Chapter
1
1
The Capital Market
CHAPTER OUTLINE What is Investment Capital?
• Characteristics of Capital • Why Capital Is Needed
Who are the Sources and Users of Capital?
• Sources of Capital • Users of Capital
What are the Financial Instruments?
• Financial instruments • Private Equity
What are the Financial Markets?
• Auction Markets in Canada • Dealer Markets
• Other Trading Systems
• Fixed-Income Electronic Trading Systems • Trends in Financial Markets
1. Defi ne investment capital and describe its role in the economy.
2. Describe how individuals, businesses, governments and foreign agencies supply and use capital in the economy.
3. Differentiate between the types of fi nancial instruments used in capital transactions.
4. Explain the role of fi nancial markets in the Canadian fi nancial services industry, distinguish among the types of fi nancial markets, and describe how auction markets and dealer markets work.
THE CAPITAL MARKET
The Canadian securities industry plays a signifi cant role in sustaining and expanding the Canadian economy. The industry grows and evolves to meet the ever-changing needs of Canadian investors, both from domestic and international perspectives.
In some way, we are all affected by the securities industry. The vital economic function the industry plays is based on a simple process: the transfer of money from those who have it (savers) to those who need it (users). This capital transfer process is made possible through the use of a variety of fi nancial instruments: money market, stocks, bonds, mutual funds and others. Financial intermediaries, such as banks, trust companies and investment dealers, have evolved to make the transfer process effi cient.
The fi rst two chapters of this textbook focus on the three central elements of the securities industry: investment markets, products and intermediaries. The emphasis throughout the course, however, is on securities. The text examines the main types of investment products, how to analyze them, how they are sold, and how they are used as part of a well-planned portfolio of investments.
For those new to this material, we offer a suggestion: stay informed about the markets and the industry because it will help you better understand the material presented in this textbook. There are countless sources of fi nancial market information, including newspapers, the Internet, books and magazines. The course material will be that much easier to grasp if you can relate it to the activity that unfolds each day in the fi nancial markets. Ultimately, this will help you achieve your goal of becoming an informed and effective participant in the securities industry.
Auction market Market capitalization Canadian National Stock Exchange (CNSX) Market makers Canadian Unlisted Board Inc. (CUB) Mutual fund
CanDeal Montreal Exchange (ME)
CanPX Open-end fund
Capital Option
CBID Preferred shares
Common shares Primary market
Dealer markets Quotation and trade reporting systems (QTRS)
Debt Retail investors
Derivative Secondary market
Equity Stock exchange
ICE Futures Canada Toronto Stock Exchange (TSX) Institutional Investors TSX Venture Exchange Investment advisors (IAs)
WHAT IS INVESTMENT CAPITAL?
In general terms, capital is wealth – both real, material things such as land and buildings, and representational items such as money, stocks and bonds. All of these items have economic value. Capital represents the invested savings of individuals, corporations, governments and many other organizations and associations. It is in short supply and is arguably the world’s most important commodity.
Capital savings are useless by themselves. Only when they are harnessed productively do they gain economic significance. Such utilization may take the form of either direct or indirect investment. Capital savings can be used directly by, for example, a couple investing their savings in a home; a government investing in a new highway or hospital; or a domestic or foreign company paying start-up costs for a plant to produce a new product.
Capital savings can also be harnessed indirectly through the purchase of such representational items as stocks or bonds or through the deposit of savings in a financial institution. The indirect investment process is the principal focus of this course.
Indirect investment occurs when the saver buys the securities issued by governments and
corporations, who in turn use the funds for direct productive investment – equipment, supplies, etc. Such investment is normally made with the assistance of the retail or institutional sales department of the investment advisor’s firm.
Characteristics of Capital
Capital has three important characteristics. It is mobile, sensitive to its environment and scarce. Therefore capital is extremely selective. It attempts to settle in countries or locations where government is stable, economic activity is not over-regulated, the investment climate is hospitable and profitable investment opportunities exist. The decision as to where capital will flow is guided by country risk evaluation, which analyzes such things as:
The political environment:
whether the country is involved or likely to be involved in internal or external confl ict
Economic trends: growth in gross domestic product, infl ation rate, levels of economic activity, etc.
Fiscal policy: levels of taxes and government spending and the degree to which the government encourages savings and investment
Monetary policy: the sound management of the growth of the nation’s money supply and the extent to which it promotes price and foreign exchange stability
Investment opportunities:
opportunities for investment and satisfactory returns on investment when considering the risks to be accepted
Characteristics of the labour force:
whether it is skilled and productive
WHAT IS INVESTMENT CAPITAL?
The political environment:
whether the country is involved or likely to be involved in internal or external confl ict
Economic trends: growth in gross domestic product, infl ation rate, levels of economic activity, etc.
