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I Give Up: What Did RBC Do To Piss Off the CFTC?

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Okay one more from the recent CFTCtrilogy: what is up with RBC? Is it the strangest of them all? I'm pretty sure I haven't earned the right to have an opinion on that, or even a theory, but I have some questions.

One is: what was the scam here? I mean, here was the scam:
(1) RBC buys or owns stocks whose dividends are deductible for Canadian tax purposes,
(2) RBC hedges those stocks by selling single stock futures or narrow-based index futures to other bits of itself,
(3) So RBC is flat, gets the div one way and pays it the other, but gets a tax benefit from the div it gets and also presumably a deduction on the div it pays, so its net position is zero + tax benefit,
(4) EXCEPT that the bit of it that owns the stock and is short the future is flat but the bit of it that bought the future is, of course, long, so summing over all of its bits RBC is still long the stock, which is a part of this that confuses me, though not the only one,*
(5) anyway though the trades were arranged between bits of RBC rather than competitively bid,
(6) but then they memorialized them by printing them to the OneChicago exchange overseen by the CME and the CFTC,
(7) which created misleading prints because they were non-competitively-priced wash sales instead of real market trades between arms'-length counterparties,
(8) so the CFTC sued.

So, sure, I'll go along ... that sounds sort of scammy. But one thing that is weird is that OneChicago as far as I can tell is just a market for memorializing your privately negotiated trades. RBC was trading narrow-based index futures on OneChicago. Here is what OneChicago has to say about those:

Narrow Based Indexes (NBIs) are cash settled futures on custom indexes comprised of not more than 9 underlying equity names. The indexes are created at the customer’s request, futures on those indexes can be traded just like any other OneChicago future.

And here's what the CFTC has to say about RBC's NBI trades:

RBC' s Central Funding Group members designed all of the specific NBI products offered by OneChicago that RBC (Canadian Transit) traded with RBC EL. As relevant here, the NBIs that RBC designed were custom products comprised of baskets of Canadian securities.

So RBC created and traded these custom baskets, and I suspect there weren't a lot of copycats trading in them. Actually I know there weren't a lot of copycats, because, not to put too fine a point on it, but OneChicago may in fact be just a market for memorializing RBC's privately negotiated trades: the CFTC says "Between 2006 and 2010, transactions between RBC (Canadian Transit) and RBC EL accounted for 100% of the total NBI volume on OneChicago," and over 50% of physical-settled single-stock-future volume on OneChicago in each of those years. And OneChicago is the only US single-stock futures exchange.

So ... did they create sketchy prints in the NBIs they traded? I don't know. But they created the only prints in those products. There would never come a time when you'd go to OneChicago's web page and say "hmm what is the price for a cash-settled future on an approximately equally weighted basket of my three favorite Canadian stocks" and be misled by RBC's trading. RBC was manipulating a market that consisted entirely of itself.

RBC is vigorously denying that it manipulated ... itself ... or something:

“Before we made a single trade, we proactively contacted the exchange to seek its guidance,” [RBC spokesman Kevin] Foster said. “These trades were fully documented, transparent, and reviewed by both the CFTC and the exchanges, and for the next several years were monitored by them.”

Though the CFTC got out in front of that a little bit by claiming that they were lied to in all that fully documented review.

You can sort of guess most of what happened here, which is that someone in RBC's tax group was all "hey, I have a tax scheme, but it requires us to trade with ourselves over an exchange," and they went to a (relatively) wee little exchange with a probably mostly-true description that maybe made these trades sound a bit more arms'-length than they were (because "we will trade with ourselves in a coordinated way" doesn't sound great when a tax authority later reads it), and the exchange thought "ooh, listings, and fees, and also, what possible harm could come from letting these guys trade with themselves on an exchange and in a product where nobody else trades?," and so they listed them, and then [something happened], and now bitterness and recrimination etc.

So what's the [something] that [happened]? Well, DealBook seems to think it's that the CFTC hired a more serious enforcement chief and he stepped up crackdowns on shenanigans. That seems as plausible as anything else.

I guess my favorite part, though, is what doesn't seem to have ruined RBC's fun: heat from Canadian tax officials. I don't know much about Canadian tax law AND DON'T WANT TO, and I suppose RBC's tax folks knew what they were doing when they built the scam that the CFTC alleges, even if their futures-regulation folks maybe didn't. Still, if you look at this as a price-manipulation scam, it doesn't seem to have done anyone any harm, and they seem to have been more or less above-board with the exchange as these things go, maybe. If you look at it as a tax scam, it supposedly cost Canadian revenue twenty or thirty million bucks and, yeah, it actually looks pretty scammy.

RBC Sued by U.S. Regulators Over Wash Trades [Bloomberg]
CFTC v. Royal Bank of Canada [CFTC]

* I assume there's a physical sale lurking in the confusing complaint that I missed - presumably RBC was actually flat because otherwise this isn't a tax scam, it's just, like, investing in stocks that pay dividends. But if you're actually flat then the setup is (1) real market buy + (2) fake internal futures sell + (3) fake internal futures buy + (4) real market sell. So your ability to manipulate is somewhat constrained, though I guess you're manipulating not the underlier price but the financing legs of the futures - which seems sort of small potatoes for reasons a bit further down in the text - but the point is that these trades wouldn't create bad prints in the actual stocks.


So Maybe Greek CDS Won't Be Fine, Who Knows, I Give Up

ISDA decided today that there has been no credit event for purposes of Greek CDS. Obvs! And by "obvs!" I mean what I said the other day, which is that with 100% certainty there's been no credit event yet, but with 100% certainty there will be, so everyone should just chill out. Except that it seems like that last part may be wrong. So go ahead and panic. I used to make convertible bonds and some of my time was spent answering questions about what happened to things upon Events. The most popular was: what happens after a merger? If you have a convertible that converts into 10 shares of XYZ stock, but now XYZ is being acquired and each share of XYZ is being acquired for $30 in cash and 4.5 shares of PQR stock and a pony - what happens to the convertible? And the answer I would give usually started with "don't trouble your pretty little head about it." Like, it's fine: you have a convertible that converts into 10 Things, and before the merger each Thing was an XYZ share, and after each Thing is exactly what an XYZ share transformed into, so you convert into $300 and 45 PQR shares and 10 ponies. It just works because it has to work. Economic interests follow without interruption from changes in form; derivative securities poof into derivatives of things that the underlying poofs into. There is no arbitrage! That assumption is central to doing any sort of derivative work, and it spoiled me a bit. Sometimes people would come up with more complicated scenarios involving dividends, multiple-step transactions, weird splits and spinoffs and sales, etc. etc. And I would generally start from the bias "it has to work, so I am sure the document written in the way that works." Where "works" means "the economics and intent of the trade are preserved after the change in form." But of course the document was written by humans, often specifically me, and those humans, often including me, are fallible. So there may well be documents from my former line of work that don't "work" in the sense that an issuer could do some structural tricks that would screw holders out of their economics - where the derivative doesn't follow the underlying everywhere it might go. These tricks are unlikely enough that I don't lose sleep over them. You can't predict everything. I sort of assumed that Greek CDS also had to just work but here is Felix Salmon at Reuters saying no. Lisa Pollack at FT Alphaville said something similar a week ago but I could not fathom that she meant it so I read it to mean something else. But she means it, and Felix does too. Go read it but the basic gist of this theory is: