During the past three years, the foreign-exchange franchise at the Bank of New York Mellon Corp. has been challenged by unhappy clients who want more transparent pricing and by the advent of electronic trading.

This one-two punch threatens to undermine the most lucrative trades at the custody bank, which is also feeling the pressure from what one executive described as the "State Street effect."

BNY Mellon is battling to preserve a foreign-exchange franchise that once generated 20 times more in sales margin on non-negotiated trades than ones routed through a competitive electronic platform, according to internal company email made public this week.

Also called standing-instruction trades, those trades are at the center of a number of lawsuits filed against No.1 custody bank BNY Mellon and No. 3 State Street Corp .

A July 2010 email distributed among BNY Mellon executives reveals it preserved its forex profit margin partly because it was less transparent than rivals.

"Another way to say this is that BNY Mellon is late to the transparency space," Bob Near, a BNY Mellon forex executive, wrote in the email.

William Galvin, the top securities regulator in Massachusetts, put a spotlight on BNY Mellon's internal handwringing when he made public a number of email exchanges among the bank's top forex executives.

The disclosures coincided with Galvin's accusation that BNY Mellon overcharged the state pension by $30.5 million on a decade's worth of forex trades.

BNY Mellon denied any wrongdoing. A representative said the bank provides all clients with a valuable service at competitive prices and any suggestion otherwise is simply wrong.

Nevertheless, the central challenge for BNY Mellon and other custody banks is how to preserve profit margins on a decreasing number of forex trades that U.S. public pension funds allow to be executed without any price negotiation.

Total forex accounted for $221 million, or 6 percent, of BNY Mellon's third-quarter revenue. Forex trading is typically tied to the work the banks do as financial custodians, which entails recordkeeping, securities lending, mutual-fund accounting, and asset valuations.

Shouldering Risk

But now, standing-instruction trades are being challenged in the courts and the marketplace. During the first nine months of 2009, BNY Mellon's sales margin on $149 billion in standing-instruction trade volume was 23.75 basis points, or 0.24 percent, internal email shows. In sharp contrast, $653 billion in trade volume on the company's electronic platform generated a sales margin of just 1.2 basis points, or 0.01 percent.

When standing-instruction trade volume drops, BNY Mellon's global forex sales team has to capture trillions of dollars more in volume to make up for revenue loss, Jorge Rodriguez, a senior executive, said in one of the internal emails made public.

Michael Trotsky, executive director of the $46 billion Massachusetts pension fund, said he is urging his investment managers to do more negotiated trades with BNY Mellon to lower expenses. The State Universities Retirement System of Illinois, which has about $15 billion in assets, asked custody banks if they are willing to provide time stamps on trades for better price transparency, according to an October request.

Meanwhile, BNY Mellon's senior executives say publicly there is nothing wrong with the bank's pricing or transparency on the standing-instruction trades that have sparked controversy. The bank said fund managers value the work custody banks do on standing-instruction trades because they shoulder risk and administrative hassle.

Sausage Factory

BNY Mellon and State Street steadfastly deny they overcharged on standing-instruction trades. These trades typically are less than $1 million and are all the more profitable when they involve restricted currencies. California brought a civil action against State Street in 2009, sparking subsequent lawsuits by other states.

Each morning, custody banks publish a guaranteed range of prices for standing-instruction trades. Clients can opt out and take their trade to a third-party broker and get what usually is a better price.

For example, Galvin's complaint says BNY Mellon's standing-instruction program contained hidden markups on trades. The bank disagrees, saying the program offers attractive prices on small trades that are assigned wholesale rates that are better than what clients could otherwise get through third-party forex providers.

Standing-instruction trades produce higher margins because there are more services involved, including assuring settlement so the client is not left exposed to an unfavorable currency swing.

"The reason [standing instruction] looks like a sausage factory in operation, and the reason for how we price it and trade it, is the significant difficulties surrounding processing," BNY Mellon executive David Almeida wrote in a February 2010 email.

BNY Mellon has discussed "revenue-neutral" pricing options while questioning whether fixed-rate pricing models are too vanilla to account for the number of intricacies associated with each currency market, according to internal email discussions.

In a July 2010 email, BNY Mellon executive David Green offered a solution to preserving forex revenue.

"You come up with a revenue-neutral model that is transparent and clear and you market the program as if you just figured out how to slice bread," Green wrote.

(Reporting by Tim McLaughlin in Boston; Editing by Matthew Lewis and Tim Dobbyn)

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