Conservatives Finally Take the Scythe to the Wheat Board, But Will Canada's Farmers Lose Out?

by Zachary Walker 
Staff Writer

Will getting the government out of the grain market actually help farmers? Or has it simply set-off a buying frenzy for Canadian agricultural and grain companies, giving Canada’s farmers fewer buyers to choose from and lower profits? 

<a href="http://www.publicdomainpictures.net/view-image.php?image=16901&picture=gold-fields">Gold Fields</a> by Larisa Larisa

On August 1st, the Canadian Wheat Board's 60-year plus monopoly on wheat and barley exports will end.[i] Yes, the Wheat Board will exist in a voluntary form for up to five years, at which point it could either be privatized or dissolved. But its key function, controlling the export and interprovincial trade of grain products will end, and with it Canadian farmers will be able to sell their gain to any private buyer they choose. There are some outstanding appeals that can still be lodged, but with a Manitoba court tossing out a prominent challenge, the odds for success seem low.[ii]

The Harper government has claimed that eliminating the Wheat Board “will spur our economy, attract investment, encourage innovation and create jobs”.[iii] Previous Canadian regimes had supported the Wheat Board on the basis that it allowed farmers to capture economies of scale, thereby reducing marketing and other transaction costs.[iv] The Government expected that competition between Canadian agricultural and grain companies, such as Patterson Grain, Parrish & Heimbecker Limited, and Viterra, would offer farmers the best price for their wheat and barley.[v]

But one of these companies, Viterra, has recently attracted international merger attention. The takeover of Viterra has included bids from agricultural giants Archers Daniels Midland and Glencore.[vi] Will a Viterra takeover kill competition, which could lead to farmers getting less than under the old-style Canadian Wheat Board?

The takeover of Viterra, located in the province of Saskatchewan, takes place as traders seek to benefit from the upcoming deregulation of the Canadian wheat market. The battle for Viterra reached a conclusion on March 20, 2012 when Glencore agreed to pay $6.1 billion USD for Viterra.[vii] Glencore is a Swiss company with a revenue that approached $200 million USD in 2011.[viii] Interestingly, Glencore is involved in a merger of its own, with it appearing likely that the company will merge with Swiss mining company Xstrata.[ix] Two of Xstrata’s largest shareholders are the Qatar Investment Authority and the private equity company BlackRock.[x] The two companies control about 11.5% of Xstrata’s stock.[xi]

The hourglass shape of international grain market, where the vast majority of grain commodities pass through a handful of processors, shifts market power from the many producers and consumers to the handful of processors.[xii] The purchase of Viterra will further restrict the market forces that the Canadian government had hoped to promote by ending the Wheat Board. So far, farm groups are split on the future impact of the Viterra takeover.[xiii] The main concern remains the impact on ensuring a competitive market for producers.[xiv] Whether the expiration of the Canadian Grain Board and the Viterra takeover will increase competition is yet to be seen; however, Liberal MP and former federal agriculture minister Ralph Goodale fears that competition “could be less, and certainly a lot less Canadian."

But the Canada’s Library of Parliament offers the best sum-up of the politics and impact of ending the Wheat Board:

The issues surrounding the CWB’s single desk and the prohibitions on prevenint farmers from marketing their grain themselves have been highly contentious for a number of years. Some farmers are passionate about the maintenance of the single desk and feel that they will suffer in terms of bargaining power and net revenues if the single desk is removed. Other farms are equally passionate about the removal of the CWB’s single desk, both as a matter of principle and because they believe their revenues will increase in an open market. Countless studies and economic analyses have been undertaken over the years in an effort to support each of these positions, without any obvious dominant position emerging. (Page 24, emphasis added).

_____________________________
[i] Bruce Johnstone, End of Wheat Board, possible Viterra takeover increase uncertainty for farmers, available at http://www.canada.com/business/Wheat+Board+possible+Viterra+takeover+increase+uncertainty+farmers/6296883/story.html’ See Bill C-18: An Act to Reorganize the Canadian Wheat Board and to Make Consequential and Related Amendments to Certain Acts, Library of Parliament (Canada), http://www.parl.gc.ca/Content/LOP/LegislativeSummaries/41/1/c18-e.pdf.
[ii] Former Canadian Wheat Board directors appeal Manitoba court ruling, available at http://www.canada.com/business/Former+Canadian+Wheat+Board+directors+appeal+court+ruling/6411778/story.html.
[iii] Andrew Mayeda, Canada Government Introduces Bill to End Wheat Board Marketing Monopoly, available at http://www.bloomberg.com/news/2011-10-18/canada-government-introduces-bill-to-end-wheat-board-marketing-monopoly.html.
[iv] Secretariat of the World Trade Organization. 1995. Operations of State Trading Enterprises as They Relate to International Trade, G/STR/2 (2005). October, 1995).
[v] Johnstone, supra.
[vi] Jack Farchy, Glencore agrees C$6.1bn Viterra deal, available at http://www.ft.com/cms/s/0/ea495296-727e-11e1-9c23-00144feab49a.html#axzz1raRoMxsm.
[vii] Farchy, supra.
[viii] Glencore International, Financial Overview, available at http://www.glencore.com/financial-overview.php.
[ix] Marietta Cauchi, Qatar boosts stake in Xstrata to 5% ahead of Glencore tie-up, available at http://www.nasdaq.com/article/qatar-boosts-stake-in-xstrata-to-5-ahead-of-glencore-tie-up-20120409-00489.
[x] Id.
[xi] Id.
[xii] Raj Patel, Stuffed and Starved, (2008).
[xiii] Bruce Johnstone, Farm groups split on Viterra deal, available at http://www.leaderpost.com/business/Farm+groups+split+Viterra+deal/6339944/story.html.
[xiv] Id.

