Fund Foreign Exchange Transactions Mutual Fund Directors Forum. Ben Haskin Willkie Farr & Gallagher LLP November 16, 2011

Transcription

1 Fund Foreign Exchange Transactions Mutual Fund Directors Forum Ben Haskin Willkie Farr & Gallagher LLP November 16, 2011

2 Foreign Exchange Transactions Used primarily for transactions in international securities. Increasingly relevant as the volume of international transactions increases and funds invest in more emerging and frontier market countries. 1

3 Reasons for Foreign Exchange Transactions Settlement of trades Repatriating dividends and distributions Investment purposes Payment of fund dividends and distributions 2

4 Foreign Exchange Transactions For asset managers, there are several options for exchanging currency: Run foreign exchange trades through internal trading desks, which may use technology platforms (such as those offered by Reuters, Bloomberg, FXall, etc.) to find the best rate among a variety of banks. Hire a consultant or agent to help negotiate better rates from banks. Opt for a standing instruction where a custody bank oversees currency transactions with no negotiation with the fund regarding each rate at which the conversion takes place. Conduct a foreign exchange through a custodian s bank services, but negotiate the price of individual transactions. 3

5 Custody Banks and Foreign Exchange Foreign exchange trading is different from other services provided by custodians because the counterparties (such as the custodian bank) act as principal to the transaction and the bank performs the transaction for its own profit. Since the cost of foreign exchange trading with a custodian is found in the spreads and not the commissions, the spreads had been seen as implicit trading costs rather than expenses attributed to the funds, such as custody fees. There is no regulatory obligation to disclose a time stamp of a specific foreign exchange transaction, making it difficult for clients to confirm whether they received the prevailing exchange rate at the time the exchange was requested. 4

6 Components of Cost Two basic components of cost to a fund: The Rate of Exchange The Spread 5

7 The Rate of Exchange Benchmark rate established by contract (London rate as reported by Reuters, for example). Often a particular time of day may be used. How much discretion does the counterparty have to select a rate? 6

8 The Rate of Exchange (cont.) Lawsuits have been filed by pension funds alleging that State Street and BNY Mellon have improperly priced foreign exchange transactions. State attorneys general have also filed lawsuits against State Street in California and against BNY Mellon in Virginia, Florida and New York. It is alleged that internal communications at the custodians indicated that profit margins would fall if the custodian s foreign exchange transactions were more transparent to its customers. The Justice Department later filed suit against BNY Mellon, and the SEC is investigating both BNY Mellon and State Street (to be discussed later). 7

9 The Rate of Exchange (cont.) According to complaints filed against the banks, the banks were required to secure the best possible conversion rates on the funds behalf but the banks breached this fiduciary obligation. Instead of giving the fund a price based on the time of day the trade was actually executed, the banks allegedly assigned the transaction an exchange rate near the worst rate of the day so as to profit from the difference. While these differences may have been small for each transaction, the volume of currency transactions processed by the banks produced a large profit in the aggregate. 8

10 The Spread Foreign currency trading is a principal market. There are spreads between the bid and the asked price, rather than commissions. These spreads can vary substantially, depending on the risk that the counterparty is taking and the liquidity of the market for the particular currency. 9

11 Netting or Matching Trades Also at issue is a common industry practice called netting or matching trades, which is when a bank saves a client transaction costs by taking two transactions by the same client involving the same currencies (such as an exchange of dollars for yen and an exchange of yen for dollars) and offsets the two transactions. In a civil suit, Florida s attorney general alleged that BNY Mellon did not net trades for a pension fund and that the bank instead improperly charged the pension fund for two trades, not one as had been promised. (Carrick Mollenkamp, BNY Mellon Forex Trades Cost Pensions, The Wall Street Journal, Sept. 14, 2011). Netting presents special issues for investment companies under the 1940 Act. 10

12 Foreign Exchange Cross-Trades In Fidelity Management & Research Co. ( FMR ), SEC No-Action Letter (June 13, 1988), the SEC staff declined to take action under Section 17(a) of the Investment Company Act of 1940 ( 1940 Act ) related to netting currency transactions across affiliated funds. The SEC relied on the representation by FMR that: The proposed program was consistent with Rule 17a-7(b)(4) under the 1940 Act for establishing current market price because this price would be obtained by averaging the three most recent dealer bid/asked spreads for a given foreign currency from a recognized and independent currency quote service; The transactions would not involve overreaching on the part of any person concerned; and The Board of Directors of each of the registered funds involved had approved of the inter-fund currency trading program. 11

