Despite your best efforts and making well-researched financial choices, market volatility can abscond with the returns you were hoping to have at the end of the year, leaving you with a thinner coffer. What do you do? You might sell a losing security, incurring a capital loss. Often individual investors file their tax returns claiming the loss for the lesser of $3,000 (or $1,500 if filing jointly); if it exceeds that amount, losses can be carried forward to future years.

Some individuals attempt to game the system by dumping losing securities on December 31, claiming the deductible and repurchasing the security immediately afterward at a reduced price, while enjoying the lighten tax burden. It seems like a neat strategy, but the IRS calls it by another name – a wash sale – and it comes with some restrictions that make it a little tougher to deploy. Market regulators have also coined a corresponding term for financial firms – wash trading – which has recently put the Royal Bank of Canada (RBC) under the spotlight. Wash trading shares some similarities to wash selling, in that it aims to take advantage of tax benefits; however, there are a few differences, with one being markedly big - it's illegal.

The Allegations
On April 2, U.S. regulators accused RBC, specifically key executives, of operating a wash trading scheme. The Commodity Futures Trading Commission (CFTC) claims that subsidiaries of RBC allegedly conducted transactions worth millions of dollars utilizing wash trades, whereby through the purchase of both narrow-based stock index futures and single-stock futures, the bank was able to hedge its positions resulting in a gain/loss of zero. What does that have to do with wash sales? In Canada, you can receive tax credits for dividend payments.

According to the Canadian newspaper The National Post, in this alleged wash scheme RBC purchased American dividend-paying stocks and afterward sold futures to subsidiaries, which have been claimed by the CFTC to be located in the Cayman Islands, allowing the risk in the stock to "wash" away. Thus, a company that does this can dramatically reduce volatility in those positions while reaping the rewards of tax credits.

What prompted U.S. regulators to take action against RBC are claims of collusion between various arms of the bank, distorting the price of the securities and demonstrating non-competitive behavior in the futures market. Since the announcement of the lawsuit, Royal Bank of Canada has denied any wrong doing.

SEE: Can IRA Transactions Trigger The Wash-Sale Rule?

Wash Trading
What exactly is wash trading? Well, it falls under the category of market manipulation and exists in the company of other foul-play tactics such as churning, ghosting and bear raids. Generally, as mentioned before, the name is derived from the act of cleaning detritus (which in the context of investing, would be risk) from a stock, using methods that can be seen as undermining free and fair operations espoused by the market. Moreover, wash trading can also make a stock's volume appear to have a lot of activity resulting from the repeated buying and selling done by an individual or firm when the shares have never changed owners to begin with.

Why Should You Care?
If the charges being thrown at RBC hold any water, it will be the largest wash trading scheme that the CFTC has ever levied prosecutions for. In the wake of the MF Global Holdings collapse, the regulator has been the target of much criticism by officials for its perceived mishandling of the situation, where the loss of nearly $1.2 billion of client funds graced the pages of media outlets everywhere.

The swift legal action taken against RBC can be seen as a demonstration of the CFTC's revitalized fervor of tackling dishonest behavior before deeper consequences are realized. That, and this past January's new set of rules regarding swaps, and a proposal of their own version of the Volcker Rule, show that the regulator is stepping up its game in the derivatives market. Time will only tell whether this change will be effective.

SEE: Bank Regulations: Good Or Bad?

The Bottom Line
The Royal Bank of Canada has stated that they will defend against the allegations of wash trading, insisting that it has been compliant with the rules set out by the CFTC and did so legally and with steady oversight by regulators. However, despite this, shares of the bank on both the TSX and NYSE dipped a few points this week as investors reacted to the poor press. Whether or not the alleged wash trades are in fact what they are, the fact remains that the CFTC is posing for a fight and will hopefully relinquish whatever credibility it may have lost in the past year.

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