Vancouver Finally Pipes Down Over Bagpipe Ban

By Justin McNeil 
Senior Editor

Buskers go bust in Vancouver? Senior Editor Justin McNeil—showing off his own cultural heritage and bagpipe love—provides a glimpse into Vancouver’s cultural politics. 

Buskers march on Vancouver? No, not really, but they make their voices heard after the city attempts to ban bagpipes. [Photo of Stirling 2006 Highland Games in Scotland] 

Vancouver, bowing to local and international outrage, repealed a ban on bagpipes that it put into place last week. The bagpipe ban, put forward by the engineering department of British Columbia’s largest city as a measure to reduce street noise, had applied to the playing of bagpipes, bongos, and other percussion instruments. 

Backlash to the ban was swift. Local pipers spoke up loudly, fueling a protest that ultimately forced the city’s hand in reversing its decision. This put Vancouver Mayor Gregor Robertson, one of the 5 million Canadians with Scottish ancestors—and who even sported a kilt at his latest swearing in ceremony—in the awkward position of supporting a ban on an essential part of his own cultural heritage. When first asked for his reaction to the ban by local media he responded:

Buskers play a very important role in making Vancouver’s streets lively and dynamic, particularly in our vibrant downtown. We do however have to monitor noise complaints and ensure that music from our streets isn’t excessively disruptive to neighbouring residences or workplaces. I’ve asked city staff to review this issue; Council won’t support an outright ban on specific instruments. My first reaction is that a complete ban on bagpipes and percussion instruments across the city is ridiculous and culturally insensitive. The clans won’t stand for it!

The Mayor now clarifies the City’s current position on his own website, where his influence has contributed to the lifting of the ban. But the Mayor makes clear that while he does not support any prohibition on specific instruments, the City will continue to gather noise level readings and monitor complaints regarding instrument noise.

Now, in the Mayor’s defense, an acquired degree of tolerance is certainly necessary when bagpipes blare in the wee morning hours. I learned this all too well during a summer in Stirling, Scotland, where pipe bands from all over the world in town for the nearby Royal Edinburgh Military Tattoo would begin practice sessions at 7 a.m. on the lawn outside my room.

But, I have to agree with the head of the British Columbia Pipers’ Association and my namesake, Rob MacNeil, that an outright ban crossed the line and discounted the entertainment and cultural value proper piping can provide. Though initially shortsighted, Vancouver should be commended for ultimately recognizing the importance of the role that pipes play in many Canadians’ Scottish cultural identity and their expression thereof. Scotland has also voiced its official approval of the ban being lifted, after its Cabinet Secretary for Culture and External Affairs, Fiona Hyslop, received a personal assurance from Mayor Robertson that the ban had been lifted. Fittingly, Ms. Hyslop was in Vancouver during these events for Scotland Week 2012, a set of weeklong engagements in major North American cities to promote Scotland.

Then again, Vancouver seems to have a particular penchant for peculiar bylaws. Hopefully, noise-related bylaws won’t come to emulate Vancouver’s seemingly convoluted traffic and parking ordinances, which a fellow blogger hilariously shares in this 2011 blog post. In the meantime though, buskers don’t fret: your euphonious blasting will undoubtedly ring in British Columbia’s 2012 Highland Games and Scottish festival this June.

More On Canada’s Exports

By Keith Edmund White, Editor-in-Chief

Canada's losing its share of the global export market, some blame the United States, but is this whole debate just a way to bury potentially troubling Canadian marco-economic policies underneath a swallow rhetorical debate on Canada's place in the world?

So...is America to blame for Canada’s dwindling share of the world’s export market? And what does this matter anyhow?

Last week’s speech by the Governor of the Bank of Canada Mark Carney has led to some interesting economic discussion in Canada. 

Carney, noting Canada’s decade-long slide in the global export market, placed blame on “overexposure to the US market and underexposure to emerginng markets….”

