CSC Volume 1 Section 1.pdf

SECTION 1 THE CANADIAN INVESTMENT MARKETPLACE 1 The Canadian Securities Industry 2 The Capital Market 3 The Canadian Regulatory Environment © CANADIAN SECURITIES INSTITUTE ...

SECTION 1 THE CANADIAN INVESTMENT MARKETPLACE 1 The Canadian Securities Industry 2 The Capital Market 3 The Canadian Regulatory Environment © CANADIAN SECURITIES INSTITUTE  The Canadian Securities Industry 1 CHAPTER OVERVIEW In this chapter, we describe the interrelationships between the various participants in the Canadian securities industry. In particular, we discuss the important role that investment dealers and other financial intermediaries play in channelling funds between lenders and borrowers. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the relationships between the Overview of the Canadian Securities Industry major participants in the Canadian securities industry. 2 | Distinguish between the three categories of The Investment Dealer’s Role as a Financial investment dealers including how they are Intermediary organized. 3 | Explain the difference between principal and agency transactions. 4 | Distinguish between the roles of the various Financial Intermediaries Other Than financial institutions. Investment Dealers 5 | Discuss the trends affecting the financial Financial Market Trends services industry in Canada and globally. © CANADIAN SECURITIES INSTITUTE 1 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. agent Investment Industry Association of Canada broker mutual fund Canadian Investment Regulatory Organization open-end fund capital markets pension fund CDS Clearing and Depository Services Inc. primary market distribution clearing principal closed-end fund retail firm consumer finance company robo-advisor discount broker sales finance company financial intermediary savings bank fintech schedule I bank firewall schedule II bank institutional firm schedule III bank integrated firm self-directed broker investment dealer settlement investment fund © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 3 INTRODUCTION Consider the following scenarios: A couple needs to borrow money to buy a home. An entrepreneur needs to raise funds to develop a new product. A mother wants to set up a regular program to save for her children’s education. Both the couple and the entrepreneur, as borrowers, are users of capital, whereas the mother, as an investor, is a supplier of capital. What they all have in common is the need for a financial intermediary to help them meet their goals. A financial intermediary is an institution such as a bank that borrows money from suppliers of capital and lends it to users of capital. In other words, investors lend funds to the intermediary, and the intermediary, in turn, lends those funds to borrowers in the form of loans, mortgages, and other products. An intermediary can also play a more direct role. The intermediary can raise capital by bringing a new issue of securities to the financial markets. For example, a company wishing to expand its business might generate the necessary investment capital by issuing securities to the public in the form of stocks. An investment dealer helps the company issue the stocks and sell them to investors. The investors who buy the stocks transfer their money to the company through the intermediary. In return, they receive the stocks, which represent a share of ownership of the company. The company can use the proceeds from the stock transaction and reinvest them in the firm, which spurs further economic development. In addition, the intermediary earns a profit on the transaction. If the firm does well following the expansion, and the price of its stock rises in value, investors will be able to sell them in the marketplace to earn a profit. By these means, financial intermediaries help to establish efficient methods of channelling funds between lenders and borrowers. DIVE DEEPER To fully understand the concepts presented in this textbook, you should stay informed about the financial markets and the industry in general. The lessons will be easier to grasp if you relate them to the activities that unfold each day in the financial markets. Countless sources of information about the financial markets are readily available online, as well as in newspapers, books, and magazines. Ultimately, by staying informed, you will more easily reach your goal of becoming a competent and trusted participant in the securities industry. OVERVIEW OF THE CANADIAN SECURITIES INDUSTRY 1 | Describe the relationships between the major participants in the Canadian securities industry. Canada has one of the most sophisticated and efficient capital markets in the world. Market activity is measured by the variety and size of new issues that are brought to the market, as well as the depth and liquidity of trading of those issues. Canada’s securities industry is highly competitive, and it is becoming more competitive each year. Market participants must have extensive, specialized, and up-to-date knowledge about securities issuers and investors in a securities market that is constantly changing. An entrepreneurial spirit of innovation and calculated risk-taking are among its hallmarks. Change and volatility are frequently the norm. © CANADIAN SECURITIES INSTITUTE 1 4 CANADIAN SECURITIES COURSE      VOLUME 1 The Canadian securities industry is mainly regulated by the provinces. They have the power to create and enforce their own laws and regulations through securities commissions (called securities administrators in some provinces). Securities commissions delegate some of their powers to the Canadian Investment Regulatory Organization (CIRO). CIRO is the national self-regulatory organization (SRO) that oversees all investment dealers, mutual fund dealers, and trading activity on Canada’s debt, equity, and mutual fund marketplaces. CIRO establishes and enforces industry regulations that protect investors and maintain fair, equitable, and ethical practices. As of January 1, 2023, the former Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA) were amalgamated to form the Canadian Investment Regulatory Organization (CIRO). The major participants in the industry and their interrelationships are illustrated in Figure 1.1. Figure 1.1 | Structure of the Canadian Securities Industry Suppliers of Capital Investment Users of Capital (Investors) Dealers (Borrowers) Self-Regulatory Organization Clearing & Markets Canadian Investment Regulatory Settlement Organization (CIRO) Legend: Industry Players Canadian Securities Canadian Investor Provincial Industry Support Institute Protection Fund Regulator Money Flow Industry Educator Industry Insurance Fund Securities Commission Information Flow The various participants interact with each other as follows: Suppliers and users of capital trade financial instruments through financial markets such as stock exchanges and money markets. Investment dealers (also called brokers) act as intermediaries by matching investors with the users of capital. Each side of a transaction has its own dealer who matches the trades through the markets. Trades and other transactions are cleared and settled through organizations such as CDS Clearing and Depository Services Inc. and banks. Clearing is the process of confirming and matching security trade details; settlement is the irrevocable moment when cash and securities are exchanged. The SRO sets and enforces rules that govern market activity and monitor the markets to ensure fairness and transparency. © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 5 The Canadian Investor Protection Fund provides insurance against investment dealer and mutual fund dealer insolvency. Provincial regulators oversee the markets and the SRO. The Canadian Securities Institute and similar organizations provide education for industry participants. DID YOU KNOW? Advocacy and Resources The Investment Industry Association of Canada (IIAC) is the national association that represents investment firms across Canada. The association represents investment and mutual fund dealers, exempt market dealers, portfolio managers, and investment fund managers. For more information about the IIAC, visit their website at https://iiac-accvm.ca/. THE CANADIAN SECURITIES INDUSTRY OVERVIEW How well do you know the structure of the Canadian securities industry and the interrelationships between its major participants? Complete the online learning activity to assess your knowledge. Note: To access the online components of your course, log in to your Student Profile at www.csi.ca and, once logged in, click on the ‘Access Online Courses’ button. THE INVESTMENT DEALER’S ROLE AS A FINANCIAL INTERMEDIARY 2 | Distinguish among the three categories of investment dealers including how they are organized. 3 | Explain the difference between principal and agency transactions. The term financial intermediary describes any organization that facilitates the trading or movement of financial instruments that transfer capital between suppliers and users of capital. Intermediaries are a key component of the financial system. They include investment dealers, banks, credit unions, trust companies, and insurance companies. Let’s look at the role of the investment dealer as a financial intermediary. Investment dealers act on their clients’ behalf as agents in the transfer of financial instruments between different investors. They sometimes also act as principals, rather than agents. In both cases, they play a significant role in the securities industry’s two main functions: 1. They help to transfer capital from suppliers to users through the underwriting and distribution of new securities. This activity takes place in the primary market in the form of a primary market distribution (or primary offering). When a private company goes public and issues stocks in the primary market for the very first time, the sale is known as an initial public offering. 