CSC Volume 1.pdf

THE CANADIAN SECURITIES INSTITUTE The Canadian Securities Institute (CSI) has been setting the standard for excellence in life-long education for ﬁnancial professionals for more than 45 years. CSI is part of Moody’s Analytics Training and Certiﬁcation Services, which offers education programs and credentials throughout the world. Our experience training over 800,000 global professionals makes us the preferred partner for individuals, ﬁnancial institutions, and regulators internationally. Our expertise extends across the ﬁnancial services spectrum to include securities and portfolio management, banking, trust, and insurance, ﬁnancial planning and high-net-worth wealth management. CSI is a thought leader offering real world training that sets professionals apart in their chosen ﬁelds and helps them develop into leaders who excel in their careers. Our focus on exemplary education and high ethical standards ensures that they have met the highest level of proﬁciency and certiﬁcation. CSI partners with industry regulators and practitioners to ensure that our programs meet the evolving needs of the marketplace. In Canada, we are the primary provider of regulatory courses and examinations for the Investment Industry Regulatory Organization of Canada (IIROC). Our courses are also accredited by the securities and insurance regulators. CSI grants leading designations and certiﬁcates that are a true measure of expertise and professionalism. Our credentials enable ﬁnancial services professionals to take charge of their careers and expand their skills beyond basic licensing requirements to take on new roles and offer broader services. CSI is valued for its expertise, not only in the development of courses and examinations, but also in their delivery. CSI courses are available on demand in a variety of formats, thus enabling anytime, anywhere learning. We are continually leveraging new technology and pedagogical tools to meet the changing needs of learners and their organizations. TELL US HOW WE’RE DOING At CSI, we make every effort to ensure that what you learn is accurate, practical, and well written, and we update our courses regularly. However, we recognize that there is always room for improvement, so please let us know what you think. Your feedback counts in helping us keep our learning content fresh and accurate. You can submit comments, suggestions, or concerns to [email protected] © CANADIAN SECURITIES INSTITUTE (2017) CANADIAN SECURITIES COURSE (CSC)® VOLUME 1 PREPARED & PUBLISHED BY CSI 200 Wellington Street West, 15th Floor Toronto, Ontario M5V 3C7 625 René-Lévesque Blvd West, 4th Floor Montréal, Québec H3B 1R2 Telephone 416 364 9130 Fax 416 359 0486 Toll-Free 1 + 866 866 2601 Toll-Free Fax 1 + 866 866 2660 Website www.csi.ca Credentials that matter.® Copies of this publication are for the personal use Notices Regarding This Publication: of properly registered students whose names are This publication is strictly intended for information entered on the course records of the Canadian and educational use. Although this publication is Securities Institute (CSI)®. This publication may not designed to provide accurate and authoritative be lent, borrowed or resold. Names of individual information, it is to be used with the understanding securities mentioned in this publication are for the that CSI is not engaged in the rendering of ﬁnancial, purposes of comparison and illustration only and accounting or other professional advice. If ﬁnancial prices for those securities were approximate ﬁgures advice or other expert assistance is required, the for the period when this publication was being services of a competent professional should be prepared. sought. Every attempt has been made to update securities In no event shall CSI and/or its respective suppliers industry practices and regulations to reﬂect be liable for any special, indirect, or consequential conditions at the time of publication. While damages or any damages whatsoever resulting from information in this publication has been obtained the loss of use, data or proﬁts, whether in an action from sources we believe to be reliable, such of contract negligence, or other tortious action, information cannot be guaranteed nor does it arising out of or in connection with information purport to treat each subject exhaustively and should available in this publication. not be interpreted as a recommendation for any speciﬁc product, service, use or course of action. CSI © 2017 Canadian Securities Institute assumes no obligation to update the content in this All rights reserved. No part of this publication may publication. be reproduced, stored in a retrieval system, or transmitted in any form by any means, electronic, A Note About References to Third Party Materials: mechanical, photocopying, recording, or otherwise, There may be references in this publication to third without the prior written permission of CSI. party materials. Those third party materials are not under the control of CSI and CSI