Fiscal policy: levels of taxes and government spending and the degree to which the government encourages savings and investment
Monetary policy: the sound management of the growth of the nation’s money supply and the extent to which it promotes price and foreign exchange stability Investment
opportunities:
opportunities for investment and satisfactory returns on investment when considering the risks to be accepted
Characteristics of the labour force:
Because of its mobility and sensitivity, capital moves in or out of countries or localities in anticipation of changes in taxation, exchange policy, trade barriers, regulations, government attitudes, etc. It moves to where the best use can be made of it and attempts to avoid areas where the above factors are not positive. Thus, capital moves to uses and users that offer the highest risk-adjusted returns. Capital is scarce worldwide and is in great demand everywhere.
Why Capital Is Needed
An adequate supply of capital is essential for Canada’s future well-being. Enough new and efficient plant and equipment must be put in place to ensure expanded output capability, improved productivity, increased competitiveness and the development of innovative, sought-after new products. If capital investment is inadequate, the result will be insufficient output, declining productivity, rising unemployment, decreasing competitiveness in domestic and international markets – in short, lower living standards.
The securities industry attaches great importance to the savings and investment process. It is constantly in touch with governments with a view to improving the saving and investment process. The industry advocates changes, when appropriate, in both government policies and the tax system. These proposed changes are designed to encourage more saving and the investment of savings in productive plant and equipment.
WHO ARE THE SOURCES AND USERS OF CAPITAL?
The only source of capital is savings. When revenues of non-financial corporations, individuals, governments and non -residents exceed their expenditures, they have savings to invest.
Non-financial corporations, such as steel makers, food distributors and machinery manufacturers, have historically generated the largest part of total savings mainly in the form of earnings, which they retain in their businesses. These internally generated funds are usually available only for internal use by the corporation and are not normally invested in other companies’ stocks and bonds. Thus, corporations are not important providers of permanent funds to others in the capital market.
Individuals may decide, especially if given incentives to do so, to postpone consumption now in order to save so that they can consume in the future. Governments that are able to operate at a surplus are “savers” and able to invest their surpluses. Other governments are “dis-savers” and must borrow in capital markets to fund their deficits.
Non-residents, both corporations and private investors, have long regarded Canada as a good place to invest. Canada has traditionally relied on savings for both direct plant and equipment investment in Canada and portfolio investment in Canadian securities.
Sources of Capital
Retail, institutional, and foreign investors are a significant source of investment capital.
Retail investors: Retail investors are individual investors who buy and sell securities for their own personal accounts, and not for another company or organization.
Institutional investors:
Institutional investors are organizations, such as a pension fund or mutual fund company, that trade large volumes of securities and typically have a steady fl ow of money to invest. Retail investors generally buy in smaller quantities than larger, institutional investors.
Foreign investors: Foreign investors also are a signifi cant source of investment capital. Historically, Canada has depended upon large infl ows of foreign investment for continued growth. Foreign direct investment in Canada has tended to concentrate in particular industries: manufacturing, petroleum and natural gas, and mining and smelting. Some industries also have restrictions with respect to foreign investment.
Users of Capital
Based on the simplest categorization, the users of capital are individuals, businesses and
governments. These can be both Canadian and foreign users. The ways in which these groups use capital are described below.
INDIVIDUALS
Individuals may require capital to finance housing, consumer durables (e.g., automobiles,
appliances) or other types of consumption. They usually obtain it through incurring indebtedness in the form of personal loans, mortgage loans or charge accounts. Since individuals do not issue securities to the public and the focus of this text is on securities, individual capital users are not discussed further.
Just as foreign individuals, businesses or governments can supply capital to Canada, capital can flow in the other direction. Foreign users (mainly businesses and governments) may access Canadian capital by borrowing from Canadian banks or by making their securities available to the Canadian market. Foreign users will want Canadian capital if they feel that they can access this capital at a less expensive rate than their own currency. Access to foreign securities benefits Canadian investors, who are thus provided with more choice and an opportunity to further diversify their investments.
BUSINESSES
Canadian businesses require massive sums of capital to finance day-to-day operations, to renew and maintain plant and equipment as well as to expand and diversify activities. A substantial part of these requirements is generated internally (e.g., profits retained in the business), while some is borrowed from financial intermediaries (principally the chartered banks). The remainder is raised in securities markets through the issuance of short-term money market paper, medium- and long-term debt, and preferred and common shares.
Retail investors: Retail investors are individual investors who buy and sell securities for their own personal accounts, and not for another company or organization. Institutional
investors:
Institutional investors are organizations, such as a pension fund or mutual fund company, that trade large volumes of securities and typically have a steady fl ow of money to invest. Retail investors generally buy in smaller quantities than larger, institutional investors.
Foreign investors: Foreign investors also are a signifi cant source of investment capital. Historically, Canada has depended upon large infl ows of foreign investment for continued growth. Foreign direct investment in Canada has tended to concentrate in particular industries: manufacturing, petroleum and natural gas, and mining and smelting. Some industries also have restrictions with respect to foreign investment.
GOVERNMENTS
Governments in Canada are major issuers of securities in public markets, either directly or through guaranteeing the debt of their Crown corporations.