2. They maintain secondary markets in which previously issued or outstanding securities can be traded. For example, buying and selling stocks through the Toronto Stock Exchange. TYPES OF INVESTMENT DEALERS The following three categories of investment dealers make up the Canadian securities industry: Retail firms include full-service investment dealers and self-directed brokers (also known as discount brokers). Full-service retail firms offer a wide variety of products and services for the retail investor. They also provide various levels of advice, depending on the financial and wealth management concerns of their investor © CANADIAN SECURITIES INSTITUTE 1 6 CANADIAN SECURITIES COURSE      VOLUME 1 clients. Self-directed brokers, on the other hand, are considered the do-it-yourself approach to investing. They execute trades for clients at reduced rates, but they do not provide investment advice. Institutional firms are investment dealers that serve exclusively institutional clients, organizations that trade large volumes of securities. Institutional clients include pension funds and mutual funds and may be domestic or foreign institutional firms. In Canada, foreign firms account for about one-third of all institutional clients. Foreign firms include affiliates of many of the major U.S. and European securities dealers. Integrated firms offer products and services across the industry and participate fully in both the retail and institutional markets. Most integrated firms underwrite all types of federal, provincial, and municipal debt, as well as corporate debt and equity issues. They are active in secondary markets, including the money market, as well as on all Canadian stock exchanges and some foreign exchanges. Many smaller retail or institutional investment dealers, known as investment boutiques, specialize in particular market segments. For example, an investment boutique might specialize in stock trading, bond trading, or trading strictly in unlisted stocks. ORGANIZATION WITHIN FIRMS The operational structure of investment dealers varies widely in the industry. A typical configuration divides the firm into different departments, with each department focusing on a specific task. A larger, integrated firm, for example, might be organized into front, middle, and back offices, with senior management overseeing all departments. The roles of the various departments are described below. SENIOR MANAGEMENT Senior management usually includes a chairperson, a president, an executive vice-president, directors, and departmental vice-presidents, some of whom are also directors. Some firms may have directors from outside the securities industry. Most senior officers work at head office, but some may be in charge of regional branch offices in Canada or abroad. FRONT, MIDDLE, AND BACK OFFICES The three-level organizational structure of most investment dealers allows them to manage client portfolios effectively and process trades efficiently, in compliance with regulatory requirements. The functions and duties of each department are described in Table 1.1. Table 1.1 | Departmental Functions at an Investment Dealer Role Functions Front Office Performs all staff functions pertaining directly Portfolio management to portfolio management activities Trading Sales Marketing Middle Office Performs functions critical to the efficient Compliance operation of the firm Accounting Audits Legal Back Office Settles the firm’s security transactions Trade settlement © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 7 The success of an investment dealer rests largely on profits generated by its sales department, which is usually the largest unit in the firm’s front office. In an integrated firm, the sales department is typically separated into institutional and retail sales. The retail sales force serves individual investors and smaller business accounts. It usually comprises the largest single group of a firm’s employees. Retail investment advisors normally perform a wide range of activities to meet the complete spectrum of the investors’ types and needs. THE PRINCIPAL AND AGENCY FUNCTIONS OF AN INVESTMENT DEALER Investment dealers facilitate the trading of securities and the transfer of capital between suppliers and users. They sometimes act as principals; at other times, they act as agents for their clients. PRINCIPAL TRANSACTIONS When they act as principals, investment dealers may own the securities as part of their inventory, at some stage of the buying and selling transaction with investors. The difference between the buying price and the selling price of the securities is their gross profit or loss. Another principal transaction is underwriting. In the securities business, underwriting refers to purchasing from a government body or a company a new issue of securities, on a given date at a specified price. When investment dealers act as principals by underwriting, they use their own capital to buy an issue to then sell it at a profit in the primary market. After a primary distribution is completed, investment dealers also act as principals in secondary markets by maintaining an inventory of already issued, outstanding securities. In these transactions, the dealers buy securities in the open market, hold them in inventory for varying periods of time, and subsequently sell them. AGENCY TRANSACTIONS When investment dealers act as agents on behalf of buyers or sellers, they do not own title to the securities that they deal with, at any time during the transactions. Their profit is the agent’s commission they charge for each transaction. In these transactions, the principals are the clients who buy and sell securities, and who own the securities. The agent acting for the seller and the agent acting for the buyer both respectively charge their clients a commission for executing the trade. The principal and agent roles in securities transactions are illustrated in Figure 1.2. Figure 1.2 | Principal Versus Agent Transactions Principal Agent Seller Buyer Seller Buyer © CANADIAN SECURITIES INSTITUTE 1 8 CANADIAN SECURITIES COURSE      VOLUME 1 DID YOU KNOW? An agent acting on behalf of a client is often called a broker, and the broker’s role is generally thought of as that of an agent. However, the term broker is commonly used to describe an investment dealer acting in any capacity. Generally, for most secondary trading of debt securities, the investment dealer acts as principal, although occasionally some agency trades take place. With new money market issues, for example, a dealer may either sell the securities as an agent or take them into inventory as principal for a later resale. SERVICES PROVIDED BY INVESTMENT DEALERS By participating in the secondary market and maintaining an inventory of outstanding securities, investment dealers provide several useful services: They provide informed advice about the terms and features for new issues in the primary market, based on their knowledge of current conditions in the secondary markets. They add liquidity to the market with relative ease by making transactions from their inventory, rather than waiting for simultaneous matching buy-sell orders from other investors. They sometimes act as market makers and carry out market-making duties by taking positions in assigned listed stocks to enhance market liquidity and smooth out undue price distortions. They sometimes buy listed stocks as principals, thus accumulating large blocks of shares, becoming more competitive in serving their larger institutional clients. The liquidity they add to the secondary market enhances the primary market by assuring that buyers of new securities will be able to sell their holdings at reasonable prices. Investment dealers also trade from their own accounts to make a profit. THE CLEARING SYSTEM During a trading day, exchange members act as both buyers and sellers of many listed stocks. Rather than each member making a separate settlement with another member on each trade during the course of a trading day, a designated central clearing system handles the daily settlement process between members. In Canada, securities are cleared through CDS Clearing and Depository Services Inc. Although CDS is not considered a financial intermediary, it is a valued partner to dealers that operate in the securities market, providing reliable clearing services. CDS operates CDSX, the facility for the clearing and settlement of trades in equity and debt securities in Canada and for various cross-border transactions. Marketplaces such as the Toronto Stock Exchange (TSX), the TSX Venture Exchange, and alternative trading systems report trades to CDSX. Over-the- counter trades are also reported to CDS by participants in the system. Participants with access to the clearing and settlement system primarily include banks, investment dealers, and trust companies. The central clearing system uses a process called netting to establish and confirm a credit or debit position balance, in the form of cash or security, for each dealer member. The netting process compiles each firm’s clearing settlement sheets and informs each member of the securities or funds it must deliver to balance its account. In this way, the number of securities and the amount of cash that must change hands among the various members each day is substantially reduced. THE KEY ROLES OF AN INVESTMENT DEALER What is the difference between an investment dealer’s role as a principal and its role as an agent? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 9 FINANCIAL INTERMEDIARIES OTHER THAN INVESTMENT DEALERS 4 | Distinguish between the roles of the various financial institutions. So far, you have learned about the role that investment dealers play as financial intermediaries. We now discuss other financial intermediaries, including chartered banks, credit unions and caisses populaires, trust companies, insurance companies, and other types of firms that play an intermediary role in the Canadian financial services industry. CHARTERED BANKS In Canada, the primary function of the chartered banks is to accept and safeguard deposits from individuals and businesses, mainly in the form of deposits, and to then lend or transfer those funds to users, in the form of mortgages, car loans, business loans, and other lending instruments. All chartered banks in Canada operate under the Bank Act and must function within its regulatory framework. The Bank Act is the federal legislation that sets out operating rules and restrictions for banks and is updated regularly, usually through five-year revision cycles. Under the Bank Act, banks are designated as Schedule I, Schedule II, or Schedule III. Each designation has unique rules and regulations surrounding the banks’ activities. Most Canadian-owned banks are designated as Schedule I banks, whereas foreign-owned banks are either Schedule II or Schedule III banks. SCHEDULE I CHARTERED BANKS Schedule I banks are banks that are not a subsidiary of a foreign bank and are considered domestic banks even if they have foreign shareholders. There are currently more than 30 domestic Schedule I banks in operation in Canada. Six Canadian banks stand out, in terms of asset size, above all other Canadian-owned banks, as well as most other non-bank financial institutions. DID YOU KNOW? Canada’s Big Six Banks: Bank of Montreal (BMO) Canadian Imperial Bank of Commerce (CIBC) National Bank of Canada Royal Bank of Canada (RBC) Scotiabank Toronto-Dominion Bank (TD Bank Group) The six major banks have achieved their dominant asset sizes by establishing a network of thousands of retail branches and automated teller machines throughout Canada. These outlets attract and centralize most of the savings of Canadians. Schedule I banks have also expanded their international operations by acquiring or investing in foreign international financial institutions. Currently, voting shares of large Schedule I banks must be widely held, with the control of any single shareholder or group of shareholders restricted to no more than 20%. In contrast, a single shareholder (individual or company) can own up to 65% of the voting shares of a medium-sized bank, which has shareholder equity of $2 billion or more but less than $12 billion. However, the remaining 35% of the voting shares must be publicly traded. A small bank, which has shareholder equity of less than $2 billion, can be fully owned by one person or organization. © CANADIAN SECURITIES INSTITUTE 1 10 CANADIAN SECURITIES COURSE      VOLUME 1 Canadian banks offer a wide variety of consumer and commercial banking products and services, including mortgages, loans, accounts, and investments. Savings deposits are eligible for deposit insurance, which is provided by the Canada Deposit Insurance Corporation (CDIC). Banks also offer financial planning, cash management, and wealth management services—some directly and some through subsidiaries. Within the banking groups, subsidiaries also handle services such as investment dealer activities, self-directed investing, and the sale of insurance products. Current legislation allows banks to take part in diverse sectors of the financial services industry. However, the Bank Act sets controls on these activities, particularly with regard to the sharing of customer information. The barriers that inhibit information sharing across a bank’s various business units are commonly known as firewalls. EXAMPLE A bank offers chequing accounts and mortgages through its local branch. A customer visits the branch to ask about opening a self-directed investment account. The customer is then directed to the bank’s investment dealer subsidiary and receives all further related correspondence from that subsidiary. However, the bank branch has no access to any information about the customer’s brokerage account or trades. Likewise, the investment dealer subsidiary has no access to the customer’s bank account or loan balances. In this way, the operations of different businesses within the same banking group are kept separate. One major source of income for banks is the activity of lending funds to individuals or companies at an interest rate that is higher than the interest rate that the banks pay out on deposits and other borrowings. The spread between the two sets of interest rates covers the banks’ operating costs, including rent, salaries, administration, and appropriations for loan losses. The spread also provides a margin of profit for the bank. SCHEDULE II AND SCHEDULE III BANKS Schedule II banks are incorporated and operate in Canada as federally-regulated foreign bank subsidiaries. The deposits that these banks accept may be eligible for deposit insurance provided by the CDIC. The banks may also engage in all types of business permitted to a Schedule I bank. Schedule II banks derive most of their revenue from retail banking and electronic financial services. Examples of Schedule II banks in Canada include the AMEX Bank of Canada, Citibank Canada, and UBS Bank (Canada). Schedule III banks are federally-regulated foreign bank branches of foreign institutions that have been authorized under the Bank Act to do banking business in Canada. Schedule III banks tend to focus on corporate and institutional finance and investment banking. Examples of Schedule III banks in Canada include Barclays Bank and Comerica Bank. The government allows foreign banks to operate in Canada, which in turn helps Canadian-owned Schedule I banks conduct operations abroad. Foreign-owned banks in Canada also provide a conduit for investment of foreign capital in Canada, while also providing an alternative source of borrowed funds for Canadian corporate borrowers. CREDIT UNIONS AND CAISSES POPULAIRES Credit unions and caisses populaires offer businesses and consumers a wide variety of banking services. They provide deposit-taking services, lending, mortgages, mutual funds, insurance, investment dealer services, and debit and credit cards. Credit unions often cater to member-savers from common interest groups, such as individuals who live in the same neighbourhood, share similar ethnic backgrounds, or belong to the same business or social group. The federal legislation governing credit unions is the Cooperative Credit Associations Act (CCAA). This act generally limits the activities of credit unions. They can provide financial services to their members, entities in which they have a substantial investment, and certain types of cooperative institutions. They can also provide administrative, educational, and other services to cooperative credit societies. © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 11 The CCAA requires associations to adhere to investment rules based on a “prudent portfolio approach”. It prohibits associations from acquiring substantial investments in entities, other than a list of authorized financial and quasi- financial entities. It also sets out a number of limits designed to restrict the exposure of associations to real property and equity securities. TRUST AND LOAN COMPANIES Federally and provincially incorporated trust companies are the only corporations in Canada authorized to engage in a trust business. Trust companies act as a trustee in charge of corporate and individual assets such as property, stocks, and bonds. They also offer a broad range of financial services that overlap services provided by the chartered banks. For example, trust companies accept savings, issue term deposits, make personal and mortgage loans, and sell registered retirement savings plans and other tax-deferred plans. In addition, they provide estate planning and asset management. INSURANCE COMPANIES The insurance industry has two main lines of business. The first line of business is life insurance, while the second line of business is known as property and casualty insurance. Life insurance includes the following related products: Health and disability insurance Term and whole life insurance Pension plans Registered retirement savings plans Annuities Because life insurance companies act as trustees for the funds entrusted to them by policyholders, they must exercise extreme caution in selecting their investments so that they can be sure to meet future contractual obligations. Property and casualty insurance encompasses protection against loss of the following items: Home Auto Commercial business According to the Insurance Bureau of Canada, the largest aggregate premiums in the property and casualty line of business are generated by automobile insurance, followed by property insurance and liability insurance. Underwriting is the most important aspect of the insurance business in Canada. Insurance underwriting is the business of evaluating the risk and associated contractual responsibility that the insurance company is willing to accept in exchange for its clients’ insurance premiums. The other significant aspect of the insurance business is reinsurance. Reinsurance refers to the practice of exchanging risk between insurance companies to facilitate better risk management. DID YOU KNOW? The key federal legislation governing insurance companies is the Insurance Companies Act. This legislation grants companies enhanced powers to make consumer and corporate loans, but it also contains restrictions on activities such as in-house trust services and deposit-taking. Furthermore, it allows only life insurance companies to offer annuities and segregated funds. © CANADIAN SECURITIES INSTITUTE 1 12 CANADIAN SECURITIES COURSE      VOLUME 1 Some Canadian Schedule I banks fully own insurance companies. However, although these large domestic banks have established their own insurance subsidiaries, the Bank Act forbids them from selling insurance through their branch networks, with the exception of insurance related to loans and mortgages. OTHER FINANCIAL INTERMEDIARIES Several other financial intermediaries play an important role in the Canadian financial services industry. These businesses are categorized below according to the types of products and services they offer: Investment funds are companies or trusts that sell shares or units to the public and invest the