is not responsible for the contents of any third party materials or for any changes or updates to such third party materials. CSI is providing these references to you only as a convenience and the inclusion of any reference does not imply endorsement of the third party materials. ISBN: 978-1-77176-217-5 First printing: 1964 Revised and reprinted: 1967, 1968, 1969, 1970, 1971, 1973, 1974, 1976, 1977, 1978, 1979, 1980, 1981, 1983, 1984, 1985, 1986, 1987, 1988, 1989, 1990, 1991, 1992, 1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2010, 2011, 2013, 2014, 2015, 2016, 2017 Copyright © 2017 by Canadian Securities Institute Course Introduction THE CANADIAN SECURITIES COURSE Congratulations for embarking on the Canadian Securities Course (CSC)! This foundational ﬁnancial services credential is the leading industry standard and a stepping stone toward a comprehensive ﬁnancial education. Whether you are a career-minded ﬁnancial professional working towards one of CSI’s designations or certiﬁcations, or simply looking to make more informed ﬁnancial decisions, this course will help you achieve your goal. Recognized as an industry benchmark, the CSC covers a diverse range of topics, while closely reﬂecting the ever-changing nature and current trends of the securities industry. The dynamic nature of the industry itself is a compelling reason to take the CSC. Merely ten years ago, for example, exchange-traded funds (ETFs) warranted only brief coverage because they were not prevalent in the marketplace. With this version of the course, ETFs are treated in depth to reﬂect the vital role they have come to play in the ﬁnancial landscape. Studying for this course requires focus, good study habits, and time commitment. Your challenge is to adopt good CSC-study habits, read the learning materials carefully and practice regularly with the various course learning components that help you see for yourself how well you understand the content. We highly recommend that you use all of the learning components we offer, including the textbook, online learning activities, online review questions, discussion boards, and Frequently Asked Questions (FAQs). WHAT WILL YOU LEARN? The CSC covers the three central elements of the Canadian securities industry: 1. Financial markets 2. Financial intermediaries 3. Financial products Our goal is to help you understand the marketplace and introduce you to industry terminology and practices. We begin in Volume 1 with an introduction to the Canadian securities industry, the regulatory landscape, and the economy. From there, we move to the different types of markets and ﬁnancial instruments; then we go on to explain the mechanics of securities transactions. In Volume 2, we begin with a discussion of fundamental and technical analysis. Next, we introduce the portfolio approach to investment management, and we discuss the many types of managed and structured products that can make up a portfolio. Other topics include taxation, ethics, the ﬁnancial planning process, and, ﬁnally, the institutional marketplace. Consider the topics in Volume 1 as the building blocks that form a base structure of knowledge in preparation for what you will learn in Volume 2. Please note that Exam 1 covers the content of Volume 1, and Exam 2 covers the content of Volume 2. © CANADIAN SECURITIES INSTITUTE (2017) ii CANADIAN SECURITIES COURSE | VOLUME 1 WHAT IS THE BIG PICTURE? Think of the ﬁnancial markets as the engine of the economy. It is here that savings are transformed into investments, and these investments drive a nation’s growth. This vital economic function is based on a simple process—the transfer of money from those who have it (buyers of securities) to those who need it (sellers of securities). Capital transfer at its simplest occurs when you deposit money into a bank account. Once you make a deposit, the bank can lend it to a business that needs funds. For example, the business may use borrowed funds to expand their operations or to become a publicly-traded company on a stock exchange. In return, the business pays interest on the borrowed funds, and you receive a portion of that interest in exchange for the use of your money. Of course, the capital transfer process is more sophisticated in the ﬁnancial markets, especially as the securities sold in these markets become increasingly complex. In essence, the ﬁnancial markets have evolved to work as follows: Financial instruments, such as stocks and bonds, are the tools used by buyers and sellers to transfer capital. The marketplace is the mechanism by which ﬁnancial instruments are bought and sold. Financial intermediaries, such as investment dealers, make the transfer process faster and easier. Together, these three components—instruments, markets, and intermediaries— facilitate the efﬁcient allocation of capital. As such, they are the key elements of the securities industry, and for this reason, they form the foundation on which the CSC is built. KEY CHAPTER FEATURES Each chapter is organized around