SEC Joins Other Entities in Investigating FX Trading

(May 24, 2011) — The Securities and Exchange Commission (SEC) is heightening its scrutiny of foreign-exchange trading.

According to the Wall Street Journal, the SEC is probing whether two of the world’s largest custody banks — State Street and BNY Mellon — made proper representations to pension fund clients about the manner in which their currency trades were handled and priced. While State Street had already revealed the investigation by the SEC into its currency trades, it hadn’t been previously known that the SEC was examining BNY Mellon’s activities.

In its latest quarterly filing, Boston-based State Street, the third-largest custody bank, noted that “attorneys general from a number of [states] as well as US attorney’s offices, the SEC and other regulators have made inquiries or issued subpoenas.” State Street is also currently being investigated by Massachusetts’ chief securities regulator over its handling of foreign-exchange transactions. Regarding the pricing of its foreign-exchange transactions, State Street has already been sued by California and the Arkansas Teacher Retirement System for alleged fraud. Filed in early February in the US district court in Boston, the suit alleges that State Street, the custody bank for more than 40% of US public pension funds, violated state law by overcharging customers for currency trades. According to the suit, the bank generated as much as $500 million in profits annually — a rate of profit that accounts for about 50% of State Street’s foreign exchange profits over the last decade. In response, State Street said the Boston-based company is “firmly committed to providing its clients with quality service and transparency in meeting their FX needs. We will vigorously defend the allegations made in the complaint and we stand by our business practices,” State Street said.

Industry observers have been criticizing custodial banks recently over this practice. Chris Havener, Founder & Managing Director of Royal Oak Capital Management, told aiCIO that even though the foreign exchange market is an efficient market pricing system, the issues that have arose over forex pricing highlights the inefficiency in the way banks and pensions are interacting. “There are no regulations within the FX market. Trades happen 24 hours a day, all over the world,” he told aiCIO. “State Street and other large banks have been asleep at the wheel,” he said.

“Pension funds, which pay millions and millions of dollars in custodial fees, have been lazy. They decide to outsource to custodial banks, and they don’t understand FX issues. Pension funds’ Chief Financial Officer or Treasurer should look at the time and price of trades, but they don’t,” Havener indicated, adding that pensions are slowly waking up to the problem of FX manipulation.

“This isn’t a perfect world, and despite greater scrutiny, this problem will persist.” Havener said. “This is the problem when you have people running other people’s money. Even though banks have a fiduciary responsibility to their clients, pension funds have dropped the ball on this…Perhaps, but not likely, this will serve as a wakeup call to act upon their naivety.”

The solution to avoid misrepresentations in regards to foreign-exchange trading is for banks and pensions to form contractually-bound agreements, setting more specific details on the pricing of currency trades, according to Havener. However, smaller companies will not have the clout of larger funds in negotiating contracts, he added.