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A. INTRODUCTION

Economists are fond of saying that the capital market the market for trading debt andequity securities is the engine of the Canadian economy. By this they mean that thecapital market transforms savings into investments, and these investments drive thegrowth of our nation.

This vital economic function is based on a simple process: the transfer of money from those whohave it (savers) to those who need it (users). At its simplest, the process might involve a youngcouple who borrows money from a friend to start a small business. The deal is sealed with ahandshake and the couple then works to make the business profitable so that they can laterrepay the loan with interest.

This informal capital transfer works well in simple situations where the transfer takes placebetween people who know each other. In our more complex economic system, however, thereare millions of savers and users of capital, and countless transfers must take place each day.

To reflect our increasingly complex economy, the capital transfer process has become moresophisticated. Instead of handshakes, financial instruments such as stocks and bonds now for-malize the transfer of capital. These instruments are also known as securities or financial prod-ucts. Instead of isolated transactions, financial markets have developed to provide a forum fortransferring capital using these financial instruments. Instead of direct contact between saversand users, financial intermediaries, such as investment firms and banks, have evolved to makethe transfer process faster and easier.

These three components, financial instruments (products), financial markets, and financial inter-mediaries, are the key elements in the securities industry. This industry facilitates the efficientallocation of capital through the various types of investment products. A typical example of thisallocation of capital occurs when a company needs money in order to operate and expand itsbusiness. One way to generate the necessary capital is by issuing securities such as stocks andbonds. Investment dealers help the company issue the securities and sell them to investors. Bybuying the securities, the investors temporarily transfer their money to the company and, inreturn, receive securities representing claims on the companys real assets.

If the firm does well, it earns a profit. Part of these earnings may be distributed to the investorsas dividends or interest, depending on the type of security that was purchased. The price of thesecurity also may increase, yielding a profit for the investor when the security is sold in the mar-ketplace.

But investors arent the only ones to profit. Part of the money earned by the company may bereinvested in the firm, spurring further economic development. Thus securities investment bene-fits not only the investor and the user of capital, but also the country as whole.

The securities industry plays a significant role in sustaining and expanding the Canadian econo-my. This textbook discusses the three central elements of the securities industry: investmentproducts, markets, and intermediaries. The emphasis, however, is on the securities themselves.The text examines the main types of investment products; how to analyze them; how they aresold; and how they are used as part of a well-planned portfolio of investments.

Chapter 1

Capital Markets and Financial Services

CSI Global Education Inc. (2005)

PRE-TEST

The first chapter describes Canadas evolving capital market and its major players. We startwith a brief look at the nature of investment capital and the major investment objectivesof clients both individual and institutional. The three major suppliers of investment cap-ital in Canada individuals, corporations and foreign investors, are discussed. This is fol-lowed by a description of Canadas major users of investment capital individuals, foreignusers, corporate users, and public users (i.e., various levels of government).

The focus then turns to an introduction of the primary financial instruments that areused to facilitate the movement of funds from the suppliers to the user. Since theseinstruments are traded, the role of financial markets in increasing trading efficiency isexplained and the primary Canadian markets are identified. Trading is facilitated byfinancial intermediaries. These intermediaries are identified, and their different activitiesare described. The chapter concludes by narrowing the focus from the financial systemas a whole to the structure and function of the securities industry itself.

B. INVESTMENT CAPITAL1. What Is Investment Capital?

In general terms, capital is wealth both real, material things such as land and build-ings, and representational items such as money, stocks and bonds. All of these itemshave economic value. Capital represents the invested savings of individuals, corpora-tions, governments and many other organizations and associations. It is in short supplyand is arguably the worlds most important commodity.

Capital savings are useless by themselves. Only when they are harnessed productively dothey gain economic significance. Such utilization may take the form of either direct orindirect investment.

Capital savings can be used directly by, for example, a couple investing their savings in ahome; a government investing in a new highway or hospital; or a domestic or foreigncompany paying start-up costs for a plant to produce a new product.

Capital savings can also be harnessed indirectly through the purchase of such representa-tional items as stocks or bonds or through the deposit of savings in a financial institu-tion. The indirect investment process is the principal focus of this course.

Indirect investment occurs when the saver buys the securities issued by governments andcorporations, which in turn use the funds for direct productive investment in plant,equipment, etc. Such investment is normally made with the assistance of the retail orinstitutional sales department of the investment advisors firm.

In the case of indirect investment through a financial intermediary or financial institu-tion, the individual, corporation or government may deposit funds in a bank or trustcompany savings account. This is a non-contractual commitment because funds may bereadily withdrawn on short notice. Savings may also be deposited in contractualaccounts such as pension or life insurance plans where withdrawal is less easy or perhapsnot permitted until some fixed future date. In either case, the financial intermediaryattempts, in the meantime, to reinvest the deposited funds profitably until they must bepaid back to the original saver. The institutional sales department and the money mar-ket department of the investment advisors firm assist financial intermediaries in prof-itably investing the pooled savings of their thousands of depositors.

The Capital Markets and Financial Services

1-2 CSI Global Education Inc. (2005)

2. Characteristics of Capital

Capital has three important characteristics. It is mobile, sensitive to its environment andscarce. Therefore capital is extremely selective. It attempts to settle in countries or localitieswhere government is stable, economic activity is not over-regulated, the investment cli-mate is hospitable and profitable investment opportunities exist. The decision as to wherecapital will flow is guided by country risk evaluation, which analyzes such things as:

The political environment whether the country is involved or likely to beinvolved in internal or external conflict;

Economic trends growth in gross domestic product, inflation rate, levels of eco-nomic activity, etc.;

Fiscal policy levels of taxes and government spending and the degree to which itencourages savings and investment;

Monetary policy the sound management of the growth of the nations money supply and the extent to which it promotes price and foreign exchange stability;

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.

Because of its mobility and sensitivity, capital moves in or out of countries or localitiesin 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 andattempts to avoid areas where the above factors are not positive. Thus, capital moves touses and users that offer the highest risk-adjusted returns. Capital is scarce worldwideand it cannot be increased synthetically or by government decree. It is in great demandeverywhere.

3. Why Is It Needed?

An adequate supply of capital is essential for Canadas future well being. Enough newand efficient plant and equipment must be put in place to ensure expanded outputcapability, improved productivity, increased competitiveness and the development ofinnovative, sought-after new products. If capital investment is inadequate, the result willbe insufficient output, declining productivity, rising unemployment, decreasing compet-itiveness 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 andinvestment process. The industry advocates changes, when appropriate, in both govern-ment policies and the tax system. These proposed changes are designed to encouragemore saving and the investment of savings in productive plant and equipment.

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C. SOURCES OF CAPITALThe only source of capital is savings. When revenues of non-financial corporations,individuals, governments and non-residents exceed their expenditures, they have savingsto invest.

Non-financial corporations such as steel makers, food distributors and machinery man-ufacturers have historically generated the largest part of total savings mainly in the formof earnings, which they retain in their businesses. These internally generated funds areusually available only for internal use by the corporation and are not normally investedin other companies stocks and bonds. Thus, corporations are not important providersof permanent funds to others in the capital market.

Individuals may decide, especially if given incentives to do so, to postpone consumptionnow in order to save so that they can consume in the future. Governments that are able tooperate at a surplus are savers and able to invest their surpluses. Other governments aredissavers and must borrow in capital markets to meet their deficits. Most governmentsalso own or control Crown corporations or agencies that may generate retained earningsfor investment. Both federal and provincial governments, until recently, have been run-ning deficits and, therefore, have not been significant suppliers of investment capital.

Non-residents, both corporations and private investors, have long regarded Canada as agood place to invest. Canada has traditionally relied on savings for both direct plant andequipment investment in Canada and portfolio investment in Canadian securities.

1. Individuals as Capital Suppliers

Individual or retail investors are a significant source of investment capital. Retailinvestors are individual investors who buy and sell securities for their own personalaccounts, and not for another company or organization. Institutional investors areorganizations, such as a pension fund or mutual fund company, that trade large volumesof securities and typically have a steady flow of money to invest. Retail investors gener-ally buy in smaller quantities than larger institutional investors.

