If there are at least two sides to every foreign exchange transaction, there are at least two sides to every story too – often diametrically opposed to one another.

This is particularly true in the unfolding saga of lawsuits involving US pension funds, FX trades made on their behalf by custodian banks, and professional investment managers. In short, a small but growing number of pension funds or parties acting with their interest at heart is undertaking some form of legal action against their custodians.

In the vanguard is the California attorney-general, alleging that State Street has made excessive profits from FX transactions arising from the day-to-day servicing needs of assets belonging to California Public Employees’ Retirement System (Calpers). Virginia and Florida have filed similar suits against Bank of New York Mellon.

The actions can trace their roots back to 2003, when Calpers, the world’s largest pension fund, appointed currency risk specialist Record Currency Management to analyse foreign exchange transactions.

A recent paper by Record, FX Transaction Costs – Plugging Leakage in Returns, says the extent to which custodian banks profit from foreign exchange activity seems excessive to most, especially when they fail to provide proper disclosure of actual profits. Record points to the absence of time-stamps on individual trades as an important factor in the broader equation.

Record says its methodology gives a statistically significant indication of poor pricing, by comparing trades with the trading day’s highs and lows. In many cases, it argues, custodians’ execution by this measure exhibits a skew either towards the day’s low or outside the trading range.

It adds that FX revenues for custodians are significantly greater than those of other banks (for the equivalent volume of trades), suggesting that for similar activities custodian banks are profiting excessively.

If rates are significantly skewed towards the low, or well outside the range against the sponsor, this raises questions about the competence or integrity of the execution process, concludes Record.

Record makes several suggestions to limit or eliminate such activity: the publication of time-stamps for each trade; a regular audit of FX execution; and execution of FX by an independent agent.

One of several important points it fails to mention, according to some observers, is the fiduciary duty of the investment managers issuing the execution instructions, without which the custodians cannot act. A second is that its methodology can attract criticism for not comparing like with like. A third is that the key parties involved are supposedly sophisticated financial professionals; it ill behoves them to express widow- and orphan-like bemusement at high-level transactional practice, rather than acknowledge their own shortcomings.

BNY Mellon defends itself vigorously against any suggestion of wrongdoing. It divides foreign exchange transactions into two classifications: negotiated and non-negotiated, the latter executed under its “standing instruction service”. The bank says that rates for larger value transactions ($1m-plus) in easy-to-execute currencies are negotiated directly with clients or their fund manager representatives.

The standing instruction service offers access to wholesale rates for smaller amounts and hard-to-execute currencies (Michael Billy, managing partner at Econophy Capital Advisors, the Florida-based foreign exchange risk management specialist, says: “If a trade is being done at interbank rates you can get a very efficient rate at $100,000”).

BNY Mellon argues that it publishes daily the proposed trading range for transactions that are not directly negotiated, and that clients have until 11am each day to opt out if they want to use another provider. It also says many clients opt for the standing instructions programme because it allows them to transfer the cost and risk of the trades to BNY Mellon. This additional benefit does not seem to be acknowledged in the Record methodology.

State Street says it also continues vigorously to defend the allegations regarding its indirect FX services made in the civil proceedings commenced against it. “We offer clients and their investment managers a range of FX execution options and transparency as to our pricing methods,” it says. “We believe that our clients and their advisers choose indirect FX as an execution option when it represents the best mix of service and price to address their needs.”

State Street attached a recent press clipping highlighting the fact that Calpers signed a three-year contract in July this year for State Street to handle all its custody work. Some might say this suggests its clients do, after all, agree with the bank – irrespective of the actions of the California attorney-general.

Get alerts on Markets when a new story is published

Copyright The Financial Times Limited 2019. All rights reserved.
Reuse this content (opens in new window)

Follow the topics in this article