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.