ASX’s Proposed Distributed Ledger and the Future of Clearing and Settlement

Two days after the launch of Airswap (a decentralized exchange or DEX), Australian Securities Exchange (ASX) revealed more information on their proposed CHESS (Clearing House Sub-Register System) replacement in a second consultation paper. Whilst DEXs are attempting to show that “The beauty of the blockchain is that you don’t need a clearing house”, ASX is proposing to replace the tech used by their clearing house (i.e CHESS) with Distributed Ledger Technology (DLT also known as Blockchain technology).

Unlike DEXs, where (at least in theory) there is no central operator/intermediary that controls the user’s funds, ASX retains centralized authority over their platform:

“While permissioned users may initiate transactions, only ASX has the authority to commit transactions to the ledger … All users …will be subjected to an on-boarding process governed and managed by ASX.”

According to ASX, the benefits of their proposed DLT implementation are that users will be provided with “improved record keeping, reduced reconciliation, more timely transactions, and better quality data.” Below I discuss some of the features that ASX asserts will contribute to a more efficient clearing and settlement system.

Node access

According to the ASX consultation paper, all permissioned users will be able to request and access data they are entitled to through an Application Programming Interface (API). In addition, users, if authorized by ASX, may choose to interact directly with the new system via a node. The paper further explains that users may run a DLT node (through a service managed by ASX) to query, monitor, and interact directly with the distributed ledger. It isn’t entirely clear what the benefits of running a node are other than the ability to have access to accurate real time view of ledger data:

“A node is software that allows users to join the distributed network directly and rely on its data as a realtime, auditable source of truth. [E]xisting systems and business processes can now be optimised to operate with the confidence that comes with an accurate, real time view of ledger data.”

Will node-less users be meaningfully disadvantaged relative to other users with access to this added feature? Perhaps, especially considering the opportunities offered by smart contracts.

Smart contracts

The paper introduces the idea integrating smart contract functionality through the Digital Asset Modelling Language (DAML) Software Development Kit (SDK) being offered by Digital Assets, ASX’s technology partner. The DAML SDK would enable users to:

“… develop applications that integrate directly with a DLT node … Applications can both read and write to the platform and are responsible for services such as stakeholder management or trade registration”

It will be interesting to see the full range of applications that users will be able to build and whether users will actually adopt the new software kit. Will users be able to build applications that allow companies to automate back office processes relating to corporate governance such as the payment of dividends and voting, or that allow issuers to manage their own share registry (in direct competition with Computershare)? Will ASX vet each of these applications to ensure compliance with the Corporations Act, and/or will DAML have regulatory restrictions embedded in the platform?

Regulation through smart contracts

DAML enforces the rules of the market through software and is used to model contractual rights and obligations in executable code within the boundaries of those market rules.

This footnote is packed with legal and technological implications. For one, which rules will DAML be enforcing — rules relating to the market, to issuers, clearing participants, or to clearing houses? Second, given that this is a CHESS replacement project (i.e. dedicated to post trade clearing and settlement), it is interesting that the paper is suggesting that DAML may be used to enforce the rules of the market as a whole.

Ledger split

The ASX platform breaks out its ledger into two subcomponents:

1. Private Contract Store (PCS): Each participant node in the network will have its own privately segregated PCS, which contains all validated contracts to which the user is a party.
2. Global Synchronization Log (GSL): a shared, replicated, append-only log of immutable evidences of transactions or events, used to verify the accuracy of individual transactions.

According to the paper, the purpose of the divide is to preserve privacy and provide scalability. This seems to suggest the PCS is a separate editable off-chain/off-ledger database that stores the actual transactions whereas the GSL is the distributed ledger used to verify and authenticate the data stored in the PCS. Perhaps this proposed structure is ASX’s attempt at solving the immutability problem by moving transactions off chain so that amendments can be made.

Assuming this is correct, it appears that the DLT platform is being used as a verification method to record and authenticate transactions that are located in separate ledgers operated by clearing/settlement participants. But has ASX really solved the reconciliation problem if each participant is still updating their own personal ledger? In comparison, DEXs typically employ a singular technological implementation to effect the clearing and settlement of transactions (i.e. the actual delivery of the cryptoassets between parties) and require no involvement of a clearing or settlement participant to do so.

This distinction is important as one platform is merely acting as a record of transactions that have occurred, and the latter is giving effect to the transactions.