For example, by the end of 2004, individual Canadians had more than $400 billion inpersonal savings deposits at the chartered banks alone. They had many more billions ofdollars at other financial intermediaries such as trust companies, credit unions, andinvestment dealers. Canadians also have other substantial assets in the form of CanadaSavings Bonds, securities investments made either directly or indirectly through invest-ment funds and pension plans, equity in homes and businesses, cash values of insurancepolicies, retirement plans, etc. Roughly one half of all working Canadians are directlyand indirectly invested in the equities market. Over the past ten years, Canadianinvestors holdings of securities have doubled to more than $550 billion today. Ten yearsago, 22 per cent of the average investor financial assets (bank accounts, RRSPs, pen-sion, insurance, etc.) were stocks. Today, this share has grown to 30 per cent. Canadiansare increasingly turning to the securities industry to ensure their prosperity and futureretirement security.

As Table 1.1 shows, historically Canada exhibited a relatively high rate of personal savings:as a percentage of personal disposable income (the amount of after-tax income availablefor purchases of goods and services). Savings were historically around 10%, compared to5% in the United States. Strong incentives in our tax system encourage Canadians to saveand to invest these savings, either directly in securities, or by depositing savings withfinancial institutions that invest these funds for their depositors. Such tax incentivesinclude a dividend tax credit system and several types of tax deferral plans like registeredretirement savings plans (RRSPs). These are described in detail in later chapters.



The personal savings rate in Canada has been trending downward since the 1990s asconsumers battle high debt levels and slow growth in personal disposable income. Table1.1 shows that the personal savings rate fell dramatically in 2004 to its lowest level onrecord since the 1930s.

TABLE 1.1

Canada and the United States % Ratio of Savings to Personal Disposable Income

Canada United States

1980 14.3 5.7

1985 14.0 6.9

1990 11.1 5.1

1995 7.3 3.4

2000 3.9 1.0

2001 3.4 2.3

2002 3.7 2.3

2003 2.3 2.0

2004 0.4 1.0

Sources: STATISTICS CANADA, National Income and Expenditure Accounts, cat.# 13-001, U.S. Bureau of EconomicAnalysis, Economic Indicators

2. Foreign Investors as Capital Suppliers

Historically, Canada has depended upon large inflows of foreign investment for contin-ued growth. In 2004, foreign direct investment in Canada amounted to just over $8.5billion, down substantially from previous years.

Foreign direct investment in Canada has tended to concentrate in particular industries:manufacturing, petroleum and natural gas, and mining and smelting. There are manyindustries that are largely Canadian-controlled (e.g., merchandising, finance, agriculture,transportation, construction, utilities). Some industries also have restrictions withrespect to foreign investment.

Canadas use of foreign investment, while necessary, has its costs. Some Canadian eco-nomic nationalists feel that direct foreign investment implies control. They feel that for-eign investment leads to long-term outflows of interest and dividend payments, nega-tively affecting our international balance of payments. They also fear that foreign own-ers may favour their own domestic plants, or subsidiaries in other countries over theirCanadian subsidiaries in the pursuit of export markets, research and developmentefforts, and in plant closings or layoffs during recessions.

The debate on the appropriate level of foreign investment in Canada will, no doubt,continue. But over the past 20 years there has been a significant swing in governmentpolicy away from the protection of Canadian businesses. The Canadian Governmentand the business community recognize that foreign capital continues to be needed andthat foreign investors must be made to feel that Canada is a safe and attractive countryin which to invest. Further, it is widely felt that controls on foreign ownership should berelaxed so that Canada can expand its international trading partnerships.

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3. Principal Investment Objectives

Those organizations and individuals that are the source of a societys capital have atremendous range of investments in which they may place their savings. This choiceamong investments is guided by the investors broad investment objectives. In general,investors have three primary investment objectives (1) Safety of Principal, (2) Incomeand (3) Growth of Capital and two secondary objectives (4) Liquidity and (5) TaxMinimization. These investment objectives are described below in the context of choos-ing among different securities. A more detailed discussion of these objectives can befound in the chapters on portfolio management and financial planning.

a) Safety

If an investor requires the highest degree of safety, it may be obtained by accepting alower rate of income return and giving up much of the opportunity for capital growth.In Canada, most federal, provincial and municipal bonds offer a high degree of safety ofprincipal and certainty of income, especially if held to maturity. Selected high-grade cor-porate bonds also fall into this category. Shorter-term bonds also offer a high degree ofsafety because they have shorter maturity dates. Government of Canada treasury billsoffer the highest degree of safety they are virtually risk-free.

b) Income

An investor seeking to maximize the rate of income return must usually give up somesafety if he or she purchases corporate bonds or preferred shares with lower investmentratings. The term usually is used because there are times when the informed investorwith access to accurate and current information may be able to obtain bargains. In gen-eral, however, safety goes down as yield goes up. But it should not be assumed that asthe yield goes down the safety of the bond or preferred share improves because otherfactors may affect price and yield.

c) Growth of Capital

Many investors, particularly those in high tax brackets, seek capital gains over invest-ment income because they receive more favourable tax treatment. Only 50% of mostcapital gains must be added to an individual taxpayers income where it is taxed at thetaxpayers ordinary rate of income tax.

The following summary, in very broad terms and disregarding inflation and its effects,shows the three major kinds of securities and evaluates them in terms of the three basicinvestment objectives:

Safety Income Growth

Bonds

Short-Term Best Very Steady Very Limited

Long-Term Next Best Very Steady Variable

Preferred Stocks Good Steady Variable

Common Stocks Often the Least Variable Often the Most

d) Marketability or Liquidity

A fourth goal sought by many investors is marketability, which is not necessarily relatedto safety, income return or capital gain. It simply means that at nearly all times there arebuyers at some price level for the securities (sometimes at a small discount from fairvalue). For some investors who may need money on short notice (i.e., liquidity), thisfeature is very important. For others, it may not be vital. Most Canadian securities



(excluding some real estate related securities) can be sold in reasonable quantities atsome price usually within a day or so.

e) Tax Minimization

When assessing the returns from any investment, the investor must consider the effectof taxation. The tax treatment of any investment varies depending on whether thereturns are categorized as interest, dividends or capital gains. Thus, tax treatment of thereturns influences the choice among investments.

D. USERS OF CAPITAL1. Introduction

In this section we turn our attention from the suppliers of capital to the users. Based onthe simplest categorization, the users of capital are individuals, businesses and govern-ments. These can be both Canadian and foreign users. The ways in which these groupsuse capital are described below.

2. Individual Users

Individuals may require capital to finance housing, consumer durables (e.g. automo-biles, appliances) or other types of consumption. They usually obtain it through incur-ring 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 onsecurities, individual capital users are not discussed further.

3. Business Users

Canadian businesses require massive sums of capital to finance day-to-day operations, torenew and maintain plant and equipment as well as to expand and diversify activities. Asubstantial part of these requirements is generated internally (e.g., profits retained in thebusiness), while some is borrowed from financial intermediaries (principally the char-tered banks). The remainder is raised in securities markets through the issuance ofshort-term money market paper, medium and long-term debt, and preferred and com-mon shares. These instruments are discussed in detail in later chapters.

4. Government Users

Governments in Canada are major issuers of securities in public markets, either directlyor through guaranteeing the debt of their Crown corporations.

a) Federal Government

Each year the Minister of Finance presents the governments budget to Parliament. Thebudget details the governments estimate of its revenues and expenses, which in turnresults in a projection of a budget surplus or budget deficit.

When revenues fail to meet expenditures and/or when large capital projects are plannedthe federal government must borrow. The government makes use of three instruments:treasury bills (T-bills), marketable bonds, Canada Savings Bonds (CSBs) and CanadaPremium Bonds (CPBs). The characteristics of each of these instruments are discussedin detail in the material on fixed-income products.

b) Provincial Governments

Like the federal government, the provinces issue debt directly themselves and may guar-antee unconditionally the interest and principal of securities issued by their Crown cor-porations such as the Alberta Municipal Financing Corporation, Hydro Qubec, andNew Brunswick Electric Power Commission.

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The British North America Act of 1867 and the Constitution Act of 1982 allocated cer-tain responsibilities along with certain revenue-generating powers to the provinces. Afew of the provinces more important functions are: highway construction and mainte-nance, providing public education, construction and maintenance of hospitals and relat-ed health services, control and development of natural resources, agricultural andforestry assistance and electric power distribution.

