Legal action against custodian banks charging unduly high foreign exchange transaction fees could already have been launched by as many as 50 pension funds worldwide, Pension Funds Insider understands. This has led to increasing numbers of funds in the UK checking their FX fee arrangements

Nearly all of the legal activity to date has taken place in the US, where a number of high profile state retirement funds have launched legal action against State Street Corporation and other custodian banks. 

This action in the US has understandably provoked concern amongst major pension funds in the UK, and several have been contacting asset managers or seeking alternative solutions to prevent the same issues of performance erosion affecting them.

With overseas holdings typically increasing and many UK funds having a greater exposure to non Sterling-based currencies in their portfolios, Pete Eggleston, executive director of Morgan Stanley told Pension Funds Insider that "there has been a definite increase of interest in the subject over the past few months".

A 2010 study from Russell Investments, who have been highlighting the issue for a number of years, claimed funds may be paying more than 24 basis points above market rates per trade. This has been suggested by Californian state employees' fund CalPERS to have eaten away at $56m of their giant $152bn portfolio over an eight year period in the legal action they launched against State Street in 2009.

Unduly high charges could apply to any holdings in foreign currency, making for "a significant effect on portfolio performance over time," says Eggleston.

It has been argued by Russell Investments that simple economies of scale are not working in the foreign exchange custodian market, with big providers having the potential to exploit the lack of knowledge in the highly technical area. Report authors Shashank Kothare and Lloyd Raynor say: "FX trading is not a core competency of many investment managers, with managers often viewing FX trading as an administrative process. These managers will typically regard the potential cost of FX transactions as de minimis and will often allow the custodian bank to execute the FX transaction by means of a default instruction attached to the trade ticket without a strict process for monitoring the price achieved."

One of the possible sleights of hand of the custodians in dealing foreign exchange is that they do not always time stamp currency transactions. This means that if a pension fund wants to cash in a set number of foreign holdings at the start of any given trading day for instance, the bank could wait until the rate is cheap to do the transaction but charge the asset managers, and ultimately pension funds, a more expensive rate of the day and pocket the difference.

Every little helps

Christina Weisz, director of forex broker Currency Solutions told Pension Funds Insider: "If a bank hasn't time stamped a deal they are well within their rights to retrospectively set a daily rate but this may mean clients aren't getting the best deal. Forecasting the best time to trade is impossible without the help of a crystal ball but currency volatility can be as much as 2% in a day, coupled with some banks taking up to 3% spread on a transaction, a badly judged deal could wipe out as much as 5% of the value of a holding - which is understandably concerning for fund managers."

Weisz added: "In addition, many banks offer little transparency on what exchange rate can be achieved each month, leaving the gates wide open for them to make as much in the margin as possible with transactions not being time-stamped or booked on a very elusive 'rate of the day'."

Lenore Kantor, head of marketing at New York based FXall, said to Pension Funds Insider that custodian charges can be managed provided that funds are willing to organise themselves on the issue. She said there "have always been institutional investors that have paid attention to this but perhaps FX fees haven't historically merited as much of a primary focus. Due to the declining returns within equity markets since the crisis, currency has become more important than ever for portfolios - and when you add that investment in emerging markets is opening up new currency risk it is no surprise greater attention is going onto FX fees."

Kantor added: "Pension funds should ensure that they have a thoughtful approach to FX, for example by instructing their asset managers to execute transactions at a standard market rate, such as an industry benchmark." She agreed that smaller funds are less likely to have looked into their charges, which if anything suggests the risks of overcharging may be greater in the UK than the US owing to its more fragmented pension market.

"That doesn't mean that the smaller funds have any less chance to control their FX transactions, but they should make sure they have guidelines and means to evaluate their fees," said Kantor. She added, however, that the issue has mainly only sparked legal action from large public funds in the US, and "our experience has been that the level of sophistication around FX trading has always been fairly high in Europe and the UK in particular".

In Eggleston's view there are two fundamental steps that funds looking to lower FX transaction costs should take: insisting that custodians do time stamp transactions and measuring costs. He says "what you can't measure you can't manage and a lot of participants have neglected to do this in the past. Getting all that data on trades you need to do this has traditionally been difficult but as soon as an institutional investor can start measuring this, it immediately has an affect on taking their prices down."

Eggleston added that he was aware of major institutional investors in Europe who had been nonetheless unable to persuade their custodian banks to time stamp transactions. Morgan Stanley offers a service to funds to gauge their FX payments against standard rates.

The view from custodians

Pat Sharman, Head of Relationship Management Sales at HSBC's securities services, defended the custodian model by saying: "an extensive geographic footprint and expertise in many local markets gives us an additional insight into developments all over the globe, whilst also providing clients with local support in their home market."

While not commenting on other custodians' use of time-stamping, Sharman argued that HSBC have put transparency at the heart of their transaction offering for years and that "we will provide evidence of times at which foreign exchange trades were executed and report this to clients on demand".

Sharman added that European legislation is helping pension funds on transaction fees, saying that "we feel that transparency is being driven into the investments business through government proscription, for example the EU's MiFID directive and target2 (a clearing system for large Euro transactions) for securities".

One US-based analyst suggests, intriguingly, that funds may be happy to tolerate high FX transaction prices for retaining custodian services. Brad Hintz said in a report for Sanford Bernstein that funds may "knowingly and willingly overpay for foreign exchange trades as a quid pro quo for obtaining more competitive rates on core asset services likes safekeeping and custody."

Hintz added that as administrative fees are the ones that earn US funds criticism it suits their trustees to channel more of their overall custodian charges to opaque FX transacting costs and thus spare the wrath of any activist members poring over an annual report for high management costs.

Despite the practical reasons to execute trades through custodians, it may not be the prudent approach given that custodians have proven to provide inferior execution, argue Russell. The investment house claims that there have been an increasing number of funds hiring third parties like itself to oversee the trading and settlement of currency transactions as agents. 

"Investors do have options other than allowing their custodian to execute their FX trades. Employing a trusted agency provider to manage the FX execution process in a transparent and aligned manner serves the dual purpose of improving execution outcomes and governance. In recent months we have seen a significant increase in interest from both asset managers and pension funds globally looking to utilise Russell's agency approach." said Joe Hoffman, Head of FX at Russell Investments.

Kantor says, however, that using custodians to execute FX transactions can make sense in some situations. FXall offers an electronic trading platform which allows traders (large funds that handle their own transactions and asset managers) to chose which bank or trading method offers the most desired way to execute FX transactions, while retaining the overall services of their particular custodian. 

dbillingham@wilmington.co.uk

First published 20.04.11