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Contract costs

Banks’ profits could take hit in fight over forex fees

5 public pension funds are suing custody banks over charges

The legal battle over fees for foreign exchange trading could hit the bottom line of global custody banks if public pension plans are successful in their civil suits.

Five legal actions have been filed and attorneys general in at least 20 states are reviewing whether to sue over claims that public pension plans in their states were overcharged when they traded U.S. dollars and other currencies, sources said. The currency conversions at issue occurred when non-U.S. stocks were bought and sold and when stock dividends were converted into U.S. dollars.

The legal actions are all aimed at State Street Corp. (STT), Boston, and Bank of New York Mellon (BK), New York, the two largest U.S. custodians.

Reducing the foreign exchange spreads for what is known as non-negotiated currency trades could potentially reduce custodian FX revenues by 55% for State Street, BNY Mellon and Northern Trust Corp., according to a February report by Sanford C. Bernstein and Co. Inc., New York. Those trades make up the bulk of currency trading between institutional investors and custodian banks, the report notes. FX trading represents roughly 8% of State Street's total revenue and about 7% of BNY Mellon's revenue, said Brad Hintz, the analyst who wrote the report.

FX trading also represents 12% of the revenue of Northern Trust. Northern Trust has not been named in any of the lawsuits

Although the first suit was filed in December 2009, this year has seen another wave of litigation against both State Street and BNY Mellon.

The most recent suit was filed March 7 against BNY Mellon by the Southeast Pennsylvania Transportation Authority, on behalf of its $800 million pension fund. State Street was sued by the $9.6 billion Arkansas Teacher Retirement System on Feb. 10, while attorneys general in Florida and Virginia began legal actions against BNY Mellon on Feb. 3 and Feb. 4, respectively, on behalf of public plans in their states.

Carolyn Cichon, spokeswoman for State Street, and Kevin Heine, spokesman for BNY Mellon, denied any wrongdoing by the banks on foreign currency overcharges.

The suit that started it all was filed by the California attorney general in December 2009. The suit said State Street, custodian for the $230.1 billion California Public Employees' Retirement System and the $150.1 billion California State Teachers' Retirement System, overcharged both systems by at least $56 million for currency trades between 2001 and 2008.

All of the suits focus on non-negotiated or standing instruction trades, rather than directly negotiated trades in which the currency rates are set in advance. The non-negotiated trades are usually $1 million or less and represent the bulk of trades by pension funds and their custodial banks.

The lawsuits maintain the banks didn't charge the lowest interbank rate, the rate banks charge each other, as their contracts had required.

In a written response to the California lawsuit, State Street didn't deny it added a surcharge, but said if the bank charged the interbank rate, it would not be able to make a profit. State Street said it fulfilled its promise because “the starting point of the rate calculations (is) ‘based on' interbank rates.”

Contract costs

The costs of custodial contracts for basic services such as safeguarding assets, handling paperwork on transactions and doing tax reporting are small when compared with fees paid to investment managers.

For example, CalPERS paid out more than $1 billion to external money managers in the fiscal year ended June 30; its custodial contract was less than $5 million for the same period.

But custodial contracts also give banks access to sell other lucrative services, such as foreign exchange and securities lending. Those services can bring in four times or more the revenue generated from the basic contract, said one consultant, who asked not to be identified.

Mr. Hintz in his report said some pension plans may “knowingly and willingly overpay for foreign exchange trades as a quid pro quo for obtaining more competitive rates on core asset services like safekeeping and custody.”

“This bundled pricing arrangement may be tolerated because pension plan professionals are held accountable by pension boards for explicit administrative fees, but they are less frequently made to answer for implicit trading costs (which are far more difficult to measure),“ Mr. Hintz said. “Clients therefore prefer to receive core safekeeping and custody services for next to nothing and understand that custodians ‘nickel and dime' them with opaque charges to earn an economic return on the overall bundle of services provided.”

Late last week, officials at the $154.7 billion Florida State Board of Administration, Tallahassee, issued a request for bids for a new custodial contract, asking applicants to show how they would price services on an unbundled basis.

Its contract with BNY Mellon, which expires in July 2012, used a combination approach that bundled the pricing of some services and kept others on an unbundled approach, said Dennis MacKee, spokesman for the Florida board. The previous contract did not address foreign currency trading, he said.

Mr. MacKee said the board had hired a consultant in December to determine whether its bundled arrangement should be kept or whether an unbundled approach would be better. He said the consultant's work was factored in the request for bids, but he couldn't discuss the matter further because of a quiet period revolving around the bidding process.

A review of the Florida's documents to bidders shows a series of questions detailing transparency practices in pricing for foreign currency trading.

BNY Mellon's Mr. Heine said the bank will rebid.

In the meantime, currency trading consultants say the legal actions seem to have promoted greater transparency by custodians.

