Securities Industry News

Custodian banks spend millions of dollars each year to ensure they have the best technology to process transactions across the globe for fund managers and pension plan sponsors.

They have also spent millions of dollars to ensure that their client reporting is up to snuff. That means understanding the intricacies of just what the customer is paying for, at what price and when.

But when it comes to executing foreign exchange trades-a basic service related to buying and selling securities outside the home market of the plan sponsor-custodian banks may have fallen short of the mark.

Sometimes they disclose the time and price at which they executed a foreign exchange transaction; sometimes they don't. The reason is often unclear; sometimes bank systems aren't coded to provide such detail and at other times they simply don't want the client to know the real cost of the deal-and what the bank is making off of it.

Until now that is. An October 2009 lawsuit versus State Street Bank highlights just what plan sponsors and banks should and shouldn't do. The lawsuit seeks more than $200 million in overcharges and damages on behalf of the California Public Employees Retirement System (Calpers) and the California State Teachers Retirement System (Calsters).

The suit filed in Superior Court in Sacramento by California Attorney General Jerry Brown alleges that the Boston-based global custodian-one of the world's largest-transacted tens of thousands of transactions over an eight-year period at unfavorable rates to the plan sponsors. The suit contends State Street made too much profit off of the two customers-and didn't follow the terms of its contracts.

Calpers and Calsters claim they asked State Street to base the price of foreign exchange trades on interbank rates. However, State Street consistently executed trades in excess of the interbank rate when the bank converted dollars into foreign currencies. And when State Street executed FX trades to repatriate foreign currency into US dollars for the two pension plans, it marked down the price the pension plans received to an amount far below the interbank rate.

The interbank rate-the rate at which major banks buy and sell currency-is considered the best rate for a plan sponsor to conduct a foreign exchange trade because it results in the tightest spread.

According to the lawsuit, State Street then concealed its fraudulent pricing practices by entering erroneous exchange rates into its online reporting database, mystatestreet.com. That is where the pension funds found reports detailing their account activity. State Street further disguised its fraud, the plan sponsors say, by failing to timestamp the trades which would indicate when they were executed.

Calpers and Calsters declined to provide Securities Industry News with an interview on the lawsuit. Calpers referred all written inquiries to Brown's office, which did not respond by presstime. Carolyn Cichon, a spokeswoman for State Street in Boston, would only say that the bank "vehemently denies any wrongdoing."

Among the questions which Calpers and Brown's office declined to address are: Is Calpers still using State Street as its custodian bank? And is Calpers still executing foreign exchange trades through State Street?

Calpers, Calsters and Brown's office also would not comment on whether Calpers and Calsters ever audited State Street's foreign exchange transactions either themselves or through a consultant over the course of the eight years. Such auditing is commonplace among large pension plans, say industry consultants with knowledge of the foreign exchange and securities services businesses.

In his written response to SIN's questions, Ricardo Duran, a spokesman for Calsters, would only say that Calsters continues to use State Street as its custodian bank.

"State Street has provided master custodial services to Calsters since about 1986. The duties performed include recordkeeping, performance reports, custody of assets, securities settlement, money transfers, performance measurements and risk measurements," Duran wrote.

He emphasized that Calpers is cooperating with the California Attorney General's office in its investigation of State Street.

Whistleblower Twist

Brown's office did issue a statement last October in which it explained that the alleged fraud against Calpers and Calsters was brought to its attention by whistleblowers. Notably, those whistleblowers stand to earn an undisclosed percentage of whatever Calpers and Calsters win, if the case goes to trial. Calpers, Calsters and Brown's office also would not comment on the status of the suit or disposition of any amounts that might be won.

Pension plans don't typically do a large number of foreign exchange trades to hedge the risk that changes in the value of currencies in which they are invested will have a sizable impact on the value of their holdings.

Fund Repatriation

But they do 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 home funds must be converted into another currency to buy a security.

Custodian banks can execute anywhere from a handful to several thousand trades monthly for each pension plan they service. 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.

Equity deals are often done on an agency basis and have clearly defined and regulated best execution rules; the plan sponsor client will always know the price paid and the commission it was charged.

