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Wait, Sorry, Bank Of New York Thought You Wanted To Buy High And Sell Low, Was That Wrong?

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The last few weeks have provided some good examples of the trend toward unbundling products and making hidden fees explicit - with mostly pretty angry results from customers and shareholders. Meanwhile, in another part of town, Bank of New York Mellon has been operating what seems like a pretty shady hidden fee setup, and that's pissing people off too.

We’ve only really heard the prosecutors’ side, and BoNY is pretty adamant that those prosecutors are full of shit, but here's the US Attorney's explanation anyway:

BNYM offers foreign exchange services to its custodial clients, for whom it holds domestic and international financial assets, including currency and securities. In particular, BNYM offers a "standing instruction" foreign exchange service pursuant to which BNYM automatically provides currency exchange on an as needed basis when, for example, the client buys or sells foreign securities or receives dividends on foreign securities that are repatriated to the United States.

The Complaint alleges that BNYM has provided its clients with false, incomplete and/or misleading information about how it determines what currency exchange rates or prices will be used for standing instruction foreign exchange transactions. For example, according to the Complaint, BNYM has represented to standing instruction clients that the service is free of charge and that transactions are executed according to "best execution standards." Offering "best execution standards" is commonly understood to mean that the client receives the best available market price at the time that the currency trade is executed. The Complaint alleges that, BNYM’s standing instruction service is actually far from free and, instead of providing clients with favorable rates within a specified daily range, BNYM waits until the end of the trading day to price standing instruction currency trades and consistently gives standing instruction clients virtually the worst rates of the day. According to the Complaint, BNYM obtains more favorable prices for itself on the spot market, reaping large profits on the price differential or "spread.”

As someone who worked in a field with opaque options-based pricing in which “free” was a thing you might plausibly tell people was the cost of their product, I've gotta say: this is kind of neat! BNYM was basically long a floating-strike, intra-day option on their FX transaction: they could fill their customer at the worst rate of the day, and try to trade for themselves at the best rate of the day. Since they were long an option, you'd expect them to do best during times of high volatility, and so they did:

The size of the spread BNYM derives from its clients depends in large part upon volatility in currency prices –- the greater the volatility, the greater the opportunity for a large spread. During the financial crisis in 2008, when currency prices fluctuated dramatically, the profits BNYM generated at the expense of its custodial clients were enormous, the Complaint alleges.

So how could this continue for 10 years, and what was BoNY thinking? The simplest answer would be that they were just gouging and achieving outsize profits by deception. That's what prosecutors think - pointing out that this program represented 20% of BoNY's FX transactions but 65-75% of its FX revenue - and they're not happy about it. As someone said about BofA's debit card fee, "you don’t have some inherent right just to, you know, get a certain amount of profit." You have an inherent right just to, you know, get a different amount of profit. Lower, specifically.

Or maybe it was a cross-subsidy among customers. There's some evidence for that. As with overdraft fees for consumer banking, not only were some customers subsidizing others, but unsophisticated customers were subsidizing sophisticated ones:

Favored clients received a price based on a fixed markup from a third party reference price (usually the 4 p.m. WM/Reuters London rate) which, in virtually all instances, was a far more favorable price to the client than the price given to clients whose trades were priced in the standard manner.

"Favored" here, according to the complaint, means "noticed that they were getting gouged."

The most charitable way to conceive of this situation for BoNY is that maybe customers legitimately sold volatility to BoNY. That is, BoNY went to them and said "rather than pay us $1 a trade, you can just buy from us at a rate picked arbitrarily by us from some rate that day, pay no fees, and we'll make money on the vol."

That would be a legitimate thing, and it's actually a thing that can happen and makes sense. One useful function of big banks is that they're much better monetizers of volatility than most of their customers. A small pension fund manager doesn't have the capacity to pick the best time of day to make a currency trade; if you force him to choose, he'll choose arbitrarily and have no particularly high chance of getting it right. He can offload that function to BoNY, but there's a price. A simplistic model would be: "BoNY will (a) give you a benchmark price (e.g. 4pm London) and charge you [x] basis points; or (b) do its best and guarantee you the best price of the day, and charge you [2x] basis points; or (c) do its worst and guarantee you the worst price of the day, and pay you [x] basis points."

Presented with that choice it's not at all clear that you should choose (a). You can pay for optionality, or get paid for it. If you think FX volatility will be low, you should choose (c) and get paid for agreeing to be hosed sometimes. If you think it will be high, you should choose (b) and pay extra to avoid intraday risk. Maybe you have no idea - probably you have no idea! - but it's a choice that you could legitimately make. And it's a choice that you could have optics or agency-cost reasons for making: as a pension manager you maybe won't get penalized for getting a slightly worse intraday FX price, but you might get credit for reducing things called "commissions" or "fees."

Now clearly prosecutors don't believe that clients got a fair chance to make an informed choice here. And frankly it's kind of hard to believe after reading the complaint, which claims that BoNY told clients that they'd get "best execution" and the "market price at the time of execution" and then gave them the worst price of the day. Also they didn't get paid anything for being in the Worst Price Of The Day Club, though that could just be a case of it subsidizing other custody businesses so that clients paid less for something else.

Still, isn't it pretty to think so? If this lawsuit leads to better disclosure, well, that seems like a good result. If the message is "you can't tell clients you'll give them the best price of the day and then give them the worst," it's hard to object to. But I worry a little that the message will be one of forced unbundling and fee disclosure: "you can't give FX customers the worst price of the day and make up for it elsewhere; you have to give them a benchmark price and an explicit fee." Judging by the reaction to Netflix's and BofA's new explicit fees, it's not clear that that's what customers want. And for these sorts of standing FX transactions, it's not clear that it's what's good for them either.

U.S. and New York Sue BNY Mellon [WSJ]

Press Release [SDNY USAO]

Press Release, complaint [NY AG]