What do you do when the lights go out?

state street

Professional Pensions run the story of the £22.9m fine dished out to State Street who had been double charging clients for years. I had thought of custodians till recently as their name suggests as guardians of assets, not as asset strippers.

The six clients affected by the overcharging included Ireland’s National Treasury Management Agency, the Kuwait Investment Authority and the Royal Mail and Sainsbury pension funds.

The fine is one of the largest imposed by the watchdog in recent years, and the latest where financial firms have been found to put profit before the interest of their customers.

Between June 2010 and September 2011, State Street UK , a unit of the world’s second-largest standalone custody bank State  Street, overcharged six clients a total of $20.2 million, the Financial Conduct Authority (FCA) said.

Excellent as the Professional pension story is, I prefer the comments sent me by Gina Miller that appear here but for those who want to read the article here it is!

I confess I’d never really heard of “transition management” until a couple of weeks ago. Apparently, it is a service provided by some banks and dealers to big investors who need to sell, or buy, or sell and then buy, a bunch of securities all at once. This would happen if, for instance, the investors “were changing fund managers or investment strategies,” because I guess you can’t just have your old fund manager messenger over all your stuff to the new fund manager? (The strategies bit I get.)

I heard about it a few weeks ago because ConvergEx got in some trouble with the Securities and Exchange Commission for mismanaging transitions. Just from the structure of the business you can understand how this would happen. If you’re selling like $5 billion worth of stuff, and then buying it all back again, for whatever reason you do that for, you will simultaneously:

  • care a whole lot about how much      you’re paying in commissions, because two cents a share might work for      your everyday trades but not for trading all of your stuff at once; and
  • not really have the desire or      ability to keep track of exactly what’s happening what with all the buying      and the selling, because there are just so many trades.

And so you get ConvergEx’s SEC settlement, where ConvergEx charged clients small, highly competitive, fully disclosed commissions to execute their transitions, and then snuck in secret markups whenever the clients weren’t looking. Literally — ConvergEx would pay attention to time differences and charge markups on trades that happened when the clients were asleep.

Today the UK Financial Conduct Authority settled a pretty similar case with some UK bits of State Street Corp., which the FCA found overcharged six clients by a total of just over $20 million. The Final Notice is full of funny quotes; let’s read some!

First there is Client A, who had a 4.7 billion euro portfolio to transition. It hired State Street’s Portfolio Solutions Group (“PSG,” or “EMEA PSG” since it covered Europe, the Middle East and Africa) to do it, for a flat management fee of 1.65 basis points, later reduced to 1.25 basis points for a portion of the trade. How did State Street decide on that price?

In deciding what bid to make to Client A, a series of emails were sent between members of PSG senior management which included the following comments on how revenue would be earned from the transition: “Gotta win this one! Any ideas how to get more revenue would be appreciated.” “How about a 1bp management fee or something of that nature, no commissions and then take a spread? We need to charge fee then otherwise they get suspicious.” “Just to clarify – 1.25bps is the management fee. The extra quarter point makes it look like we actually thought about it and did the calculations.”

My favourite word there is “the”: “we actually thought about it and did the calculations,” as though there were some math that could produce the right answer for how much State Street should make on these trades. There are no calculations! It’s just, what feels right to the client, what can you get away with, etc. State Street quite charmingly thought that a number with three significant digits would seem more real than a number with one, and that that would help it get away with more. Surely no one who takes the time to write three whole digits and a decimal point would rip you off. Only harmless nerds would write three digits where one would suffice.

But, nope, State Street, like ConvergEx before it, charged various secret undisclosed markups. State Street was supposed to make $1.6 million from Client A in agreed fees, but made an additional $3.7 million from undisclosed markups. Clients B, C, D and F are similar: State Street agreed to various small fees and then also took a bunch of larger undisclosed markups.