But William Watson from McGill makes an interesting counter-point when it comes to the impact of Carney’s words: in short, let the markets work. From Watson’s editorial in the Ottawa Citizen:

On average since 2000, the rich countries to which we send 85 per cent of our exports have been growing at under two per cent per year, while the “emerging markets,” some of which have pretty much completely emerged by now, have been growing at over four per cent. The import of these numbers is that Canadian exporters will want to think about focusing more on rapidly growing markets and, if they agree with Carney that these trends will continue, less on our traditional markets.

Of course, the great thing about a capitalist economy is that businesses don’t actually need a high government official to tell them where to turn their export intentions. As if on cue, on Wednesday Statistics Canada released its annual review of our merchandise trade. While in 2002, 87.1 per cent of our exporting and 62.6 per cent of our importing was with the United States, last year those numbers were 73.7 and 49.5 per cent, respectively. Canadian businesses, not policy-makers, are who we want making decisions about where they can get the best deals for their products. It seems they’re already on the case.

Naturally, this back-and-forth is covering up an important question: why are Canadian exports getting this much attention? Well, first, Carney is reacting to Canada’s post-recession export boom not really mirroring past trade trajectories. Second, Canada’s exports represented 26% of the Canadian economy. So it is an important chunk of Canada’s economy. But, on the other hand, simply increasing exports doesn’t naturally equate to greater economic growth: if new exports, for example exports in manufactured goods, triggers the need for more oil imports, could dilute the impact of positive export growth.

But the real issue behind this debate is how Canada can keep finding markets for their exports, especially in the face of an American economy is not growing like it was in the 90s. With Canada's population 1/9 the size of America's but maintaining an average income that is 50% higher than America's, diversifying markets in face the of an uneven American recovery seems an obvious economic and political priority. And this is especially important as the Canadian economy has been floating on robust consumer spending that has, in Carney's opinion, generated an unsustainable increase increase in household debt.

But, as Watson points out, Canadian businesses act economically rationally: having policy makers tell Canadian businesses where to trade doesn't really make sense--the businesses will make the best choice for them. You want to make Canadian exports more competitive? Raise the currency. You want to cut back Canadian debt levels? Raise interest rates. What I take from his article: 'Thanks, but don't lecture Canadian businesses for responding to the environment you've put them in.'

Naturally, these policies in effect take away 'free money' that Canadians are enjoying: a stronger dollar allows consumers to enjoy travel and more foreign goods, and low interest-rates allow them to over-consume, which is always fun until the party ends. And why would a Conservative government, just enjoying its majority government, want to get in the way of this party. So, instead, we seem to see the Bank of Canada Governor's speech trying to find another way to protect Canada's long-term economic interests without engendering public blow-back: let's focus on who are businesses are and are not trading to and if we can put some blame on the States--why not?

But, whether or not my cynical reading is even close to accurate, one thing is clear: that there’s some serious economic soul-searching going on in Canada, and it might have bad ramifications on the Canada-U.S. bilateral relationship. The graphs below show just how important a trading partner the United States is to Canada.

But, first, more from the AFP article assessing Canada’s current export health:

Over the past decade, Canada's share of world exports has declined from about 4.5 percent to about 2.5 percent, and its manufactured-goods export market share has been cut in half, he added. 

Meanwhile, export growth is almost five percentage points slower than the global average per year, ranking Canada's performance as the second worst in the G20. 

Carney pointed to Germany, which has maintained its market share in manufactured goods by exporting capital goods and automobiles to China and Australia's rising exports of commodities to China as examples to follow. 

He noted that strong household spending has lifted Canada's fortunes of late, but at a cost -- rising household debt, which he said is "unsustainable."

RBC 'Wash' Suit Heading to Court, and Will This All Depend on CRA’s Tax Assessment?

By Keith Edmund White, Editor-in-Chief 

RBC turned down settlement offer from the Commodities Futures Trading Commission (CFTC), prepares for court battle, and lays forth the broad outlines of its defense.  And guess what?  RBC's snagged a pretty good lawyer.  For people wondering why is this news, check out my earlier CFTC-RBC post.

RBC's 'Wash' Suit Lawyer Talks To the Press

Bloomberg and The Star, splitting updates from RBC’s defense attorney, report that the Royal Bank of Canada (RBC) has opted to fight CFTC’s charges in court, and even turned down a settlement offer from the CFTC.  This leads me to suspect that the settlement offer was rather high, which—in turns—increases the odds that the CFTC is looking for big financial penalty from the Manhattan federal district court.