Optional early settlement

ASX’s new system will also provide a mechanism for optional early settlement (i.e. other than the default position of a T+2 settlement cycle).

This is probably one of the more exciting innovations that no other securities exchange has been able to do. Interestingly, DTCC also recently suggested the possibility of accelerating time to settlement, and Vitalik Buterin recently questioned why existing systems don’t just switch immediately to instant settlement.

Although the paper notes that optional early settlement may benefit the market by reducing time-based settlement risks, it fails to mention new challenges it may bring including (according to DTCC):

1. Fragmented markets
2. “Accelerated settlement that abandons the significant capital and operational efficiencies gained through centralized multilateral netting would be a step backward for the world’s most liquid markets.”

Electronic payments in AUD

The new system will facilitate electronic payments in AUD by settlement participants (on behalf of holders) to issuers. In this context, it will be interesting to see how and whether electronic payments in AUD will be (1) processed via the DLT platform (perhaps via a digital AUD token like Circle’s proposed USD coin) or (2) processed and automated outside ASX’s DLT platform. It also remains to be seen whether the DAML applications will be able to interact with the external payment/banking system.

Centralized data capture and Privacy Implications

The new system proposes to capture and store certain additional information including personal data such as investor information, bank account details, tax file numbers. ASX seems to acknowledge that there may be privacy implications when it comes to storing personal data on the DLT platform:

Further consideration of the privacy implications for the collection, storage, use or disclosure of personal information associated with the additional investor information is required to support this requirement.

These will be important considerations in light of the EU privacy laws (GDPR) coming into effect on May 25 2018, especially if personal data is stored on the distributed ledger. For example, if personal data of an EU investor is stored on the distributed ledger, will ASX be able to comply with a request to erase that person’s personal data from the ledger?

Concluding thoughts on the future of clearing and settlement

While other blockchain-related exchanges have been developed and gone live, ASX has taken two and a half years to reach its second consultation stage. By the time ASX is ready for implementation at scale (projected timeline Q4 2020 — Q1 2021), other exchanges may have already moved to new ideas and concepts.[1] For a 5-year project (first announced late 2015), the advancements in ASX’s capabilities seem somewhat minimal in comparison to DLT’s full potential and what other similar startups are doing in the space.

Are traditional market infrastructures such as ASX, DTCC and Euroclear lagging behind blockchain startups by trying to superimpose new technology onto existing legacy systems within a highly regulated environment? Incumbents’ biggest challenge right now is an inability to disintermediate the clearing broker industry due to a confluence of factors including regulations, reduced profit making opportunities, vested interests, and embedded traditions. As a result, platforms that are able to achieve the same result (transferring share ownership and funds between parties efficiently and safely) without the intermediaries are likely to become superior — that is, if they can get around regulations AND properly manage the risks.

To be fair, it is always more difficult for a regulated platform to switch gears, than for a startup to come up with new applications that evade existing inefficiencies through regulatory arbitrage and innovative strategies. This may put ASX at a significant disadvantage, evidenced at least somewhat by their cautious tone:

While ACCC, ASIC and RBA have provided feedback on this draft, this should not be taken to imply that the paper, or any particular functionality described in the paper, have regulatory approval.

Will clearing houses follow in the footsteps of trading pits and be a thing of the past? Will share registries and custodians still have a place in this world if exchanges are able to handle all of those functions on a distributed ledger? While the possibilities are extremely promising, getting regulators comfortable with the technology will be no easy feat. I wonder how CPMI-IOSCO would feel about this.[2]

[1] For example it was reported this month that Binance, a centralized cryptocurrency exchange who is also looking to build a decentralized exchange, recorded higher profits than Deutsche Bank in the first quarter of 2018.

[2] CPIMI-IOSCO recently did an assessment of CCPs/clearing houses ability to meet guidelines set out in Principles for Financial Market Infrastructures (PFMIs) that aim to ensure that payment, clearing, and settlement systems are able to withstand financial shocks and maintain their support of global markets. Should CCPs/clearing houses start to use DLT, it will be interesting to see how the PFMIs may apply — e.g., whether probabilistic settlement on the blockchain can be reconciled with the requirement for settlement finality (see Vitalik Buterin’s comments on this issue).

About me: I am an Australian lawyer living in New York with experience at the Australian Securities and Investments Commission (ASIC). I am interested in the legal questions on whether emerging tech fits under existing laws, policy questions as to what should be regulated, and technical questions as to how uses of tech can be regulated (where necessary).