Bank of New York Mellon provides custody services to a lot of big investor clients, pensions, endowments, etc. When those custody clients have foreign exchange needs — to buy or sell foreign securities, for instance – they come to BoNY Mellon. This creates a nice opportunity for efficiency: BoNY Mellon has a lot of clients who want to exchange dollars for foreign currency, and a lot of clients who want to exchange foreign currency for dollars, so it can pair them off against each other, operating its own little internal foreign-exchange trading venue.
Or it could do this:
Throughout a trading day or session (which could be as long as 24 hours), as each custodial client’s account generated FX transactions to be executed pursuant to SIs, the Bank’s practice was to aggregate those FX transactions for all SI clients and group them by currency pair. Near the end of the trading day or session, the Bank priced those SI FX trade requests it had received throughout that day or session.
So that seems a little inefficient — why wait until the end of the day to price the trades? — but it’s basically fine. Sometimes the currency goes up, sometimes it goes down, in expectation clients shouldn’t lose much by waiting. Everyone trades at the end-of-day fix, and in the long run it evens out. Right?
To determine the price for each SI FX transaction for most currencies, the Bank examined the range of reported interbank rates from the trading day or session and assigned the rate on SI trades as follows: if the client was purchasing foreign currency, the client received a price at or close to the highest reported interbank rate for that day or session (at or near the least favorable interbank price for the client reported during the trading day or session), and if the client was selling foreign currency, the client received a price at or close to the lowest reported interbank rate of the day or session (also at or near the least favorable interbank price for the client reported during the trading day or session).
Because SI clients received pricing at or near the high end of the reported interbank range for their currency purchases and at or near the low end of the reported interbank range for their sales, the Bank was generally buying low from, and selling high to, its own clients. The Bank recorded the difference or “spread” between the rates it gave clients and the interbank market price at the time the SI transactions were priced as “sales margin.”
That’s probably the best use of scare quotes around the words “sales margin” you’re ever likely to see. This is so bad! Come on! BoNY Mellon netted off its clients against each other, giving the buyers the highest price of the day and the sellers the lowest price of the day, and then pocketed the difference. And then, to add euphemism to injury, called it “sales margin.” Now. There are hypothetical defenses of this practice. (I sort of offered one, once, when the case against BoNY Mellon was first announced.) The main hypothetical defense goes like this: The client doesn’t have a view on intraday FX rates. In particular, the equity manager or pension treasurer or whoever is actually setting up the “standing instructions” with BoNY Mellon has no view on intraday FX rates. For all he knows, the price when he puts in the order will be the worst price of the day. What he wants is not really to get an efficient instantaneous price. What he wants is to not pay for the service: He is measured, not on getting the best rate, but on his measurable commissions and fees, and if he reports back fees of zero then he wins. He wants “free” foreign exchange trading, and knowingly sacrifices efficiency for a price of zero.