The Bloomberg article also begins to outline how RBC may defend itself in court.  At Bloomberg, RBC’s defense attorney Arthur W. Hahn chats with Doug Alexander and Silla Brush, and appears to lay out two lines of defense: 

“No Injury.”  Hahn argues that there was “no injury” to the market from RBC's allegedly 'wash' transactions. What does this mean?  Well it appears to implicitly concede two chief points of the CFTC’s complaint:  that (a) RBC’s OneChicago LLC exchange transaction were between RBC and its affiliate, and (b) that senior RBC officials set the prices on the trades. Doesn’t look good, but Hahn’s cournter:  “The trades all took place art absolutely appropriate calculable market prices” and hence there was “no injury…” What this leaves out? The small fact that RBC was the only market participant, which to me seems the real crux of this case.  

RBC Followed the Rules.  Hahn also states that RBC’s transactions were “within standard rules and the guidances put out” by the CFTC. 

The Star’s Madhavi Acharya and Tom Yew give two additional insights from Hahn:

CFTC Changed the Rules on RBC After the Fact.  The Star talks to Hahn too, and adds this interesting gloss that could work in a jury trial: 

RBC says that it informed the regulator and the exchange, OneChicago, as far back as 2005 that it was making large block trades between various subsidiaries.

“We called the exchange and fully detailed everything we were doing and we wanted to make sure this is okay. We had essentially a green light. We proceeded to do these exact trades as we described them, all the way through 2010,” Hahn said. 

“They now would like to take a different position. Our view is that’s fine. Change the rule but don’t bring in enforcement action after the fact.”   

Will This All Come Down to a Canadian Tax Ruling? The Star also gives us this nugget of insight from former CFTC general counsel and current D.C.-based partner for Arnold & Porter LLP:

“The question is whether the tax scheme is legitimate. If it’s not, the whole thing looks very unsavoury,” Waldman said. “If the tax scheme is legitimate, then it’s an issue of the trading mechanisms that were used and what was said to the regulator.” 

Naturally, the Canada Revenue Agency isn't talking.

A Bit More On RBC's Lawyer, and my Burning Market-Of-One Quandary for Him (and the CFTC)

Finally, here’s more on RBC’s attorney David W. Hahn.  He’s a long-time “super lawyer” partner at Katten Muchin Rosenman LLP, A Northwestern law grad, and worked for Senator Paul Douglass (a finance committee member back in the 60s).  Not only has he taken on suits like this on both sides of the ‘v’, Katten LLP’s website boasts their knowledge of CFTA’s recent legislative changes and regulatory moves (which serves as a good introduction to the statute sections and regulations that will be defining this case).

The burning issue (maybe):  Perhaps Hahn or someone at CFTA will catch this post and explain to me how the injury of price distortion works in a one-participant market setting, or simply showthat my ‘injury’ focus in utterly misplaced.

Securities Lawyers Get the Best Discovery Process Settings?  And, on a lighter note, I hope Hahn gets a nice trip out what's shaping up to be a deeply contested and consequential court battle.  RBC's tax-avoidance/alleged 'wash' trading scheme taking place between RBC subsidies in Toronto, Europe, the Bahamas, and the Cayman Islands, suggesting--perhaps--a more pleasant-than-not discovery process.  Sadly, I suspect most of the documents and witnesses with be flown in Chicago.

Canada-U.S. Commentary Highlights

by Keith Edmund White, Editor-in-Chief

*Note an earlier version of this article incorrectly referred to James Coan as Joan Coan, and omitted to refer to other Woodrow Wilson materials related to deepwater drilling.

A wrap up some commentary from March and April I thought might be of interest. Topics include Canada's federal and Ontario's provincial budget, Canada's Asia pivot, offshore drilling, a chat with the Prime Minister, and some summit forecasting.

Canada’s Asia Push. Paul Wells blogs on Bank of Canada governor Mark Carney’s tying Canada’s “unsteady” recovering with Canada’s shrinking share of the world’s export since 2000. The cause: the high Canadian dollar and “a reflection of who we traded with than how effectively we did it.” And guess what “who” he’s talking about? The United States. The solution? “[R]efocus[ing] on commodities exports to Asia.”

Two Budgets, Four Commentaries Plus a Quick US Comparison. Last week, Canada’s Conservative federal government released its first majority budget; at the same time, Ontario Liberal government released its first budget as a minority government. Fleishman Hillard’s Anne Marie Quinn provides some context to the budget proposals. Even in these two different situations, American readers can glean the dramatic difference in Canada's budget politics. The Fraser Institute slams the Conservative government “no-cut” (but rather cost savings budget), arguing that the Conservatives should have used their new majority government to “enact a bold and aggressive plan to balance the budget more quickly through actual reductions in spending.” Finally, going back to Ontario, this Atlantic Market Institute for Market Studies sets forth broad guidelines of balancing Ontario’s budget through cuts, not new revenues. Best budget overview, though, goes to Michael Holden's blog post at the Canada West Foundation.

Assessing Summits—More Players, Less Substance? Chris Sands reads the past and future Summit dance-card, predicting which ones are worth watching—and which aren’t.

