First, I’ll note that nothing has been proven in court and right now it’s a matter of “he said, she said” in the Commodity Futures Trading Commission’s (CFTC) civil suit against RBC which hit the headlines as “hundreds of millions of dollars in sham futures trading”. This post is simply to explain the basis of claim by the CFTC against RBC since no one has really done that in detail.
Also, I wanted to see how many times I could use the word “alleged”.
What’s the charge?
The CFTC (a US regulator of futures and options markets) is alleging that RBC conducted a series of wash trades on futures markets in the US between 2007 and 2010 to the tune of hundreds of millions of dollars in order to capture tax benefits associated with holding dividend paying companies while not being materially exposed to price changes in those companies. A wash trade in this context means you are trading against yourself by buying a security in one account and at the same time selling it in another. What money is lost by one account is offset by the money gained in the other account. Further, it is alleged that the overall strategy was conducted using Single Stock Futures (SSFs) and Narrow Based Index Futures (NBIs) with two foreign subsidiary companies in a manner that was non-arm’s length in nature.
What is an NBI?: A Narrow Based Index future is a cash-settled future on a custom index. Upon expiration, one party of the transaction must pay to the other party a cash payment depending on whether or not the underlying index outperformed or underperformed the contract price. These contracts can be rolled over to future settlement dates if the parties so decide.
What is an SSF?: A Single Stock Future is the same thing, except the underlying investment is not an index, it is simply a single stock, and the settlement can be handled with the actual stock, OR a cash payment. If you are short the SSF, you deliver the stock to whomever is long the SSF contract at expiration.
The Basic Breakdown
It’s alleged that a few key senior RBC employees controlled the trading behaviour of three units which they argue are distinct, but which the CFTC argues are acting in a consolidated matter. That means the view of the CFTC is that the transactions were non-arm’s length in nature since one group within RBC allegedly directly controlled the trading of all three units in an orchestrated manner.
Now, the exchange on which the trades were made permitted two parties to enter into pre-arranged block trades (large trades essentially) as long as they were at reasonable prices that were mutually agreed to and subject to “The Rules of The Exchange”. The exchange did NOT have a rule that explicitly permitted block trading between affiliated parties. This is the crux of the whole thing. Everything up until now would’ve been fine had the two trading parties not been affiliated with each other within the SSF or NBI trades.
Essentially, the charges are that RBC 1) Engaged in wash trades and fictitious trades to limit market exposure to underlying stocks (for the purpose of capturing tax benefits associated with holding the underlying stocks in two of the units), 2) Engaging in non-competitive transactions – which means that they did not seek non-affiliated trading partners who would presumably help set prices through an open market system (think open bids and asks like you see at your retail discount brokerage account) and 3) Made false statements to the CFTC during the investigation into this trading activity.
What are the tax benefits alleged to have been sought?
As per the CFTC document:
1. Canadian taxpayers are entitled to an offset against their Canadian taxes equal to the US taxes they pay on dividend income from US securities.
2. Canadian companies are entitled to an offset against Canadian taxes equal to Canadian taxes paid on dividend income from securities issued by other Canadian companies, so long as the securities are held for one year or longer.
The Technical Breakdown
On the NBI side, this was conducted between the RBC Canadian Transit group in Toronto and the RBC Europe Limited group in the United Kingdom (London). This is a four legged strategy in which offsetting positions are held in the underlying stock (Toronto was long, Europe was short) and Toronto sold NBIs to Europe. The gain or loss on one side of the futures contract were offset by the other side since profit/loss between these two groups were consolidated. RBC Canadian Transit captures the tax credit (the end goal) while overall, there was no material market exposure to the underlying investments.
The SSF side is basically the exact same thing. The only difference is the use of SSF contracts which are timed to expire just after the dividends are collected, to ensure capture of the tax benefit for the offshore Canadian account at the RBC Caribbean unit. These trades were executed, allegedly, in coordination with the RBC Capital Markets Arbitrage group based in Luxembourg (with offices in New York). Again, the offsetting trades ensured that there was no material market exposure overall, but one of the groups captured tax credits that increased the consolidated groups’ bottom line.
Also of note is that the Central Funding Group (CFG), which oversaw both the NBI and SSF sides of these wash trades, was based in the Caribbean, but “Member 1” of the CFG was a member, and then later Chairman, of the board of directors for the Capital Markets Arbitrage group (the other side of the SSF trades from the Caribbean).
As mentioned, this post is simply to explain the details of the scheme as alleged by the CFTC. The point of debate is whether or not the groups acted independently in a manner that would provide proper price discovery of the futures contracts had there been other trading partners (i.e. non RBC affiliated trading partners), and whether the trades were of a wash or fictitious nature.
Hope that helps clear things up.