Best execution in the forex market is subject to the agreement between the plan sponsor and the custodian bank. And even then contracts can be subject to interpretation if they are not clearly written, plan sponsors say.

Banks make their money in foreign exchange trades by 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.

Specialist consulting firms-those with knowledge of securities services pricing-say that one of the reasons pension plans aren't getting the best rates on their foreign exchange trades is because the custodian banks are executing their order (orders are typically under $5 million in size and frequent in number) based on standing instructions the pension plan has given the custodian bank rather than through the phone.

Trading via the phone typically involves executing fewer but larger forex deals at close to interbank rates. By contrast, automatically executed deals allow plenty of room for the foreign exchange salesman at the custodian bank to hike the price, said an ex-FX global custodian salesman. That is because the price of such deals is often set only once or twice a day and there is no audit trail for the client.

"Sometimes it isn't even clear what day the conversion was done let alone at what time," said an operations executive at a plan sponsor.

High Time for

Time Stamps

That means plan sponsors must keep closer tabs on their custodian banks who may not always time-stamp their deals to show the exact time it was executed.

Regardless of whether a trade is time-stamped or not, the pension plans can always hire a consultant to analyze the custodian bank's activities via a monthly collection of inventory. That means the consultant can take a sample of several hundred trades conducted by the custodian bank and compare those to the interbank rate or the mid-market rate on that date.

"We can look at the foreign exchange trades conducted on behalf of particular clients and compare the rate given by the custodian to its pension plan client for the automated trades to the mid-market rate," said Aidan Dennis, co-founder of Amaces, a London-based consultancy. "We can also find out how clients might be getting different results from a common custodian as well as the price at which the fund managers acts as agent for the pension plans."

Operations executives familiar with the forex market say it isn't that difficult to determine whether a plan sponsor has obtained a fair price for its foreign exchange transactions.

But it is far more difficult to prove whether the custodian bank actually fulfilled the terms of its contract with the plan sponsor unless it timestamps the transactions. The contract, if written correctly, should dictate what times of the day the plan sponsor wants the foreign exchange trades executed.

Time Only For the

Priviledged few

Time-stamping is not a common practice among custodian banks and even the ones that do so suggest it's a privilege given to a select few clients. "We only do it for a few clients and not all our clients," said a foreign exchange operations director at a global custodian bank in London who declined to be identified.

Why not? The operations executive declined to explain his bank's rationale, but two IT executives with knowledge of the foreign exchange market said that it was 'very costly" to code a foreign exchange system trading system to allow for time-stamping for each foreign exchange transaction.

That cost could amount to several hundred thousand dollars, for starters. However, one plan sponsor has a different viewpoint: "The bank doesn't want the plan sponsor to know how much of a spread its making on each deal."

In most cases, according to the London FX operations director, a custodian bank will aggregate all of its settlement transactions or income payments recorded on its custody system during certain intervals during the day and execute all of the required foreign exchange deals at either a single time or multiple times during the day.

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 can deliver a better overall average foreign exchange rate for the plan sponsor.

How to Avoid The Post-FX Syndromes

In executing foreign exchange trades, plan sponsors and custodian banks need to take special precautions to avoid misunderstandings that can affect their finances and reputations.

Here are a few ways to avoid problems:

Plan Sponsors Should:

Put it in writing: Clearly spell out the time or times of the day trades should be executed and at what prices.

Require Proof: Spell out in the contract how the custodian bank can prove it met the terms of its contract. That includes whether or not the bank will timestamp the foreign exchange trades or provide other types of documentation on when and at what price the transactions were made.

Use Outside Help: Hire a consultant to check up on the custodian bank.

Renegotiate or Cancel: You can change the terms of the contract if you don't think the custodian is fulfilling its end of the deal. If that doesn't work, be prepared to cancel.

Custodian Banks Should:

Explain Clearly: Make sure each plan sponsor understands the terms of a contract.

Never Make Promises That Can't Be Kept: Explain in writing what can and cannot be done up front. That means specifically at what prices the foreign exchange trades can be executed.

Prove Their Worth: Explain in writing how they plan to fulfill the plan sponsor's requirements for documentation.

Verify: Ensure the forex trading system executes trades according to the plan sponsor's requirements.

Source: SIN Research

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.