Woodrow Wilson Center Gets Two Shout-Outs:

Canada’s Offshore Drilling—Decentralized Better (Or Should We Be Looking at Other Variables)? Woodrow Wilson’s Canada Institute chats with two experts on the differences in the U.S. and Canadian offshore drilling political regimes. interviews Alexander MacDonald, managing partner of the St. John’s, Newfoundland and Labrador office of Cox & Palmer, an Atlantic Canadian law firm. Offers some nice (and thankfully well-edited) clips with Mr. MacDonald. Key insight: offshore drilling is a provincial-federal issue, not like America’s debate which is held hostile on the national stage. Joan James Coan, Energy Forum research associate at the James Baker III Institute for Public Policy then comes up and pushes back a bit: he notes that even if a (future Republican) U.S. president took the federal obstacles away, how many States would actually opt for drilling? While he might be right on western coast Florida and the Northwest, I’m not so sure about Virginia. 

Some omissions additional aspects of note: (1) discussion on the politics of Canada west coast offshore moratorium, and (2) the different model of offshore regulation Canada uses ("goal oriented") from the United States (criticized as overly "prescriptive"). Yes, a bit wonky--but critical to assessing whether any U.S. offshore expansion sticks (not to mention if Canada is sticking on its own Deep Water Horizon time bomb).

The Woodrow Wilson Center offers more of these topics in their publication The Risk and Regulation of Deepwater Offshore Drilling: American and Canadian Perspectives and the 14th edition of the Center's One Issue, Two Voices series with James Coan, Alexander MacDonald, and moderator David Longly Bernhardt on the topic of deepwater offshore drilling. This March 7, 2012 event is what led to the shorter interviews discussed above.

[Note: CUSLI-Nexus thanks the Woodrow Wilson Center for bringing the misnaming of Rice University Research Associate James Coan and its deepwater drilling materials to its attention]

Woodrow Wilson Snags PM Harper for hour-long chat in DC. Harper chats on Canada’s envious economic performance over the recession, among other topics. A “very solid system of financial regulation” – really? What about that murky, provincial system of securities regulation?) Harper notes Canada’s stimulus response (emphasizing “shovel-ready projects” like the U.S.), but emphasizes that Canada’s smaller debt as giving it greater flexibility. But let’s be fair: Canada had the nice buffers of a booming economy market and a property market that hasn’t crashed. And, perhaps, a less polarized political sphere? And what about simple differences in scale between the two stimulus approaches? But I would be interested in reading a comparison on Canada and America’s stimulus approaches. Harper also dishes on Keystone XL, foreign policy, health-care, Canada joining the Trans-Pacific Partnership, and other topics. Two additional topics worth noting here: Canada’s push for FTAs around the world, and Canada’s “profile challenge” when it comes to addressing tensions in the U.S.-Canadian relationship.

And Canada West Foundation Reports on Water in Stress Points. Could federal involvement in water policy be on its way? This March 2012 Report describes seven stress points in Canada’s water security. The culprits? Agricultural demand for water, shale gas development, oil sands development, uranium mining, urban growth in Canada’s west, the deteriorating health of Lake Winnipeg—which could pose become a thorn in the US-Canadian relationship. One important point brought up by the report: where do aboriginal rights fall into increasing Canada’s water security? Another point not really discussed: assuming the federal government wants to stretch its muscle in this provincial area, in light of the Canadian Supreme Court’s ruling on securities regulation, what shape should it/will it take? Final note: were getting a national water policy in Canada depend on the NDP leadership race?

And Yes, It Is All About Gas. Finally, Metanoodle cuts through some of the noise on what can and can not be solved when it comes to North American energy prices. Key points: (1) gotta think in oil districts and (2) the sexy topic of transfer capacity. And is four cents enough when it comes to the Keystone XL pipeline?

CFTC's Washout: CFTC Goes After RBC Alleging Illegal Wash Transactions, But Is This Really About Market Integrity or Creating Positive Spin?

by Keith Edmund White, Editor-in-Chief

As has been reported pretty much everywhere over the last 48 hours, the Commodity Futures Trading Commission (CFTC) filed charges against the Royal Bank of Canada (RBC) yesterday, alleging RBC conducted wash trading on transactions worth millions.

In this post I'll make my best attempt to (1) break down what's meant by 'a wash trading scheme' and why they matter, and then (2) review why the CFTC has singled out over this admittedly very large, but rather unorthodox trading scheme.

In short, we'll see that while this looks like a wash trading scheme, it really seems more like a tax dodging scheme. And, even stranger, is seems that neither U.S. market participants or the market that hosted RBC's trade were negatively or positively impacted. Rather, the only loser in these transactions seems to be Canada's tax agency. So, why is the CFTC launching a full-court press? It may have more to do with making up for past mistakes than actually keeping markets free of corrupting wash transactions.

