.
In the lead-up to Christmas 2015, ASX boss Elmer Funke Kupper discussed the potential benefits of implementing Blockchain technology for post-trade processing and was enthusiastic about the potential benefits. Shortly after, ASX announced it was purchasing a 5% equity stake in Digital Asset for AU$14.9 million, with the intention of working with Blockchain group Digital Asset to develop new post-trade solutions using distributed ledger technology.
The ASX is careful to emphasise that implementing distributed ledger technology is not a done deal – in the words of Peter Hiom, deputy CEO at ASX, they are in “a race to the starting line”.
Meanwhile experts caution that while all exchanges should be looking at the potential that blockchain brings, it is not a panacea and that significant, cooperative work must be done by exchanges, regulators and participants around the world to develop common standards for implementing blockchain solutions.
An overdue upgrade?
Most importantly, ASX is looking at distributed ledger technology because it wants to replace its core post-trade system CHESS.
Hiom explains: “I think it comes from a realisation that the world we now live in as financial services providers is in the midst of structural changes, not a cyclical downturn in volumes [from the] global financial crisis.
“That creates real challenges for market participants, in terms of the fact that their costs have gone up, the capital has gone down, and the regulation is significantly increased. They’re looking for solutions to radically simplify the cost of doing business. Anything that looks at bits of the process, or simply replacing the system with a slightly better one is fiddling at the edges.”
Hiom believes that a private distributed ledger system would represent a huge cost-saving opportunity.
ASX estimates that the whole equity market system in Australia costs AUD $4-5 billion each year, and the costs attributed to ASX for equity post-trade services are around $90 million, as reflected in ASX’s FY15 revenue for those services.
Hiom explains: “We are in a six month process of building out a parallel universe that will sit alongside CHESS.
“We’re going to build an alternate universe that allows both regulators, government and customers to see first-hand what that alternative world could look like and that could dramatically simplify the way the equity market operates. We think that prize is an interesting and material one and has implications beyond the equity markets.”
The ability to settle transactions in near-real time means that there will be flow on impacts on collateral management and other arrangements currently in place to offset risks of failed transactions, which are all global concerns, not just Australian concerns.
Experts believe the ultimate prize on offer from Blockchain is far greater than cost-savings alone, however.
Niki Beattie, managing director of trading consultancy Market Structure Partners, says: “Blockchain presents opportunities because people have creaking systems that can’t deal with the transaction volumes they have today.
“Cyber-security is becoming a massive issue. We have to look at solutions that may improve that. I think that those are the risks and opportunities that get presented.”
If they decide to implement Blockchain for clearing and settlement, ASX would develop a private distributed ledger in which participants are regulated and known to the regulator.
A private distributed ledger would have permissioned access to varying degrees, with the regulator to have a clear view of operations. This could therefore satisfy anti-money laundering and know your customer regulations and also has the potential to offer a more resilient system to fend off cyber-attacks.
Hiom says: “[With distributed ledger], there are multiple instances of the ledger, and the way in which this works is more resilient to attack than traditional systems.
“That’s better than what you have today. Let’s say that ASX had a problem with its primary data centre. We have a version of CHESS in our primary data centre, we have a version of CEHSS in the secondary data centre. We have to make sure that the database that’s working is actually correct.”
Safety in numbers
With a distributed ledger system, multiple copies of the ledger exist, and it is up to the participants – including the regulator- to set the parameters on what percentage of the ledgers have to be in agreement to be the true form, anywhere from 51% to 100%.
Creating a permissioned distributed ledger is an opportunity for institutions like exchanges to use Blockchain technology while retaining the central business.
“We are seeing a lot of firms recreating the Blockchain as a private, internal system rather than leveraging the Bitcoin Blockchain,” said Adrian Przelozny, chief executive officer of Independent Reserve, a Bitcoin exchange.
“I see why this is appealing, as their biggest risk if the experiment works is that they will innovate themselves out of business. That’s because the central philosophy behind the Blockchain is the reduced need for intermediaries to facilitate transactions.”
Przelozny said that he doesn’t expect institutions to create private distributed ledgers.
“I expect that these companies will soon find there is little benefit to recreating the Blockchain for themselves, as its key benefits don’t lend themselves to private enterprises,” he said.
“I expect they will ultimately choose to implement something simpler, like a traditional database, or migrate onto the Bitcoin Blockchain.”
All large exchanges should be looking at Blockchain, according to Beattie although she admits that there are risks to being a pioneer of a new technology.
“Use of distributed ledger technology is going to absolutely revolutionise the world we live in from a financial services perspective, but I wouldn’t necessarily bet the farm on it
“I think it’s at the stage where it’s good for experimentation, any large exchange should be looking at what Blockchain means. There’s nothing wrong with doing experimentation and learning.”
Currently, a number of groups are experimenting with Blockchain solutions. Of course, there is the risk of fragmented application of distributed ledger systems, which could actually complicate current international, cross-market transactions.
The Depository Trust & Clearing Corporation (DTCC) recently issued a white paper – Embracing Disruption – Tapping the Potential of Distributed Ledgers to Improve the Post-Trade Landscape – on that subject, calling for industry-wide “collaboration” in the use of distributed ledgers.
Benefits of distributed ledger supposedly range from a complete and traceable transaction history shared between nominated parties to the ability to improve operations and mitigate risk and post-trade costs.
However, the technology is still immature and there is a lack of infrastructure to integrate the new technology to existing environments and it may not be the solution to all problems.
There are also other challenges that need to be met and satisfied before the ASX can proceed with Blockchain. ASX currently holds a monopoly on cash equity clearing and settlement in Australia, despite the consultation launched by the Council of Financial Regulators (CFR) in February 2015. Market participants have previously said that this will need to be revisited at some time in the future.
There is also the question as to whether it is cost effective to develop a distributed ledger as the pioneer of the technology.
Finally, there is an existential question that comes with distributed ledger. If Blockchain can produce a resilient, near-real-time settlement platform, what happens to the services that exchanges like ASX have typically conducted for customers?
“It’s not just how the world looks different for ASX, but for a number of parties as well,” Hiom said. “Some of our existing businesses would change. Clearing would play less of a role, because we would be managing less of a risk of transaction failure because the transaction is settling in near-real time, albeit at the choice of the investor.”