* BNY Mellon, State Street losing forex market share
* New firms pinpoint trading costs, allege excesses
* Pension funds turning to new traders like Russell Investments
By Tim McLaughlin
BOSTON, May 2 Three years ago, John Galanek co-founded FX Transparency LLC to give big investors a more sophisticated view of their foreign exchange trades.
But Galanek, who previously managed forex trading for Harvard University's massive endowment, was surprised to find little initial interest from major pension funds and other potential customers. To help keep the consulting startup going, he had to max out a second mortgage, tap his savings and even "broke the glass" on his 401(k) account.
Prospects included the clients of the world's two largest custody banks -- BNY Mellon Corp and State Street Corp -- but most seemed satisfied with the prices they got on their trades even though there hadn't been independent audits. The highly lucrative corner of Wall Street generated $1.5 billion in revenue for the two banks in 2009.
But today, the once-fat forex profit margins at the two banks are under attack. Small forex analysis firms have disrupted the marketplace by providing a clearer picture of what the banks have been charging. As a result, many pension funds and other major investors are set to pay much lower fees for foreign exchange transactions than they have in the past.
BNY and State Street have countered by rolling out more transparent, but less lucrative services. Both banks also are spending more on their legal bills as they fight a host of federal and state lawsuits and investigations alleging they massively overcharged their pension fund clients on forex trading.
The civil fraud cases include claims by pension funds in several states, including Arkansas, California, Florida and Massachusetts. And New York state Attorney General Eric Schneiderman says BNY Mellon, for example, made nearly $2 billion on fraudulent trades, a charge the bank denies. The U.S. Justice Department also filed a lawsuit.
The banks deny any wrongdoing and say demand for their forex services remains robust. They declined to make executives available for comment.
Demand for expert analysis of foreign exchange trades is on the upswing for Galanek's firm and a dozen or more others, according to money management executives. Pension funds and other big institutions need to trade currencies in large amounts when they buy foreign securities or collect non-dollar dividends or interest payments. The upstart firms provide in depth trade analysis using not just forex market data but also proprietary databases to show what others pay.
And once clients get the data, they are either demanding much cheaper trading costs or shifting business away from the two big banks to smaller firms like Russell Investments, according to state pension fund managers. Russell is one of the first to offer to act as a fiduciary on forex trades, a legal promise to keep clients' interest foremost, instead of acting as a principal trading for its own book.
The forex money train appears to have slowed for BNY and State Street. T hough they do not disclose profitability, the combined forex revenue at the two banks in 2011 was off 4 percent from 2009 levels. And it dropped another 13 percent in the first quarter, "a worrisome trend," according to Sanford Bernstein Research analyst Brad Hintz.
BNY's global ranking among banks trading forex for institutional clients dropped to 35th from 31st last year and State Street fell to 15th from 7th, according Euromoney Magazine's most recent annual survey released in May, 2011.
Both banks declined to comment on profitability trends.
State Street supports clients using outside analysts, according to spokeswoman Carolyn Cichon. The bank has "enhanced our FX reporting services to include additional reporting and disclosures about costs of FX trading," Cichon said in an emailed statement.
BNY Mellon, the world's largest custody bank, said it is offering new forex services to meet customers' needs. BNY is speaking with clients so they "understand the terms and benefits of our foreign exchange services and the new options we are making available," spokesman Kevin Heine said via email.
Galanek and his co-founder, James McGeehan, a veteran Wall Street forex trader, are expanding rapidly and pitching their services to corporate treasurers as well as big investors. In December, they opened an office in London, saying European investors were just as exposed to the kinds of over-priced forex trades targeted in U.S. lawsuits.
Galanek and McGeehan got their start in forex trading in the 1990s as interns for BankBoston, where they learned how banks had the incentive -- and the ability -- to give clients uncompetitive rates. Now, they show those same kinds of bank clients just how much they can save, even providing them with a peer percentile ranking after analyzing billions of dollars of trades.
Last year, their firm snagged a high-profile assignment from the $50 billion Massachusetts public employee pension fund to analyze its trading history with BNY Mellon. FX Transparency's audit found $30.5 million of overcharges since 2000, bolstering the administrative complaint of William Galvin, Massachusetts' top securities regulator, against BNY Mellon last year.