When revenues fail to meet expenditures and/or when large capital projects are planned,provinces must borrow. They may issue non-marketable bonds (i.e., bonds that do nottrade in the secondary markets) to the federal government or borrow funds fromCanada Pension Plan (CPP) assets (or the QPP in the case of Qubec).

Alternatively, a province may issue debt domestically through a syndicate of investmentdealers who sell the issue to financial institutions or to retail investors. In addition toconventional debt issues, some provinces issue their own short-term treasury bills and, insome cases, their own savings bonds similar to CSBs issued by the federal government.

As an alternative to domestic issues, a province may also issue marketable debentures,payable in U.S. currency in the American market or in other currencies in internationalmarkets.

c) Municipal Governments

Municipalities are responsible for the provision of streets, sewers, waterworks, police andfire protection, welfare, transportation, distribution of electricity and other services forindividual communities. Since many of the assets used to provide these services areexpected to last for twenty or more years, municipalities attempt to spread their cost overa period of years through the issuance of instalment debentures (or serial debentures).

5. Foreign Users

Just as foreign individuals, businesses or governments can supply capital to Canada, cap-ital can flow in the other direction. Foreign users (mainly businesses and governments)may access Canadian capital by borrowing from Canadian banks or by making theirsecurities available to the Canadian market. Foreign users will want Canadian capital ifthey 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 withmore choice and an opportunity to further diversify their investments.

E. THE ROLE OF FINANCIAL INSTRUMENTSTransferring 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 manyadvantages. Securities are formal, legal documents, which set out the rights and obliga-tions of the buyers and sellers. They tend to have standard features, which facilitatestheir trading. Furthermore, there are many types of securities, enabling both investors(buyers) and users (sellers) of capital to meet their particular needs.

Much of this text deals with the characteristics of different financial instruments. Thefollowing brief discussion of instruments is included here to remind the reader thatfinancial instruments (products) are one of the three key components of the securitiesindustry. The other two components, financial markets and financial intermediaries, willbe covered in detail elsewhere in this chapter.



1. Debt

Financial instruments can be broadly categorized as either debt or equity. Debt instru-ments formalize a relationship in which the issuer promises to repay the loan at maturi-ty, and in the interim makes interest payments to the investor. The term of the loanranges from very short to very long, depending on the type of instrument. Bonds,debentures, mortgages, treasury bills and commercial paper are all examples of debtinstruments.

Bonds and debentures are among the most common forms of debt instrument. They areissued by all levels of government, many corporations and some educational and reli-gious organizations. The term bond is sometimes used colloquially to refer to bothbonds and debentures, but these two instruments differ in terms of how they aresecured. A bond is secured by specific assets of the issuer, while a debenture is securedonly by the general credit of the issuer and not by a specific pledge of assets. These secu-rities are discussed in more detail in the chapter on fixed-income products.

2. Equity

Equities are usually referred to as stocks or shares because the investor actually buys ashare of the company, thus gaining an ownership stake in the company. As an owner,the investor participates in the corporations fortunes. If the company does well, thevalue of the company may increase, giving the investor a capital gain when the sharesare sold. In addition, the company may distribute part of its profit to shareowners in theform of dividends. Unlike interest on a debt instrument, however, dividends are notobligatory.

Different types of shares have different characteristics and confer different rights on theowners. In general, there are two main types of stock: common and preferred.

Ownership of a companys common shares (or stock) usually gives shareholders theright to vote at the companys annual meeting and also a claim on its profits. The com-pany may issue a dividend to common shareholders when business is profitable, but it isunder no obligation to do so.

In contrast, owners of preferred shares generally are entitled to a fixed dividend thatmust be paid out of earnings before any dividend is paid to common shareowners. Aswell, should the firm wind up its affairs, preferred shareholders have a prior claim onthe assets of the company before common shareholders. Unlike common shareholders,however, preferred shareholders usually have no vote on the direction of managementunless the company fails to pay preferred dividends.

3. Investment Funds

An investment fund is a company or trust that manages investments for its clients. Themost common form is the open-end fund, also known as a mutual fund. The fund rais-es capital by selling shares or units to investors, and then invests that capital. Asunitholders, the investors receive part of the money made from the funds investments.

The key advantages of investment funds are that they are professionally managed andprovide a relatively inexpensive way to diversify a portfolio. For example, an equity fundmay invest in hundreds of stocks, which many individual investors could not afford to dodirectly. The Canadian market offers a wide and ever-expanding range of mutual funds.

4. 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 astock or an index.

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For example, an option grants the holder the right, but not the obligation, to buy or sell acertain quantity of an underlying instrument at a set price for a set period of time. Optionsand futures enable investors to profit or protect themselves from changes in the underlyinginstruments price. The wide range of option trading strategies makes them useful for manyinvestors. Successful trading, however, requires a high degree of knowledge.

5. Other Investment Products

In the past few years investment dealers have used the concept of financial engineeringto create hybrid products that have various combinations of characteristics of debt, equi-ty and investment funds. Two of the most popular are income trusts and exchange-traded funds. Both of these types of securities trade on stock exchanges.

These instruments, and other products, will be discussed in later chapters.

F. THE ROLE OF FINANCIAL MARKETSSecurities are a key element in the efficient transfer of capital from savers to users, bene-fiting both. Many of the benefits of investment products, however, depend on the exis-tence 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 ahigh degree of liquidity and effective regulation.

Like a farmers market, a securities market provides a forum in which buyers and sellersmeet. But there are important differences. In the securities markets buyers and sellers donot meet face to face. Instead, intermediaries, such as Investment Advisors or bonddealers, 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 noteven that. Of course, some securities markets do have a physical component. Othersecurities markets, such as the bond market, exist in cyberspace as a computer andtelephone-based network of dealers who may never see their counterparts faces. InCanada, all exchanges, with the exception of the Winnipeg Commodity Exchange, are electronic.

The capital market or securities market is made up of many individual markets. Forexample, there are stock markets, bond markets, and money markets. In addition, secu-rities are sold on primary and secondary markets. The primary market is the marketwhere a security is sold when it is first issued and sold to investors. It is on this marketthat the user of capital, such as a business or government, receives capital frominvestors. Subsequent trading takes place in the secondary market and it is here whereindividual investors trade among themselves.

At first glance the primary market may seem to be the most important in the capital-raising process. This is the part of the process in which the user of capital, such as abusiness or government, receives capital from investors. In the secondary market, trad-ing takes place between investors, and the issuer receives no money.

Nonetheless, the secondary market is extremely important. It enables investors whooriginally bought the investment products to sell them and obtain cash. Without sec-ondary market liquidity the ability to sell the securities with ease at a reasonable price investors would not buy securities in the primary market.



POST-TEST

PRE-TEST

Markets can also be divided into auction and dealer markets. In an auction marketclients bids and offers for a stock are channeled to a single central market and competeagainst each other. Brokerage firms usually act as agents for their clients. The prices ofall transactions are publicly visible. Canadas stock exchanges are auction markets.Dealer markets, also known as over-the-counter or unlisted markets, do not necessarilyhave a central trading location or exchange through which trades flow. Market makerspost bid and ask prices, but the prices at which transactions occur are less publicly visi-ble and may differ from the posted prices. Almost all bond trading in Canada takesplace over-the-counter. As well, there is an organized Internet-based post-trade reportingsystem used by dealers to report trades in unlisted securities called the CanadianUnlisted Board (CUB).

1. Auction Markets in Canada

a) Canadian Exchanges

A stock exchange is a marketplace where buyers and sellers of securities meet to tradewith each other and where prices are established according to the laws of supply anddemand. On Canadian exchanges, trading is carried on in common and preferred shares,rights and warrants, listed options and futures contracts, installment receipts, exchange-traded funds (ETFs), income trusts, and a few convertible debentures. On some U.S. andEuropean exchanges, bonds and debentures are traded along with equities.

Canada has four major exchanges: the Toronto Stock Exchange (TSX) and the TSXVenture Exchange, both owned by the TSX Group Inc., the Bourse de Montral (alsoknown as the Montral Exchange or ME), and the Winnipeg Commodity Exchange(WCE). Rationalization amongst the exchanges in Canada has resulted in each exchangebeing responsible for the trading of certain products.

The Toronto Stock Exchange (TSX) lists senior equities, some debt instrumentswhich are convertible into a listed equity, income trusts and ETFs.

