Richard Croft

Tuesday, July 04, 2006

Mr. G writes, "Perhaps you can help me with this conundrum: Since we are now allowed unlimited foreign content in registered (i.e. RRSP) accounts, I decided to test our government's generosity. Unfortunately, I discovered that our government has in effect given our brokers the right to eat half my lunch, by allowing them exorbitant foreign exchange conversion costs."

Mr. G. manages his own affairs and deals with a discount brokerage firm. His discount broker allows him to hold a U.S. money market fund, but he cannot hold U.S. cash -- although his broker did promise a "wash rate" when converting from U.S. to Canadian currency and back again.

"How exactly this wash rate works," Mr. G writes, "I was not able to worm out of my broker." His broker also told him that after buying a U.S. security, he must phone during trading hours to speak with a trader in order to benefit from this "wash rate."

After some further inquiries, Mr. G. discovered other brokers were of the opinion it was illegal to hold U.S. currency in a registered retirement savings plan.

But give him marks for tenacity; he dug through the Income Tax Act and found that under regulation IT-320R3, "Money and deposits of money may be qualified investments. Money denominated in any currency is a qualified investment except where the money is held for its collectible value, or the fair market value of the money exceeds its stated value as legal tender in its country of issue."

It is indeed a conundrum.

Mr. G. raises two questions, which I will try to deal with: (1) What is a wash rate? and (2) What is the real story behind foreign currency inside an RRSP?

To the first question, I believe the bank is offering Mr. G. a rate that effectively reduces the fee a bank charges to convert cash from one currency to another. When you think about cash, it is like any other security, where there exists a bid and offered price.

For example, suppose there are two people needing to convert U.S. dollars; one wanting to acquire U.S. dollars for a trip, the other wanting to sell U.S. dollars after returning from a trip.

The U.S. dollar was recently quoted at US89.80 cents for $1 Canadian. That is the quote you hear every day when financial commentators talk about where the Canadian dollar is relative to the U.S. dollar.

The bank knows that the market price is US89.80 cents, and knows it can buy and sell close to that price. However, the bank needs to manage its foreign exchange risk when buying or selling a currency whose price can change dramatically during the day.

The so-called risk premium is the spread. In this case -- and these are simply numbers off the top of my head -- the bank might offer to buy U.S. dollars from you at US89.60 cents and offer to sell you US90 cents. The actual amount you pay or receive will depend in large part on the size of the transaction. The larger the transaction, the tighter the spread.

Back to our wandering travellers. The one who wants to buy U.S. dollars as he goes on vacation will exchange his Canadian dollars at the offered rate of US90 cents. The traveller who is returning from vacation and wants to convert back into Canadian dollars, will receive the bid price of US89.60 cents. The wash rate is a rate that is better than the standard bid offer spread, which in this case, would be somewhere between US89.60 cents and US90 cents.

The second question has more to do with how brokerage accounts operate. An RRSP is simply a Canadian dollar brokerage account. Like any brokerage account, you are assigned an account number. With a non-registered (i.e. non-RRSP) account, you are typically assigned a Canadian and U.S. brokerage account with the same account number. In such cases, you hold U.S. cash in your U.S. account and Canadian cash in your Canadian account.

The problem for Mr. G. is that an RRSP cannot be an account denominated in a foreign currency. An RRSP account must be a Canadian dollar account, and any cash held in that account must be in Canadian dollars.

This conundrum can be circumvented by holding a U.S. dollar-denominated money market fund, which the brokerage firm simply defines as a foreign security, just as a U.S. equity fund or shares of Microsoft Corp. are considered a foreign security. The brokerage firm translated the quoted price of the money market fund or Microsoft into Canadian dollars, so when you see your account value at the end of the month, it is denominated in Canadian dollars.

Perhaps not the answer Mr. G. wanted to hear, but an answer nonetheless.