the following key learning features: Icons Features Description Learning Objectives The learning objectives show what you will be able to accomplish after studying the chapter. Be sure to read the learning objectives before you begin a chapter. Key Terms Understanding the terminology and jargon of the securities industry is an important part of your success in this course. To help in this regard, we provide a list of key terms at the start of each chapter. Each term is boldfaced in the chapter and is deﬁned in the glossary at the end of the textbook. Online Learning Each chapter has learning activities accompanying the text that are Activities available online. To access the online components of your course, log in to your Student Proﬁle at www.csi.ca. Did You Know? This feature provides important information, including facts, statistics, clariﬁcations, and insights, that supports the chapter content. Make sure you read the concise material covered in the Did You Know? feature to keep your knowledge up to date and be fully prepared to write your exams. © CANADIAN SECURITIES INSTITUTE (2017) COURSE INTRODUCTION iii Icons Features Description Dive Deeper This feature takes you into insights that go a little deeper into the content to help you stay informed about ﬁnancial markets and the industry, sharpen your understanding and expand your knowledge. Furthermore, by making a habit of staying informed, you will ﬁnd it easier to reach your goal of becoming a competent and trusted participant in the securities industry. Review Questions Each chapter has a series of multiple choice questions that allow you to test your knowledge of the subject. The review questions for each chapter are available in the online course. Frequently Asked After studying the chapter, you may have questions that have already been Questions asked by previous students. Use the Frequently Asked Questions (FAQs), available in the online course for each chapter, to ﬁnd answers for questions you might have. YOUR JOURNEY THROUGH THE COURSE Although each student will develop an individual technique for studying, you may ﬁnd the suggestions we offer below helpful. The most important suggestion we can offer is that all of the content in the textbook is examinable—with one exception: you will not be tested on information named For Information Only. You may be more familiar with some areas of knowledge than others, but we advise strongly against skipping those sections. You can read the material in any order you choose, depending on your particular needs and level of familiarity with the content. However, we recommend instead that you avoid shortcuts and read all chapters in the sequence given. DID YOU KNOW? When you practise with our various assessment tools, keep in mind that your journey is NOT about ﬁnding the right answers and memorizing them. Rather, it is about knowing HOW to arrive at the right answer. Three crucial behaviours will help you succeed: Build good study habits. Turn the page only after you understand the concept. Practise to assess your knowledge. With this method, you should reap the rewards of your hard work and complete the course successfully. Your registration includes access to online course components, which are designed to reinforce the textbook content and help you assess your knowledge. © CANADIAN SECURITIES INSTITUTE (2017) iv CANADIAN SECURITIES COURSE | VOLUME 1 Before you read a chapter, we recommend that you log in to the online course and use the online chapters along with your text. We suggest the following approach: Read the overview section and the learning objectives for each chapter. Read the chapter in your textbook or the online PDF. Use this ﬁrst reading to familiarize yourself with the material. Take notes where necessary, especially if there is a concept you don’t understand. Complete the online learning activities for each chapter. If you have any questions related to the course material, review the online FAQs section. You may ﬁnd the answers there. Read the chapter slowly a second time. Pay particular attention to those areas you found challenging during your ﬁrst reading. Pay attention to the tables, charts, and ﬁgures. These will help you with the practical aspects of the material. Work through all examples and calculations, making sure you understand how we arrived at the correct answers. Complete the review questions for each chapter. Read the chapter summary to reinforce your learning. Don’t forget to review the key term deﬁnitions in the glossary at the end of the textbook. Familiarity with the terminology and jargon used in the industry will help you fully understand the learning material. © CANADIAN SECURITIES INSTITUTE (2017) CANADIAN SECURITIES COURSE Content Overview Volume 1 1 The Canadian Securities Industry 2 The Capital Market 3 The Canadian Regulatory Environment 4 Overview of Economics 5 Economic Policy 6 Fixed-Income Securities: Features and Types 7 Fixed-Income Securities: Pricing and Trading 8 Equity Securities: Common and