FX, Lies, and Marked-Up Rates

(July 10, 2013) – “Note: No transaction fees.”

When Louisiana’s police pension system hired JP Morgan as its custodian, the contract stipulated an $85,900 annual flat fee, plus “reasonable out-of-pocket expenses” and other amounts “agreed upon in writing from time to time.”

The brief and vague fee schedule is however explicit on one point: no transaction fees.

But as every CIO would now know (or ought to), foreign exchange services were not part of the package.

The $1.4 billion Louisiana Municipal Police Employees’ Retirement System (LAMPERS) would not disclose how much it paid JP Morgan over and above market rates for FX transactions since hiring the firm in 2005. But whatever the amount, LAMPERS, like many other public funds, felt its custodian had earned a lawsuit.      

A New York court threw out the case on July 3, along with another FX-related suit against Bank of New York Mellon the day before.    

“LAMPERS identifies no foundation for its ‘reasonable expectation’ that, in addition to reporting the charged exchange rate, JP Morgan would also reveal its mark-up on the indirect FX transactions,” Judge Denise Cote of New York’s southern district court wrote in her decision. “Rates for FX transactions are not fees, and therefore the rates disclosed by the bank to LAMPERS do not constitute ‘fees,’ as that term is used in the custody agreement.” 

JP Morgan was not contractually obligated to perform FX transactions at the best execution rates, charge the pension fund at the rate it paid, or deal with foreign exchange at all, Cote ruled.

Furthermore, the bank did not breach its fiduciary duty by keeping a spread on the transactions, the decision said, because it had no fiduciary duty.

The bank agreed. “We’re gratified by the court’s decision and believe it vindicates our position and our business,” a spokesperson for JP Morgan told aiCIO. “The opinion speaks for itself and we have no further comment.”

“We’re of course not happy about it,” Randy Roche, the fund’s general counsel, told aiCIO. But, he pointed out, LAMPERS didn’t put all of its legal eggs in one basket. “We have three cases active against JP Morgan right now.”

If not custodians, whose duty is it  to look out for assets under custodial care?

According to one custodial banker-turned-consultant, it belongs foremost to investment managers.

“Ultimately, it’s the manager’s responsibility to get the best rates, whether it is with equities, FX, fixed income, or anything else,” Ross McLellan told aiCIO. “It’s very rare for pension plans to place transactions directly.” 

McLellan spent nearly 15 years in custody banking before setting up his own  transaction costs analysis shop, Harbor Analytics. 

Consultants’ duties are weighted to the front end of their clients’ relationships with custodians, he said, and center on the due diligence phase. After contacts have been signed, consultants typically step back and monitor from a high level. According to McLellan, the recent spat of unhappy asset owners does not suggest a failing by consultants. “Most managers were using their custodians for FX, which would never be a red flag for consultants.”

In his experience, certain consultants have responded to the industry’s ongoing scandals by gaining deep knowledge of what he calls the “nuts and bolts” of contract and standing order design. Bespoke terms could prevent another round of what are—at minimum—the profound miscommunications currently playing out between funds and their custodians. (Story continues on following page…)

LAMPERS: Distribution of FX Rates Used for its Transactions 

Did they or didn’t they?  

Litigation against FX practices by custody banks has taken various tacks. The LAMPERS-led suit claimed breaches of contract, fiduciary duty, and the “obligation to act in good faith.”

The suit BNY Mellon recently had thrown out was brought by shareholders against the corporation’s board members. In the wanton pursuit of profit, the complaint alleged, the board allowed “illicit” FX practices to continue and jeopardized the company’s value. The judge disagreed. Asked for comment, a bank spokesperson kept it brief: “We are pleased with the court’s decision.”

At the core of all of the cases is the question of deception: did custody banks willfully lie about their practices to garner profit, or simply mislead clients who ought to have known better?

It depends whom you ask.

“It is very difficult for a pension plan that didn’t have access to quite sophisticated data and a good knowledge of FX markets to figure out if they’re being charged or not,” he said. “But, if someone is providing a service for you, of course they’re making money.”

Cote, in contrast, contended that JP Morgan’s profit taking in FX was not “hidden” as LAMPERS claimed, or an abuse of its “superior position.”

“The bank did not misrepresent the rates for the FX transactions,” she wrote. “The spreads were evident from monthly transaction statements and publicly available databases of currency exchange rates.” 

She ruled that the onus was on clients to monitor and control the terms of transactions. Her opinion pointed out several ways an asset owner could have protected itself against its custodian selecting unreasonable rates, such as establishing a “master foreign exchange” contract that stipulated transaction terms and conditions. Furthermore, LAMPERS could have given JP Morgan standing instructions on rate selections, and cross-checked the rates used (as disclosed in account statements) with FX databases.

LAMPERS relied on this last method to build its case against JP Morgan. According to the ruling, “having concluded that it is no longer satisfied with the rates reported by the bank, the plaintiff cannot claim that the FX transaction rates are now fees and that it should not have been ‘charged’ some portion of those ‘fees’.” 

What Cote suggested was flightiness on the part of asset owners, finance scholar Carol Osler would call a symptom of a faulty system. Assessing the magnitude of markups on custodial foreign exchange transactions is extremely difficult, the Brandeis business school professor said in a 2012 paper, titled “Asymmetric Information and the Foreign Exchange Trades of Global Custody Banks“.

Before the unsealed lawsuit against State Street came to light in 2009, Osler wrote, “asset managers had long suspected their custodians of setting extremely high markups on currency trades.” But transaction prices—the practice’s only data trail—provided incomplete information and were already out-of-date when they arrived. According to Osler, the State Street case was the confirmation many had been looking for, since the numbers were hardly robust enough evidence on their own. 

In the same paper, Osler and co-authors Tanseli Savaser and Thang Tan Nguyen gave their analysis of an unusually rich data set: one “midsized” global custody bank’s entire FX trading record for 2006, comprising more than 70,000 transactions in 25 currencies against the US dollar. 

The results were atypical of market trading data, and suggested the bank was trying to maximize profits while shrouding its markups. For example, the custodian took wider spreads at times of high volatility, where daily high and lows left greater room to maneuver. Markups were smaller for currencies that were more costly to trade. Finally, according to the paper, the bank took smaller profits off of clients “that appeared to be more sophisticated.”

The slow turnover of custody relationships means any lessons learned in the current FX turmoil will likely take years to show up in the average contractual relationship. 

“Funds don’t want to change custodians,” McLellan said. “It is a lot of work, and people perceive that there won’t be a huge upgrade between different providers. A lot of the current contracts are probably very old.”

The document at the heart of LAMPERS’ lawsuit, for example, dates from 2005. As of January 17, when the pension fund filed its most recent complaint, JP Morgan was still serving as its custodian. 

Now, however, Louisiana’s police pension fund is shopping for a new one. According to its next board meeting agenda, scheduled for July 17, the fund will interview representatives from four major US custody banks for the job. This includes one interviewee with the unenviable task of pitching JP Morgan.