The TSX Venture Exchange trades junior securities and a few debenture issues.

The Bourse de Montral trades all financial and equity futures and options.

The Winnipeg Commodity Exchange (WCE) trades agricultural futures andoptions.

Liquidity is fundamental to the operation of an exchange. A liquid market is characterized by:

Frequent sales;

Narrow price spread between bid and offering prices; and

Small price fluctuations from sale to sale.

During trading hours Canadas exchanges receive thousands of buy and sell orders fromall parts of the country and abroad. Traditionally, the trading floors of the exchangeshave been the focal points for trading in equities. More recently, there has been a trendto use computerized systems for trading. The Winnipeg Commodity Exchange is theonly exchange in Canada to have a physical trading floor.

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Table 1.2 provides a comparison of the share volume and dollar value of listed tradingon Canadas stock exchanges.

TABLE 1.2

Total Share Volume and Dollar Value of Transactions for all Stock Exchanges in Canada

COMPARATIVE SHARE VOLUMES (millions)

Exchange 2004 % 2003 %

Toronto 61,278.0 78.7 55,562.9 80.7

TSX Venture 16,627.7 21.3 13,284.3 19.3

Total Shares 77,905.7 100.0 68,847.2 100.0

COMPARATIVE DOLLAR VALUES OF TRANSACTIONS ($millions)

Exchange 2004 % 2003 %

Toronto 833,906.6 98.7 648,654.1 99.0

TSX Venture 10,846.5 1.3 6,510.5 1.0

Total Value $ 844,753.1 100.0 $ 655,164.6 100

Source: The TSX Group Annual Report 2005

b) Recent History of the Canadian Exchanges

Securities trading has existed in Canada since 1832. Over the years there have beenmany changes. The late 1990s saw radical changes to securities trading in Canada. InMarch 1999, Canadas four major stock exchanges announced that they had reached anagreement to restructure along lines of market specialization. The restructuring wasintended to ensure a strong and globally competitive market system, and this resulted inthree specialized exchanges:

The Toronto Stock Exchange became Canadas senior equities market and gave up itsparticipation in derivatives trading and the junior equity market.

The Alberta Stock Exchange, the Winnipeg Stock Exchange and the Vancouver StockExchange merged to create a single, national junior equities market, called the CanadianVenture Exchange (CDNX). This new market also consolidated the operations of theCanadian Dealing Network (CDN) as of October 2000.

The Bourse de Montral became the exclusive exchange for financial futures andoptions in Canada. Responsibility for all equities once traded on Montreal transferred tothe TSX or the TSX Venture Exchange.

During the year 2000, the Toronto Stock Exchange also joined the Global EquityMarket Alliance with seven other stock exchanges to discuss the creation of a round-the-clock, global marketplace.

The Canadian Venture Exchange became a wholly-owned subsidiary of the TorontoStock Exchange in 2001. In April 2002, the Toronto Stock Exchange rebranded itsabbreviated name from the TSE to TSX, while CDNX was renamed the TSX VentureExchange. These changes were part of a rebranding initiative as the TSX and its sub-sidiaries prepared to go public in the Fall of 2002. Under the rebranding program, theTSX, TSX Venture Exchange and TSX Markets Inc. (the arm of the TSX that sell marketinformation and trading services) are collectively known as the TSX Group of companies.

In November 2002, the TSX Group Inc. went public, becoming the first listed stockexchange in North America.



2. Stock Exchanges around the World

There are over 80 stock exchanges in over 60 nations. Usually a good gauge of a coun-trys economy is the size and organization of its exchanges. North America has 10exchanges; Europe has in excess of 35; Central and South America, around 10; and thebalance are in Africa, Asia, and Australia.

The World Federation of Exchanges reports that, as at the end of 2003, the New YorkStock Exchange was the largest stock exchange in the world in terms of market capital-ization, followed by Tokyo, NASDAQ, London and Euronext stock exchanges. TheTSX ranked seventh in terms of market capitalization. Table 1.3 shows the ranking ofsome of the largest stock exchanges by dollar value of shares traded as at the end of2003, the latest year in which data is available.

TABLE 1.3

Top World Exchanges Equity Trading Summary (In Millions of U.S. Dollars)

Market CapitalizationValue Traded $ Domestic Shares Only

End of 2003 End of 2003

New York (tsv) 9,691,335 11,328,953.1

NASDAQ (rev) 7,068,213 2,844,192.6

London (rev) 3,609,718 2,460,064.0

Tokyo (tsv) 2,108,732 2,953,098.3

Euronext (rev) 1,936,573 2,076,410.2

Deutsche Bourse (tsv) 1,299,327 1,079,026.2

Spanish Exchange (BME) 933,059 726,243.4

Swiss 610,361 727,103.0

Taiwan (tsv) 591,717 379,060.4

Toronto (tsv) 471,543 888,677.7

Australia (tsv) 371,970 585,431.0

Stockholm (rev) 303,291 293,016.8

Shanghai 255,964 360,106.3

Hong Kong (tsv) 296,155 714,597.4

Source: World Federation of Exchanges www.world-exchanges.orgREV: Includes all transactions subject to supervision by the market authorityTSV: Includes only transactions which pass through their trading systems or take place on the trading floor

3. Exchange Memberships

When a stock exchange is founded, memberships are sold to different individuals.Historically, in order to trade on an exchange, a firm had to own a seat. The term seatoriginated with the old practice of brokers trading securities while seated around a table.Today, the term means a right of entrance to a stock exchange. The seat itself is a validand valuable asset that may be sold or leased subject to conditions in the exchanges by-laws. There are currently two types of exchange ownership. One is the original not-for-profit membership, in which the firm must own a seat to be a member.

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The second type of exchange ownership is a for-profit private company, where theexchange is owned by shareholders. All Canadian exchanges are set up as for-profit com-panies. Firms who have access to the trading facilities are known as ParticipatingOrganizations or Approved Participants, and do not have to be shareholders. TheToronto Stock Exchange became a for-profit private company in 2000. The TSX Groupbecame the first North American exchange to become a publicly listed company. Manyexchanges, throughout the world, are moving in this direction.

There is much duplication in membership and participation on Canadian exchanges.Many firms hold memberships (or access rights) on more than one exchange in Canadaand some are members of one or more US exchanges. Several US brokers, operating inCanada, also maintain membership on Canadian exchanges.

Each exchange sets its own requirements for permitting access to trading facilities.Member firms may be publicly owned. There are requirements regarding the amount ofcapital necessary to carry on business and key personnel (officers and directors and allothers who deal with the public) must complete required courses of study. Table 1.4shows the number of exchange memberships and number of ParticipatingOrganizations.

TABLE 1.4

Exchange Memberships and Participating OrganizationsAs of January 2005

ME TSX TSX Venture WCE

Memberships or Participating Organizations 74 104 79 70

4. Governing Bodies and Administration

a) Boards of Directors

The administration and policy setting of the exchanges are the responsibilities of eachexchanges Board of Directors. Each board is comprised of at least one permanentexchange official (e.g., the president) plus some experienced senior executives from themember firms who serve as Directors for stipulated terms of office. Included on eachboard are two to six highly qualified Public Governors appointed or elected from out-side the brokerage community. Public Governors represent the interests of investors as awhole as well as listed companies and provide governing bodies with outside points ofview and expertise.

Table 1.5 shows the composition of the Boards of Directors of the Canadian Exchanges.

TABLE 1.5

Board of Directors as at January 2004

ME TSX* WCE

Participating 12 14 13

* The Toronto Stock Exchange (TSX) and the TSX Venture Exchange are governed by the same Board of Directors.

b) Statutory Responsibilities

The provincial securities acts allow the exchanges to exercise considerable self-regulation.These exchanges define acceptable standards of behaviour for member firms and theirdirectors, officers and employees. They also have established extensive rules for tradingsecurities and any other approved instruments on the exchange. They set listing and



reporting requirements for listed companies and they assist in the screening of state-ments of material facts or exchange offering prospectuses which are frequently acceptedby securities commissions in lieu of standard prospectuses for some types of distribu-tions on the exchanges.

5. How Exchanges are Financed

Sources of income used to meet operating and development costs include:

Transaction fees paid for each order executed on the exchange;

Fees paid by corporations when their securities are originally listed;

Sustaining fees paid annually by corporations to keep listings in good standing;

Fees paid by corporations subsequent to listing with respect to any changes in capi-tal structure; and

The sale of historic trading and market information.