proceeds in a diverse securities portfolio. Closed-end funds typically issue shares only at start-up or at other infrequent periods, whereas open-end funds (commonly called mutual funds) continually issue shares to investors and redeem these shares on demand. Of the two types of funds, open-end funds are by far the larger, accounting for approximately 95% of aggregate funds invested. ATB Financial (originally established as the Alberta Treasury Branches), known as savings banks, was formed in 1938 when chartered banks pulled out their branches from many smaller towns. The ATB became a provincial crown corporation in 1997 and was renamed ATB Financial in 2002. These banks provide a full range of financial services to Albertans. Consumer finance companies make direct cash loans to consumers, who are usually unable to secure a loan from a bank. Consumer finance companies typically charge higher rates of interest than banks. Sales finance companies purchase instalment sales contracts from retailers and dealers at a discount, when items such as new cars, appliances, or home improvements are bought on instalment plans by consumers. Pension plans have accounted for remarkable growth in the institutionalization of savings during the past 60 years. OTHER FINANCIAL INTERMEDIARIES Apart from investment dealers, who are the intermediaries, and what role do they play in the capital markets? Complete the online learning activity to assess your knowledge. FINANCIAL MARKET TRENDS 5 | Discuss the trends affecting the financial services industry in Canada and globally. Various recent trends have made an impact in Canada and around the world. Some of the more important trends are described below. FINANCIAL TECHNOLOGY Financial technology companies, known collectively as the fintech industry, take advantage of computer technology to support or enable a variety of banking and financial products and services, including online loans, electronic wallets, and automated financial planning software. The fintech industry is challenging the role of traditional financial services institutions in Canada and around the world. © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 13 ROBO-ADVISORS In recent years, a new online investment service has emerged that provides clients with advice, in contrast to the execution-only model of self-directed brokerage. Popularly known as robo-advisors, these firms began to appear in the United States after the 2008 financial crisis but did not gain traction until 2012. By 2023, they had amassed more than US$1 trillion in assets under management. In Canada, online investment advice platforms began to proliferate in 2014, with multiple service providers registered in several provinces by mid-2023. Many variations of robo-advisor services exist in the United States and Canada, but most share several of the following attributes: They provide clients with goal-based online investment management. Portfolios are created using algorithms based on modern portfolio theory and online client questionnaires. A telephone call with an advisor verifies that the computer-generated portfolio is suitable for the client. Advisor support is offered to varying degrees, typically online or by phone. Portfolios are built primarily with exchange-traded funds. Portfolios are regularly rebalanced. Financial planning may be offered in varying degrees. Service may be provided to the end client as well as to intermediaries such as advisors and employers. Competitive positioning is based on the client experience, which typically encompasses the following services: Ease of online navigation Speed of account opening and transfers Integration of service delivery across devices Transparency of performance and fees Portfolio management is optimized with tools such as tax-efficient rebalancing across account types. SOCIAL AND ECONOMIC SHIFTS Lifestyle and social trends continuously affect the financial industry, especially trends related to the following key factors: Demographics Defined benefit and defined contribution pension plans Savings rates Debt levels DEMOGRAPHICS Demographic shifts are reshaping Canada’s economy and will continue to do so. Baby boomers comprise roughly 9.5 million Canadians born between 1946 and 1965. The number of baby boomers entering retirement will continue to rise over the next twenty years, and their demand for products that offer interest income and principal replacement will become more prominent. Advisors are expected to adjust their service offering to reflect the needs of their client base, which is increasingly made up of retired Canadians. Much has been written on the aging population and its effect on virtually all aspects of life, including education, product delivery, and health care. Ultimately, as the Canadian population ages, we are becoming a society heavily influenced by the needs and attitudes of consumers over age 50. © CANADIAN SECURITIES INSTITUTE 1 14 CANADIAN SECURITIES COURSE      VOLUME 1 At the other end of the spectrum, millennials (those born in the 1980s and the first half of the 1990s) represent 27% of the total population, making it the largest generation of Canadians. There are significant economic differences between millennials and baby boomers. According to Statistics Canada, millennials have higher mortgage debt, higher student loan debt, and a lower net worth than baby boomers at that age. Millennials, though, still have the time and resources to catch up by employing sound savings and investment strategies. DEFINED BENEFIT AND DEFINED CONTRIBUTION PENSION PLANS A defined benefit (DB) pension plan provides employees with a pre-determined specified payment amount of funds when they retire, whereas a defined contribution (DC) pension plan allows employees and employers to contribute to a plan that invests funds over time to save for retirement, but the final benefit amount at retirement will depend on how the contributions are invested over the plan’s life. A DB pension plan’s risks, such as longevity, market volatility, and low interest rates, are borne entirely by the employer because they have to cover a pension shortfall, which is classified as a liability on financial statements. As a result, employers are gradually shifting to DC pension plans to pass on the risks to the employees. Hybrid pension plans—a combination of DB and DC plans—are also gaining traction in Canada. SAVINGS RATES Generally, Canadians have several common sources of retirement income: Employer pension plan Canada Pension Plan, Quebec Pension Plan, and Old Age Security Income from personal savings, such as registered retirement savings plans, tax-free savings accounts, and non- registered accounts The liquidation of fixed assets or downsizing of a principal residence The sale of a business or the creation of a succession plan where the business passes on to family members but still pays the original owner an income A common notion is that Canadians will need 70% of their income at retirement. This figure is a rule of thumb. Some clients might need less; others might need more, depending on their expected retirement lifestyle. It is recommended that individuals save 10% to 20% of their pre-tax income during their working years. However, recent studies indicate that the level of Canadian savings has fallen below 6%. HOUSEHOLD DEBT LEVELS Household debt is defined by Statistics Canada as mortgage debt on principal residences, vacation homes, and other real estate as well as consumer debt. Consumer debt refers to outstanding debt on credit cards, personal and home equity lines of credit, secured and unsecured loans from financial institutions, and unpaid bills such as rent and taxes. Debt levels continue to be an area of concern in Canada. While debt-to-income levels have remained steady in the past three years at approximately 172% of disposable income, the level of debt-to-income was closer to 100% of disposable income in 2000. An individual’s inability to service debt can increase stress levels. Concerns arise when interest rates are poised to increase because the cost of servicing debt and bankruptcies tends to rise. EDUCATION Investor Economics reports that education is one of the more important ways that advisors will be able to distinguish themselves among their competitors as competition continues to grow in the financial services industry. Most clients in a recent survey1 agreed that designations are an important way that industry professionals can demonstrate expertise and a key determining factor for clients deciding whether to work with a new advisor. Clients also shared the belief that multiple designations indicate a greater ability to provide a varied range of services. 