Norbert's Gambit

Banks charge retail customers substantial fees, typically 1% or more, to exchange Canadian dollars to or from foreign currencies. However, in the common case of Canadian to US dollars (or vice versa), there is an extremely inexpensive method to do this foreign exchange transaction.

Key facts

• Interlisted stocks trade on both a Canadian and US stock exchange.
• Deviations from equivalent value on either side of the border will quickly result in trades by financial institutions to capture a few riskless pennies of profit (an arbitrage). These financial institutions will keep cross-border share prices virtually identical after adjustment for the current exchange rate.

The method in brief

Non-registered Canadian discount brokerage accounts typically have sub-accounts in both Canadian and US dollars. Investors using this method should verify that the account has this feature before beginning. The mechanics are simpler for margin accounts, especially if short sales are allowed, but neither is strictly necessary. The method can also be used in registered accounts, even within a single Canadian dollar sub-account, if the brokerage offers automatic or on demand "wash trades" (e.g., TD Waterhouse).

Choose a reasonably liquid interlisted stock. The large Canadian banks and resource companies are usually good choices. (At time of writing, Research in Motion would also be a reasonable choice.) The simultaneous purchase of such a stock in one country and sale of the same stock in the other country will effectively convert one currency to the other at close to the spot rate. The investor's cost is two trading commissions and some bid-ask spread, which is usually much less than the standard 1% (or greater) fee at a bank or broker.

An example

Consider the exchange of C$120,000 to US dollars at a time when US$1=C$1.20. A happy result for someone exchanging funds would be US$100,000. Allowing a reasonable fee for what (in bank terms) is a common transaction, a customer should be happy with, say, US$99,900 or even US$99,800. But a typical bank or broker's spread would be a penny and the customer would receive US$99,174.

Now assume that Royal Bank of Canada stock is trading at 49.96-50.03 on the New York Stock Exchange (US$) and 59.99-60.02 on the TSX (C$). The ratio of the prices is approximately 1.2 : 1, to be expected if arbitrageurs are doing their jobs. Assume also that stock trading commissions are a flat $30.

Buy 2000 Royal Bank in Toronto at the asking price, which costs 2000 × $60.02 + $30.00 = C$120,070. Immediately upon confirmation of the purchase, sell 2000 Royal Bank in New York at the bid, producing 2000 × $49.96 - $30.00 = US$99,890.

While the dollar amounts are not exactly comparable between the examples, a quick comparison of the achieved exchange rates tells the story. The bank will exchange the Canadian dollars at 1.21, when a discount broker (perhaps the very same bank's discount broker) will exchange at 120,070 / 99,980 = 1.202. The difference (in this example more than $600) remains with the customer.

Pitfalls and problems

• The commissions and bid-ask spreads make this method uneconomic for amounts under about $10,000 (this amount will vary based on the commissions charged).
• Automated trading systems at discount brokers can pose roadblocks and therefore risk a change in the realized exchange rate. While the initial purchase is usually problem free, the sale of the position on the other side of the border may not be automatic. (This is usually an artifact of the way the broker separates the Canadian and US parts of one account, something computerized systems aren't necessarily equipped to handle.) Markets can move against you, so it's best to get the balancing sale done as soon as possible. It may be necessary to use a short sale or to override the electronic systems by making a phone call and speaking to a representative. Telephone trades handled by staff are usually more expensive than electronic trades, but investors using this technique should insist on being charged the lower electronic commission in such cases, as the telephone and staff wouldn't have been required if the broker's system was up to snuff.
• If using a short sale, execute the short before you buy, otherwise you might run into a roadblock based on the "shorting against the box" rule.
• If your broker's system requires you to use a short sale, you usually must request that the broker journal shares from the long side to cover the short on settlement date three business days later. This usually requires a phone call to the broker.
• Exchanging funds on a wild day in the markets may get you a rate nowhere near spot.
• Never use a stock you currently own to exchange funds with this method, nor any stock that you have owned within the previous 30 days or will own in the following 30 days. You will run afoul of the superficial loss rules in the Income Tax Act needlessly, so pick another stock.

The origin of the name

The technique was first described publicly to members of The Wealthy Boomer, a predecessor to the Financial Webring Forum, by Norbert Schlenker in 2001. He developed the method for his personal use some years earlier. A lengthy discussion of the technique, its nuances, potential problems, and the idiosyncratic behaviour of various discount brokers can be found here.