Last month, BNY Mellon reached a partial settlement with the Justice Department regarding claims the custodian overcharged clients on FX transactions. The two agreed BNY Mellon would be transparent to clients about the way it sets its foreign transaction pricing. Three years after a whistleblowera former BNY Mellon employeeleaked confidential information supposedly showing the firm exploited the lack of transparency of FX transactions, the foreign exchange industry has changed for good.
Custodians are working toward giving clients what they wantmore transparency and greater reporting on FX pricingbut FX revenue for custodians continues to plummet as pensions opt for alternative FX providers. Nonetheless, experts question whether it is the pensions themselvesthe ones suing BNY Mellon and fellow custodian State Streetthat are to blame for allowing the custodians to process FX transactions at spreads they were unhappy with, in some cases for years on end before raising a red flag.
According to analysts, the partial settlementBNY Mellon still faces civil suits in several statesis a win for the custodian, because it is already transparent about the way it prices its FX transactions.
The settlement is in BNY Mellons favor, says Josh Galper, managing principal of Finadium LLC, the custody and securities lending consultancy. They are already taking action to provide more alternatives for clients, and provide clients with data about the rates they are getting versus the rates in the market. The fact that BNY Mellon said they would do that to the Justice Department really is saying, Yes, were going to provide the data just as we are already doing.
BNY Mellon says it provides full transparency with regard to the way it prices its FX transactions. Each day, for example, the firm publishes a guaranteed range of FX rates that may be reviewed by clients and, if they are unhappy with the terms, they may opt out and use an alternative provider. Clients also have access to daily reports showing the rates applied to the previous days transactions, allowing them to compare the rates they were charged to alternative market rates. The firm has offered these services for several years, a spokesperson says.
BNY Mellon is pleased with the progress represented by this agreement, according to a statement sent to GC by the firm. While we are confident that we have provided our clients and their investment managers with the information they need to make informed trading decisions, this agreement addresses disclosure questions raised by the U.S. Attorney and is consistent with our ongoing commitment to implement enhancements that will benefit our clients.
BNY Mellon is not the only global custodian involved in litigation over foreign exchange transactions. The California attorney general launched a lawsuit in 2009 against State Street with claims the firm overcharged California public pensions CalPERS and CalSTRS on FX transactions for a number of years from 2001 onward. That was the first suit that set into motion the slew of lawsuits by public pensions against their custodians seen in the years since. The ongoing case attempts to recover $56 million from State Street. (For more on the State Street case, see Conspiracy of silence, Global Custodian, Winter Plus 2010.)
The remaining BNY Mellon lawsuitsby attorneys general in Florida, Virginia and New Yorkwere filed after a whistleblower, former BNY Mellon employee Grant Wilson, leaked information that purportedly contained evidence the custodian added fictitious charges on top of normal FX transaction fees. Pensions who subscribed to BNY Mellons standing instruction FX program, whereby they turned over control of FX trades to the custodian, were charged falsified trade price[s], the documents allege. State Street and BNY Mellon both vehemently deny any wrongdoing.
State Street revamped the way it discloses its FX pricing to clients in 2009, when it launched comprehensive pricing dataincluding markups and markdownson its online client portal. Its methods are not dissimilar from those employed by BNY Mellon. State Street has always accurately disclosed the amount of currency exchanged in every foreign exchange transaction where State Street Global Markets is the counterparty, including every indirect FX transaction, a spokesperson told GC. Among other things, this information has been available to custody clients and their investment managers via our online client portal. Beginning in 2009, we provided additional information about the way we set rates for indirect foreign exchange transactions, including the difference between the rates we set and interbank market rates at the time that State Street Global Markets sets them.
While the two custodians comply with legal and client demands that they provide more transparency in the way they price FX transactions, they are also collecting lower FX revenue. At the same time that pension funds and other institutional clients are showing greater scrutiny of FX pricingonce considered a mundane back-office task, but now the subject of front-office and even underlying investor concerncustodians are no longer earning the revenues of years past.
BNY Mellons revenue attributable to foreign exchange and related trading activity sank in the fourth quarter of 2011 to $228 million, from $258 million in Q4 2010. In Q4 2007, before the frenzied trading of the financial crisis inflated FX volumes and revenue, the total was $305 million. The firm attributes the latest drop to lower volumes.