“We are seeing a greater willingness to discuss hitherto undisclosed methodologies and spreads. Many of our (institutional)clients are seeing positive results from this process,” said Aidan Dennis, a co-founder of Amaces, a London consulting firm specializing in helping institutional investors with their custodial services.

Still difficult

But Mr. Dennis said that even with greater transparency, it's still difficult for pension executives to determine if they are getting the best FX rate because currency rates can change so frequently.

“Notwithstanding the increase in transparency, it is clear that the market has some way to evolve before all plans receive rates in line with their particular currency requirements and that all participants view these to be fair and reasonable to both sides,” he said.

The cost of non-negotiated foreign exchange trading by global custodians dropped 63% in 2010 compared to the average cost over the previous nine years combined, according to a study in February by FX Transparency LLC, Framingham, Mass. John Galanek, chief operating officer and co-founder, said its likely rates have dropped because of the legal actions by some pension funds.

State Street's Ms. Cichon said that since December 2009, State Street has provided all of its custody clients and their investment managers with comprehensive disclosure of the pricing and execution methodology (including the maximum markup or markdown that may be applied) for each of its standing-instruction FX services.

BNY Mellon's Mr. Heine said the firm has always been transparent in its standing-instruction program.

“The pricing and terms of our standing-instruction program are spelled out in various materials provided to clients and their money managers,” he said. “They acknowledge and agree to those terms in writing. Our U.S. trading desks publish a guaranteed range of FX prices every morning. Clients and money managers can compare those guaranteed rates to other market rates, and they can easily switch to a different option or provider every day.”

Despite the lawsuits, the working relationships between some pension plans and their custodians do not appear to have suffered. Sacramento-based CalPERS, for example, is finalizing a new three-year custodial agreement with State Street.

One of the key reasons for selecting State Street was the firm's specialized capability to help CalPERS monitor its investment assets daily, a switch from the more traditional monthly analysis, said Janine Guillot, CalPERS' chief operating investment officer, in an interview. “Because we manage so much money internally, we really need to know what our risk is and what's driving our performance every single day,” she said.

The new agreement calls for complete transparency on the pricing of all services, including foreign currency trades, said Matt Flynn, chief of the operations, performance and technology division at CalPERS.

What's unclear is how the new contract differs from the old one because CalPERS officials wouldn't discuss them in detail.

Mr. Flynn did say that even before the new contract, State Street had implemented new foreign exchange rules that gave CalPERS daily information to accurately monitor FX trades, including the exact markup in spread that is applied to all transactions. He said the new information includes time stamps enabling CalPERS staff to determine the exact currency rate in effect when a transaction was made.

The lawsuit says State Street consistently charged at or near the highest rate of the day, even if the interbank rate was lower at the time of trade. The suit says State Street concealed what it called “fraud” by deliberately failing to include time stamp data in its reports, so the pension funds could not determine the true execution costs by verifying when State Street actually executed the trades. Mr. Flynn would not discuss the suit, which is still in discovery. No trial date has been set.

Open contract

Documents examined by Pensions & Investments under the California Public Records Act show that CalSTRS, West Sacramento, which has had an open-ended contract with State Street since 2000, has taken no public action to discuss the matter or consider rescinding its contract since the suit was filed in December 2009. Ricardo Duran, a CalSTRS spokesman, said system officials would have no comment on their contract with State Street given that the matter was under litigation.

A senior official of one pension plan that is involved in litigation with its custodian over the currency trading overcharge issue said he had no plans to drop the custodian. “They overcharged us on foreign currency trades, but they still do good work for us in other areas,” said the official, who requested anonymity. “Everyone is sued for fraud these days so you don't stop doing business with them over one thing.”

Disputes over currency overcharging can occur because of a lack of regulation in the business, said FX Transparency's Mr. Galanek. “The over-the-counter FX market is still the Wild West,” he said.

At least one state has settled its issues with its pension fund custodian over the cost of foreign currency trading.

Without filing a lawsuit, the $76.7 billion Washington State Investment Board, Olympia, reached an $11.7 million agreement with State Street in October. Steve Dietrich, an assistant attorney general, said state officials treated the matter as a “pricing dispute” in negotiating the settlement. The investment board had alleged that it was overcharged for non-negotiated foreign currency trades that occurred between 1997 and 2007. (State Street later was replaced by J.P. Morgan.)

“Our contractual obligations to the state of Washington were significantly different from those presented in our ongoing litigation in California,” State Street's Ms. Cichon said in a statement. “You will note that we are vigorously defending the state of California's allegations, which is consistent with our conclusion that these circumstances are significantly different.”

However Washington's Mr. Dietrich, who helped negotiate the settlement with State Street, said investment board officials first learned of overcharging allegations from the California suit. He said the issues with Washington were the same as those in the California suit.