6. Future Trends

There have been many changes to global capital markets over the last several years:

Physical marketplaces (the trading floors) are becoming obsolete, while virtual mar-ketplaces or electronic trading systems are reducing the need for human participantsin the market mechanism.

Exchanges are merging to meet the challenge of globalization. Ten years ago, therewere over 200 exchanges in the world, today there are fewer than 100.

In addition to mergers, exchanges are forming alliances, partnerships and electroniclinks with exchanges in other countries to foster global trading.

To prepare themselves for accelerating competition, most exchanges have demutual-ized, moving from not-for-profit organizations run by their members to for-profitcorporations.

Most of these changes were driven by increased global trading, aggressive competition,the ease of electronic communication, improved computer technology and the increasedmobility of capital. The speed of innovative computer technology and the globalizationand integration of financial marketplaces is likely to increase. Some of the future trendsmay include:

Exchanges taking the next step from becoming a for-profit corporation to becomingpublicly traded companies.

Consideration of free trade between stock exchanges to improve the flow of capitalacross borders. This proposal would allow institutional investors and brokeragefirms to trade directly on each others stock markets.

A movement to Straight Through Processing, a system which would electronicallyconsolidate all of the settlement information passed between dealers, custodians andbrokers, enabling trades to settle in one day and facilitating the movement of capital.

Despite the number of exchange mergers in recent years, new exchanges are emerg-ing to focus on niche markets. In the summer of 2003, the TSX Group launched asecond board of the TSX Venture Exchange called NEX, which provides a tradingforum for listed companies that have fallen below TSX Ventures listing standards.

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G. DEALER MARKETS THE UNLISTED MARKETDealer markets or over-the-counter (OTC) markets are the second major type of marketon which securities trade. They consist of a network of dealers who trade with eachother, usually over the telephone or over a computer network. Unlike auction marketswhere the individual buyers orders are entered, a dealer market is a negotiated marketwhere only the dealers bid and ask quotations are entered by those dealers acting asmarket makers in a particular security.

Almost all bonds and debentures are sold through dealer markets. These dealer marketsare less visible than the auction markets for equities, so many people are surprised tolearn that the volume of trading on the dealer market for debt securities is 14 timeslarger than the equity market.

1. The Unlisted Equity Market

a) Size of the Unlisted Equity Market

The volume of unlisted equity business is much smaller than the volume of stockexchange transactions. The exact size of Canadian OTC dealings cannot be measuredbecause complete statistics are not available. Many junior issues trade OTC but so toodo the shares of a few conservative industrial companies whose boards of directors havefor one reason or another decided not to seek stock exchange listing for one or moreissues of their equities. The unlisted market does not set listing requirements for thestocks traded on its system (hence the term unlisted market) nor does it attempt toregulate the companies. Many of the stocks sold on the unlisted market are more specu-lative, and in most cases offer lower liquidity, than listed securities.

b) The Mechanics of Trading

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 theOTC market individual investors orders are not entered into the market or displayedon the computer system. Instead, dealers, who are acting as market makers, enter theirbid and ask quotations. These market makers hold an inventory of the securities inwhich they have agreed to make a market. They sell from this inventory to buyers andadd to the inventory when they acquire securities from sellers. The market makers posttheir individual bid (the highest price the maker will pay) and ask (the lowest price themaker will accept) quotations. The willingness of the market makers to quote bid andask prices provides liquidity to the system (although the market makers do have theright to refuse to trade at these prices). When an investor wishes to buy or sell an unlist-ed security, the broker consults the bid/ask quotations of the various market makers toidentify the best price, and then contacts the market maker to complete the transaction.The broker charges a commission for this service.

c) Unlisted Reporting Systems

In most of Canada, there is no requirement for firms to report unlisted trades. Ontariois the exception. The Ontario Securities Commission (OSC) requires that trades ofunlisted securities be reported through the Canadian Unlisted Board Inc. (CUB). CUBwas launched as an automated system after the reorganization of the equity markets inCanada. It offers an Internet web-based system for dealers to report completed trades inunlisted and unquoted equity securities in Ontario, as required under the OntarioSecurities Act.



d) Quotation and Trade Reporting Systems

Quotation and trade reporting systems (QTRS) are recognized stock markets thatoperate in a similar manner to exchanges and provide facilities to users to post quota-tions and report trades. Traditionally, a QTRS is a mechanism for dealers to post quota-tions indicating the prices at which they are willing to buy and sell stock. The marketitself does not match buy and sell orders; they are negotiated and trades are reportedafter the fact. This is the traditional model for NASDAQ.

e) The Canadian Trading and Quotation System (CNQ)

In 2003, the Canadian Trading and Quotation System Inc. (CNQ) opened as a quota-tion and trade reporting system and in 2004 it gained recognition as a stock exchangeby the Ontario Securities Commission. The intent of CNQ is to provide an alternativemarket to the TSX Venture Exchange for emerging companies. Listed companies candirectly post information for investors about its operations and public material transac-tions on CNQs website (www.cnq.ca) without having to wait for exchange permission.

CNQ is based on a combination of auction and dealer markets and liquidity isenhanced on a security by security basis via market makers. Dealers accessing this mar-ketplace are required to be members of the Investment Dealers Association (IDA) ofCanada and must comply with CNQs trading and sales practice rules.

Trading on CNQ is regulated by Market Regulation Services Inc. (RS) in the same wayas the other Canadian exchanges and must therefore follow the Universal MarketIntegrity Rules (UMIR). CNQ also has its own trading rules and policies in addition toUMIR.

Companies must make application to have their shares traded and must agree to complywith CNQs rules and policies. CNQ requires enhanced disclosure by issuers in returnfor a streamlined regulation program. CNQ has minimum quotation requirements forpublic float and business activity that are less stringent than those of the TSX VentureExchange.

f) Alternative Trading Systems

Alternative Trading Systems (ATSs) are privately-owned computerized networks thatmatch orders for securities outside of recognized exchange facilities. These are alsoreferred to as Proprietary Electronic Trading Systems (PETS) or Non-SRO-operatedTrading Systems (NETS). They can be owned by individual brokerage firms or bygroups of brokerage firms. Profits are made via revenues from the trading system itselfand go to the owner(s) of the system.

These systems bypass the exchanges because a brokerage firm operating an ATS canmatch orders directly from its own inventory, or act as an agent in bringing buyers andsellers together. Since there is one less intermediary, more of the commission charged tothe client is kept by the dealer. Most client users of these systems are institutionalinvestors, who can reduce transaction costs considerably. Some non-brokerage-ownedATSs even allow buyers and sellers to contact each other directly and negotiate a price.

In the United States, alternative trading systems have now created a significant andgrowing off-exchange marketplace. Alternative trading systems have the potential,however, to threaten market stability due to lessened market transparency, cross-bordertrading issues and technological glitches such as insufficient system capacity. Therefore,some sort of regulatory oversight is preferable. In Canada, ATSs are members of theIDA and must retain the services of a regulation services provider, such as RS Inc., toregulate trading activity.

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There are dozens of ATSs in the U.S. In Canada, the introduction of ATSs has beenmuch slower. There is currently only one registered ATS in Canada BloombergTradebook.

2. The Fixed-Income Marketplace

With the exception of a few debentures listed on the TSX and TSX Venture Exchanges,all bond and money market securities trade OTC. In the past few years, three electronictrading systems have been launched in Canada.

CanDeal, a member of the IDA, is a joint venture between Canadas six largest invest-ment dealers, and is operated by the TSX. It is recognized as both an ATS and aninvestment dealer. It offers institutional investors access to federal bond bid and offer,prices and yields from its six bank-owned dealers, which represent more than 80% ofthe transactions in the bond market. CanDeal intends to expand to provincial bonds,corporate debt and commercial paper.

CBID, also a member of the IDA and an ATS, operates two distinct marketplaces: retailand institutional. The retail marketplace, Canadas first electronic fixed-income multi-dealer retail marketplace was launched in July 2001 and is accessible by registered deal-ers on behalf of retail clients. The institutional marketplace, launched in July 2002, isaccessible by registered dealers, institutional investors, governments, and pension funds.CBID currently has over 2,500 Canadian debt instruments trading.

CanPX is a joint venture of several IDA member firms. The CanPX system providesinvestors with real-time bid and offer prices and hourly trade data. Issues includeGovernment of Canada bonds and treasury bills, provincial bonds, and some corporatebonds.

H. THE ROLE OF FINANCIAL INTERMEDIARIESIn the following sections we turn our attention to another of the key components of thefinancial system, the intermediaries. The term intermediary is used to describe anyorganization that facilitates the trading or movement of the financial instruments thattransfer capital between suppliers and users. We will discuss intermediaries such asbanks and trust companies, which concentrate on gathering funds from suppliers in theform of saving deposits or GICs and transferring them to users in the form of mort-gages, car loans and other lending instruments. Other intermediaries, such as insurancecompanies and pension funds, collect funds and then invest them in bonds, equities,real estate, etc., to meet their customers needs for financial security.

Investment dealers serve a number of functions, sometimes acting on their clientsbehalf as agents in the transfer of instruments between different investors, at other timesacting as principal. Investment dealers sometimes are known by other names, such asbrokerage firms or securities houses.

Investment dealers play a significant role in the securities industrys two main functions.First, investment dealers help to transfer capital from savers to users through the under-writing and distribution of new securities. This takes place in the primary market.Second, investment dealers maintain secondary markets in which previously issued oroutstanding securities can be traded.

Investors confidence in Canadian financial institutions is high. It is based upon a longrecord of integrity and financial soundness reinforced by a legislative framework thatprovides close supervision of their basic activities. It is not surprising that deposit-takingand savings institutions have experienced strong growth, as Table 1.6 illustrates.



POST-TEST

PRE-TEST

On June 1, 1992, federal legislation affecting financial institutions was brought in. Theculmination of a lengthy process of reform, this legislation had a major impact on thefinancial industry. Many of the barriers that existed between the traditional four pil-lars of the financial services sector the banks, trust companies, the insurance industryand securities dealers were removed. In line with global trends, the legislation permit-ted banks, trust and insurance companies to compete more directly with one another.As a result, the activities of many financial institutions changed significantly and theindustry experienced many mergers.

In todays financial environment, most banks own a number of other corporations, suchas investment dealers, trust companies, as well as operating in the insurance marketthrough subsidiaries. The various activities described above are becoming more and moreintegrated. An investor, for example, can walk into a bank today and receive advice onpurchasing mutual funds and other securities. In the same visit, a mortgage can bearranged. A life insurance salesperson will often sell mutual funds and segregated funds.

TABLE 1.6

Asset Growth of Selected Canadian Financial Institutions($ Millions)

Assets % Growth

2004 1998 Since 1998

Chartered Banks 1,898,703 1,432,114 32.58

Trust Companies (unaffiliated) 12,529 55,787 77.54

Life Insurance Companies including Segregated Funds 353,537 230,786 53.19

Credit Unions and Caisse Populaires 168,869 110,851 52.34

Investment Funds 508,329 299,430 69.77

Sales Finance and Consumer Loan Companies 121,334 71,687 69.26

Totals 3,063,301 2,200,655 39.20

Bank of Canada Banking and Financial Statistics, March 2005

Table 1.6 also highlights growth rates between different types of financial institutions.Assets of the chartered banks have increased the most in dollar terms, while those ofinvestment funds have recorded the highest percentage growth. The decline in the totalassets of trust companies is caused primarily by the disappearance of independent trustcompanies as they are bought by chartered banks. The expansion of chartered bankassets has been facilitated by several factors. These include:

Much greater international activity;

Changes in the Bank Act permitting the banks to compete vigorously in new sec-tors of the financial services industry;

The creation of more banks, notably the foreign-owned Schedule II and ScheduleIII banks; and

The purchase of many major trust companies by banks..

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I. THE CANADIAN SECURITIES INDUSTRYIn this, and subsequent sections, we turn our attention to the securities industry. Themajor participants in the industry and their relationships are illustrated in Chart 1.1.

Although Canadas investment dealers compete with each other for business frominvestors and issuers, they also cooperate in many areas. For example, securities firmsjoin together as owners of the stock exchanges and the Investment Dealers Associationof Canada (IDA).

In addition to providing their members with trading-related services, these organizationsplay an important regulatory role in the securities industry by acting as Self-RegulatoryOrganizations (SROs). In that capacity, they are responsible for setting rules governingmany aspects of their members operations, including sales and finance.

CHART 1.1

Securities Industry Flowchart

1. Size and Characteristics of the Securities Industry Today

Table 1.7 shows that there were 208 firms in the securities industry that were membersof the IDA. Although total employment improved compared to 2003, employment lev-els remain well below those recorded in 2000, which continues to represent a peak yearin employment levels for the industry. Capital employed in the securities industry was$14.46 billion in 2004, representing a 37% increase over the 2000 level.

Brokers &Investment

DealersInvestors Users of

Capital

Clearing &SettlementMarkets

Self-Regulatory Organizations

Investment Dealers AssociationOf Canada

Mutual Funds Dealers AssociationBourse de Montral

The Toronto Stock ExchangeTSX Venture Exchange

CSIGlobal

Education Inc.(Industry Educator)

CanadianInvestor

Protection Fund(Industry Insurance Fund)

ProvincialRegulator

(Securities Commission)

Market Flow Ancillary Services



TABLE 1.7

Securities Industry Indicators

2004 2003 2002 2001 2000

Regulatory Capital*($ Millions) 14,419 13,962 12,960 12,454 10,557Number of Employees 37,860 37,362 37,949 37,121 39,433

Number of Firms 208 205 206 198 191

* Industry Regulatory Capital is defined as capital, retained earnings, subordinated debt, and stand-by subordnated debt.Source: IDA Industry Statistics

Still, the industry is small compared to other segments of the financial services sector oreven to some companies operating within competing segments. For instance, Canadaslargest bank, Royal Bank, employed over 60,000 people in 2004, and had total assets of$428 billion. The entire Canadian securities industry is likewise eclipsed in size by sev-eral individual U.S. and Japanese securities houses.

In spite of its comparatively small size, the industry has provided Canada with a capitalmarket that is one of the most sophisticated and efficient in the world. These qualities aremeasured in terms of the variety and size of new issues brought to the market and thedepth and liquidity of secondary trading markets. Table 1.8 shows that new issues broughtto the Canadian market have increased by 52% since 2000, while Table 1.9 illustrates thatmoney market, bond and listed stock secondary trading reached $12,943 billion in 2004,up 8.3% from 2003. Stock trading was 29% higher in 2004 compared with 2003.

TABLE 1.8

New Financing through Canadian Securities Markets(excluding treasury bills, short-term paper and CSBs)

($ Millions)

2004 2003 2002 2001 2000Government

Federal 61,527 60,766 61,389 47,664 45,918Provincial 39,923 23,964 19,298 18,180 25,191Municipal 3,873 3,846 4,681 3,655 3,105

Total Government 105,323 88,576 85,368 69,499 74,214Common Equity

IPOs 4,074 1,073 956 1,569 5,372Non IPOs 21,857 22,729 14,789 10,549 15,394

Preferred EquityConventional 2,900 3,457 2,866 3,764 2,345Convertible 414 503 232 825 50

Total Equity 29,245 27,762 18,843 16,707 23,161Debt Securities

Conventional 26,094 19,306 13,378 20,237 20,422Convertible 1,904 1,975 1,287 1,573 2,290Medium Term Notes 21,772 22,696 16,247 16,716 16,797Other 9,770 10,165 2,301 0 0

Total Debt 59,540 54,142 33,213 38,526 39,509Total Other 19,001 20,949 2,100 1,750 3,140Grand Total 213,109 195,389 139,524 126,482 140,024

Source: IDA Industry Statistics

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Today the industry is highly competitive and becoming increasingly so. It calls for ahigh degree of specialized knowledge about securities issuers, investors and constantlychanging securities markets. An entrepreneurial spirit of innovation and calculated risk-taking are among its hallmarks. Change and volatility are frequently the norm.

TABLE 1.9

Secondary Market Trading in Canada ($ Billions)

2004 2003 2002 2001 2000

Debt SecuritiesMoney Market 6,613 6,187 6,229 6,448 6,220Bond Market 5,485 5,111 4,257 4,324 3,750Total Debt 12,098 11,298 10,486 10,772 9,970

EquitiesStock Market 845 655 637 716 961

Total Trading 12,943 11,953 11,123 11,488 10,931

Source: IDA Industry Statistics

2. Types of Firms

Three categories of firms make up the Canadian securities industry: integrated firms,institutional firms, and retail firms.

Integrated firms offer products and services that cover all aspects of the industry, includ-ing full participation in both the institutional and the retail markets. The seven largestof these firms, including the securities dealer affiliates of the major domestic banks andone major U.S. dealer, generate about 70% of total industry revenues. Most underwriteall types of federal, provincial, municipal and corporate debt and corporate equityissues, actively trade in secondary markets including the money market, trade on allCanadian and some foreign stock exchanges and provide many ancillary services tosecurities issuers and large and small investors. Such services include economic, industry,corporate and securities research and advice, portfolio evaluation and management,merger and acquisition advice, tax counselling, loans to investors with margin accountsand safekeeping of clients securities.

Many smaller securities dealers or investment boutiques specialize in such areas asstock trading, bond trading, research on particular industries, trading only with institu-tional clients, unlisted stock trading, arbitrage, portfolio management, underwriting ofjunior mines, oils and industrials, mutual funds distribution, and tax-shelter sales.

Some 50 foreign and domestic institutional firms serve institutional clients exclusively.Foreign firms account for about one third of total institutional firms and include affili-ates of many of the major U.S. and European securities dealers.

Retail firms account for the remainder of the industry. Retail firms include full servicefirms and discount brokers. Full service retail firms offer a wide variety of products andservices for the retail investor. Discount brokers execute trades for clients at reducedrates but do not provide advice. Discount brokers are more popular with those investorswho are willing to research individual companies themselves in exchange for lower com-mission rates.



3. Organization of Firms

The operational structure of securities firms vary widely in the industry, depending onsize of capitalization, number and location of employees and branch offices, businessmix and degree of specialization. Some of the bank-owned firms have integrated thefunctions of the banking side of their business with the securities side. A typical config-uration divides the company into wealth management (which focuses on the retail clientand small businesses, both from a banking perspective and a securities perspective) andglobal capital markets (which concentrates on the trading, investment banking andinstitutional sales).

a) Management

A key element in the success of any securities firm is the depth and quality of seniorpersonnel. A firms success will depend on how well these key people are able to respondto change, seize new business opportunities, penetrate existing markets, maximize theuse of available capital and create a responsive and enthusiastic team effort among allemployees.

Senior officers usually include a chairman, a president, an executive vice-president, vice-presidents, some of whom are also directors, and other directors, including, in a fewfirms, directors from outside the securities industry. Most senior officers work at headoffice, but some may be in charge of regional branch offices in Canada or abroad.

Lines of management authority tend to be flexible, especially in smaller firms where sen-ior personnel are more directly involved in day-to-day management. A director may beresponsible for more than one major area of the business.

Securities firms may be very different in the way management functions are performed.For example, in some firms, the chairman of the board is the chief executive officer andplays a dominant role in the firms management; in others, the chairman is more of aconsultant who can draw on extensive business contacts and many years of experience.

Regardless of a firms size, decision and policy making usually rest with the chairman,president, executive vice-president and senior vice-presidents who comprise theExecutive Committee.

b) Departments

While the organization structure is flexible, a larger, integrated firm might be organizedinto the following departments.

Sales

Although trading is the core function of investment dealers, they perform many otherservices. The success of a securities firm rests largely on profits generated by its salesdepartment, which is usually the largest and most geographically dispersed unit in afirm. Typically, the sales department is divided into institutional and retail divisions.

Institutional salespeople deal mainly with traders at major financial institutions andlarger non-financial companies. Working with their firms underwriting department,they help sell new securities issues to institutional accounts. In cooperation with thefirms trading department, they help generate day-to-day trading in outstanding securi-ties with such accounts. They are normally located at head and major branch offices andare in constant telephone communication with major accounts throughout the countryand abroad.

Some larger firms also maintain separately managed portfolio departments, which adviselarger clients on their investment portfolios on a fee basis or manage in-house pooled ormutual funds.

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The retail sales force serves individual investors and smaller business accounts and usual-ly comprises the largest single group of a firms employees. The activities of retailInvestment Advisors (IAs) are extremely diverse, reflecting the spectrum of investortypes and needs.

To sell securities to the public, a salesperson (called an investment advisor or IA) mustbe registered with the provincial securities commission, be of legal age, and have passedthe CSC, the Conduct and Practices Handbook exam, and participate in a 90-dayTraining Program.

The duties of an investment advisor include developing a list of clients, meeting withthem to determine their financial position and goals, providing them with investmentinformation and advice (often based on the investment dealers in-house research), andprocessing their orders for securities. In performing these tasks, the investment advisormust follow the industrys guidelines for ensuring that clients investment decisions areappropriate given their characteristics and objectives.

Supporting the work of the sales and trading staff are personnel who work in areas suchas administration, research, operations, finance and compliance.

Underwriting/Financing

The underwriting/financing department works with individual companies or govern-ments that are interested in raising capital or bringing new issues of securities to themarketplace. The underwriting department will negotiate with a company on the typeof security, price, interest or dividend rate, special features and protective provisions thatare needed to market a new issue successfully in an ever-changing market. The under-writing/financing process is described in Chapter 3.

Trading

Traders work in close cooperation with a firms underwriting and sales departments. Thetrading department is often divided into bond, stock and specialized product divisions:

Bond: Typically traded in and out of a firms own inventory or from the inventoriesat other firms specializing in particular issues. Traders tend to specialize in govern-ment and corporate money market instruments, medium and long-termGovernment of Canada bonds, provincial bonds and guarantees, municipal deben-tures, and corporate bonds and debentures.

Stocks: Except for unlisteds, stocks normally trade on stock exchanges rather thanfrom a firms own inventory. A separate division staffed by block stock traders andphone and order clerks is maintained to link buy and sell orders flowing in frominstitutional and retail sales staff with traders and market makers on the exchanges.

Specialized Instruments: Some firms employ mutual fund specialists. Many alsohave trading specialists to handle exchange-traded options and commodity andfinancial futures contracts. More information on commodities and futures is provid-ed in the material on derivative products.

Research

The research department in a larger securities firm will often consist of an economist, atechnical analyst and several research analysts, each of whom covers one or more indus-tries (e.g. mining, retail, primary industry, oil and gas, etc.). Each analyst is responsiblefor studying conditions within his or her industry and the current operations and futureprospects of many Canadian and some foreign companies in that industry, and for coor-



dinating such data with economic and market trends. Research reports with specificinvestment recommendations are produced, often with extensive analytical coverage forinstitutional investors and shorter summaries for retail clients.

Research facilities may be divided into retail and institutional sections to service eachtype of client better. The retail side is geared to handle questions about companies andtheir securities that IAs receive from their clients and to help IAs evaluate and makeproposals for client portfolios. The institutional side may assist institutional salespersonsand traders in making investment proposals to institutional accounts and help under-writing and corporate finance department personnel in special studies involving newissues, takeovers, mergers, etc.

In recent years there has been a great deal of controversy concerning the potential forconflict of interest between the underwriting departments and the research departments.It is felt that it is difficult for a research analyst to be unbiased about a security that hasbeen underwritten by the same firm. Responding to this concern, the industry is in theprocess of developing and improving financial analysts standards.

Administration

This key department enables all other departments to function smoothly. The moreimportant administrative areas include:

Operations

This section is primarily responsible for the recording and accounting of all trades madeby the firm on its own behalf and for its clients. Incoming and outgoing cash, chequesand securities must be balanced; securities must be checked to meet proper registrationand good delivery requirements; and client accounts must be credited with interest anddividend payments paid on securities that are held in safekeeping by the firm.

Credit and Compliance

The focus here is on clients accounts. Cash accounts must be checked to see thatincoming payments or securities are received by regular delivery dates or, if overdue, aredebited or restricted according to industry requirements and in-house policies and con-trols. Margin accounts must similarly be monitored to ensure that they conform to ini-tial and maintenance margin requirements of the industry and the firm.

Financial

This area includes payroll, budgeting, financial reports and statements and financialcontrols. Regulatory bodies require firms to maintain at all times adequate minimumlevels of capital which vary according to the volume and type of business being done.Capital requirements must therefore be calculated frequently and capital allocationsmust be shifted between various departments of a firm to reflect changing business cir-cumstances. For example, a new underwriting commitment will mean that additionalfunds may have to be transferred to that department until the issue has been sold. Thosefunds can then be re-allocated to other departments.

4. Financing Securities Houses

Like other businesses, securities firms are financed by capital originally subscribed by theirowner-shareholders, by year-to-year net earnings retained in the business and by loans.

The industry is highly leveraged. Firms depend on borrowed money to a significantextent to finance their securities inventories, underwriting activity (including boughtdeals), trading commitments and client margin accounts.

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Commissions generated from agency transactions is the chief source of revenue for mostinvestment houses, on average making up about 40% of the total. Earnings arising fromfixed-income trading activities (9%) and from underwriting (22%) are other significantrevenue sources. Interest makes up 10% of revenue and includes interest earned on debtsecurities held in inventory and interest paid by clients on margin loans. It is partiallyoffset by interest paid by a firm for short- and longer-term financing, including thatpaid to clients who have cash balances in their accounts.

The past few years has seen a shift from commission-based accounts (where the IAcharges on a per transaction basis) to fee-based accounts (where the IA charges an annualfee, typically based on assets under management). Fee revenues from products such asWrap accounts, managed accounts and fee-based accounts are becoming more significant.

Returns in the securities business tend to be high in bull markets, reflecting the risksand volatility inherent in the industry. However, with their heavy exposure to loss intrading and underwriting and their costly and extensive staff and communication net-works, securities firms are especially vulnerable to:

Cyclical business swings;

Dramatic and unpredictable ebbs and surges in bond and stock trading volumes;and

Securities price and interest rate gyrations not only in Canada but also throughout the world.

5. Principal and Agency Functions

Like other intermediaries, one important role of investment dealers is to bring togetherthose who have surplus capital to invest and governments and companies who needinvestment capital. This function is performed on the primary or new issue market, andthese transactions are achieved through the underwriting and distribution to investors ofnew issues of securities. Investment dealers often function as principals in this role.When acting as a principal, the securities firm owns securities as part of its own inven-tory at some stage in its buying and selling transactions with investors. The differencebetween buying and selling prices is the dealers gross profit or loss.

A second role of investment dealers is to facilitate active and liquid secondary marketsfor the transfer of existing or already outstanding securities from one owner to another.As described below, investment dealers may function as principals or as agents in thisrole. When acting as an agent, the broker acts for or on behalf of a buyer or a seller butdoes not itself own title to the securities at any time during the transactions. The bro-kers profit is the agents commission charged for each transaction.

Earlier in the century, the securities business was composed of investment dealers on theone hand and stockbrokers on the other. The difference was largely perceived as a bondbusiness for dealers and a stock business for brokers, but this distinction was only a partof the story. The essential difference was that dealers acted as principals in securitiestransactions while brokers acted as agents. Today this sharp distinction has all but disap-peared as most firms act as both principal and agents in both bond and equities mar-kets. Few securities firms today conduct solely a bond business or a stock business, andfew act only as principals or agents. Most firms today deal in both bonds and stocks andact as both principals and agents.



6. Dealer, Principal and Agency Transactions

a) Underwriting/Financing

The term underwriting originated in Lloyds Coffee House in London. It was the prac-tice of merchants who gathered there to sign their names under or at the end of docu-ments when they agreed to assume jointly a portion of the risks of marine and otherdangerous business enterprises. Their early joint ventures led to the establishment ofLloyds of London, internationally known today for its insurance syndicates.

In the securities business underwriting or financing has come to mean the purchasefrom a government body or a company of a new issue of securities on a given date at aspecified price. The dealers act as principal using their own capital to buy the issue inanticipation of being able to make a profit when later selling it to others. The dealersalso accept a risk since market prices may fall during the time the securities remain intheir inventory. The issuer normally incurs no liability or responsibility in the sale of itsown securities since payment is guaranteed by the underwriter regardless of its success inselling the securities to investors.

Dealers do, of course, take precautions to minimize their financing risks. They workclosely with securities issuers in pricing, timing and otherwise designing the issue so thatit will be attractive to the market and sell readily to investors, thereby reducing thechance of price deterioration while the issue remains in inventory. A dealer also fre-quently spreads its financing risk by enlisting other securities houses to co-underwrite anew issue and assist in its speedy distribution to investors. The issue may also containspecial clauses, such as a market-out clause, whereby a dealer may, under exceptionalcircumstances, terminate a financing agreement before its completion.

Dealers underwrite both stock and bond issues, and the range of types available, specialfeatures and protective provisions is very broad. The selection of the specific kind ofsecurity to be underwritten and its price are determined only after extensive negotia-tions with the issuer. In the selection process, the dealer advises the issuer on currentmarket conditions and the type of security most likely to be well received by investors.The dealers expertise in this area is gained through its activities as a securities trader insecondary markets. The underwriting process is covered more fully in Chapter 3.

b) Principal Trading

Dealers also act as principals in secondary markets (i.e., after primary distribution hasbeen completed) by maintaining an inventory of already issued, outstanding securities.Here the dealer buys securities in the open market, holds them in inventory for varyingperiods of time, and subsequently sells them.

Generally, most secondary trading of non-equity securities is conducted with the securi-ties firm acting as principal, though occasional agency trades take place. For new moneymarket issues, for instance, a dealer may sell the securities as an agent or, alternatively,take them into inventory as principal for later resale.

There is no central marketplace for most principal or dealer market activities. Instead,transactions are routinely conducted on the over-the-counter market (described earlier) bymeans of computer systems of inter-dealer brokers which link dealers and large institutions.

By maintaining an inventory of outstanding securities, the dealer provides several usefulservices. Its knowledge of current conditions in secondary markets tempers the advice itgives about terms and features that should be built into a new issue in the primary mar-ket. Yields prevailing on outstanding bonds, for example, provide a benchmark whenthe yield on a new bond issue is determined in a primary distribution.

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The dealer may also complete a separate buy or a separate sell transaction from its owninventory. There is no need to wait for simultaneous, matching buy-sell orders fromother investors to complete an order. The relative speed and ease with which purchasesor sales may be made from inventory greatly adds to the liquidity of already-issued secu-rities (i.e., the size of an order that can be quickly absorbed without undue price fluctu-ation). This liquidity also enhances the primary market since it helps assure buyers ofnew securities that they will be able to sell their holdings if needed at reasonable prevail-ing prices.

Stock exchange trades may involve the securities house only as agent, but in many casesthe involvement is as principal. Trades done as principal occur when exchanges appointsome registered traders or market makers who have the responsibility of taking positionsin some listed stocks for their own firms accounts in order to enhance market liquidityand smooth out undue price distortions. In recent years, some firms have also boughtlisted stocks as principals in order to accumulate blocks of shares of sufficient size topermit them to be more competitive in serving their larger institutional clients. As well,firms trade for their own account with the intent of making a profit.

c) Broker or Agency Transactions

When acting as a broker, a securities firm is an agent or an intermediary in a secondarysecurities transaction. The brokers clients who buy and sell securities are, in fact, theprincipals or owners of the securities, and the broker acts only as an agent, never actual-ly owning them itself. Both the broker acting for the seller and the broker acting for thebuyer charge their respective clients a commission for executing a trade. Commissionrates were fixed by stock exchanges until the mid 1980s, but are now negotiatedbetween clients and their brokers.

7. Future Trends in the Securities Industry

The Canadian securities industry continues to realign and reorganize to better positionitself to compete globally. Future trends in the Canadian marketplace may include:

Continued mergers and alliances between Canadian and global brokerage houses toimprove access to capital and global trading.

An increase in the number of ATSs and other electronic communications networks(ECNs) in Canada.

Continued debate over the harmonization of securities laws across Canada and thecall for a national securities regulator.

A continuation of the trend away from commission-based accounts to fee-basedaccounts. Over the last 20 years, retail investors in Canada moved from individualownership of securities to an increase in the purchase of managed products, particu-larly mutual funds.

The creation of an ever-expanding array of innovative financial products to meetmarket demand and investor needs.



J. CHARTERED BANKSThe chartered banks operate under the Bank Act, which has been regularly updated, usu-a

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