Forex fees facing scrutiny

A lawsuit alleging State Street Corp. overcharged high-profile custody clients for currency trading services could prompt institutional investors to focus more on how much money they're leaving on the table as the non-U.S. portion of their portfolios continues to climb.

While unlikely to prove a major headache for State Street, the suit could shine a spotlight on foreign-exchange trading costs, with potential long-term ripple effects for custodial banks in general, investment consultants say.

The suit was filed Oct. 20 by California Attorney General Edmund G. Brown on behalf of the country's two biggest pension funds: the $201.1 billion California Public Employees' Retirement System and the $126.9 billion California State Teachers' Retirement System.

The huge windfall custodial banks reap from foreign exchange trading is one of the industry's worst kept secrets, and the potential cost savings for pension funds from greater due diligence in that area are great, said Cynthia Steer, chief research strategist with Darien, Conn.-based investment consultant Rogerscasey Inc.

According to U.S. government data, currency trading has been, on average, the richest source of trading revenue for U. S. banks over the past 12 years, accounting for $2.1 billion of the $5.2 billion total trading revenue in the second quarter of 2009, and $11.4 billion in revenue for all of 2008, when total trading revenue was -$836 million.

A recent study by TABB Group, a Westborough, Mass.-based financial markets research and strategic advisory firm, found that almost three-fifths of buy-side foreign-exchange desks measure foreign-exchange trading costs. But some market veterans say that figure is optimistic.

There's evidence to suggest that as much as “95% of institutional investors don't quantify their current trading costs,” said John B. Galanek, a managing partner with FX Transparency LLC, Framingham, Mass., which aims to help investors quantify and reduce those costs.

Mr. Galanek was senior vice president of foreign exchange with Harvard Management Co., Boston, where he managed currency execution for Harvard's endowment fund. He and fellow managing partner James McGeehan launched FX Transparency this year, anticipating a growing number of institutional investors looking to better control their foreign-exchange trading costs.

That would be a long overdue development, argues Rogerscasey's Ms. Steer.

Institutional investors, by and large, have failed to focus more effort on controlling those costs, even as foreign holdings surged over the past decade from 5% to 10% of their portfolios to more than 30%, she said. Ms. Steer pegged potential cost savings at two to three times what pension plans have been able to garner from securities-lending programs.

A third investment consultant, who declined to be identified, said only a small minority of custody agreements now specifically address foreign exchange-related issues, with the result that institutional investors and money managers alike are leaving money on the table.

But if the price of greater transparency is transforming a “soft” custody cost into a “hard” expense for which pension plan executives have to explicitly budget, some might decide it's better to let sleeping dogs lie, she said.

Some observers say California's attorney general was shrill enough, and CalPERS and CalSTRS are high profile enough, to ensure their legal gambit will focus more attention on the question.

Mr. Brown announced California's lawsuit, alleging “unconscionable fraud,” on the same day State Street released third-quarter earnings that came in below market expectations, reflecting an unexpectedly big falloff in securities lending and foreign exchange trading revenues, analysts said.

In a letter to clients obtained by Pensions & Investments, State Street client service executive Wendy LaBonte “categorically denied” the charges, while decrying the “inflammatory” accusations contained in the complaint. The letter was sent the day after the suit was filed.

State Street's stock closed at $41.98 on Oct. 30, down 19.66% from its close on Oct. 19, the day before the suit was filed, and worse than the Standard & Poor 500 index's 5.62% decline for the same period.

The California lawsuit wasn't a major factor in State Street's decline, analysts said.

A lawsuit by blue-chip clients such as CalPERS and CalSTRS is never a non-issue, but its impact on the company's stock price over the past week or two is probably marginal, said Gerard Cassidy, a Portland, Maine-based research analyst with RBC Capital Markets Corp. The failure of third-quarter profits to meet market expectations was the main story, said Mr. Cassidy, who recommends that investors buy the stock at current levels.

Richard Bove, a veteran financial services analyst who recently joined Rochdale Securities LLC in Stamford, Conn., agreed. “The lawsuit is not a positive,” he acknowledged. But with Mr. Brown widely seen as running for governor and CalPERS seen as litigious, investors shouldn't lose sleep over it, he said, adding he remains “very bullish on the stock.”

The lawsuit was greatly scaled back from an earlier salvo, filed May 22, 2008, in California Superior Court in Sacramento. That complaint was sealed for 60 days to allow potential plaintiffs to conduct their own investigations “to determine whether to join the action,” according to that filing.

Following that review, 12 multibillion-dollar public pension funds initially cited as damaged by State Street's foreign exchange trading “scheme” apparently opted not to move forward, along with the $50 billion University of California Retirement Plan.

The scope of the alleged State Street fraud was likewise sharply cut back from the May 2008 filing, which charged that roughly one-third of State Street's company-wide trading revenue — or $400 million out of $2007's total of $1.2 billion — were “derived from the fraudulent scheme alleged herein.” The more recent suit alleges damages to CalPERS and CalSTRS that amount to more than $56 million over an eight-year period.

In State Street's letter to clients, Ms. LaBonte said Mr. Brown is basing California's complaint on an interpretation of the wording of the custody contract negotiated with CalPERS and CalSTRS that “we dispute.” The wording is specific to those two clients, and “we believe that we have acted consistently with it,” she said.

Rogerscasey's Ms. Steer said whether or not California's lawsuit is found to have any merit, the ripple effects could be considerable, enabled by recently developed high-frequency trading tools that have paved the way for institutional investors to gain greater insight on their foreign-exchange trading costs.

One currency manager in Boston, who declined to be named, agreed there's ample room for institutional clients to exercise greater due diligence: It's an open secret that there are a lot of profits being made on foreign exchange, and a chunk of those profits reflects the fact that “institutional investment clients don't watch this carefully,” he said.