Federal Government
When revenues fail to meet expenditures and/or when large capital projects are planned, the federal government must borrow. The government makes use of four main instruments: treasury bills (T-bills), marketable bonds, Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs).
Provincial Governments
Like the federal government, the provinces issue debt directly themselves. When revenues fail to meet expenditures and/or when large capital projects are planned, provinces must borrow. They may issue bonds to the federal government or borrow funds from Canada Pension Plan (CPP) assets (or the Québec Pension Plan in the case of Québec).
Alternatively, a province may issue debt domestically through a syndicate of investment dealers who sell the issue to fi nancial institutions or to retail investors. In addition to conventional debt issues, some provinces issue their own short-term treasury bills and, in some cases, their own savings bonds similar to CSBs issued by the federal government.
Municipal Governments
Municipalities are responsible for the provision of streets, sewers,
waterworks, police and fi re protection, welfare, transportation, distribution of electricity and other services for individual communities. Since many of the assets used to provide these services are expected to last for twenty or more years, municipalities attempt to spread their cost over a period of years through the issuance of instalment debentures (or serial debentures).
Complete the following Online Learning Activity
Sources and Users of Capital
What is capital used for and where does it come from?
Assess your understanding of the Sources and Users of Capital. Federal
Government
When revenues fail to meet expenditures and/or when large capital projects are planned, the federal government must borrow. The government makes use of four main instruments: treasury bills (T-bills), marketable bonds, Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs).
Provincial Governments
Like the federal government, the provinces issue debt directly themselves. When revenues fail to meet expenditures and/or when large capital projects are planned, provinces must borrow. They may issue bonds to the federal government or borrow funds from Canada Pension Plan (CPP) assets (or the Québec Pension Plan in the case of Québec).
Alternatively, a province may issue debt domestically through a syndicate of investment dealers who sell the issue to fi nancial institutions or to retail investors. In addition to conventional debt issues, some provinces issue their own short-term treasury bills and, in some cases, their own savings bonds similar to CSBs issued by the federal government.
Municipal Governments
Municipalities are responsible for the provision of streets, sewers,
waterworks, police and fi re protection, welfare, transportation, distribution of electricity and other services for individual communities. Since many of the assets used to provide these services are expected to last for twenty or more years, municipalities attempt to spread their cost over a period of years through the issuance of instalment debentures (or serial debentures).
Sources and Users of Capital
What is capital used for and where does it come from?
WHAT ARE THE FINANCIAL INSTRUMENTS?
Transferring money from one person to another may seem relatively straightforward. Why then do we need formal financial instruments called securities?
As a way of distributing capital in a large, sophisticated economy, securities have many advantages. Securities are formal, legal documents, which set out the rights and obligations of the buyers and sellers. They tend to have standard features, which facilitates their trading. Furthermore, there are many types of securities, enabling both investors (buyers) and users (sellers) of capital to meet their particular needs.
Financial instruments
Much of this text deals with the characteristics of different financial instruments. The following brief discussion of instruments is included here to remind the reader that financial instruments (products) are one of the three key components of the securities industry. Financial instruments, along with the other two components, financial markets and financial intermediaries, will be covered in subsequent chapters.
Debt Instruments:
Debt instruments formalize a relationship in which the issuer promises to repay the loan at maturity and in the interim makes interest payments to the investor. The term of the loan ranges from very short to very long, depending on the type of instrument. Bonds, debentures, mortgages, treasury bills and commercial paper are all examples of debt instruments (also referred to as fi xed-income securities).
Equity Instruments:
Equities are usually referred to as stocks or shares because the investor actually buys a “share” of the company, thus gaining an ownership stake in the company. As an owner, the investor participates in the corporation’s fortunes. If the company does well, the value of the company may increase, giving the investor a capital gain when the shares are sold. In addition, the company may distribute part of its profi t to shareowners in the form of dividends. Unlike interest on a debt instrument, however, dividends are not obligatory. Different types of shares have different characteristics and confer different rights on the owners. In general, there are two main types of stock: common and preferred.
Investment Funds:
An investment fund is a company or trust that manages investments for its clients. The most common form is the open-end fund, also known as a
mutual fund. The fund raises capital by selling shares or units to investors, and then invests that capital. As unitholders, the investors receive part of the money made from the fund’s investments.
WHAT ARE THE FINANCIAL INSTRUMENTS?
Debt
Instruments:
Debt instruments formalize a relationship in which the issuer promises to repay the loan at maturity and in the interim makes interest payments to the investor. The term of the loan ranges from very short to very long, depending on the type of instrument. Bonds, debentures, mortgages, treasury bills and commercial paper are all examples of debt instruments (also referred to as fi xed-income securities).
Equity Instruments:
Equities are usually referred to as stocks or shares because the investor actually buys a “share” of the company, thus gaining an ownership stake in the company. As an owner, the investor participates in the corporation’s fortunes. If the company does well, the value of the company may increase, giving the investor a capital gain when the shares are sold. In addition, the company may distribute part of its profi t to shareowners in the form of dividends. Unlike interest on a debt instrument, however, dividends are not obligatory. Different types of shares have different characteristics and confer different rights on the owners. In general, there are two main types of stock: common and preferred.
