Wednesday, March 31, 2010

Washing Trades

With the exception of Questrade, most brokerages in Canada don’t permit investors to hold US dollars in their RRSP accounts. This may not seem like a big deal until you check out the currency conversion costs when trading US securities. A solution to this problem is called “washing” the trades. I recently did this and thought it might be useful to describe exactly how it is done at my discount brokerage.

Before going any further, it’s important to know that “washing trades” means something completely different from “wash trading”. Wash trading is an illegal activity where someone simultaneously buys and sells a stock to drive up trading volume and give the appearance of something big about to happen. Washing trades is a brokerage service that means eliminating currency conversion costs.

I got my trades washed recently as I continued my transition from owning individual stocks to owning index ETFs. I wanted to sell several US stocks and buy a US index ETF in my RRSP. Without doing anything special, the following would have been the sequence of events for me:

– Place the order to sell US stocks
– The order is executed and US dollars arrive in my RRSP
– US dollars get converted to Canadian dollars at CDN$1.0035 per US dollar
– Place an order to buy the US index ETF units
– Canadian dollars get converted to US dollars at CDN$1.021 per US dollar
– The buy order is executed

Note the pointless conversions in the middle from US dollars to Canadian dollars and back again. This would have cost me 1.7% of my money if I hadn’t had BMO Investorline wash the trades. At Investorline, they actually call this “exchange rate matching” because they just make the two exchange rates equal rather than actually eliminating the currency conversions.

The exact method of exchange rate matching depends on whether the total number of US dollars involved in your buy orders is more or less than the total number of US dollars in your sell orders. This determines whether you are a net buyer or net seller. If you are a net buyer, then the sell order exchange rates get changed to be equal to the buy order rates. If you are a net seller, then the buy order exchange rates get changed to be equal to the sell order rates. Either way the portions of the trades that match up in total US dollars don’t cause any losses. The excess US dollars created or consumed are exchanged at the correct rate that favours the brokerage.

A restriction on wash trading is that it only applies to trades within a single day. So, if you sell US securities one day and buy other US securities the next day at Investorline, you’ll get hit with the full currency conversion costs.

Another restriction is that you have to ask for exchange rate matching with a phone call between 3:15 and 4:30 pm. Apparently, the day’s exchange rates get set around 3:15. I tend to be a little paranoid about these things and place the call before 3:30.

There is no good reason why washing trades couldn’t be done automatically without any phone call, except that BMO makes more money if you don’t make the call. There is also no good reason why the call has to be placed between 3:15 and 4:30. Surely I should be able to call at noon to say “when the rates get set, please wash my trades.” Again, BMO makes more money if I trade in the morning and forget to call later.

So, it is possible to avoid currency conversion costs, but you have to follow the silly rules. This is yet another of life’s taxes on the unwary.

10 comments:

  1. At TD Waterhouse one must call anytime on the same day that the trade occured. It used to be by the time the trade settles (which is probably still acceptable on an occasional, exception basis).

    When you sell US stock they effectively put the proceeds into the TD US$ Money Market fund, when you buy US stock they transfer money out of it. So you don't have to trade in both directions on the same day to take advantage of this.

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  2. AS: It's interesting that TD offers a completely different way to achieve the same goal. I'm looking forward to the day when the brokerages feel enough pressure to allow their customers to hold foreign currencies in their registered accounts.

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  3. I believe Qtrade also offers USD RRSP accounts. Unlike Questrade, they charge $50 per year for the account. But once your account gets big enough, you can justify the fee to avoid forex conversion fees on dividends if most of your holdings are securities denominated in USD.

    So it looks like this could be a trend that is gaining momentum.

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  4. That's another plus for QTrade. I like it.

    Is QTrade the only brokerage in Canada that actually tracks your performance? I think it's terrible that you have to use alternative software to track returns if you use CIBC, RBC or TD's brokerage.

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  5. I didn't know that BMO even offered wash trades (aka exchange rate matching aka wash rates).

    I was tempted to switch to QTrade and even talked about it with Canadian Capitalist (http://www.canadiancapitalist.com/your-turn-opening-an-us-dollar-self-directed-rrsp-account-with-qtrade/). Alas, I didn't pull the trigger and QTrade's offer to reimburse transfer fees is expiring today.

    @as: Just to add to your comments, TD automatically matches the exchange rates of US$ buys and sells that occur on the same day.

    Like you say, they require a phone call to put any excess amounts of US$ into a US$ money market fund. I simply arrange my trades so the excess of either C$ or US$ is minimal, preferably under $10, so that I don't have to call them to arrange purchase of the US$ money market fund, and exchange costs are minimized.

    I never could figure out exactly how the money market purchases worked mechanically, and relying on human intervention on a semi-complex arrangement like this makes me nervous. Let the computers sort it out, I figure. I consider QTrade's method ideal, except for their $50US annual fee.

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  6. gene, regarding "relying on human intervention on a semi-complex arrangement like this makes me nervous":

    It is indeed a very primitive (to say the least) way of doing things. I can always hear the agent on the phone doing what appears to be calculating (not merely retrieving) the exchange rate employed in the trade, in order to use the same for the Money Market transaction order. Just to be on the safe side, I always verified the jumble myself as it progressed during the course of the few days to settlement. Surprisingly, never an error (so far)...

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  7. I just noticed that QTrade has removed the time limit on their reimbursement of transfer fees. Now they will reimburse up to $125 fees for transferring $25,000+ to an account. Like I mentioned, this offer seems to have no expiry date.

    @as Thanks for the response. Glad to hear someone is keeping an eye on those kids @ TD. :-)

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  8. RBC Direct Investing is the only brokerage owned by a big bank that also offers US$ in ALL registered accounts (exccept RESP).

    They reimburse transfer fees too.

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  9. BMO Investorline wrote back to me in July last year that FX matching is NOT available with mutual funds including money market funds.

    So, BMO IL "trade washing" is much more limited than the TD Waterhouse because you cannot park money in US$ Money Market fund, you have to buy and sell US stocks on the same day.

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  10. @Anonymous: Thanks for the information. It seems that TD is superior to Investorline in this important respect.

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