“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change” – Charles Darwin

In the worlds of finance and technology, a form of natural selection identifies those adaptations best suited to the current climate and conditions, favoring them in the broader ecosystem. Presently, many commentators are suggesting that advances in data processing and transmission from fintech companies and cloud-based innovations such as blockchain are creating a revolution which will eventually disintermediate banks from their customers. One area cited as ripe for overhaul is the securities processing industry. But how many times have we heard over the past 25 years that global custody is dead? And yet, it remains. Is this time different?

Our view is that it is not. Blockchain and cloud technology represent a natural technological evolution — not a revolution — that will continue to highlight the core competence of banks, namely risk management, the safe transfer of value and regulatory compliance. The banking world has always been quick to adopt and adapt to technological advances in data transmission and processing, such as the tested telex, SWIFT, and data-transfer protocols. These advances have increased standardization, automation, and security. Furthermore, banks have created and embraced the commoditization of process and the creation of utilities, such as CSDs, CCPs, and other centralized functions including T2S. So if history is an indication, not only will banks continue to adapt to the newly emerging technological ecosystem, they will benefit from it.

BANKS’ NATURAL SELECTION ADVANTAGE: RISK MANAGEMENT AND TRANSFER OF VALUE

The Internet and cloud technologies have enabled a dramatic increase in “self-service”, as individuals gain greater access to real-time account information and data and transaction input online. While self service has changed the way banks interact with customers and clients, it has not affected the fundamental role of banks: managing the risk associated with trade and investments and the exchanges of value between their clients and the market. In fact, regulation has reinforced banks’ natural advantages. The cost and expertise required to comply with it have heightened barriers to entry by increasing banks’ defenses against outsiders encroaching on the risk management and transfer of value functions.

New technologies, like blockchain, promise to continue this evolution by centralizing and widening access to a single, undisputed record, which facilitates record maintenance, security, and reconciliation.

Won’t this potentially put a dent into custodian bank’s earnings? Possibly, but while banks and custodians historically charged for these and other, similar functions, it was never their core business. Rather, their core functions have always been to provide liquidity, risk management, and credit. Until blockchain or fintech companies can actually achieve transfer of value and risk management, they will serve an important but complementary role to the financial industry.

Risk management and regulation provide banks with inherent stability, thereby generating the trust that allows them to fulfill the role of managing their clients’ risk, and thus successfully transferring value. Risk management is manifested in knowledgeable and experienced delivery of service and relationship management — qualities lacking in some new technologies. This is perhaps best illustrated by the crypto-currency, Bitcoin, which exists outside of the sphere of traditional banking infrastructure, and is viewed with growing suspicion by regulators. Rather than assume that fintech companies have a natural leg up over the banking industry “dinosaurs” it is not unreasonable to assume that banks will evolve too; just as technology companies may someday evolve into financial services firms, banks can and, in many cases, have evolved into technology companies. Banks’ expertise, infrastructure, and client trust position them well to evolve rapidly into the future. After all, evolution favors the fittest — not necessarily the newest.

While Bitcoin uses blockchain, the volatility and risks associated with this application of the technology place it outside common usage. There is a lack of consensus as to what a Bitcoin represents and, therefore, what value or credit can be assigned to it. When combined with traditional banking principles, however, such technologies’ efficiency and transparency can provide a legitimate framework for future possibilities. Indeed, in the securities industry, the lack of anonymity for which Bitcoin is often criticized could become a real advantage as participants seek to comply with concerns over omnibus accounting structures.

TECHNOLOGY ENHANCES CLIENT INTIMACY AND LOYALTY

To manage the risks of facilitating trade and investment, banks have always needed and employed a deep knowledge of their clients. For prudential, regulatory, fiduciary, and commercial reasons, banks must now know far more about their clients than ever before, and they must be able to demonstrate that knowledge through documentation and digital records.

Banks can achieve this, in part, by adopting new technologies that enhance a sense of trust and stability. But the investment in technology and resources required to maintain heightened client intimacy is increasing. Indeed, an approximate 17.1% of 2015 IT spend will be focused on managing new risk and regulatory requirements.1

The costs of maintaining competitive technological infrastructure, together with advances in accessibility and standardization, have increased the potential for banks to share their investment in processing platforms or to outsource non-differentiated functions to third parties. Centralized transaction processing seems a natural evolutionary step toward ensuring accurate, timely, and secure transaction record-keeping and data access.

UNLOCKING HIGHER-VALUE OPPORTUNITIES

Banks have historically based fees for core services on the perceived costs of processing transactions, a tradition rooted without doubt in the “paper age” when the proportional cost of manual processing, physical storage, and security were very high. But digital-age advances have rendered this pricing model obsolete, and have added complexity and risk to the market.

It is now important for banks to adopt a commercial structure which prices the real value - risk management, rather than mere data processing. Pricing on the basis of risk mitigation or performance enhancement, rather than processes, represents a welcome opportunity for banks to re-cast themselves as delivering value, rather than merely cost-based services, to clients.

For banks, especially custodians, this may mean more granular pricing aligned to the risk profile of specific transactions and assets, such as the size of the account or the relative risk of the assets therein (derivatives versus lower-risk cash or fixed-income products, for example). Meanwhile, clients will expect greater relationship value as demonstrated through service excellence, accuracy, and responsiveness.

EVOLUTION, NOT REVOLUTION

While it is true that transaction data is increasingly in the public domain, adopting more efficient ways of recording and processing transactions is a natural evolution and, in fact, a timely one that unleashes value. Those companies that possess the technology infrastructure and distribution to deliver such services will thrive and grow, but they will not, however, disintermediate banks from the value chain. Their roles are simply too different and complementary.

What may be viewed as disruptive and revolutionary today, might in retrospect be seen as part of a broader evolutionary process. Banks would be wise to recognize and capitalize upon the opportunities this evolution presents by adapting their business models and embracing new technology. Those institutions that do evolve will be focused on risk management and able to capture the spoils of their key natural advantage. After all, evolution favors those best equipped for their environment. In the world of banking, as in nature, those who embrace change will be favored over those who do not.