Investment Funds:
Aninvestment fund is a company or trust that manages investments for its clients. The most common form is theopen-end fund, also known as a mutual fund. The fund raises capital by selling shares or units to investors, and then invests that capital. As unitholders, the investors receive part of the money made from the fund’s investments.
Derivatives: Unlike stocks and bonds, derivatives are suited mainly for more
sophisticated investors. Derivatives are products based on or derived from an underlying instrument, such as a stock or an index. The most common derivatives are options and forwards.
Other Financial Instruments:
In the past few years, investment dealers have used the concept of fi nancial engineering to create structured products that have various combinations of characteristics of debt, equity and investment funds. Two of the most popular are linked notes and exchange-traded funds (ETFs).
Private Equity
Private equity is the financing of firms unwilling or unable to find capital using public means – for example, via the stock or bond markets. The term “private equity” is a bit of a misnomer as this asset class really encompasses debt and equity investment. Long term returns on private equity typically exceed most other asset classes. But in exchange for these returns, private equity also exposes investors to far higher risks.
Private equity plays a specific role in financial markets, in Canada and in other markets worldwide. It complements publicly traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible. A good example is venture capital. Venture capital finances businesses at a time when they produce little or no cash flows, invest most or all revenue in more or less unproven technologies or production processes, and have little or no assets to offer as collateral. In such situations, firms must typically turn to investors that are ready to take substantially more risk against significantly higher profit prospects if the venture is successful.
There are several means by which private equity investors finance firms.
Leveraged Buyout:
This is the acquisition of companies fi nanced with equity and debt. Buyouts are one of the most commonly used forms of private equity.
Growth Capital: The fi nancing of expanding fi rms for their acquisitions or high growth rates.
Turnaround: Investments in underperforming or out of favour industries that are in either fi nancial need or operating restructuring.
Early Stage Venture Capital:
Investments in fi rms that are in the infancy stages of developing products or services in high growth industries such as health care or technology. These fi rms usually have a limited number of customers.
Late stage Venture Capital:
The fi nancing of fi rms which are more established but still not profi table enough to be self-suffi cient. Revenue growth is still very high.
Distressed debt: This is the purchase of debt securities of private or public companies that are trading below par due to fi nancial troubles at the fi rm.
Leveraged Buyout:
This is the acquisition of companies fi nanced with equity and debt. Buyouts are one of the most commonly used forms of private equity.
Growth Capital: The fi nancing of expanding fi rms for their acquisitions or high growth rates. Turnaround: Investments in underperforming or out of favour industries that are in either
fi nancial need or operating restructuring. Early Stage
Venture Capital:
Investments in fi rms that are in the infancy stages of developing products or services in high growth industries such as health care or technology. These fi rms usually have a limited number of customers.
Late stage Venture Capital:
The fi nancing of fi rms which are more established but still not profi table enough to be self-suffi cient. Revenue growth is still very high.
Distressed debt: This is the purchase of debt securities of private or public companies that are trading below par due to fi nancial troubles at the fi rm.
Derivatives: Unlike stocks and bonds,derivatives are suited mainly for more
sophisticated investors. Derivatives are products based on or derived from an underlying instrument, such as a stock or an index. The most common derivatives areoptions andforwards.
Other Financial Instruments:
In the past few years, investment dealers have used the concept of fi nancial engineering to create structured products that have various combinations of characteristics of debt, equity and investment funds. Two of the most popular arelinked notes and exchange-traded funds (ETFs).
SIZE OF THE PRIVATE EQUITY MARKET
The growth of private equity has been remarkable over the last 25 years. Investment minimums in the private equity market tend to be relatively high compared to the general retail market. As a result, investments in private equity cater mostly to individuals and organizations with sizeable portfolios and resources. For this reason, private equity investors are typically:
• Public pension plans
• Private pension plans
• Endowments
• Foundations
• High net worth investors
Given the features of private equity and the differences it shows with other assets typically held in investor portfolios, its role is one of return enhancement and to a certain extent, of portfolio diversification. Return enhancement is the reward for accepting much lower liquidity typical of private equity, particularly when compared to investing in the common shares of highly liquid stocks like large banks or oil companies.
WHAT ARE THE FINANCIAL MARKETS?
Securities are a key element in the efficient transfer of capital from savers to users, benefiting both. Many of the benefits of investment products, however, depend on the existence of efficient markets in which these securities can be bought and sold. A well-organized market provides speedy transactions and low transaction costs, along with a high degree of liquidity and effective regulation.
Like a farmers’ market, a securities market provides a forum in which buyers and sellers meet. But there are important differences. In the securities markets, buyers and sellers do not meet face to face. Instead, intermediaries, such as investment advisors (IAs) or bond dealers, act on their clients’ behalf.
