On Thursday morning, the Australian Stock Exchange announced that it intends to use blockchain or distributed ledger technology to replace the current Clearing House Electronic Sub Register System (CHESS) to settle share 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 technology could deliver real-time clearing and trade settlements over a distributed ledger, which 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 - where settlement of a trade occurs two days after the transaction.
On the back of Thursday'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.
Here are five ways blockchain could forever change the game for share markets:
Real-time clearing and settlement
Some evangelists of the technology claim it 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. At the same time, share 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.
Lower brokerage fees
Brokerage fees could also decline, due to increased competition fuelled by lower barriers to entry. The prospect of lower barriers to entry is something the ASX flagged in its announcement.
Easier access to other markets
Eventually, a distributed ledger could mean retail investors are able to buy US or European shares using the same settlement account.
More profit for the big guys
The real winners from blockchain though could be the investment banks and investment administration, asset servicing and custody giants such as HSBC, Bank of New York Mellon, JP Morgan, and Citigroup.
As 30-year-old trade processing methods at clearing houses are consigned to the history books, they might be able to slash costs by seeing their cash market settlement fees reduced.
Lower risks for participants
Clearing houses and brokers currently wear the risk of default by a clearing participant (protecting investors as well). The also have supervisory rights to demand costly intraday margining - a process that protects traders and brokers against possible losses on open trades - as well end-of-day exposure monitoring, and pose capital adequacy requirements on market participants such as brokers.
Some of these monitoring obligations could lessen as counterparty exposures disappear in instant settlement times.
This is why 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.
Foolish takeaway
The ASX proposals simply involve replacing its clearance system with a software-powered distributed ledger and won't instantly bring about the changes above,. But the move does represent the first step towards some big potential changes for tomorrow's investors.
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Motley Fool contributor Tom Richardson owns no shares mentioned in this article. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson
