Lawsuits and regulatory investigations have undermined pension funds' faith in foreign exchange rates offered by custody banks. Nicholas Pratt looks at changes in the aftermath of legal wrangling.
There is nothing like a multi-million dollar lawsuit or two to focus attention on certain operational concerns. For years pension funds and asset managers have been happy to rely on standing instruction programmes for the foreign exchange, or FX, transactions carried out by their custodians, presuming they are paying a reasonable rate for the privilege.
Then, in 2009, the California Attorney General filed a lawsuit against State Street on behalf of the state’s biggest two pension funds – California Public Employees’ Retirement System (Calpers) and California State Teachers’ Retirement System (Calsters) – alleging that FX charges had been inflated.
There was an immediate effect. According to a study by US-based research firm FX Transparency, transaction costs on custodian-handled standing instruction FX trades for institutional investors decreased by 63% in the 12 months following the lawsuit.
There also followed a string of similar suits in neighbouring US states. Many of these have since been settled or dismissed, but some are still ongoing, including one filed against BNY Mellon by New York State Attorney General on behalf of the $137 billion (€101.4 billion) New York City Retirement Systems (NYCRS).
What has been notable, however, is the effect on the relationships between the pension funds and their custodians. For example, in October 2013, BNY Mellon reached a $28 million settlement with the Florida State Board of Administration, with a promise to “provide full transparency” and was subsequently retained as global master custodian for $168.8 billion in assets.
Meanwhile, in 2011, Calpers rehired State Street for all its custody arrangements, two years after its landmark lawsuit against the same firm, while Calsters never parted company with State Street either as of 2011. But let it not be said that the lawsuits were heavy-handed ways of negotiating better custody arrangements. The actions were beneficial to others, as the reduction in costs show.
Also, the role that the lawsuits have played in making FX services offered by custodians more transparent cannot be dismissed even if some of the lawsuits can. For example, BNY Mellon has responded to the litigation by forming a new global group called Enterprise FX to answer client concerns over their FX execution and offer new FX-related products.
The changes have come in four main areas, says Jim Cecere, co-head of Enterprise FX: more transparency, including timestamps for standing instructions and major currencies; more tools for providing oversight, including board level-style reports that show which currencies have been traded; pricing that reflects the value of the service; and greater flexibility for the managers deciding what routes their FX executions should take.
“Managers want more ways to execute rather than just the standing instruction channel,” says Cecere. For example, his firm has introduced a new product, FX Direct, which offers automated, custody-agnostic FX execution.
The fallout from the litigation has affected the bank to a degree from both a perception and business standpoint, Cecere acknowledges, but the business has maintained an even level of growth.
“We have had some attrition, yes, but clients know that we are vigorously defending ourselves, and we have won new FX mandates from key clients, the states of Kentucky, Hawaii and New Hampshire being three recent examples in the US.”
Every single custodian has now moved to more transparent pricing for FX executions, says James Economides, director and co-founder of Amaces, a custodian benchmarking company, which offers benchmarking for custodian FX services. “Gone are the opaque arrangements of yesteryear and in their place is a schedule of choices that sets out a spread of FX prices and options for managers and pension funds.”
There is also a wider variety of alternative providers available to carry out FX execution for pension funds and asset managers, all of which carry out the trades on an agency basis rather than as principals, meaning they take no revenue from the spread but merely a fee for each transaction.
Should asset managers decide to employ agency specialists, they must be aware of the operational issues involved, says Economides. “It is not straightforward and the best price is not always the best trade. Fund managers aren’t stupid. There is a cost to doing this and generally operational risk is reduced by having custodians do the FX and that gives managers and investors a level of comfort.”
The high volume, low value FX trades, such as dividend repatriations, are most likely to remain with the custodians given the complexity of trying to send them to someone else. But the large value, one-off FX trades, as a result of a portfolio transition, may well end up being sent to an alternative provider offering agency-style trading.
One such provider is Record Currency Management, a UK-based independent currency manager with more than £30 billion (€36 billion) of client currency exposure. According to its chief executive, James Wood-Collins, transparency lies at the heart of the issue.
“The institutional FX market is deep, efficient and liquid, but it is also disaggregated with multiple market makers and while this creates competition that should keep trading costs low, it also makes it harder to discern a reasonable market rate.
“That there is no consolidated tape in FX has created the opportunity for certain parties to take advantage of the knowledge they have over clients.”
And while no one denies custodians should not be rewarded for the trades they execute, the question is whether these have been excessive.
The first step for managers or pension funds looking to answer this question is to enhance their monitoring of execution rates. Transaction cost analysis in FX is improving and Record offers a currency audit service that looks at FX trades undertaken by a custodian and benchmarks them.
The next step for clients is to look at using an alternative service for large one-off spot FX transactions. Finding a provider to execute these transactions is straightforward enough. The complex part is approaching the custodian to change current arrangements, says Wood-Collins.
“Custodians are an integral part of managers’ and pension funds’ infrastructure and one that is very hard to remove or change,” says Wood-Collins. Clients can also be reticent to even challenge custodians over their FX rates for fear that they will simply end up paying more for another service such as general custody. “They sometimes prefer to pay more for the mostly hidden FX rates rather than pay more for the more evident custody fees.”
On the positive side, some of the alternative execution services on offer are becoming larger which makes them more effective counterparties and better able to negotiate with both custodians and the market-making banks, he says. Greater size also creates opportunities to net transactions and avoid spreads.
Russell Investments has offered FX execution to asset owners and managers for 20 years and in January launched an FX execution platform specifically for local government pension schemes (LGPS) in the UK. The central premise of the new platform is that the more LGPSs sign up, the greater the savings can be.
“We look at the pool of participating LGPSs as a single client,” says Klaus Paesler, head of currency and overlay strategy. This enables certain FX trades within the LGPS pool to be netted thereby removing both the spread cost and the execution fee. Whatever trades remain are then routed through Russell’s matching process, in a further attempt to reduce cost.”
Interest in agency services such as Russell’s has increased in the last three years as a result of the lawsuits, says Paesler, especially in the LGPS space where these local authority pension funds are under pressure to save taxpayers money and FX represents a way to achieve those savings.
So how is this market likely to play out? Custodians are never going to make fundamental changes to their services such as scrapping principal trading in favour if agency trading but they will likely accept a reduction in market FX rates and look to recoup costs elsewhere. Similarly pension funds and managers need not demand that FX be unbundled from other custody services.
As Wood-Collins says: “Rather than negotiating the whole custody arrangement, just sending a letter to the custodian informing them that you are putting them on notice will often have the desired effect.
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