Unlike most markets, a securities market may not manifest itself in a physical location. This is possible because securities are intangible – at best, pieces of paper, and often not even that. Of course, some securities markets do have a physical component. Other securities markets, such as the bond market, exist in “cyberspace” as a computer- and telephone-based network of dealers who may never see their counterparts’ faces. In Canada, all exchanges are electronic.
The capital market or securities market is made up of many individual markets. For example, there are stock markets, bond markets and money markets. In addition, securities are sold on primary and secondary markets.
• In the primary market new securities are sold by companies and governments to investors for the fi rst time. Companies can raise capital by selling stocks or bonds to investors while governments raise capital by selling bonds. In this market, investors purchase securities directly from the issuing company or government. When a company issues stocks for the very fi rst time in the primary market, the sale is known as an initial public offering (IPO).
WHAT ARE THE FINANCIAL MARKETS?
• In the secondary market investors trade securities that have already been issued by companies and governments. In this market, buyers and sellers trade among each other at a price that is mutually benefi cial to both parties. The security is then transferred from the seller to the buyer. The issuing company does not receive any of the proceeds from transactions in the secondary market - the issuer received payment when the securities were fi rst issued in the primary market.
Auction Markets in Canada
Markets can also be divided into auction and dealer markets. In an auction market, buyers enter bids and sellers enter offers for a stock. The price at which a stock is traded represents the highest price the buyer is willing to pay and the lowest price the seller is willing to accept. These orders are than channelled to a single central market and compete against each other.
There are a number of important terms you need to understand when talking about trading stocks.
• The bid is the highest price a buyer is willing to pay for the security being quoted.
• The offer (or ask) is the lowest price a seller will accept.
• The spread is the difference between the bid and ask prices.
• The last price is the price at which the last trade on that stock took place. This price can fl uctuate back and forth between the bid price and the ask price as buying and selling orders are fi lled. The last price is also referred to as the market price. It is important to understand that the last price may not refl ect the price for which you can currently buy or sell the stock, and only refl ects the latest price at which a purchase or sale occurred.
Let’s see how this terminology is used on the Toronto Stock Exchange. EXHIBIT 1.1 AUCTION MARKETS IN ACTION
Let’s say there are three investors who want to buy a share of ABC and they enter the following bids on the stock: $5, $5.03 and $5.06. On the other side of the trade, there are three investors that want to sell their share in ABC. These sellers submit offers to sell their ABC stock at the following prices: $5.06, $5.07, and $5.11.
The trade is executed and settles only when there is a match in the bid and offer prices.
On the ABC trade, the investor who entered the bid and the seller who entered the offer of $5.06 will have their orders executed. The other bid/offers will not be immediately executed. In fact, the price of $5.06 becomes the last price (or market price) of ABC.
CANADIAN STOCK EXCHANGES
A stock exchange is a marketplace where buyers and sellers of securities meet to trade with each other and where prices are established according to the laws of supply and demand. On Canadian exchanges, trading is carried on in common and preferred shares, rights and warrants, listed
options and futures contracts, instalment receipts, exchange-traded funds (ETFs), income trusts, and a few convertible debentures. On some U.S. and European exchanges, bonds and debentures are traded along with equities.
Liquidity is fundamental to the operation of an exchange. A liquid market is characterized by:
• Frequent sales
• Narrow price spread between bid and ask prices
• Small price fl uctuations from sale to sale
Canada’s stock exchanges are auction markets. During trading hours, Canada’s exchanges receive thousands of buy and sell orders from all parts of the country and abroad.
Canada has five exchanges: the Toronto Stock Exchange (TSX) and the TSX Venture Exchange, the Montreal Exchange (MX, also known as the Bourse de Montréal), owned by the TMX Group Inc., the Canadian National Stock Exchange (CNSX), and the ICE Futures Canada. Each exchange is responsible for the trading of certain products.
• The TSX lists senior equities, some debt instruments that are convertible into a listed equity, income trusts and Exchange-Traded Funds (ETFs).
• The TSX Venture Exchange trades junior securities and a few debenture issues.
• CNSX trades securities of emerging companies.
• The Montreal Exchange trades all fi nancial and equity futures and options.
• ICE Futures Canada trades agricultural futures and options.
EXHIBIT 1.2 CHANGES TO THE CANADIAN EXCHANGES
Securities trading has existed in Canada since 1832. Over the years there have been many changes. The late 1990s saw radical changes to securities trading in Canada. In March 1999, Canada’s four major stock exchanges announced that they had reached an agreement to restructure along lines of market specialization. The restructuring was intended to ensure a strong and globally competitive market system, and this resulted in three specialized exchanges:
• The Toronto Stock Exchange became Canada’s senior equities market and gave up its participation in derivatives trading and the junior equity market.
• The Alberta Stock Exchange, the Winnipeg Stock Exchange and the Vancouver Stock Exchange merged to create a single, national junior equities market, called the Canadian Venture Exchange (CDNX). This new market also consolidated the operations of the Canadian Dealing Network (CDN) as of October 2000.