What's a "Wash Trading Scheme"? Or The Story of the Lackluster Lunch 

The classical wash trading scheme would go something like this:

-I'm Investor 'A' and I want to generate trading activity, why? Because trading activity will influence the price by luring other buyers.

-Investor A now thinks about the how. He gets Investor 'B' to agree to buy the stock at a certain price, and then sell it back to me at a certain price. The cycle continues.

-So while we're just throwing the stock around, with no net-gain or loss, trading activity goes up, which artificially brings up the stock price.

-As we start to see the little bubble we've created, one of us sells before the bubble pops.

What's another way to think about this? Imagine an unhappy kid who brings in a lackluster lunch, and wants to trade it. Problem is, no one wants it. His way around it: get his friend to chat up how great this lackluster lunch truly is. Suddenly, crowd mentality and peer pressure take hold; a bidding frenzy ensues; and, suddenly, our unhappy kid suddenly can trade his lackluster lunch for a feast.

Why Washing Isn't Just Bad Ethics, but Bad for Financial Market Integrity

Now--yes, this looks scammy--but securities regulators go after this for a more important reason: A & B's 'wash' trading scheme artificially raised the value of the stock, which then they cashed out on. As you might guess, this undermines an essential ingredient of the efficient market theory: that the market takes in and incorporates legitimate information about its assets so that buyers can be rewarded for making 'smart' choices on companies that will grow. This is good because the market rewards what it should: the more economically efficient investment. But when A & B take their wash scheme, they are rewarding themselves for tricking others, which--over the long-term--hurts market credibility and then--at the extreme--makes (1) everyone cheats or (2) everyone quits. And that's when the sky falls down.

RBC's Futures & Sole-Market-Participant Alleged Twist in Wash Trading

Now RBC was apparently more sophisticated than our unhappy kid. The goal wasn't to artificially inflate stock values, but rather to earn tax incentives from the Canadian government. Since the Canadian government offered tax credits for companies that hold dividend-paying stock for a year, RBC did just that--and held dividend-paying stock for a year on the OneChicago Exchange.

But, this is where it gets interesting [note what follows is simplified version of Matt Levine's excellent piece for Dealbreaker]: RBC it had its foreign affiliate buy futures on these stocks, basically taking out insurance that the stock values wouldn't fall. So, in short, its buying stock and ensuring that any money it lost on the investment would be outset to the gain from its affiliate. The net-effect: RBC wouldn't be making money from the investment.

What does this mean? That the price quotes for these futures insurance we're competitively priced, but rather set by the RBC to ensure no net-loss.

The Rub: If No One Else Could Buy RBC's Futures Besides RBC And It Was the Only Market Transaction of its Kind in the Marketplace, Is This a Victimless Crime? And Does That Matter?
But here's the rub: the RBC was doing all this trading on the OneChicago Exchange, where it was the only party doing this type of trade. This means, that there was no way for another user of OneChicago to get into the market for insuring RBC's stock. End-result: In a market of one, how can you manipulate prices to the detriment of others?

Now, Levine appears to suggest that this lack of effect on other market participants could cut against a CFTC's lawsuit. But I'm not so sure. Looking at the complaint's quick recitation of charges, wash trades aren't bad if they actually cause non-competitive pricing, but rather--by law--are simply bad because the CFTC says so. Hence, effect on other market participants may not legally matter. Now where intent may come in to play with possible knowledge requirements under CFTC: that of RBC (1) knowing the trades were happening and (2) that the trades were washed transactions. (But, I must admit, that from what RBC appears likely to argue, it seems the case will hinge on whether there trades were competitively prices--which, means, in essence should RBC have been willing to pay enough for its self-insurance that it did actually lose money on the transaction. But this brings up, seemingly, a gobbly gop of data being argued about--because how can you accurately value these transactions between companies and their affiliates when there are no other buyers (other then by analogy, which it seems--as described above--would be hard to show in these rather unique circumstances.). And, most importantly, this isn't the stuff that distorts markets--or causes bad information to lead investors to lose their cash. Or is it?

I would be interested in knowing is what impact RBC's trades had on the OneChicago overall marketplace. For example, if the Dow Jones Index saw a bunch of wash trading that didn't lead to artificial prices in particular stocks, increased trading volume could still impact stock rates and would impact anyone who simply invests in the index's bundle itself. Or, in terms of the RBC's transactions, did OneChicago draw other investors who saw increased transactions and jumped in? If so, Levine's effects concern may be satisfied.