BNY denies overcharging the fund.
"We provide all clients with a valuable service at competitive prices and any suggestion otherwise is simply wrong," BNY said in a statement.
The bank is fighting several other similar allegations in civil lawsuits brought on behalf of pension funds in California, New York and Virginia, for example.
The nascent FX analysis industry is emerging in a similar pattern to the firms that began drilling down on equity trading costs in the 1980s, said James Noser, president of Abel Noser Solutions, whi ch offers a f orex analysis pro duct th at he launched this month as he diversifies after more than 25 years of experience examining equity and bond trades.
Stock trading costs have plummeted since commissions were deregulated.
"The profits of custody banks are going to shrink from this business as investment managers begin analyzing these costs systematically," Noser said.
It had been long suspected that custody banks were capitalizing on a forex franchise that provided little transparency to clients. The banks disagree. They say they provide valuable services, such as taking risk on small trades or ones involving hard-to-trade currencies.
But Carol Osler, a professor and forex expert at Brandeis University, studied a mid-size global custody bank and found that forex clients paid wider price spreads on trades in which they were least informed.
"Our evidence suggests that custodians set wider markups when the ambiguity or 'fog' surrounding their prices is highest," Osler said in a June 2011 research paper.
That fog may now be lifting. In October 2009, the California Attorney General's office roiled the banks when it accused State Street of massive forex fraud against the state's pension fund giants CalPERS and CalSTRS.
"All of a sudden there's a giant spotlight cast on forex trading, and that alone is going to change behavior," said John Halligan, president of Global Trading Analytics LLC, a forex analysis pioneer that opened in 2005 in Rutherford, New Jersey.
The firm reviews more than $3 trillion in trades a year. It recently won an assignment from the $20 billion-plus Iowa Public Employees' Retirement System to analyze the fund's forex trades.
OPENING FOR RUSSELL
Once the analysis suggests excessive costs, trading competition heats up. One firm that has been winning a growing share of trades is Russell Investments in Seattle, Washington. Known as a money manager and index provider, Russell's forex volume grew over ten-fold to $391 billion in the last eight years.
"The California lawsuit was a watershed moment. Before then, I couldn't find a transaction cost analysis firm for FX," said Michael DuCharme, head of foreign exchange for Russell. "Now I can tell you a dozen, if not 15."
Price concerns and subsequent analysis laid the ground work for Russell to poach from BNY Mellon the lucrative business of two large state pension funds that the bank had handled for years.
In December, Massachusetts Treasurer Steve Grossman said the pension fund dropped BNY as the manager of some of its forex trades. The pension fund estimates it will save $1.1 million initially on private-equity distressed debt forex trades with Russell.
And more recently, the Iowa Public Employees' Retirement System said it picked Russell to save money and dropped BNY Mellon for private equity-related forex trades. Last year, a $6 billion pension fund for Qantas Airways Limited employees hired Russell to save members more than $1 million a year.
During the search process in Iowa, BNY Mellon told the pension fund about its new and improved forex product, which at first appeared similar to Russell's offering. But further analysis showed it would end up charging almost three times the level of commissions, Iowa officials said. BNY Mellon declined to comment on the Iowa pension fund's remarks about its pricing.
Another key difference: Russell agreed to act as the pension fund's fiduciary, requiring that it keep the fund's interests front and center. In fact, no other firm offered to act as a fiduciary for Iowa, the fund's staff said.
Custody banks like BNY, by contrast, typically act as a principal, meaning they make forex trades to create profits for their own portfolios. They are accused by pension funds of hiding markups on trades, a c harge the banks deny.
The rise of the small fries has clearly rankled BNY Mellon Chairman and Chief Executive Gerald Hassell.
After BNY Mellon reported its third-quarter earnings in late October, Hassell told Reuters that his new upstart adversaries in transaction analysis were "dense" and didn't understand the nature of the custody bank's forex business. The bank has said some of the analysis is flawed because it compares large negotiated trades, which typically have lower profit margins, to small transactions involving hard-to-trade currencies.
Hassell quickly apologized for using the word dense.
"I get a little worked up," he explained.