• The Montréal Exchange became the exclusive exchange for fi nancial futures and options in Canada. Responsibility for all equities once traded on Montréal transferred to the TSX or the TSX Venture Exchange.
The CDNX became a wholly owned subsidiary of the Toronto Stock Exchange in 2001. In April 2002, the Toronto Stock Exchange rebranded its abbreviated name from the TSE to TSX, while CDNX was renamed the TSX Venture Exchange. These changes were part of a rebranding initiative as the TSX and its subsidiaries prepared to go public in the fall of 2002. Under the rebranding program, the TSX, TSX Venture Exchange and TSX Markets Inc. (the arm of the TSX that sell market information and trading services) are collectively known as the TSX Group of companies. In November 2002, the TSX Group Inc. went public, becoming the fi rst listed stock exchange in North America.
In 2004, the CNSX gained recognition as a stock exchange by the Ontario Securities Commission. The intent of CNSX is to provide an alternative market to the TSX Venture Exchange for emerging companies.
Trading on CNSX is also regulated by IIROC in the same way as the other Canadian exchanges and must therefore follow the Universal Market Integrity Rules (UMIR).
In 2007, the Winnipeg Commodity Exchange became a wholly-owned subsidiary of ICE and became ICE Futures Canada. This exchange trades options and futures of agricultural commodities such as Canola, Barley, and Wheat.
In 2008, the TSX and the Montreal Exchange merged to form the TMX Group.
In 2012, the Maple Group acquired the TMX Group Inc. As a result, the Maple Group was renamed TMX Group Limited.
There are over 80 stock exchanges in over 60 countries around the world. Including the auction markets in Canada, North America has 10 exchanges, Europe has in excess of 35, Central and South America, around 10, and the balance are in Africa, Asia and Australia.
Dealer Markets
Dealer markets are the second major type of market on which securities trade. They consist of a network of dealers who trade with each other, usually over the telephone or over a computer network. Unlike auction markets, where the individual buyer’s and seller’s orders are entered, a dealer market is a negotiated market where only the dealers’ bid and ask quotations are entered by those dealers acting as market makers in a particular security.
Market makers work for investment dealers and must be approved by the exchange to carry out market making duties on assigned stocks. The responsibilities include monitoring the opening of trading to ensure that orders are properly executed, maintaining a continuous two-sided market at an agreed upon maximum spread throughout the day (e.g., $0.10 between the bid and ask), and executing all tradable orders that meet a maximum number of shares as agreed upon with the exchange. By making a market, the market maker assists in creating fair and orderly markets and contributes to market liquidity for all parties who want to participate in the buying and selling of stocks.
The CDNX became a wholly owned subsidiary of the Toronto Stock Exchange in 2001. In April 2002, the Toronto Stock Exchange rebranded its abbreviated name from the TSE to TSX, while CDNX was renamed the TSX Venture Exchange. These changes were part of a rebranding initiative as the TSX and its subsidiaries prepared to go public in the fall of 2002. Under the rebranding program, the TSX, TSX Venture Exchange and TSX Markets Inc. (the arm of the TSX that sell market information and trading services) are collectively known as the TSX Group of companies. In November 2002, the TSX Group Inc. went public, becoming the fi rst listed stock exchange in North America.
In 2004, the CNSX gained recognition as a stock exchange by the Ontario Securities Commission. The intent of CNSX is to provide an alternative market to the TSX Venture Exchange for emerging companies.
Trading on CNSX is also regulated by IIROC in the same way as the other Canadian exchanges and must therefore follow the Universal Market Integrity Rules (UMIR).
In 2007, the Winnipeg Commodity Exchange became a wholly-owned subsidiary of ICE and became ICE Futures Canada. This exchange trades options and futures of agricultural commodities such as Canola, Barley, and Wheat.
In 2008, the TSX and the Montreal Exchange merged to form the TMX Group.
In 2012, the Maple Group acquired the TMX Group Inc. As a result, the Maple Group was renamed TMX Group Limited.
Market makers work for investment dealers and must be approved by the exchange to carry out market making duties on assigned stocks. The responsibilities include monitoring the opening of trading to ensure that orders are properly executed, maintaining a continuous two-sided market at an agreed upon maximum spread throughout the day (e.g., $0.10 between the bid and ask), and executing all tradable orders that meet a maximum number of shares as agreed upon with the exchange. By making a market, the market maker assists in creating fair and orderly markets and contributes to market liquidity for all parties who want to participate in the buying and selling of stocks.
Almost all bonds and debentures are sold through dealer markets. These dealer markets are less visible than the auction markets for equities, so many people are surprised to learn that the volume of trading (in dollars) on the dealer market for debt securities is significantly larger than the equity market.
Dealer markets are also referred to as over-the-counter (OTC) or as unlisted markets - securities on these markets are not listed on an organized exchange as they are on auction markets.