13 SEC Investigation The SEC is investigating State Street and BNY Mellon s foreign exchange transaction practices. The probe focuses on whether these banks accurately explained to pension funds the pricing and handling of foreign exchange transactions. (Joe Morris, SEC s Forex Probe Widens: Report, Ignites, May 24, 2011). The SEC typically does not have jurisdiction over the foreign exchange market, and the private agreements between custody banks and their clients may have provided the custodians with the necessary discretion over how they could charge clients for a specific currency transaction. Section 3(a)(10) of the Securities Act of 1933 exempts currency from its definition of a security. 12

14 Broker-Dealer Obligations Broker-dealers typically owe their customers: a duty of fair dealing that includes the duties to promptly execute orders, disclose certain material information and conflicts of interest, and charge prices reasonably related to the prevailing market. a duty of best execution that requires obtaining the most favorable terms available under the circumstances. Bank custodians, however, may not be acting as brokers or dealers as defined by the Securities Exchange Act of

15 Implications for the Custody Banks In one settlement, the Washington State Investment Board received $11.7 million from State Street the full amount demanded and did not have to pay attorney s fees. (Joe Morris, Forex Settlement Sets High Bar for Banks, Ignites, Feb. 22, 2011). Custodians are providing more information on how they execute foreign exchange transactions and BNY Mellon recently began offering an option to price currency transactions over a benchmark currency rate at the time of the trade. (Jean Eaglesham & Liz Moyer, BNY Mellon Strikes Balance on Currency Lawsuit Talks, The Wall Street Journal, Nov. 15, 2011). A report issued by FX Transparency shows that: trading costs for standing instruction trades fell 63% in 2010, to 11 basis points, which is down from an average of 30 basis points between 2000 and 2009; and foreign exchange costs for standing instruction trades are three to four times higher than a negotiated trade. (Jackie Noblett, Under Fire, Custodians Open Forex Black Box, Ignites, Mar. 2, 2011). 14

16 Best Execution The SEC staff has stated: Both advisers and broker-dealers have an obligation to obtain the best execution of securities transactions when they arrange for or execute trades on behalf of clients and customers. (Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, The Office of Compliance, Inspections and Examinations, U.S. Securities & Exchange Commission, Sept. 22, 1998). Advisers are not obligated to obtain the lowest possible commission cost, but rather should seek to obtain the most favorable terms for a customer transaction reasonably available under the circumstances. While these are general standards, there is imperfect clarity when applying those standards to foreign exchange transactions, as the banks may not be acting as broker-dealers and the foreign exchange itself is not a security. Nevertheless, the best execution standard is a reasonable analogy. 15

17 Implications for Funds The recent lawsuits have increased awareness of the costs of exchanging currency through a custodian. In some cases, fund boards are examining such costs, while in other cases asset managers are examining the costs and reporting to the board. 16

18 Role of a Fund s Board In exercising their general oversight responsibilities over fund operations, directors may wish to request information about the placement of foreign currency transactions. By analogy, the SEC has previously indicated that boards have the duty to request and evaluate all necessary information for considering terms of soft dollar arrangements. Generally, a fund board would not need to review individual transactions, but would exercise its oversight responsibilities over the adviser and custodian. 17

19 Reviewing Past Transactions Some fund complexes and/or boards have reviewed past transactions with custodial banks. In individual cases, consultants have been hired to review foreign exchange trading history. Reviews have included comparing trading date to contractual language with the counterparty custodian. 18

20 Other Foreign Exchange Alternatives Advisory personnel negotiate all exchange trades directly with the custodian or with other counterparties. Instead of exchanging small amounts of currency, wait until the fund accumulates enough to execute a trade at lower costs or a more favorable rate. Use a consultant to help negotiate better rates from custodians and require more transparency from custodians. Use a foreign exchange brokerage service to act as a broker on behalf of the asset manager. There may be times when using a standing instruction with a custodian is advantageous, such as when exchanges involve small amounts of money, an emerging market restricts access to currency, there is limited liquidity in a particular currency or there is risk a trade will not settle. Questions of cost involved in developing infrastructure or hiring outside parties. 19

21 Other Potential Issues Benchmark rate time Reporting Recordkeeping 20