But beyond lower volumes, custody clients are also taking their FX business elsewhere. Massachusetts PRIM (Pension Reserves Investment Management), for one, whose state attorney general has filed a complaint blaming the pensions custodian BNY Mellon of unfair FX pricing, is said to have moved some of its FX business to an alternative provider, Russell Implementation Services. Another measure of client use of other providers is the falling percentage of respondents rating global custodians on FX in the annual Global Custody Survey.
Pension funds and other institutional clients are also paying closer attention to the spreads being charged by their custodians now that BNY Mellon, State Street and others are providing more detail about the way prices are set. If BNY Mellon is having to answer more questions about FX, or show more transparency in its FX pricing, thats something clients are going to pay attention to, as Galper explains.
State Streets FX revenue is down, too. In the fourth quarter of 2011, State Street earned tracking services revenue, which includes foreign exchange trading revenue and brokerage and other fees, of $273 million, a decrease of 12% from $310 million in the fourth quarter of 2010. Back in Q4 2007, revenue was $352 million.
Although clients may be switching providers for some services formerly done by their custodians, such as MassPRIM using an outside FX provider, it is believed that none has taken the decision so far as to switch custodians entirely over it. Pension funds and other institutional investors are maintaining their relationships with their custodians, in some cases even at the same time they are taking them to court: CalPERS renewed its contract with State Street in July last year despite its ongoing lawsuit against the custodianeven opting to pay an extra million dollars in fees per year for more reporting servicesand none of the pensions suing BNY Mellon is believed to have opted for another provider.
Javier Paz, senior analyst at Aite Group, says that is mainly due to the simple fact that it is not easy to migrate assets from one custodian to another, and doing so would probably be more hassle than it is worth. There is a lot of convenience of continuing to do business with the same custodian, Paz says. We saw that with CalPERS. It is just convenience. Having many assets kept in many different parts of the world for equities, it made sense for them to just keep certain parts of the processing in one location. But there has been some movement on the FX side of the business to other firms that are trying to create a niche, providing more transparency on how they execute particular trades and how certain cost savings are achieved. That balances the need for convenience.
Galper concurs: Certainly this whole episode has shined the light on FX prices. This is something that over the years has gone from something that wasnt even thought about to more of a front-office, pre-trade consideration. As institutions began to focus and consider their actual rate, thats when change began to occur. For more attuned investors, theyve had options for quite a number of years to trade their own FX prices. The choice to use BNY Mellon or State Street or another custodian as the FX firmthis is a matter of convenience.
As State Street continues to field its FX lawsuit in California, and BNY Mellon defends itself against a $1 billion lawsuit in Virginia and a $2 billion lawsuit in New York, the industry awaits a definitive verdict in each case for clues on what this means for potential future lawsuits. If a ruling were made in favor of the pensions, it could open up the floodgates for further suits by attorneys general against custodians. If a ruling were made in favor of the custodians, it could minimize the likelihood of more lawsuits.
The question, analysts say, is not necessarily whether custodians are at fault for overcharging on FX transactions. It is also whether the pensions, as fiduciaries, should have paid more attention to the pricing they were getting all along.
My primary concern about lawsuits in FX and related areas is the fiduciary responsibility of asset holders themselves, Galper says. In many cases, we find that asset holders could have paid greater attention to these financial activities while they were occurring, rather than seek to recoup perceived losses through a lawsuit.
Mercer recently launched a service that allows pension funds and other institutional investors to request reviews of spot and forward FX transactions undertaken at multiple trading locations, which allows them to determine the competitiveness of the prices they are getting from their custodian or other FX provider. Due to the opaque nature of FX markets, there has been a lack of investor oversight on FX transactions, often leading investors to pay more for trades than they should, which can erode the value of their assets considerably, Mercer wrote in a statement at the launch of the service.
The fact that a market exists for such a product is another sign that pensions and other institutional investors are paying closer attention to FX fees. That should have happened a long time ago, says Paz.
It would be good for the industry, for BNY Mellon and State Street, to put this behind them, he says. Its been in the news on and off for two-plus years, and its good to get closer to a sense of finality there, because at the end of the day its just about the need for greater education on the part of the buy side. They [pensions] also made a lot of agreements without the proper due diligence. They should be accountable for that as well, and not just blame it on the banks.
Christopher Gohlke