OPED: Executing Forex Deals: Trust But Verify
Bank of New York Mellon has become the whipping boy for everyone who wants to complain about being overcharged on their foreign exchange transactions. It is facing allegations of wrongdoing -- and lawsuits from New York, Virginia and Florida's state prosecutors, among others, for fraudulently earning about $2 billion over a decade in executing forex deals on behalf of state and local pension plans.
The bank- the world's largest global custodian-- has also become a case study of how a whistleblower can meticulously collect enough information against its employer. Thanks to the work of Grant Wilson, a former foreign exchange trader who worked for BNY Mellon and a predecessor bank for more than a decade, state prosecutors have compiled plenty of documentation on how they say bank made a killing in what are called "standing instructions" to execute forex deals on behalf of its pension plan clients. The Department of Justice is also investigating the matter.
Whether or not the allegations are accurate is a matter for the courts to decide. BNY Mellon has repeatedly denied any wrongdoing but is naturally willing to settle with clients. Rival State Street did so in 2010.
What is clear is that all the media -- and legal attention- has brought to light a well-kept secret, say BNY Mellon's critics; those are the state prosecutors. Custodian banks have been ripping off plan sponsors on forex deals executed on a "non-negotiated basis." Those typically involve transactions in restricted currencies or even major currencies particularly when they involve hundreds of small income, dividend and corporate action payments that must be made daily. Until now, the phrase non-negotiated was synonymous with carte blanche.
If that's really the case, there is yet another well-kept secret that is no longer a secret. Plan sponsors, who have a fiduciary responsibility, may well have been asleep at the wheel. They either didn't read, didn't understand or didn't verifying what custodian banks have been telling them about what they have been charging-- and earning -- on forex deals.
"Custodian banks should earn a spread on forex deals, but it should be reasonable," says James Economides, a director at London-based consultancy Amaces. "Excessive spreads can really drag down a fund's performance." There are no official figures on just how much plan sponsors are really losing on their investment returns because of either the alleged fraud, at worst, or inefficiency at the very least, of custodian banks when it comes to executing forex deals. But doing some simple math can provide some inkling. Lets say a custodian bank has been executing forex deals ten to thirty basis points above the interbank rate. That's the best rate a bank can get on a forex deal when it negotiates a ratel with other professional traders for the client. And let's say a pension plan has invested 20 percent of its assets overseas. That means, say investment fund specialists that a fund with about $100 million in assets can lose between $20,000 and $60,000 a year.
That doesn't sound like a lot, does it. But lets take an investment fund with $1 billion in assets. Given the same scenario, it could lose $200,000 to $600,000 a year.
But defining reasonable isn't that easy. It has historically depended on the size of each transaction, the currency involved, the market rate, what other plan sponsors or fund managers are being charged by the same bank for similar transactions and what other custodian banks are charging, says Economides. It could even depend on just how much other business the plan sponsor brings to the table- the value of its assets safekept by the bank.
How can a plan sponsor figure out whether a custodian bank is ripping it off? Custodian banks, which often act on a principal basis, don't provide a lot of details, if any, on when each trade was executed or at what price. And they certainly don't do any benchmarking- that means telling a plan sponsor what a rival bank might charge for the same deal.
Leaving a fund manager to come up with answers may sound ideal; after all it has lots of investment expertise, right. Not exactly. Fund managers may be good at negotiating the rates of large forex transactions but when it comes to smaller ones- such as less than $1 million in value- they don't really stand a chance. Several U.S. fund managers in New York contacted by this writer, say they have no leg to stand on because "standing instructions" are addressed by plan sponsors and custodian banks in the contract -- signed by the plan sponsor, not the fund manager. Surprisingly, that's not what plan sponsors think. When officials at several state pension plans -- unrelated to the BNY Mellon lawsuit- were asked what they do to ensure they are receiving a "reasonable" price on their forex deals with their custodian banks, the overwhelming answer was: "Our fund manager handles that."
Requiring a custodian bank to timestamp all of the forex transactions executed- giving the price and when they were executed- may also sound like a good idea. But Economides insists that it isn't a panacea. "Many banks will attempt to timestamp many forex deals but only those done on a negotiated basis should be trusted as being accurate," he says. Why" It's difficult to know when timestamped deals were actually priced; timestamping isn't an exact science. "It's not really done to any great level of precision," says Economides.
What's left for a plan sponsor to do? Here are three choices.
Get an expert: Hiring a consultancy, such as Amaces, could help. It will provide the plan sponsor with some sort of peer analysis to understand whether or not its getting a raw deal from the custodian bank. Economides won't elaborate on Amaces' methodology other than to say its based on principles of transaction cost analysis. It's a common practice used in the equities market for a fund manager to determine whether or not its trade were executed fairly by a broker-dealer.
Negotiate up front. Plan sponsors should agree with the custodian bank at the time a contract is signed about what the overall cost should be of their forex deals measured in basis points from a consistent point in time. "It's not as important whether one deal is done at too high a cost, but whether the average cost over an extended period of time is too high, says Economides.
Last but not least, speak up. Silence isn't golden. Plan sponsors who are either not happy with the reports they are receiving from their custodian banks or are concerned about whether or not the custodian bank is earning too much money on their forex transactions have plenty of leverage. Custodian banks would rather pay up than be caught in a nasty lawsuit.
What should custodian banks do? Don't be greedy, for starters. Try to ensure the best deals for clients and ensure they understand exactly what you are earning. If the client doesn't have enough financial incentive to monitor its custodian, a whistleblower certainly will. And he or she will have the upper hand: all the necessary insider information, and plenty of political figures and attorneys only too willing to file a lawsuit to make a name for themselves.
And let's not forget the biggest motivation of all. Not only is the U.S. is a litigious country, but regulations allow whistleblowers to also make a killing if a lawsuit is successful. Wilson reportedly left $5 million in deferred bonuses on the table when he resigned from BNY Mellon in 2011. He stands to make ten times that -- up to a whopping $500 million or 25 percent of the $2 billion U.S. state prosecutors want to recover from BNY Mellon.
Now that sounds like a pretty lucrative-- and simple to understand - forex deal, doesn't it.
Written by Chris Kentouris, Editor-in-chief (Chris can be reached at Chris.Kentouris@hotmail.com)