1 Are You Ready for the Roaring Twenties? Advice Evolves with Client and Competition. (June 2023). Investor Economics © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 15 CRYPTOCURRENCY Cryptoassets have been gaining in popularity around the world. Cryptoassets are assets that exist only in digital form and use cryptography to prevent counterfeiting and fraudulent transactions. They rely on peer-to-peer networking and a public ledger to regulate the creation and transfer of assets without the use of an intermediary. One of the more popular examples of a cryptoasset is bitcoin. BITCOIN Bitcoin is the asset that gave birth to the adoption of many other cryptocurrencies. It was created largely as an alternative payment system that would operate outside of central banking control. It was launched in 2008 when confidence in financial markets was very low, and its continued (albeit volatile) rising long-term price trend has been supported by continued debasement of fiat currencies. Bitcoin is based on the decentralized, open-source protocol of the peer-to-peer Bitcoin computer network. The network creates a decentralized public transaction ledger, called the blockchain, on which all Bitcoin transactions are recorded. Movement of bitcoin is facilitated by a digital, transparent, and immutable ledger that enables the rapid transfer of value across the internet, without the need for centralized intermediaries. The Bitcoin concept can be separated into two components: Bitcoin the token Bitcoin the token is a piece of code that represents ownership of a digital concept (a bitcoin) with financial value. Investors may invest in and own the bitcoin, either directly or indirectly, through an investment vehicle. Bitcoin the protocol Bitcoin the protocol is the distributed network, or blockchain, that maintains the ledger of balances of bitcoin the token. Both concepts are referred to as “bitcoin”, although, typically, Bitcoin with a capital B represents the protocol layer (the Bitcoin blockchain), and bitcoin with a small b refers to the bitcoin as financial value. Each bitcoin is a computer file stored in a digital wallet on a computer or smartphone. The bitcoin trading symbol is BTC or, less commonly, XBT. Typically, bitcoin investors’ interest lies only in what they own, no different from their interest in ownership of a share in a company. As a medium of exchange, store of value, and investment, bitcoin’s growth in popularity has gone through different stages, starting with its early adoption by cypher-punks and gamers through to the more recent phase of institutional acceptance. Today there are numerous ways by which retail investors, wealth managers, institutional investors, and treasuries can invest in bitcoin, including through crypto-exchanges and investment products such as a closed-end mutual fund or ETF. The infrastructure behind bitcoin and the method by which transactions are processed and validated (the blockchain) should also be of interest because it is this infrastructure that is critical to the integrity of a bitcoin purchase. To understand how bitcoin works, it helps to understand the two terms: blockchain and private and public keys. Blockchain Bitcoin is powered by open-source code, known as the blockchain, which creates a shared public ledger. The ledger is available to record and validate the transactions that have taken place in the past, which cannot be altered. Each transaction is a “block” that is “chained” to the code, creating a permanent record of the transaction. Blockchain technology is at the heart of more than 4,000 cryptocurrencies that have followed in Bitcoin’s wake. © CANADIAN SECURITIES INSTITUTE 1 16 CANADIAN SECURITIES COURSE      VOLUME 1 Private and public keys A bitcoin wallet contains a public key and a private key, which work together to allow the owner to initiate and digitally sign transactions. The private key is essentially the bitcoin owner’s secret password. Both keys provide proof of authorization and, ultimately, the authorization to proceed with transactions (which are also irreversible). Bitcoin was programmed to maintain its value as a deflationary currency by limiting the number of total bitcoins in existence. The Bitcoin network software has pre-programmed the creation of new coins through the mining reward process and a well-thought-out economic model that decreases the availability of new coins. Availability will end when the 21 million bitcoin limit has been reached. Currently, there are around 19.6 million bitcoins in circulation. Bitcoin’s limited supply and various demand factors mentioned earlier (medium of exchange, store of value, and investment), have resulted in tremendous price appreciation and market capitalization. As of March, 2024, the total value of all bitcoins in circulation was around US$1.3 trillion. CASE SCENARIO Can you help your friend Marty by answering his questions about investment dealers? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 1      THE CANADIAN SECURITIES INDUSTRY 1 17 SUMMARY In this chapter, we discussed the following key aspects of the Canadian Securities Industry: Canadian capital markets are among the most sophisticated and efficient in the world, as indicated by the variety and size of new issues brought to the markets and the depth and liquidity of secondary market trading. The three categories of investment dealer firms are integrated, institutional, and retail. Integrated firms offer products and services that cover all aspects of the industry. Institutional firms primarily handle the trading activity of large clients such as pension funds and mutual funds. At the retail level, full-service firms offer a wide variety of products and services, and self-directed brokers offer reduced trading rates but do not provide advice. One main role of investment dealers is to bring new issues of securities to the primary markets. They also facilitate trading in the secondary markets. These firms can act as principals or agents in either market. The Canadian chartered banks are the largest financial intermediaries in the country. They are designated as Schedule I, Schedule II, or Schedule III banks. Each designation has different rules and regulations regarding ownership levels and the types of services they are allowed to offer. Financial intermediaries offer a broad range of financial services that, in many cases, overlap with the services provided by chartered banks. Services include deposit-taking and lending, debit and credit cards, mortgages, and mutual funds. Investment funds sell their shares to the public, most often in the form of closed-end or open-end funds, and invest the proceeds in diverse portfolios of securities. Loan companies make direct cash loans to consumers, who typically repay principal and interest in instalments. Pension plans represent a type of institutionalized savings. These plans are offered to the employees of many companies, institutions, and other organizations. In contrast to the execution-only model of self-directed brokerage, a new online investment service that provides investors with advice, popularly known as robo-advisors, has emerged in Canada. Robo-advisors offer goal-based online investment management, portfolios created using algorithms based on modern portfolio theory, and advisor support among other services. Bitcoin is slowly making its way into the traditional investing world. Its value is derived from both its use as a medium of exchange and as a store of value. Bitcoin investment or trading vehicles include trusts, mutual funds, hedge funds, futures, and options. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 1 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 1 FAQs. © CANADIAN SECURITIES INSTITUTE  The Capital Market 2 CHAPTER OVERVIEW In this chapter, you will learn about investment capital, including what it is, why we need it, where it comes from, and who uses it. You will also learn about the different types of financial instruments that are traded in the financial markets. In discussing the financial markets themselves, we explain the difference between primary and secondary markets and between auction and dealer markets. Finally, you will learn about the electronic trading systems that are used in both equity and fixed-income markets. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the role of investment capital in the Investment Capital economy, including its supply and use. 2 | Differentiate between the types of financial The Financial Instruments instruments used in capital transactions. 3 | Describe the distinguishing features and The Financial Markets operation of the various types of financial markets. © CANADIAN SECURITIES INSTITUTE 2 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. alternative trading system investment advisor ask price last price auction market liquidity bid-ask spread MarketAxess bid price market maker Canadian Securities Exchange money market Canadian Unlisted Board Inc. Montréal Exchange CanDeal over-the-counter market CanPX preferred share capital primary market CBID retail investor CBID Institutional secondary market Cboe Canada stock exchange common share stocks dealer market Toronto Stock Exchange equity securities TSX Alpha Exchange ICE NGX Canada TSX Venture Exchange institutional investor unlisted market © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 3 INTRODUCTION The securities industry plays a significant role in sustaining and expanding the Canadian economy. The industry is growing and evolving to meet the ever-changing needs of Canadian investors, from both domestic and international perspectives. The vital economic function the securities industry plays is based on a simple process: the transfer of money from those who have it (suppliers of capital) to those who need it (users of capital). Three elements are of central importance to the securities industry: financial intermediaries, financial markets, and financial instruments. In the previous chapter, we focused on the intermediaries that have evolved to enable the transfer of capital, such as investment dealers, banks, and trust companies. In this chapter, we discuss the characteristics of capital, and we look at the markets within which suppliers and users of capital transfer it through the intermediaries. We also provide a brief introduction to some of the financial instruments that make capital transfer possible. INVESTMENT CAPITAL 1 | Describe the role of investment capital in the economy, including its supply and use. Capital is synonymous with wealth, both real (i.e., land, buildings, and other material goods) and representational (i.e., money, stocks, and bonds). All of these items have economic value that represents the invested savings of individuals, corporations, governments, and other organizations. Representational capital becomes more significant when it is harnessed productively, through either direct or indirect investment. Table 2.1 shows examples of each investment type. Table 2.1 | Direct and Indirect Investing Direct Investment Indirect Investment A couple invests their savings in a home. An investor buys stocks or bonds. A government invests in a new highway. A parent invests in an education savings plan. A company pays start-up costs for a new plant. A couple deposits their