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5 ways blockchain technology could revolutionise share market trading

This morning the Australian Stock Exchange trading under the ticker ASX Ltd (ASX: ASX) announced that it intends to use blockchain or distributed ledger technology to replace the current Clearing House Electronic Sub Register System (CHESS) to settle equity trades.

The CHESS system is the current digital middleman that acts as an intermediary between two participants exchanging legal ownership of an equity holding for cash payment.

A clearing house splits trade processing into the two distinct parts of clearing and settlement, with another core role being to act as a guarantor if a counterparty to a trade defaults on its obligations or goes into liquidation for example.

Blockchain’s proponents claim the tech could deliver real time clearing and trade settlements over a distributed ledger that approved market participants are privately granted permission to access.

This is important as it promises a revolution in eliminating settlement periods and many of the operational and counterparty risks carried by market participants under the T+2 settlement process.

On the back of this morning’s announcement the ASX should become the first exchange in the world to use the blockchain technology being developed by its partner Digital Asset Holdings.

From March 2018 stakeholders have been invited to propose feedback on the blockchain implementation and global share market trading could be on the verge of a radical transition.

5 ways blockchain could forever change the game for share markets

1) Some distributed ledger evangelists claim the tech could eventually deliver real time clearing and settlement of trades. In other words investors would have to pre-fund brokerage accounts to place trades as cash debits would be instant when orders were matched. While shares sellers could expect to receive cash funds into settlement accounts almost instantaneously.

If ordinary investors were required to fund their brokerage accounts prior to trading it would (in theory) prevent the costly occurrence of failed trades and subsequent reconciliation gaps for retail or institutional brokers.

Traditionally retail brokers and fund managers have employed substantial back office settlements and reconciliation teams (among other functions like fund accounting) that may see reduced headcounts if the days of failed trades are eliminated by the blockchain.

2) Brokerage fees could also lower due to increased competition fuelled by lower barriers to entry. The prospect of lower barriers to entry is something the ASX flagged today.

3) Eventually a distributed ledger could mean retail investors are able to buy U.S. or European equities using the same settlement account.

4) However, the real winners from blockchain could be the investment banks and investment administration, asset servicing and custody giants like, inter alia, HSBC, Bank of New York Mellon, JP Morgan, and Citigroup.

If they are able to slash costs by seeing their cash market settlement fees reduced as 30-year-old trade processing methods at clearing houses are consigned to the history books.

5) Clearing houses and brokers also currently wear the risk of default by a clearing participant (protecting investors as well) and have supervisory rights to demand costly intraday margining, end-of-day exposure monitoring, and capital adequacy requirements on market participants such as brokers. Instant settlement times could lessen some of these monitoring obligations as counterparty exposures disappear with real time settlement.

No surprise then that the investment banks and ASX are so enthusiastic about the cost-decimating potential of blockchain in managing their multiple compliance, counterparty, margining, and operational risks when processing trades.

Notably, today’s proposals from the ASX simply involve replacing its clearance system with a software-powered distributed ledger  and won’t instantly bring about the changes above, however, the announcement does represent the first step towards some big potential changes for tomorrow’s investors.

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Motley Fool contributor Tom Richardson has no position in any of the stocks mentioned.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia owns shares of ASX Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.