ASX and blockchain: A necessary innovation?

At their annual September event, Apple announced the apparent demise of the humble headphone jack and social media immediately exploded with memes mocking the decision. Potential customers complained about having to spend money on new connectors or headphones. The current hardware works just fine, so why make us change? Even an undisputed leader in innovation faces questions from all but the evangelical.

The Australian Stock Exchange's own big announcement was made in January. Then Chief Executive, Elmer Funke Kupper, disclosed that ASX is building a private blockchain as a possible replacement for its current platform for the clearing and settlement of trades. Furthermore, it acquired an 8.5% holding in Digital Asset Holdings for a reported $17.4m. The subscription proceeds are to fund the development of the private blockchain. It is fair to say that social media was not ablaze with the news.

Nonetheless, the ASX has faced criticism regarding its decision, including claims that it did not meaningfully consult with its users over the decision. There are also claims that any such move would be away from globally implemented systems, bringing uncertainty and the fear of increased costs.

The reality is that ASX is a top 15 listed exchange group, with over 2,000 companies and securities listed on the exchange. The number of people using the exchange is vast. It would be extremely difficult for ASX to meaningfully consult with its users, let alone expect to receive a consensus of usable opinion, in hypothetical terms. New MD and CEO, Dominic Stevens, has since said ASX will open a detailed dialogue with its users now that it has built the prototype.

ASX is evaluating the technology; it is not (yet) adopting the technology, let alone forcing it on its unsuspecting customers. The timetable is also noteworthy; the final decision on the technology will be made in the financial year ending June 2018. If the decision is in favour of adoption there will surely be a transitional stage, perhaps with the present and the new technologies operating side-by-side for a period of time.

A common argument for taking a particular stance on an issue is that it is "market standard". If that line of argument was always accepted then we would still be transacting on outdated positions. Scenarios and environments change and markets and arguments must adapt accordingly. Blockchain technology has potentially great application for securities exchanges. If the technology is robust enough then it is entirely possible for it to move on the state of the art.

Blockchain and a distributed ledger can modernise many facets of securities trading and settlement. An open dataset can be interrogated by parties to a trade without requiring third party involvement. The verification of fundamental matters such as securities ownership and the means to pay for the asset by way of reviewing the asset and securities ledgers provides substantial comfort. In entering into the trade, each party will need to use its private key to unlock the asset or cash and the public key for the transfer. These affirmative actions should help reduce legal challenges to trades on the basis of foul play.

Once the transaction has been completed the consensus ledger will be updated as part of the next settlement cycle. These cycles should occur every few seconds. From an efficiency perspective, this will remove the need for post-trade confirmations and central clearing. The attraction is not only the efficiency. In order for the ledger to be updated it must occur in accordance with particular mutual consensus protocols. All local copies of the ledger must be updated. In other words, it should prevent manipulation of the ledger.

From a legal standpoint, this could provide a very robust proof of ownership and less susceptible to error or fraud. However, there is not yet the clarity around the legal status of the ledger. In English law, absent a court order, the definitive statement of legal ownership of a share is the company's statutory register. The securities ledger will need to be given equivalent status for it to be entirely reliable and the irrevocable nature of the ledger may need to give way to court orders from competent bodies in applicable jurisdictions. The rule of law is an essential component of confident trade.

Smart contracts have found favour in the context of automatable financial transactions. Such contracts can self-execute once particular conditions have been met, such as specified market events. The efficiency is in the simplicity and the certainty of execution, with the asset and cash validation benefits. Despite the moniker, it must not be believed or assumed that all parts of contracts can be reduced to algorithmic code. Smart contracts will co-exist with more conventional forms of legal contract or legal frameworks, with the coding providing at least the execution mechanism. Complex contractual arrangements defy attempts to codification, and when disputes arise the resolution will still require human involvement and reference to traditional contractual principles.

Innovators do not always succeed. The Apple Newton tablet was sufficiently flawed to be mocked in 'The Simpsons'. Yet the vision about tablets was not misplaced. Who is to say Apple are wrong to remove the headphone socket? Perhaps Apple are the first to take the step of removing outdated technology in favour of efficiency and greater performance. There is a substantial amount of technological, legal and regulatory development needed for blockchain to provide a viable trading architecture. We should be grateful ASX has taken steps to try to move the established order on. ASX benefits from a regulator willing to listen and learn about new technologies and the intersection with financial services. Other exchanges are also exploring the uses of blockchains and distributed ledgers. The users should celebrate the possibility of savings and greater certainty, and the law makers need to play their own enabling role.

Sam Pearse is a partner in Pillsbury Law's Corporate & Securities practice samuel.pearse@pillsburylaw.com