Furthermore, Levin postulates that OneChicago was making money off this arrangement: could it be that RBC-like transactions risk eroding integrity in these smaller markets, which in aggregate, would definitely pack a punch on the greater U.S. financial landscape? I don't know--but I feel like whenever the briefs for these case come out, we'll finally see the bigger narrative the CFTC is pushing. Alternatively, we'll see this for what it is: hitting someone for a technical violation (of a whooping magnitude), generating positive spin, and putting a lot of resources chasing 'bad' acts that really aren't what would keep me up at night when it comes to the health of America overall financial marketplace, let alone the ever illusive world of futures trading.

But, do keep in mind, all this analysis comes from an avowedly non-expert in financial markets, and someone wholly ignorant of OneChicago's single stock futures marketplace. I'll dig more into how OneChicago works and more into how whether RBC's actions really are the stuff meriting court action (as opposed to simply telling them to stop or settling before court).

Why Did CFTC Take This Action Now?

Now there some who see a cynical motivation behind the CFTC's lawsuit: mainly, the CFTC is trying make up for the embarrassing MF Financial fiasco. The Globe and Mail's Grant Robertson casts a critical, Canadian eye on the CFTC:

After the CFTC was grilled by U.S. Senators in December over whether it did enough to police the market, and whether it was too cozy with executives at MF Financial. That has prompted observers to question whether the regulator is now looking to send a strong message that it is getting tough on alleged improprieties in the derivatives market, and whether the RBC case is a step in that direction.

“In our view, the CFTC intends its action against [Royal Bank] to be interpreted as a signal of its tougher enforcement policies, particularly in the wake of the MF Global scandal for which the CFTC has come under criticism,” NationalBank Financial analyst Peter Routledge said in a research note.

“Tougher enforcement regimes at all U.S. regulators means that regulatory complaints will be swifter and their penalties more severe. As a consequence, banking in the United States will be more risky and more costly for Canada’s banks.”

Two quick points of Robetson's piece. First, it's true: post-MF Global CFTC, with its new head, Davind Meister taking a harder line on wash transactions. But, what do you expect after dropping a ball the size of MF Global? For the CFTC to not want to get some positive spin?

Now, what's funny about this increased costs argument is this: if Canadian banks are cheating and making money off scamming U.S. markets, yes--reporting the data of their cheating will cost them money (on top of the money presumably lost 'cheating' revenue), but is anyone going to shed a tear? Now, the more nuanced way to--perhaps--make this point credible would be to say, 'This washing scheme isn't really a problem, and the resulting costs to market participates outweigh the benefits of greater regulation.' I'd like to find Routledge's entire research note to see how he might deal with that. If I grab it, it will undoubtedly be posted here.

Isn't This Really A Tax Scam?

That's what George Michaels thinks in this Advanced Trading (AT) article. But, again, this would have no bearing on the question of whether RBC vop;ated CFTC regulations. But it does make this seem like more of a show case, not one that's actually trying to stop wash trading transactions that distort prices for U.S. U.S. financial participants. From Justin Grant's AT article:

"This was not a "wash sale in the sense of the 1921 Revenue Act," said George Michaels, the founder of tax compliance software provider G2 FinTech. " From the description provided by the Wall Street Journal, the RBC technique seems to involve a hybrid of a tax straddle and a dividend farm."

A tax straddle is most commonly used in futures and options trades as a way to earn tax benefits. In order to make money using this technique, an investor who earned a capital gain takes a position that actually creates an artificial loss in the current tax year, and postpones their gain to the next.

A dividend farm, Michaels explains, is when an investor simultaneously goes long and short in two securities with similar risk profiles as a way to convert ordinary income into qualified dividend income. In this case, RBC likely found it desirable to flip its ordinary income into qualified dividend income due to the way Canadian taxes are structured, Michaels points out.

Under Canadian tax law, dividends are taxed at 19 percent, a much lower rate than the nation's 29 percent tax on ordinary income. On top of that is a provincial tax that ranges between 10 and 19 percent, Michaels adds.

But even if RBC may not be guilty of wash sales, Michaels points out that U.S. companies are barred by the nation's tax laws from executing a dividend farm scheme or a tax straddle. The Internal Revenue Service would also never allow that sort of tactic to take place.

"They're using more and more sophisticated software each year to detect and shut down anything that even remotely resembles a riskless transaction," Michaels says. "Even if the intent was to take risk, the IRS takes the position that if it 'appears' to be riskless, the tax shelter laws kick in and the deduction is denied."

What Comes Next?

Well, presumably the trial--or a big settlement. Now while I have only glanced at the statutory language, but it seems the fight will be over how regulations interpret CFTC's prohibition on wash trades. Some interesting, possible legal elements could be scienter (intent or knowledge of wrong-doing, which could be crucial here) or anything that suggests this has to cause distortion in price (which it seems would be impossible in this transaction had a market of one type of transaction that could only be between two parts of the same corporate person). But it seems RBC's defense will be focused on a much less abstract part of the charges:

RBC’s lawyer said the bank intends to show in court that the trades executed between the various subsidiaries of RBC were done at levels that closely tracked market prices, and were not done to distort the market or inflate profits. 