savings at a bank. The indirect investment process, where investors purchase representational items such as stocks or bonds, is the principal focus of this course. Indirect investment occurs when a person or entity with accumulated savings buys the securities issued by a government or corporation, which in turn invests the funds it receives directly for a productive purpose. Indirect investment is normally made with the help of an investment advisor in the retail or institutional sales department of a securities firm. CHARACTERISTICS OF CAPITAL Capital has three important characteristics: mobility, sensitivity to its environment, and scarcity. These characteristics allow capital to be selective about where it settles, which is usually countries or locations where favourable conditions exist. Favourable conditions include stable government, economic activity that is not heavily regulated, a hospitable investment climate, and profitable investment opportunities. The flow of capital is therefore guided by country risk evaluation. © CANADIAN SECURITIES INSTITUTE 2 4 CANADIAN SECURITIES COURSE      VOLUME 1 In evaluating the various components of country risk, you should consider the following factors: The political Is the country involved, or likely to be involved, in internal or external conflict? environment Economic trends How strong is growth in key areas such as gross domestic product, inflation rate, and economic activity? Fiscal policy How high are taxes and government spending, and to what degree does the government encourage savings and investment? Monetary policy How sound is the nation’s money supply management, and to what extent does it promote price and foreign exchange stability? Investment What opportunities exist for investment, and how satisfactory are the returns on opportunities investment in comparison to the risk? The labour force What percentage of the labour force is skilled and productive? Because capital is limited in quantity and considered scarce, it is in great demand everywhere in the world. And because it is mobile and sensitive, it moves in or out of countries or localities in anticipation of changes to taxation, exchange rates, trade barriers, regulations, and government attitudes. It tends to move to areas where it can be best used and where it can avoid less favourable conditions. In other words, capital always moves towards uses and users that offer the highest risk-adjusted returns. THE SUPPLIERS AND USERS OF CAPITAL An adequate supply of capital is essential for Canada’s well-being. In manufacturing, for example, capital provides the means to expand facilities, improve productivity, increase competitiveness in domestic and foreign markets, and develop innovative, sought-after new products. When capital investment is deficient, industry slackens, unemployment rises, and living standards decline. The suppliers and users of this necessary capital are described below. SUPPLIERS OF CAPITAL The lone source of capital is savings in various forms. When revenues exceed expenditures, the investor can use savings to invest. This basic tenet applies to all of the following types of investors: Individuals If the compensation to postpone current consumption is high enough, individuals tend to save their money to spend it at an opportune time in the future. They become more inclined to spend when, for example, the compensation to postpone current consumption is low, or incentives, such as tax breaks, are provided. Non-financial Corporations such as Canadian steel makers, food distributors, and machinery domestic corporations manufacturers generate large savings, mainly in the form of corporate earnings. However, these internally generated funds are usually retained by the corporation and are available only for internal use; they are not normally invested in other companies’ stocks and bonds. Therefore, corporations are not significant providers of permanent funds to others in the capital market. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 5 Governments Some governments are able to operate at a surplus and invest their profits, thus becoming suppliers of capital. Other governments, who are in a less favourable position, borrow in the capital markets to fund their deficits, thus becoming users of capital. Foreign investors Foreign investors, both corporate and individual, have long regarded Canada as a good place to invest. Canada, in turn, has traditionally relied on foreign savings for both direct investment in Canadian industries and portfolio investment in Canadian securities. USERS OF CAPITAL Users of capital may be individuals, businesses, or governments, whether Canadian or foreign. Capital flows into Canada, from foreign individuals, businesses, and governments, and equally flows out of Canada, as foreign users of capital (mainly businesses and governments) take capital out of the country. They do so by borrowing from Canadian banks or by making their securities available to the Canadian market. Canadian capital is attractive to foreign users when its dollar value is low relative to their own currency. For their part, Canadian investors benefit from access to foreign securities by using them to diversify their investments. SUPPLIERS AND USERS OF INVESTMENT CAPITAL: A SUMMARY Table 2.2 summarizes who the sources and users of investment capital are and how users obtain capital. Table 2.2 | The Sources and Users of Investment Capital Sources of Capital Retail investors Retail investors are individual clients who buy and sell securities for their personal accounts. Institutional Institutional investors are organizations, such as pension and mutual fund investors companies, that trade in large-share quantities or dollar amounts. They typically have a steady flow of money to invest. Foreign investors Foreign direct investment in Canada tends to concentrate in manufacturing, petroleum, natural gas, mining, and smelting. Some industries have restrictions on foreign investment. Users of Capital Individuals Individuals need capital to finance large purchases such as houses, cars, and major appliances. They usually obtain it in the form of personal loans, mortgage loans, and charge accounts. Businesses Businesses require massive sums of capital to finance day-to-day operations, renew and maintain plants and equipment, and expand and diversify their activities. They generate much of that capital internally, in the form of profits retained in the business. They borrow from financial intermediaries for other needs, and they raise the remainder in securities markets. Governments Governments are major issuers of securities in public markets, either directly or through guaranteeing the debt of their Crown corporations. When revenues fail to meet expenditures, or when they undertake large capital projects, governments must borrow. © CANADIAN SECURITIES INSTITUTE 2 6 CANADIAN SECURITIES COURSE      VOLUME 1 SOURCES AND USERS OF CAPITAL Where does capital come from, and what is it used for? Complete the online learning activity to assess your knowledge. THE FINANCIAL INSTRUMENTS 2 | Differentiate between the types of financial instruments used in capital transactions. Financial instruments in the form of securities are formal, legal documents that set out the rights and obligations of the buyers (capital suppliers) and sellers (capital users) of the securities. As such, these instruments have many advantages as a means of distributing capital in a sophisticated economy. They tend to have standard features, which facilitates their trading. Both suppliers and users of capital can also choose from many types of securities to meet their particular needs. Table 2.3 briefly describes some of the different types of financial instruments and provides examples of each type. Although you may already be familiar with some of these products, they will all be discussed in detail in later chapters of the course. Table 2.3 | The Different Types of Financial Instruments Financial Instrument Definition Examples Fixed-income Fixed-income securities (also called debt securities) Treasury bills securities formalize a relationship in which the issuer promises to Bonds repay the loan at maturity and, in the interim, makes interest payments to the investor. The term of the loan varies depending on the type of instrument. Equity securities Equity securities (commonly called stocks, equities, or Common stock (also shares) represent some form of ownership stake in the called common shares) company that issued them. For example, if the value Preferred shares of a company increases, the owner of stock in that company receives a capital gain upon selling it. Derivatives A derivative is a product whose value is derived from Options the value of an underlying instrument, such as a stock Forwards or an index. Unlike stocks and bonds, derivatives are more suited to sophisticated investors. Managed products Managed products (also called investment funds) are Mutual funds typically pools of capital gathered from investors to buy Exchange-traded funds securities according to a specific investment mandate. Private equity funds Structured products A structured product is a financially engineered Principal-protected notes product with the characteristics of debt, equity, and an Index-linked guaranteed investment fund. investment certificates © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 7 THE FINANCIAL MARKETS 3 | Describe the distinguishing features and operation of the various types of financial markets. So far in this chapter, we discussed the characteristics of capital, its sources, and its users. We also provided a brief introduction to the various financial instruments available. We now focus our discussion on the financial markets where people come together to complete their financial transactions. A financial market provides a forum in which buyers and sellers meet. Instead of meeting face to face, intermediaries such as investment advisors and bond dealers act on their clients’ behalf. Financial instruments and securities are a key element in the efficient transfer of capital from suppliers to users—an element that benefits both sides. Many of the benefits of financial instruments, however, depend on the efficient markets in which these securities can be bought and sold. A well-organized financial market provides speedy transactions and low transaction costs, along with a high degree of liquidity and effective regulation. Unlike most markets, a financial market often has no physical location. In Canada, for instance, the trading of securities, such as stocks, bonds, derivatives, takes place via electronic platforms. The capital market is made up of many individual financial markets, including stock markets, bond markets, and money markets. Only short-term fixed-income securities with a term of one year or less trade in the money market. Markets can also be categorized as primary markets and secondary markets, and further as auction markets and dealer markets. We will now discuss all of these different types of markets. PRIMARY AND SECONDARY MARKETS In the primary market, newly issued securities are sold by companies and governments to investors. In other words, investors purchase securities directly from the issuing company or government. Companies raise capital by selling stocks or bonds, whereas governments sell bonds only. These newly issued distributions of securities are known as IPOs, or initial public offerings. 