But my favourite is Client E, who did two fixed income transitions with a total value of about $6 billion. This client was focused on paying zero:

Following communications between EMEA PSG senior management and Client E prior to the first transition, in which Client E requested that no explicit commission be charged, EMEA PSG senior management proposed to undertake the transition on a zero commission (and no management fee) basis. In a series of communications between EMEA PSG senior management and Client E, EMEA PSG senior management made clear that State Street UK preferred to charge a disclosed commission, but in this instance it had arranged to receive: “a share of the spread from the ‘other side’ (the successful/winning counterparty for each individual security as chosen by us as your agent in a competitive bid process)”

So the FCA quibbles with State Street’s use of the “other side” — obviously, Client E was paying more to buy a security than its seller was selling it for, and that was going to State Street — but there are more interesting things going on here. For starters, note that Client E wanted to pay zero. Client E was not an idiot, or not exactly: It knew that it was going to pay State Street for its time and transition-management mojo. It just didn’t want to pay any explicit commission, for whatever reason, and that reason probably wasn’t a good one.

And State Street knew that, and said, no, please, we want to charge you an explicit commission. I like to imagine that this was because it knew that it couldn’t resist temptation. And there’s no temptation like zero commissions. Here’s how State Street management reacted to learning it was getting a zero-commission mandate:

On being awarded the second fixed income transition for Client E, members of EMEA PSG management exchanged emails commenting: “Nice!” and “Back up the truck!”

Right? State Street made $9.7 million on this one, almost half of all the overcharging that the FCA identified. There’s nothing more profitable than a zero-commission trade. If you’ve agreed to a 1.65 basis point commission, I guess you can go ahead and charge secret markups, but you’ll know that you’re being a jerk by doing it. But if you’ve agreed to do a trade for nothing? The client knows that you’re sneaking something in somewhere. They’re practically asking you to back up the truck. State Street was happy to oblige.

Similarly, the FCA says “TM services may be required when a client needs a large portfolio of securities to be restructured, or when a client decides to remove or replace asset managers.” Even odder is Wikipedia: “A typical example would be a mutual fund has decided to merge two funds into one larger fund.”

And they plotted it as obnoxiously as possible:

members of PSG senior management continued to discuss possible other sources of revenue over email: A: “need to be very creative here” B: “we will.”

Uggghhh uggghhh ugggggghhhhhh. Nothing good has ever happened after a banker says “need to be very creative here.” If I were designing the e-mail and instant-message blocker software at a bank, I’d block “creative.” “Creative” is a terrible word.

 Your guess is as good as mine as to how 1.25-1.65 basis points of 4.7 billion euros came out to $1.6 million. (This is sometime in 2010-2011, when a euro was between say $1.20 and $1.50.)

Someone, somewhere, was getting a report from Client E saying “here’s how much we paid in commissions,” and Client E wanted that report to say “nothing, aren’t we great.” And was willing to pay more in trading-costs-not-labeled-commissions to achieve that goal.

If you’re still with me and haven’t either slit your wrists (because you’re a fiduciary and you know this has happened to you or you’re not and know it’s you whose been financially raped) read on.

We are not powerless to stop this kind of thing from happening. There are organisations in this world who know as much as the banks do, who can investigate this kind of thing, stop it happening and get your money back when it does. I would be less than transparent if I didn’t admit to having some skin in the game working with a Swiss firm, full of ex-bankers, who do nothing but this kind of work.

The biggest problem they find is that no-one wants to be seen to be a mug. So no-one is going to open the door to someone who is going to laugh in your face.

This is why we have governance. Governance doesn’t just mean trustees, sometimes it’s the trustees who made the mistakes and are least able to admit it. Sometimes the governance has to come from those who pay the bills (in the UK- the sponsors of DB pension plans).

And the reason that this matters is that the money that was stolen by State Street, came ultimately from our pockets. The bill for the trades was not explicit, it resulted in poorer fund performance which would have increased the deficit of the pension schemes of Companies A to F. This would have increased the funding obligations on the sponsors and left them with less money to pay you your wages (or if they became insolvent) your pensions.

Which is why governance matters, why charges matters and it’s ultimately why we need total transparency in what happens within the funds we use.

We may not know what goes on when the lights go out- but it’s seldom very savoury.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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2 Responses to What do you do when the lights go out?

  1. Pingback: Too big to worry about – what’s should we do about State Street? | The Vision of the Pension Plowman

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