THE UNLISTED EQUITY MARKET
The volume of unlisted equity business is much smaller than the volume of stock exchange transactions. The exact size of Canadian OTC dealings cannot be measured because complete statistics are not available. Many junior issues trade OTC, but so too do the shares of a few
conservative industrial companies whose boards of directors have for one reason or another decided not to seek stock exchange listing for one or more issues of their equities. The unlisted market does not set listing requirements for the stocks traded on its system (hence the term “unlisted market”) nor does it attempt to regulate the companies. Many of the stocks sold on the unlisted market are more speculative, and in most cases offer lower liquidity, than listed securities.
TRADING IN THE UNLISTED MARKET
Over-the-counter trading in equities is conducted in a similar manner to bond trading. One veteran described the OTC market as a “market without a market place.” In the OTC market, individual investors’ orders are not entered into the market or displayed on the computer system. Instead, dealers, who are acting as market makers, enter their bid and ask quotations. These market makers hold an inventory of the securities in which they have agreed to “make a market.” They sell from this inventory to buyers and add to the inventory when they acquire securities from sellers.
The market makers post their individual bid (the highest price the maker will pay) and ask (the lowest price the maker will accept) quotations. The willingness of the market makers to quote bid and ask prices provides liquidity to the system (although the market makers do have the right to refuse to trade at these prices). When an investor wishes to buy or sell an unlisted security, the broker consults the bid/ask quotations of the various market makers to identify the best price, and then contacts the market maker to complete the transaction. The broker charges a commission for this service.
OVER-THE-COUNTER DERIVATIVES MARKET
Derivatives also trade in dealer or OTC markets. The OTC derivative market is dominated by financial institutions, such as banks and brokerage houses, who trade with other corporate clients and other financial institutions. This market has no trading floor and no regular trading hours. Traders do not meet in person to negotiate transactions and the market stays open 24 hours a day. One of the attractive features of OTC derivative products is that they can be custom designed by the buyer and seller. As a result, these products tend to be somewhat more complex, as special features are added to the basic properties of options and forwards.
REPORTING TRADES IN THE UNLISTED MARKET
In most of Canada, there is no requirement for firms to report unlisted trades. Ontario is the exception. The Ontario Securities Commission (OSC) requires that trades of unlisted securities be reported through the Canadian Unlisted Board Inc. (CUB). CUB was launched as an automated system after the reorganization of the equity markets in Canada. It offers an Internet web-based system for dealers to report completed trades in unlisted and unquoted equity securities in Ontario, as required under the Ontario Securities Act.
Other Trading Systems
Over time, different trading systems emerged to meet changing investor needs. Examples include quotation and trade reporting systems and alternative trading systems (ATSs).
QUOTATION AND TRADE REPORTING SYSTEMS
Quotation and trade reporting systems (QTRS) are entities, other than an exchange or registered dealer, that disseminate price quotations for the purchase and sale of securities and report completed transactions to the applicable securities commission. A QTRS must be recognized by a provincial securities regulatory authority.
ALTERNATIVE TRADING SYSTEMS
Alternative trading systems (ATSs) are privately owned computerized trading facilities that match buy and sell orders for securities traded outside of recognized exchanges. ATSs can be owned by individual brokerage firms or by groups of brokerage firms.
These systems compete with the exchanges because a brokerage firm operating an ATS can match orders directly from its own inventory, or act as an agent in bringing buyers and sellers together, thus bypassing the stock exchange. Since there is one less intermediary, more of the commission charged to the client is kept by the dealer. Most client users of these systems are institutional investors who can reduce transaction costs considerably and avoid the market impact of their trades if the orders were instead traded through a regular exchange. Some non-brokerage-owned ATSs even allow buyers and sellers to contact each other directly and negotiate a price.
Equity ATSs now in operation in Canada include CNSX’s Pure Trading, Bloomberg Tradebook Canada, OMEGA ATS, Chi-X Canada, Instinet Canada Cross ICX, Liquidnet Canada, and MATCH Now, operated by TriAct Canada Marketplace LP.
Alternative trading systems have the potential, however, to threaten market stability due to lessened market transparency, cross-border trading issues and technological glitches such as insufficient system capacity. In Canada, ATSs are members of the Investment Industry Regulatory Organization of Canada (IIROC). The trading activity of ATS is also regulated by IIROC.
Fixed-Income Electronic Trading Systems
With the exception of a few debentures listed on the TSX and TSX Venture Exchanges, all bond and money market securities are sold through dealer markets. Three fixed-income electronic trading systems launched in Canada include:
CANDEAL
CanDeal, a member of IIROC, is a joint venture between Canada’s six largest investment dealers, and is operated by the TMX Group. It is recognized as both an ATS and an investment dealer. It offers institutional investors access to Government securities and to money market instruments.
CBID
CBID, also a member of IIROC and an ATS, operates two distinct fixed-income marketplaces: retail and institutional. The retail fixed-income marketplace is accessible by registered dealers on behalf of retail clients. The institutional fixed-income marketplace is accessible by registered dealers, institutional investors, governments and pension funds.
