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

May 23, 2011

The Wall Street Journal and my fellow Reuters blogger Felix Salmon have both addressed the issue of the Bank of New York Mellon giving off-market or false prices on foreign-exchange trades to one of their clients, namely California pension fund Calpers.

Morally the actions of BONY, if true, are reprehensible. But are they illegal?  Felix describes the specific problem:

BNY Mellon’s clients put in FX orders, the bank executed those orders and reported back a price. Only it lied to its clients about the price it was getting, padding its own profits while so doing. This is doubly evil: not only did the bank lie, but it lied while serving as a fiduciary to its clients, with an affirmative duty to give them “best execution.”

Point one: OTC markets are barely regulated

Foreign-exchange trades are conducted “over the counter” (OTC). OTC is basically two parties coming together in some manner and the opposite of an “exchange market” where a multitude of buyers and sellers come together for regulated dealing. For example, exchanges require market-makers to provide certain levels of liquidity, trade reporting and standards of fair dealing.

OTC markets lack these requirements, and regulators have yet to address many of these issues. There are lots of opportunities for custodians or dealers to provide “off-market” or inflated trade prices to clients because trade reporting is not public. Can we blame dealers for driving the truck through a mile-wide hole in the rules?

Point two: Dealers have no “fiduciary” responsibility

BONY owed Calpers no responsibility as a fiduciary for these trades.  Wikipedia defines “fidiciary” as:

A fiduciary duty (from Latin fiduciarius, meaning “(holding) in trust”; from fides, meaning “faith”, and fiducia, meaning “trust”) is a legal or ethical relationship of confidence or trust regarding the management of money or property between two or more parties, most commonly a fiduciary and a principal.

The SEC oversees this area of the law. Law firm Morrison Foerster describes it like this:

Historically, broker-dealers have generally not been considered “fiduciaries,” even when dealing with retail customers.

The standards of conduct currently applicable to broker-dealers derive from many sources, including agency law, the “shingle” theory, antifraud provisions of the securities laws and the rules and regulations of the SEC and self-regulatory organizations such as FINRA.

Broker-dealers have a duty of fair dealing, duty of best execution, suitability requirements and various disclosure requirements. While such duties and requirements provide some degree of investor protection, they fall short of the “fiduciary” standards described by the SEC.

Away from equity markets “best execution” and “disclosure requirements” are not well-defined by regulators and therefore non-enforceable. It’s a complex and murky area for a number a reasons, and I’ll be exploring it in another post.

Point three: Basically pensions are not doing due diligence

The story that the Wall Street Journal and Felix covered relates to the Los Angeles County Employees Retirement Association (LACERA). The LACERA held $33 billion of assets at the end of 2010.

This story is a replay of  the actions of State Street Bank earlier this decade.  In 2009 it was revealed that State Street executed about $35 billion in foreign-exchange trades for Calpers and Calstrs, another big California pension fund, and overcharged them by $400 million between 2001 and 2008.

Eric Dash of the New York Times reported the following that October:

State Street tellingly referred to the state pension funds as “dumb” clients since they allowed the bank to handle foreign exchange transactions for them, according to a complaint filed by the whistleblowers. Smart clients, it said, traded directly with the bank and obtained better rates.

The lawsuit contends that State Street concealed fraudulent pricing practices by entering false exchange rates into electronic trading databases and reporting false prices in the account statements that it provided Calpers and Calstrs. The lawsuit also accuses State Street of deliberately failing to include time stamp data in its reports so that the pension funds could not verify the actual cost of the trade.

Calpers is the nation’s biggest public pension fund. It’s seems that the investment professionals there should be aggressively getting market quotes as a matter of due dilengce. There are many places that provide quotes for foreign-exchange trading. FXall is the leading “multibank” foreign-exchange platform where instituional investors can get competing bids for trades.

The chart at the top of the post shows data from the Bank for International Settlements and shows how smaller banks, non-financial institutions and retail investors have all jumped into the foreign-exchange market as direct trading participants.

These giant pension funds owe their pensioners at least some confirmation that the OTC trade prices they are getting are competitive. There is no room for these funds to be “dumb money” anymore. The successful retirement of their beneficiaries requires that they get smart fast.

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