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 beneficial to both parties, and securities are transferred from the seller to the buyer. The issuing company does not receive any of the proceeds from transactions in the secondary market; it receives payment only when the securities are first issued in the primary market. An example here is the buying and selling of stocks on the Toronto Stock Exchange. AUCTION MARKETS In an auction market, securities are bought and sold by investors. Investment dealers, who typically act as agents, execute the buy and sell orders on behalf of their clients. Buyers enter bids and sellers enter offers. These orders are channelled to a single central market where they compete against each other. A trade is executed only when there is a match in the bid and ask prices. Between trades, the best bid is lower than the best offer. The difference between the two prices is called the bid-ask spread. © CANADIAN SECURITIES INSTITUTE 2 8 CANADIAN SECURITIES COURSE      VOLUME 1 Figure 2.1 shows the bid-ask spread and defines some of the basic terminology of stock trading. Figure 2.1 | The Bid-Ask Spread Ask Price − Bid Price = Bid-Ask Spread The bid price is the highest price a buyer is willing to pay for the security being quoted. The ask price (or offer) is the lowest price a seller will accept. The bid-ask spread is the amount that the ask price exceeds the bid price. The last price is the price at which the last trade occurred on a stock. This price can fluctuate between the bid price and the ask price as buying and selling orders are filled. Note that the last price is not necessarily the price at which a stock can currently be bought or sold. It is simply the latest price at which a transaction occurred. EXAMPLE Three investors each want to buy a share of ABC Inc. They enter three bids on the company’s stock of $5.00, $5.03, and $5.06. On the other side of the trade, three investors each want to sell their share of ABC. They enter three offers to sell their stock at $5.06, $5.07, and $5.11. Because a trade is executed only when a bid matches an offer, only one trade is executed—a trade between the investor who entered the bid of $5.06 and the seller who entered the offer of $5.06. The other bids and offers are not immediately executed. After the execution of the trade at $5.06, the best bid and offer become $5.03 and $5.07, respectively, creating a price spread of $0.04. EXCHANGES A stock exchange is an auction market 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 stock exchanges, trading is carried out in common and preferred shares, rights and warrants, exchange-traded funds, income trusts, and a few convertible debentures. On some U.S. and European exchanges, bonds and debentures are traded along with equities. DID YOU KNOW? One property that is fundamental to the operation of the exchanges is liquidity. A liquid market has the following characteristics: Frequent trades Narrow price spread between bid and ask prices Small price fluctuations from trade to trade The following exchanges operate in Canada: The Toronto Stock Exchange (TSX) lists equities, some debt instruments that are convertible into a listed equity, income trusts, and exchange-traded funds. The TSX Venture Exchange lists equities and a few debenture issues. TSX Alpha Exchange offers trading in securities listed on the TSX and the TSX Venture Exchange. The Montréal Exchange trades all financial and equity futures and options listed for trading in Canada. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 9 ICE NGX Canada provides electronic trading, central counterparty clearing, and data services to the North American natural gas and electricity markets. The Canadian Securities Exchange lists equities of emerging companies. Cboe Canada is an exchange that provides listing services and facilitates trading in public companies, exchange- traded funds, Canadian Depositary Receipts™, special purpose acquisition companies, and closed-end funds. Approximately 15% of all volume traded in Canadian-listed securities trade through Cboe Canada. DID YOU KNOW? TMX Group Limited is an amalgamation of TSX Group companies that include the TSX, TSX Venture Exchange, TSX Alpha Exchange, and the Montreal Exchange, creating an integrated, multi-asset class exchange group. TMX Group Limited lists, trades, clears and offers market data for both cash and derivatives markets across multiple asset classes. TMX Group Limited common shares trade on the Toronto Stock Exchange under the symbol X. DEALER MARKETS Dealer markets, or over-the-counter (OTC) markets, consist of a network of banks and investment dealers. Unlike an auction market, where the orders of individual buyers and sellers are entered in a centralized marketplace, a dealer market is a negotiated market where market makers post bid-and-ask quotations via electronic platforms and computer networks. In the OTC market, investment dealers typically act as principals. Almost all bonds and debentures are sold through dealer markets. Compared to auction markets for equities, dealer markets are less visible. Perhaps surprisingly, the volume of trading (in dollars) for debt securities is significantly larger than that of the equity market. Dealer markets are also called unlisted markets because securities that trade on them are not listed on an organized exchange, as they are on auction markets. There is no central marketplace for most dealer market transactions. Instead, they are routinely conducted on the OTC market. Trades are made by means of the computer systems of inter-dealer brokers that facilitate trades between investment dealers. DID YOU KNOW? The Unlisted Equity Market The volume of unlisted equity business in dealer markets is much smaller than the volume of stock exchange transactions. Although many junior issues trade OTC, the shares of some industrial companies also trade on the OTC market. For various reasons, the boards of these companies have decided not to list one or more issues of their equities on a stock exchange. The unlisted market does not set minimum listing requirements for the stocks traded on its system, 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 EQUITY MARKET Over-the-counter trading in equities is conducted in a similar manner to bond trading. Individual investors’ orders are not entered into a centralized market and made public. Instead, investment dealers, who act as market makers, quote their own bids and offers. These market makers hold an inventory of the securities in which they have agreed to make a market (i.e., the securities in which they are willing to deal). They sell from this inventory to buyers and add to the inventory when they acquire securities from sellers. © CANADIAN SECURITIES INSTITUTE 2 10 CANADIAN SECURITIES COURSE      VOLUME 1 The willingness of the market makers to quote bid and ask prices provides liquidity to the system (although they do have the right to refuse to trade at quoted prices). When an investor wishes to buy or sell an unlisted security, the investor’s dealer consults the bid or ask quotations of the various market makers to identify the best price, and then contacts the market maker to complete the transaction. The dealer charges a commission for this service. OVER-THE-COUNTER DERIVATIVES MARKET The OTC derivatives market is dominated by large international financial institutions, such as banks and investment dealers that trade with corporate clients and other financial institutions. 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, with special features added to the basic properties of options and forwards. As a result, these products tend to be somewhat complex. REPORTING TRADES IN THE EQUITY UNLISTED MARKET In most of Canada, investment dealers do not have to report unlisted trades. In Ontario, however, the Ontario Securities Act requires that trades of unlisted securities and unquoted equity securities be reported through the web-based system of the Canadian Unlisted Board Inc. ALTERNATIVE TRADING SYSTEMS Along with the traditional exchanges and dealer markets, the Canadian financial markets include alternative trading systems (ATS). These systems are electronic marketplaces that provide automated matching and execution of trades in both the equity and fixed-income markets. EQUITY ELECTRONIC TRADING SYSTEMS Alternative trading systems in the equity markets provide automated trade matching and execution of orders from multiple buyers and sellers, a role once performed exclusively by stock exchanges. The Canadian Securities Administrators allow ATSs to compete with recognized exchanges and also among other ATSs, thus providing participants with a range of options in executing trades. An ATS must be registered as an investment dealer and a member of the Canadian Investment Regulatory Organization (CIRO). ATSs and traditional exchanges are subject to regulatory filings and provide similar trading services. However, ATSs are not permitted to carry out all of the same functions as traditional exchanges, such as the TSX. One notable difference is that ATSs trade securities that are listed on traditional exchanges, but they cannot themselves list securities. 