CANPX
CanPX is a joint venture of Investment Industry Association of Canada (IIAC)/IIROC dealer member firms. The CanPX system is an information processor for government and corporate debt securities that provides investors with real-time bid and offer prices and hourly trade data. The service covers Government of Canada bonds, treasury bills, and provincial bonds, and a select list of corporate bonds from major industrial issuers.
Complete the following Online Learning Activity
Auction and Dealer Markets
You have read about the differences between dealer markets and auction markets. Use this exercise to assess your understanding of the features of these markets.
Complete the Auction and Dealer Markets activity that outlines the features of these markets.
Trends in Financial Markets
There have been many changes to global capital markets over the last several years:
• ATSs are taking market share away from traditional stock exchanges.
• Exchanges are merging and taking over other exchanges to meet the challenge of
globalization. Ten years ago, there were over 200 exchanges in the world; today there are fewer than 100.
• In addition to mergers and takeovers, exchanges are forming alliances, partnerships and electronic links with exchanges in other countries to foster global trading.
Most of these changes were driven by increased global trading, aggressive competition, the ease of electronic communication, improved computer technology and the increased mobility of capital. The speed of innovative computer technology and the globalization and integration of financial marketplaces are likely to increase.
Auction and Dealer Markets
You have read about the differences between dealer markets and auction markets. Use this exercise to assess your understanding of the features of these markets.
Complete theAuction and Dealer Markets activity that outlines the features of these markets.
Complete the following Online Learning Activity
What’s the Difference?
After you have read the chapter, test whether you can differentiate between some common terms used in the securities industry.
Complete the What’s the Difference? activity to test yourself. What’s the Difference?
After you have read the chapter, test whether you can differentiate between some common terms used in the securities industry.
SUMMARY
After reading this chapter, you should be able to:
1. Defi ne investment capital and describe its role in the economy.
• Investment capital is available and investable wealth (e.g., real estate, stocks, bonds and money) that is used to enhance the economic growth prospects of an economy.
• In direct investment, an individual or company invests directly in an item (e.g., house, new plant or new road); indirect investment occurs when an individual buys a security and the issuer invests the proceeds.
• Capital has three characteristics: it is mobile, it is sensitive, and it is in short supply. 2. Describe how individuals, businesses, governments and foreign agencies supply and use
capital in the economy.
• Individuals generate investment capital through savings and use capital to fi nance major purchases or for consumption.
• Retail investors are individuals who buy and sell securities for their personal accounts; institutional investors are companies and other organizations.
• Businesses use capital to fi nance day-to-day operations, to renew and maintain plant and equipment, and to expand and diversify activities.
• Governments use capital when expenditures exceed revenue and to fi nance large projects.
• Foreign investors invest in Canada to access returns on investment not perceived to be available in other countries. Foreign investors will use Canadian capital if they can borrow at a more advantageous rate in Canada than elsewhere.
3. Differentiate between the types of fi nancial instruments used in capital transactions.
• Debt (bonds or debentures): the issuer promises to repay a loan at maturity, and in the interim makes payments of interest or interest and principal at predetermined times. The term to maturity of a debt instrument can be either short (less than fi ve years) or long (more than ten years).
• Equity (stocks): the investor buys a share that represents a stake in the company.
• Investment funds (mutual funds, segregated funds): a company or trust that manages investments for its clients.
• Derivatives (options, futures, rights): products derived from an underlying instrument such as a stock, fi nancial instrument, commodity or index.
• Other investment products (linked notes, exchange-traded funds): investments that are relatively new and do not fi t into any of the standard categories.
• Private equity is the fi nancing of fi rms unwilling or unable to fi nd capital using public means – for example, via the stock or bond markets.
• Private equity complements publicly traded equity by allowing businesses to obtain fi nancing when issuing equity in the public markets may prove diffi cult or impossible.
• Public and private pension plans, endowments, foundations, and wealthy individuals are the main investors in the private equity market.
4. Explain the role of fi nancial markets in the Canadian fi nancial services industry, distinguish among the types of fi nancial markets, and describe how auction markets and dealer markets work.
• The fi nancial markets facilitate the transfer of capital between investors and users through the exchange of securities.
• The exchanges do not deal in physical movement of securities; they are simply the venue for agreeing to transfer ownership.
• The primary market is the initial sale of securities to an investor.
• The secondary market is the transfer of already issued securities among investors.
• Dealer markets are network of dealers that trade with each other directly on a negotiated market with market makers. Most bonds and debentures trade on these markets.
• In an auction market, clients’ bid and ask quotations for a stock are channelled to a single central market (stock exchanges) and compete against each other.
Online Frequently Asked Questions
CSI has answered many frequently asked questions about this Chapter. Read through online Module 1 FAQs.
Online Post-Module Assessment
Once you have completed the chapter, take the Module 1 Post-Test. CSI has answered many frequently asked questions about this Chapter. Read through online Module 1 FAQs.
