In Forex and Futures Commentary

As if the practices on Wall Street haven't been criticized enough in the past few years, it is shameful that any added fuel gets tossed on this already roaring fire. Over the past couple of days we have seen several articles trickling in about Bank of New York Mellon's practice of trying to prove that management fees aren't enough by dipping in on foreign exchange transaction costs.

According to the Wall Street Journal, among day-to-day duties of managing assets on behalf of a Los Angeles-based pension fund, the bank was conducting foreign exchange transactions for conversion purposes.

The rate at which these orders we executed fell well beyond the daily range of the traded pairs, essentially providing the bank with a substantial markup on the trades. What resulted was approximately $4.5 million that would have gone to the retirement of a large number of L.A. employees, and instead made it on the books of the BoNY's profit column.

The biggest argument occurring as a result of this case is the way that BoNY represented the transactions to the client. If the transaction was declared, efficiently stating ahead of time that “we are going to take a 2% markup on this trade”, the client signs off, and it's out the door, then okay. But this was just one part of a leg in a transaction, one which allows the bank to profit quite a bit.

You can argue over every legal aspect of this that you want, but a three-year old could tell you that this is just vicious…..

It is something that is all too common and has been “mainstream” for all too long. Think what you may, but the BoNY is far from an innovator when it comes to what they allegedly did. In the past I have had shouting matches with client service reps at banks over transaction costs, so it comes as no surprise to me that this article hit the wires this week.

The problem?

Many people responsible for pension funds, non-profit assets, etc., don't have a clue how many of these instruments work, nor how the bank conducts transactions on the back end. When they see U.S. dollars getting converted in Canadian dollars, Euros, etc., a typical “uh huh” or “okay” seems to be the response. After a long conversation of confusing market rhetoric leaves the mouth of the portfolio manager, the client is more happy just to get out of the boring meeting and onto lunch as opposed to try to challenge any setbacks in the fund.

Here's a quick story:

Once upon a time on Wall Street there existed a large asset management division of a major investment bank.   The division's  product line was extensive and means for diversification were huge.

One particular manager had several large clients that were not-for-profit religious organizations. Religious organizations can control A LOT of money — the real estate alone on which some of these churches, synagogues or mosques rest are worth a fortune to commercial developers. For this particular organization, with millions under the wing, the main representative in charge of assets was a nun.

Yes, a nun.

Now imagine a nun going into a meeting with an asset manager at a large investment bank in New York and hearing terms like beta, delta, Sharpe ratio, risk arbitrage, etc., get tossed around the pitchbook.   How likely is she to call out a foreign exchange transaction that was not in her best interest? Did she have her laptop present at the meeting with historical FX rates loaded, spot-checking the book for inefficiencies? Probably not.

I want to highlight the fact that sometimes, those that should know everything that happens with their money, simply don't have the background knowledge needed for cross-checks. And when the livelihood of others are at stake and “advantage gaps” are wide open, there is room for manipulation.

From my own perspective, the pension fund appears to have been subject to the bank's typical protocol when it comes to forex transactions: charge around 2% or so on every leg, regardless of the size.  Most likely, this is how BoNY is going to defend their actions.

Any person knows how much their bank decks them when traveling overseas…..banks love it when you convert, because it gives them the opportunity to give you a crappy rate on the back end and take the difference. The issue here is the fact that they are already getting paid to perform a much larger service for the client — any lack of representation to larger costs are going to be a huge issue, as we are seeing in recent times.

The pension fund could have certainly avoided this issue if negotiations were made prior to any of the transactions or multi currency accounts were established, etc. This of course, didn't seem to be the case, as it rightfully should have been.

I haven't the slightest doubt that as time dribbles on we will be hearing more and more of these stories crawl out of the woodwork, but for now, all we can do is help raise awareness to this issue. If you do happen to be close-to or in charge of a large amount of money on which others depend and you don't know the ins and outs of this business, get a non-biased third party that does. They have to be non-affiliated with your asset manager and willing to work in your best interest.

Moral of the story? It is a trust issue in which due diligence just isn't enough. Out of the several jobs I have had over the years, operations was one of them, and reconciling your accounts and knowing where every penny flows is particularly more crucial when 1. large amounts of money are involved where tiny fractions can mean big dollars and 2. there is any room for confusion or ambiguity.

After passing the original article around to my peers the common response was:

“Whoa, wait, bankers trying to screw their clients? Hahaha…..scumbags.”

Sign of the times, I suppose…..or maybe just a recycling of the old, showing a different face. Whether you are running a massive pension fund or trading your own small account, just always be aware of any “deliberate” inefficiencies that might occur, and heed warnings like this very carefully. We are still very much in the territory of manifest destiny when it comes to this or any other market trading outside of an exchange.

Related Readings:

Wall Street drives a truck through mile-wide hole in the rules (Reuters)

Hidden bank fee of the day, wholesale FX edition (Reuters)

Inside a Battle Over Forex (Wall Street Journal)

SEC Deepens Probe of Forex Trading (Wall Street Journal)

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