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. In Canada, these markets include the following fixed-income electronic trading systems: CanDeal is a member of CIRO, and it is a joint venture between Canada’s six largest bank-owned investment dealers. It is operated by the TMX Group Limited and is recognized as both a debt ATS and an investment dealer. It offers institutional investors access to government securities and money market instruments. CBID, and CBID Institutional, is an ATS that 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 11 MarketAxess provides market data and a trading platform with access to multi-dealer competitive pricing for a wide range of corporate bonds and other types of fixed-income instruments. MarketAxess is a member of CIRO and operates in Ontario and Quebec. CanPX is a joint venture between several Canadian investment dealers and inter-dealer brokers (firms that facilitate trades between investment dealers). The CanPX system combines digital feeds from participating dealers to provide a composite display of real-time bid and offer quotations, in price and yield terms and with volume information. The service covers Government of Canada bonds and Treasury bills. AUCTION AND DEALER MARKETS What are the features of the different types of markets? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 2 12 CANADIAN SECURITIES COURSE      VOLUME 1 SUMMARY In this chapter, we discussed the following key aspects of the capital market: Capital has three characteristics: mobility, sensitivity, and scarcity. It can be invested directly or indirectly. An example of the first type is a house purchase. The second type might be the purchase of a company’s stock. Individuals use investment capital for major purchases and to fund savings accounts. Businesses use capital to finance operations, plants, equipment, or growth. Governments use it to finance social programs and infrastructure. Foreign investors use Canadian capital when it costs less to borrow than other currencies. Bonds and debentures represent the issuers’ debt, which investors purchase with a promise of repayment at maturity, usually in whole and with interest. Equity represents shares of ownership in a company, through which investors hope to profit as the company gains value. The financial markets facilitate the transfer of capital between investors and users, either on the primary market (where initial public offerings and other new issues are bought and sold) or the secondary market (where previously issued securities are bought and sold). The individual markets include stock markets, bond markets, and money markets. The markets can be further classified as auction markets and dealer markets. In an auction market, clients’ bid and ask quotations for a stock are channelled to a stock exchange, where they compete against each other. Dealer markets are networks of dealers that negotiate a price with each other. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 2 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 2 FAQs. © CANADIAN SECURITIES INSTITUTE  The Canadian Regulatory Environment 3 CHAPTER OVERVIEW In this chapter, you will learn about the Canadian regulatory environment, including the various regulatory bodies and the principles of regulation conducive to fair and open capital markets. In this context, you will learn about the various regulators and self-regulatory organizations, the purpose of regulation, and the meaning of principles-based regulation. You will also learn about the remediation options available to clients who feel they have not been well served. Finally, you will learn about the ethical standards you will be expected to uphold as a participant in the financial services industry. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the roles played by the agencies and The Regulators legal entities through which the Canadian securities industry is regulated. 2 | Discuss the principles that underlie securities Regulation and Supervision legislation. 3 | Describe the remediation options investors Remediation can access to resolve concerns they have with dealer members. 4 | Identify unethical practices and conduct in Ethical Standards in the Financial Services securities trading. Industry © CANADIAN SECURITIES INSTITUTE 3 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. arbitration gatekeeper Autorité des marchés financiers Investment Representative Canada Deposit Insurance Corporation National Do Not Call List Canadian Investment Regulatory Organization National Registration Database Canadian Investor Protection Fund Office of the Superintendent of Financial Institutions Canadian Securities Administrators Ombudsman for Banking Services and Client Focused Reforms Investments Financial Services Regulatory Authority of risk capacity Ontario risk tolerance front running Securities and Exchange Commission full, true, and plain disclosure self-regulatory organization © CANADIAN SECURITIES INSTITUTE  CHAPTER 3      THE CANADIAN REGULATORY ENVIRONMENT 3 3 INTRODUCTION In the previous chapters, we learned how the financial markets, along with the roles of the financial intermediaries, developed over time to meet the ever-evolving needs of investors. As these components of the securities industry evolved, so did regulation in the industry. In their response to industry developments, regulators maintained a set of rules that protect investors from harm. Investor protection is the primary goal of the regulators. However, it is not the only goal of securities regulation. The various Canadian regulatory bodies also play a key role in fostering market integrity. But what does market integrity entail? As you learned in the previous chapters, productive investing takes place when savings are funnelled through the markets into stocks, bonds, and other securities. The issuers of those securities then use the savings to fund various projects. For this process to happen efficiently, investors must feel confident that they will be treated fairly as equal participants in the capital markets. Without the assurance that they stand to benefit from projects that they help to fund, potential investors would not have the confidence to risk their savings. To protect market integrity, the regulators require that industry employees meet high proficiency standards through mandatory educational programs. In addition, investor protection funds are in place to protect individual investors in the unlikely event that a firm goes bankrupt. The regulatory bodies have the authority to prosecute individuals and firms suspected of wrongdoing. If fault is proven, regulators can impose penalties in the form of reprimands, fines, suspensions, and expulsion. In this chapter, we discuss regulation in the Canadian securities industry and the various regulatory bodies that uphold the rules. We also explore what it means to operate as an investment advisor or other financial services employee in a principles-based regulatory environment. THE REGULATORS 1 | Describe the roles played by the agencies and legal entities through which the Canadian securities industry is regulated. In Canada, each province and territory is responsible for creating the legislation and regulation under which a business in the securities industry must operate. In several provinces, much of the day-to-day securities regulation is delegated to securities commissions. In other provinces, securities administrators are appointed by the province to take on the regulatory function. In Quebec, the regulatory body is the Autorité des marchés financiers, which regulates both the securities business and Quebec’s financial sector. That sector includes life and property insurance firms, providers of deposit insurance, and distributors of financial products, among others. Outside of Quebec, the financial sector is regulated separately from the securities industry by the Office of the Superintendent of Financial Institutions (OSFI). THE CANADIAN SECURITIES ADMINISTRATORS The Canadian Securities Administrators (CSA) is an umbrella organization of Canada’s ten provincial and three territorial securities regulators designed to improve, coordinate and harmonize regulation of the Canadian capital markets. The mission of the CSA is to develop a national regulatory system that fosters fair, efficient, and vibrant capital markets in which investors are protected from unfair, improper, and fraudulent practices. © CANADIAN SECURITIES INSTITUTE 3 4 CANADIAN SECURITIES COURSE      VOLUME 1 DID YOU KNOW? The CSA has developed a number of national policies representing the regulatory framework that applies in every provincial and territorial jurisdiction. With the increasing involvement in the investment business of federally regulated financial institutions such as banks, trusts, and insurance companies, the number of national policies issued by the CSA has increased. SELF-REGULATORY ORGANIZATION A self-regulatory organization (SRO) is a private industry organization to which the provincial regulatory bodies have granted the privilege of regulating their own members. An SRO enforces their members’ conformity with securities legislation. They have the power to prescribe their own rules of conduct and financial requirements. An SRO is delegated regulatory functions by the provincial regulatory bodies. SRO by-laws and