But whether or not this meets the legal hurdles, for me, the real question is: does doing this actually make financial markets (especially smaller derivative markets like ChicagoOne) 'better' markets? Right now, I'm not sure this does anything to help that project. Instead, it looks like a potentially slam dunk case for CFTC, but one that seems to go after conduct that RBC honestly thought was legal on the securities side.

Strangely, Canadian banking regulators aren't eager to take on RBC. And--even more surprising--I can't find any press on whether or RBC's securities transactions violate Canadian tax law. I would guess that this transaction--seemingly a classic form of tax avoidance--would be legal under Canadian law.

Scroll through or download the CFTC complaint against RBC here.

North America’s Shale Energy Stockpiles: Ohio Enters The Game—But Is it too Late, and Will State Politics Get in the Way?

by Keith Edmund White, Editor-in-Chief

With all the chattering over Canada’s oil sands, it’s important not to forget what natural resource literally ties Canada and the United States: shale gas. This resource, while perhaps not as pronounced on the public mind as black-gold brother, has gained prominence over the last decade. For most readers, T. Boone Pickens—and the numerous commercials he generated extolling naturally gas—may have been your first brush with shale.. But now even CNN’s Fareed Zakaria has seemingly blessed this energy shift: noting not only can shale gas production be done responsibly, but could serve as a geo-political stabilizer: with energy-hungry nations like the United States and China not having to be as dependent on keeping oil on the market from more volatile regions on the globe. And, as Canada’s showing, shale brings with it job and GDP growth (refer to page 27). While Canada’s oil sands grab the headlines, it’s clear the natural gas—promising less environmental impact—is trying to give it a run for its dominant role on the global energy stage.

And now Ohio is in on the game. And it’s bringing about its own interesting energy-state politics. First, the geology. Ohio sits—along with about 7 other U.S. states and Ontario—on the Utica shale gas reserves. How much is there? Apparently a lot. And in Ohio is pushing to up its 7-wells, and try to get in on the shale boom.

But this is where the state politics come in. Ohio Gov. John Kasich, not known as a moderate in his former Congressional career and now still-short tenure, has used the issue to show off his inner populist. His plan: finance a across-the-board income tax cut with increased taxes on drilling, which—it should be noted—admittedly Ohio already accessing this ‘severance tax scheme’ at a lower rate than other States. But, alas, Kasich finds himself fighting his own party over the tax proposal, with others calling the tax-proposal a possible killer of shale’s potential for spurring Ohio economic growth.  Whether Kasich populist pivot results from conviction or political necessity is debatable, but in the result is the same:  Kasich is pushing shale gas in a way that presumably will be supported by most Ohio voters.

Now there are two things to consider when assessing the virtues of natural gas. On the macro-scale, its undoubtedly true that natural gas is clean than oil—but, is using natural gas as a crush keeping the American economy from entering its green phase? On the ground in Ohio, there are two far less abstract questions. First, is the market to awash in natural gas?  As pointed out in John Funk's The Plain Dealer Nov. 2011 piece, Ohio might be too late to the party to enjoy a true shale boom:

The problem for Ohio is that the gas industry has been too successful over the last three years at developing shale gas in other parts of the nation, using technologies to drill horizontal wells and then fracturing, or "fracking," the rock to release the gas. 

Now there is too much of the stuff. The glut is growing and prices are falling. Those are the facts. Additionally, no one knows for sure how much gas -- or more valuable oil and other hydrocarbons -- lies trapped beneath Ohio. "The issue for the Ohio economy is whether there is enough demand for natural gas to permit development. It's not a question of whether it will create 150,000 jobs or 170,000 jobs but a question of whether it will happen at all," said Andrew Weissman, executive director of Energy Business Watch, a national private analytical service for energy investors. 

"It will happen on some scale," he added. "But the question is whether it moves quickly or whether it moves slowly so that it has only a modest impact on Ohio's economy."

And second, are Ohioans being over-sold on the economic benefits? Yes, with gas comes drilling operations, leasing and royalties, and pipeline infrastructure (all of which equal more jobs—especially for lawyers!). But, as this OSU report makes clear, while a short-term of income burst is to be expected in drilling areas, shale gas development’s ability to create long-term job-creation is dubious at best (and still comes with some not-fully understood environmental impacts) (refer to pages 15 and 27).  One fascinating statistic: Pennsylvania counties with drilling actually had less job growth than non-drilling countries, though both saw roughly equal income growths over 2000-2010.  Assuming this is trend  continues in Ohio, Governor Kasich’s plan makes sense: use the short-term income boast to simulate growth (income taxes) or some smart government-spending that can actually lead to sustainable job creation.

In any case, shale is here to stay. And with it, at a minimum, will come even more links between Canada and the United States.