INSIDE A BATTLE OVER FOREX / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

BUSINESS

MAY 23, 2011

Inside a Battle Over Forex

Bank Gave Pension Fund Least-Favorable Rates, Analysis Shows

by CARRICK MOLLENKAMP And TOM MCGINTY

Bank of New York Mellon Corp. has been fighting accusations that it took advantage of clients while trading currencies. A Wall Street Journal analysis of more than 9,400 trades the bank processed over the past decade for a large Los Angeles pension fund could provide ammunition to its critics.

Tracking The Trades

See a reconstruction of one trade.

BNY Mellon priced 58% of the currency trades within the 10% of each day's trading range that was least favorable to the fund, the analysis shows. As a result, the trades cost the pension fund, the Los Angeles County Employees Retirement Association, $4.5 million more than if the average trade occurred at the middle of the trading range for each day, the analysis showed.

A BNY Mellon spokesman confirmed the accuracy of the data and said the bank's employees "tend" to price foreign-exchange trades at one end of each day's "interbank" trading range—the rates at which major banks like BNY Mellon buy and sell foreign currencies. But the bank said there was nothing improper about the practice. It said clients like the Los Angeles pension fund knew—or should have known—that the bank doesn't act in their interests when pricing the trades.

The Los Angeles fund disagrees. It said in a letter to BNY Mellon in January that the bank was its fiduciary, so it should have looked out for the fund's interests and offered it "best execution," or the best possible price.

It alleged BNY Mellon had used a "hidden mark-up" in currency trades and had a duty "not to make undisclosed profits" at the fund's expense. The bank says it complied with its written agreement with its client. The fund has since ceased using the bank for certain currency trades.

Controversy has spread in recent months over whether "custody" banks like BNY Mellon, which handle securities and back-office tasks for institutional investors, are overcharging public pension funds for trading in the $4 trillion-a-day foreign-exchange market. A whistleblower group has sued BNY Mellon in Virginia and Florida, and rival State Street Corp. in California, accusing them of improperly pricing currency trades for state and local pension funds.

State attorneys general in those states have taken over the whistleblower lawsuits and federal agencies also are investigating. This month, State Street said in a securities filing that the U.S. Securities and Exchange Commission was investigating the Boston bank's currency transactions for pension funds. The two banks deny the claims and say they are cooperating with the investigations.

Whether public pension funds are charged fairly for currency trades ultimately affects the value of the investment portfolios they manage for participants, including teachers, police, firefighters, librarians, mental-health workers and retirees.

The Journal used an open-records request to obtain currency-trading records for the Los Angeles fund, which manages $33 billion in pension assets for 156,000 current and retired county employees. The Journal analyzed trades involving the euro, Japanese yen, British pound and Australian dollar, comparing transaction rates with daily high and low interbank rates provided by Thomson Reuters. Those are the rates at which global banks like BNY Mellon buy and sell foreign currencies.

On March 8, 2010, for example, the pension fund used BNY Mellon to exchange €8.1 million for U.S. dollars, the records show. During that trading day, global banks got as much as $1.3704 for each euro converted into dollars. The fund got a much less attractive price: BNY Mellon priced the fund's euros at $1.3610, barely above the day's low. The fund's accounts received $35,580 less than if the trades had occurred at the midrange price.
. 

.
Banks don't charge clients commissions for currency trades, as they do for buying and selling stocks. Instead, banks make money by getting the client to buy at as high a price possible, or sell as low as possible.

The interests of banks and funds "are not aligned," says Ian Battye, a managing director at Russell Investments, a Seattle asset manager and consulting firm.

In a 2010 report, Russell Investments said an audit of nearly 40,000 currency trades between January 2008 and December 2009 revealed that "there were far more trades executed at prices close to the worst price of the day."

The currency trades at dispute in the Los Angeles pension fund case are called "indirect" or "standing-instruction" trades. In an indirect contract, clients allow banks to handle currency trades. (Alternatively, funds could negotiate their own foreign-exchange trades, potentially getting a better rate, but that requires staff and technology.)

The BNY Mellon spokesman says the standing-instruction program "allows clients to shift the significant costs and risks associated with these transactions to BNY Mellon, regardless of size—which provides significant value to clients who don't have the infrastructure needed to execute, settle and risk manage these transactions."

The spokesman says the bank offers "attractive, favorable rates" to pension funds like Los Angeles's, which he says are not necessarily entitled to the interbank rate—the rate at which BNY Mellon trades. Many of the Los Angeles fund's trades are relatively small ones, often of less than $100,000, he says. If executed in the international wire-transfer market, he said, the trades would cost the fund 2 percentage points above the interbank rate—a lot more than trading through BNY Mellon.

"Any suggestion that a price within (or even close to) the interbank range is an 'unfavorable' rate for these small trades reflects a fundamental misunderstanding of the foreign-exchange markets," the bank said. The bank says it is transparent about the rates at which it executes client trades.

The Journal's analysis showed that BNY Mellon's pricing for the fund on bigger trades above $1 million also was skewed toward the least-favorable rate. More than 54% of those 287 large trades were priced in the worst 10% of the range between the days' highs and lows, the data shows.

The suits filed in Virginia and Florida by a whistleblower legal group accuse the bank of falsifying exchange rates to benefit the bank. The lawsuits say that after BNY Mellon receives an electronic order from a pension fund, the bank executes a currency trade.

The lawsuits allege that instead of
giving the pension fund a price based on the time of day the trade was executed, bank transaction desks choose an exchange rate after the fact—usually one near the worst of the day for the client. The process for producing "falsified FX rates" for pension funds is called "locking the rates," according to both the Virginia and Florida complaints. The lawsuits allege that the bank would pocket the difference between the cost of the real trades and the "falsified FX rates" charged to the fund.

The data analyzed by the Journal doesn't reveal how much BNY Mellon profited on the trades for the Los Angeles fund, only that the fund got unfavorable pricing on its trades.

On May 8, 2009, for example, a BNY Mellon desk in Pittsburgh bought €4 million on behalf of the fund, according to trading records. Global banks bought euros that day for as little as $1.3339. The fund, however, paid $1.3625, barely below the day's highest price.

If that exchange had been priced midway between the day's high and low prices, the fund would have paid $51,585 less for the euros, according to the Journal's analysis.

.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved