Custody Conundrum

Custodial banks are defending themselves against lawsuits over standing instructions on currency trades done during the clearing and settlement process

Bank of New York Mellon Corp. last month appealed a decision by the New York State Supreme Court to allow a lawsuit brought by the New York State Attorney General against BNY Mellon over its foreign exchange trading.

In August, the state’s highest court ruled in favor of the attorney general’s office, allowing it to proceed with its lawsuit. New York’s top cop is accusing the giant custodian bank of defrauding various New York City pension funds over a 10-year period by overcharging them for currency trades.

The appeal is the latest volley in a nearly four-year legal tussle between BNY Mellon and various states, as well as the U.S. Justice Department, over its “standing instructions” foreign exchange transactions service. Other custodian banks, including J.P. Morgan and State Street, have also been the subjects of FX-related lawsuits.

Besides New York, BNY Mellon is facing lawsuits in California, Massachusetts, and Florida. It won a dismissal of a so-called whistleblower suit in Virginia. It also has had whistleblower suits thrown out in New York and California.

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Custodian banks such as BNY Mellon take custody of the financial assets of institutional investors such as pension funds, including foreign securities. As part of that service, they may automatically enter into so-called standing instructions currency trades during the clearing and settlement process.

Standing instructions trades are typically smaller than negotiated trades, falling below the $1 million minimum necessary to qualify for trading in the inter-dealer wholesale market. The custodians’ customers often don’t learn of the actual prices of the trades until weeks after the fact.

BNY Mellon and State Street are the two largest custodian banks, as measured by assets in custody. Both do a significant amount of foreign exchange trading, typically acting as dealers in the trades.


For the six months that ended June 30, BNY Mellon booked $328 million in FX trading revenues. Of that, $130 million, or 40 percent, was for standing instructions trades. The balance was for the larger negotiated trades.

In the same period, State Street booked $317 million in FX trading revenues. Of that, $150 million, or 47 percent, was for standing instructions trades. The balance was for the larger negotiated trades.

The New York State suit claims that BNY Mellon priced clients’ FX transactions “at the worst rate at which the currency had traded during the trading day rather than at the market rate at the time of the trade. The bank then pocketed for itself the difference between the worst price of the day it had given clients and the market price existing at the time it executed the transaction. Through this fraud, it earned $2 billion over a 10-year period.”

BNY Mellon “flagrantly misrepresented its practice,” writing to clients that in executing SI transactions, the bank would obtain the “best rate of the day,” “best execution” and “the interbank market rate at the time of execution,” according to the suit.

For its part, BNY Mellon contends the attorney general’s suit is without merit. In a statement following the court’s ruling in August, BNY Mellon head of corporate communications Kevin Heine praised the court for dismissing the whistleblower claims, but said, “We continue to believe the remaining claims are unwarranted, and we will vigorously defend against them.”


For some industry officials, the pension funds deserve some of the blame for the allegedly poor prices the received.

Jim Cochrane, foreign exchange transaction-cost analysis product manager at ITG and a former FX trader, says there are two sides to the story. The clients agreed to pay through transactions to cover the cost of custodial services, he said. “The banks are not innocent, but you let the fox guard the henhouse,” he said.

“The buyside knew where the markets were. They should have been doing a better job of policing their FX transactions,” Cochrane said.

As for the custodian banks, they have stepped up their game, according to Cochrane, because they know they are being watched.

Cochrane said that when he looks at the data-a custodial trade without a timestamp-and measures it against the high and low for the day, more often than not, the fills are falling inside the high and low and not outside.

That wasn’t the case when he first began examining the data. Two years ago, when he looked at 2009-2010 data, “I saw a lot more trading outside the daily range.”

Pension funds and buyside firms now want independent verification that the rates they are getting “are either within the daily range or at the time of execution it was close,” Cochrane said. That’s why ITG is getting requests for trials of its new FX TCA product, which debuted a year ago.

Firms are using the service for compliance and process improvement, but most commonly to help measure best execution, Cochrane said.

BNY Mellon was first hit with a lawsuit in December 2009. Since then, it has watched as its revenues from foreign exchange transactions dropped by nearly 40 percent. In 2009, the bank took in about $850 million in revenues from FX trades. In 2012, it grossed $520 million, a decline of 38.8 percent.

It is unclear how much of that decline is the result of fallout from the litigation. BNY Mellon does the bulk of its FX volume in negotiated trades-not standing instructions trades-according to its website. It only started disclosing the percentage of standing instructions trades in 2011.

As for State Street, it has seen its revenues from “indirect,” or standing instructions, FX trades drop from $369 million in 2009 to $248 million in 2012-a decline of 33 percent.

ITG’s Cochrane isn’t the only industry official to find the pensions remiss in their duties. Historically, according to Michael O’Brien, head of global trading at Eaton Vance, fixed income managers were more sensitive to FX execution levels than equity managers.

“If you are an equity manager and you’re worried about whether your stocks will go up or down by 30 percent, FX, on an individual trade basis, seems like such a small piece of the trade that it could have been overlooked,” he said.


On the fixed income side, however, firms are counting in basis points, so those managers were more sensitive to foreign exchange, O’Brien said. “If you had to generalize, you’d find it was more equity managers leaving their orders with custodians and fixed income managers maybe not.”

As a result of the FX custodian lawsuits, however, there is now far more sensitivity to foreign exchange, and one piece of evidence is the emergence of firms that do FX TCA, he said. “It’s not as precise as equity TCA, but you can get a general idea.”

The lawsuits are also one of the big reasons more buyside shops are trading FX more on their own now, O’Brien said. And the growth of electronic FX trading has made it more efficient for smaller shops to do their own FX. Eaton Vance, which has had a longtime policy of not using custodians for FX trades, does almost every trade in G10 currencies electronically, he said.

Still not everyone agrees that the litigation has pushed traditional buyside shops to do their own trading. According to David Mechner, chief executive of Pragma, an algorithm vendor with a line of FX trading tools, most are staying with the custodians for now.

“There’s a huge amount of inertia,” Mechner said. “A lot of ways that firms trade is entrenched. Over the next five years there will be a shift, but changing is a big undertaking that involves dealing with credit agreements.”

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