The settlement of a lawsuit involving one of the U.S.'s largest custodian banks is shedding light on just how much fund managers and their plan sponsor clients are losing from inefficient executions of foreign exchange trades.

On Oct. 28, the Washington State Investment Board said State Street Corp.agreed to pay $11.7 million to settle a dispute over prices of currencies quoted in foreign exchange transactions made by State Street between 1997 and 2007.

The agreement follows an investigation conducted this year by Washington State Treasurer James McIntire. McIntire's probe came after the state of California sued State Street in 2009 for overcharging the Calpers and Calsters pension plans on foreign exchange transactions. The lawsuit in California has yet to be settled.

What's going on? Fund managers are trading foreign currency under the assumption they are getting competitive interbank rates from their custodians which hold their assets. They aren't, these cases indicate.

Just how inefficient are custodian banks? Interbank rates are the ones which sophisticated buy-side managers and dealers can obtain when negotiating with each other.

But Harpal Sandhu, president and chief operating officer of Integral, a trading network for foreign exchange transactions, estimates that fund managers are losing as much as $50 for each million dollars executed in a foreign exchange transaction. That means that for a $50 million transaction-a typical size for a large plan sponsor-the loss would be $2,500.

John Galanek, chief operating officer of FX Transparency, a Boston-based consultancy which evaluates the costs of forex transactions for plan sponsors and fund managers, says that for a pension plan investing 20% of its assets in overseas securities, unchecked forex trades could cost it anywhere from two to six basis points of its total assets under management annually. That is because custodian banks can execute orders 10 to 30 basis points above interbank rates. That means a $100 million fund loses between $20,000 and $60,000 a year; a $1 billion fund somewhere between $200,000 and $600,000.

Pension plans typically use foreign exchange transactions to repatriate funds, either when income is received on a security or when one gets sold. Foreign exchange also can be used if domestic funds must be converted into another currency to buy a security.

Some fund managers are capable of executing their own forex transactions. That means they have their own dedicated trading desks particularly when it comes to currencies of developed markets.

But as Galanek notes, that that is not often the case with more exotic currencies such as the Korean won, Brazilian real or Chinese renminbi because the central banks of those nations do not allow their currencies to trade offshore electronically on platforms such as EBS and Reuters.

Also in the non-negotiated category are income and dividend payments. "That leaves plenty of room for custodian banks to work based on so-called standing instructions from the plan sponsor," Galanek said. "And those are pretty vague instructions."

Those banks-typically some of the world's largest-can execute anywhere from a handful to several thousand trades monthly for each pension plan they service.

It's a pretty lucrative business. In 2008 alone, the Office of the Comptroller of the Currency estimates that U.S. banks earned a whopping $11.4 billion in foreign exchange sales and trading revenue-making it the largest source of U.S. bank trading profits for the previous 12 years.

"The fact that foreign exchange deals generally don't carry any commission-they are done on a principal basis with the broker-dealer or bank buying or selling for its own account and at its own risk-makes it difficult for firms to understand their costs and how much profit the custodian bank is really making," Galanek said.

The banks make their money imposing a spread between the money put into or taken out of a security and what is taken out or put into a client's account. The wider the spread, the more profit the banks make. In many cases, a custodian bank will combine all of its settlement transactions or income payments recorded on its custody system during certain intervals in the day and execute all of the required foreign exchange deals at a single time, instead of multiple ones. Conducting forex transactions frequently throughout the day rather than in one big swoop might reduce the spread custodian banks earn on those deals. But it will ensure they deliver a better overall average foreign exchange rate for the plan sponsor, say foreign exchange experts.

Sandhu says that Integral's execution management system, called FX Inside Professional, allows fund managers and custodian banks to execute orders across multiple liquidity providers such as large financial institutions and market makers.

FX Inside Professional combines pricing and aggregation of FX spot prices, forwards and outrights with algorithmic execution services, thereby giving institutional traders a view of the order book at all times. The fund manager or custodian bank only pays a fee when executing a trade.

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