William Atwood, head of the $11.2 billion Illinois investment board, has taken a crash course in discovering his portfolio’s currency-trading costs — and he doesn’t like what he sees.

A consultant said his fund paid $2 million more than the average of other institutional investors on currency transactions during most of last year. When Atwood tried to figure out the costs on his own, he received a two-foot-high stack of trading documents he didn’t know how to interpret.

“If you don’t pay attention, you do so at your own peril,” says Atwood, a 49-year-old former money manager.

Now, Atwood is attempting something few public fund managers have tried: building a paper and financial trail to monitor whether advisers are charging his Illinois fund correct currency costs.

He has drastically pared currency trading through State Street Corp., which executed the majority of the board’s currency transactions, and he now requires investment managers to provide time stamps recording when all the trades were made. He also receives quarterly updates on currency costs.

State Street said in a statement it doesn’t comment on clients, adding: “Overall our indirect foreign-exchange services continue to be widely used by the investment managers we serve” because of the firm’s “ability to efficiently meet their foreign-exchange execution needs.”

Atwood’s efforts come amid heightened scrutiny by regulators and investors into the $4 trillion-a-day foreign-exchange market, as custody banks face allegations they have overcharged state pension funds to trade currency, charges the banks deny. His deep dive offers a peek into struggles public pension fund managers could face as they scrutinize financial firms that trade currencies to carry out their securities transactions.

All this is important for custody banks, which historically have acted as custodian for investment firms’ securities while handling mundane back-office administrative work. The banks also execute currency transactions for institutional investors.

In a March report, Nomura Securities said custody banks may “need to make serious price concessions and revamp the process in which they execute FX trades for their clients.”

U.S. public pension funds have poured into foreign securities, nearly doubling overseas holdings in the past 20 years. Pension managers only now are grappling with currency costs as they also deal with under-funded pension plans.

Three pension plans that Atwood oversees on behalf of 125,000 Illinois workers and retirees are funded between 26.3 percent and 37.4 percent, for instance—far shy of the 80 percent level that actuaries recommend.

Inside Atwood’s office, his team scrambled to get records similar to stock transactions that show a date and time a currency is traded.

Atwood asked Illinois’ five investment managers for a month’s worth of records detailing the currency traded. That’s when he got the two-foot high stack of records. He didn’t know what to do with it.

For advice, Atwood turned to a friend, a former currency trader, who told him foreign-exchange markets are far less regulated than stocks or bonds. He grew more concerned.

Atwood worked with a consultant to put the data in a digestible format. That is when he spotted the first of what he considers red flags: The fund’s investment managers had executed more than 70 percent of the currency trades through State Street, Illinois’ custody bank.

Atwood was skeptical that one bank could provide the best “execution”-or trades at the best available prices-70 percent of the time. His fund’s investment managers didn’t have good answers, he says.

He instructed the fund’s investment managers to provide “time stamps” on currency trades, indicating the specific time and price a transaction took place.

The fund also instructed its investment managers to trade through State Street only if the bank could bring the most competitive price. Illinois’ investment managers have shifted trading to 20 different banks and now execute nearly 13 percent of trades through State Street, Atwood says.

Illinois hasn’t alleged wrongdoing or pursued a legal claim. And while it hasn’t fired its investment managers, it has put those managers who are driving expenses on notice: If costs don’t go down over the next several quarters, their contract could be terminated.

Illinois in January hired Global Trading Analytics LLC, a Rutherford, N.J-based, transaction-cost analysis consulting firm, to mine its foreign exchange data. In February, Global Trading told Atwood the fund had paid on average 16.5 “basis points,” or hundredths of a percentage point, more than the average of other institutional investors for currency trades in 2010, or about $2 million.

That amount ate into the $266 million in gains Atwood’s fund earned in trading international stocks last year, he says.

The analysis showed that money manager Vontobel Asset Management, primarily exchanging British pounds and U.S. dollars for Illinois, was 0.25 percent above the consultant’s market benchmark over the last three quarters in 2010, according to information obtained from a public-records request.

Among its five managers, Vontobel traded the most on behalf of the Illinois fund — $822 million over 284 trades, documents show.

A spokesman for Vontobel, a New York unit of Zurich-based Vontobel Holding AG, called the analysis “flawed and misleading” because the firm says the consultant doesn’t accurately account for currency hedging, a strategy Vontobel uses. Hedging involves taking opposite trading positions to offset adverse market moves.

“Any conclusion — that such hedges have hurt performance over the time we’ve managed funds for Illinois State Board of Investments is simply false,” Vontobel said in a statement.

Global Trading President John Halligan said in a statement that the firm “has been accurately measuring all facets of foreign exchange trading costs, including trading for currency hedging, since 2005.”

For his part, Atwood now requests currency costs every quarter. “We expect to see improvement,” he says.