Preferred Shares 9 Equity Securities: Equity Transactions 10 Derivatives 11 Corporations and their Financial Statements 12 Financing and Listing Securities Volume 2 13 Fundamental and Technical Analysis 14 Company Analysis 15 Introduction to the Portfolio Approach 16 The Portfolio Management Process 17 Mutual Funds: Structure and Regulation 18 Mutual Funds: Types and Features 19 Exchange-Traded Funds 20 Other Managed Products 21 Structured Products 22 Canadian Taxation 23 Fee-Based Accounts 24 Working with the Retail Client 25 Working with the Institutional Client © CANADIAN SECURITIES INSTITUTE (2017) CANADIAN SECURITIES COURSE vii Table of Contents | Volume 1 SECTION 1 | THE CANADIAN INVESTMENT MARKETPLACE 1 The Canadian Securities Industry 1 3 INTRODUCTION 1 3 OVERVIEW OF THE CANADIAN SECURITIES INDUSTRY 1 5 THE INVESTMENT DEALER’S ROLE AS A FINANCIAL INTERMEDIARY 1 5 Types of Investment Dealers 1 6 Organization within Firms 1 7 The Principal and Agency Functions of an Investment Dealer 1 8 The Clearing System 1 9 FINANCIAL INTERMEDIARIES OTHER THAN INVESTMENT DEALERS 1 9 Chartered Banks 1 10 Credit Unions and Caisses Populaires 1 11 Trust and Loan Companies 1 11 Insurance Companies 1 12 Other Financial Intermediaries 1 12 FINANCIAL MARKET TRENDS 1 12 Financial Technology 1 13 Robo-advisors 1 13 Shifting Demographics 1 14 SUMMARY 2 The Capital Market 2 3 INTRODUCTION 2 3 INVESTMENT CAPITAL 2 3 Characteristics of Capital 2 4 The Suppliers and Users of Capital 2 6 THE FINANCIAL INSTRUMENTS © CANADIAN SECURITIES INSTITUTE (2017) viii CANADIAN SECURITIES COURSE | VOLUME 1 2 7 THE FINANCIAL MARKETS 2 7 Primary and Secondary Markets 2 7 Auction Markets 2 9 Dealer Markets 2 10 Alternative Trading Systems 2 12 SUMMARY 3 The Canadian Regulatory Environment 3 3 INTRODUCTION 3 3 THE REGULATORS 3 3 The Canadian Securities Administrators 3 4 The Self-Regulatory Organizations 3 5 The Ofﬁce of the Superintendent of Financial Institutions 3 5 Investor Protection Funds 3 7 REGULATION AND SUPERVISION 3 7 Purpose of Regulation 3 8 Principles-Based Regulation 3 9 Securities Regulation in Canada 3 9 Disclosure 3 10 The National Registration Database 3 10 The Gatekeeper Role 3 11 Know Your Client Rule 3 11 Client Relationship Model 3 12 REMEDIATION 3 12 Arbitration 3 13 Ombudsman for Banking Services and Investments 3 13 ETHICAL STANDARDS IN THE FINANCIAL SERVICES INDUSTRY 3 13 Examples of Unethical Practices 3 14 Prohibited Sales Practices 3 15 SUMMARY © CANADIAN SECURITIES INSTITUTE (2017) TABLE OF CONTENTS ix SECTION 2 | THE ECONOMY 4 Overview of Economics 4 3 INTRODUCTION 4 3 DEFINING ECONOMICS 4 3 Microeconomics and Macroeconomics 4 4 The Decision Makers 4 4 The Market 4 6 MEASURING ECONOMIC GROWTH 4 6 Gross Domestic Product 4 8 Productivity and Determinants of Economic Growth 4 8 THE BUSINESS CYCLE 4 9 Phases of the Business Cycle 4 11 Economic Indicators 4 12 Identifying Recessions 4 13 THE LABOUR MARKET 4 13 Labour Market Indicators 4 16 Types of Unemployment 4 16 THE ROLE OF INTEREST RATES 4 17 Determinants of Interest Rates 4 18 How Interest Rates Affect the Economy 4 18 Expectations and Interest Rates 4 19 THE IMPACT OF INFLATION 4 19 Measuring Inﬂation 4 22 The Causes of Inﬂation 4 22 Deﬂation and Disinﬂation 4 23 INTERNATIONAL FINANCE AND TRADE 4 23 The Balance of Payments 4 23 The Exchange Rate 4 26 SUMMARY © CANADIAN SECURITIES INSTITUTE (2017) x CANADIAN SECURITIES COURSE | VOLUME 1 5 Economic Policy 5 3 INTRODUCTION 5 3 FISCAL POLICY 5 3 The Federal Budget 5 4 How Fiscal Policy Affects the Economy 5 7 THE BANK OF CANADA 5 7 Role and Functions of the Bank of Canada 5 8 MONETARY POLICY 5 8 Canada’s Monetary Policy Framework 5 8 Implementing Monetary Policy 5 12 THE CHALLENGES OF GOVERNMENT POLICY 5 14 SUMMARY SECTION 3 | INVESTMENT PRODUCTS 6 Fixed-Income Securities: Features and Types 6 3 INTRODUCTION 6 3 THE FIXED-INCOME MARKETPLACE 6 3 The Rationale for Issuing Fixed-Income Securities 6 4 THE BASIC FEATURES AND TERMINOLOGY OF FIXED-INCOME SECURITIES 6 5 Bond Terminology 6 6 Bond Features 6 8 Liquidity, Negotiability, and Marketability 6 8 Strip Bonds 6 9 Callable Bonds 6 9 Extendible and Retractable Bonds 6 10 Convertible Bonds and Debentures 6 12 Sinking Funds and Purchase Funds 6 13 Protective Provisions of Corporate Bonds 6 13 GOVERNMENT OF CANADA SECURITIES 6 14 Marketable Bonds 6 14 Treasury Bills © CANADIAN SECURITIES INSTITUTE (2017) TABLE OF CONTENTS xi 6 14 Canada Savings Bonds and Canada Premium Bonds 6 14 Real Return Bonds 6 15 PROVINCIAL AND MUNICIPAL GOVERNMENT SECURITIES 6 15 Guaranteed Bonds 6 16 Provincial Securities 6 16 Municipal Securities 6 16 TYPES OF CORPORATE BONDS 6 16 Mortgage Bonds 6 17 Floating-Rate Securities 6 17 Domestic, Foreign, and Eurobonds 6 19 OTHER FIXED-INCOME SECURITIES 6 19 Bankers’ Acceptances 6 19 Commercial Paper 6 19 Term Deposits 6 19 Guaranteed Investment Certiﬁcates 6 21 Fixed-Income Mutual Funds and Exchange-Traded Funds 6 21 HOW TO READ BOND QUOTES AND RATINGS 6 23 SUMMARY 7 Fixed-Income Securities: Pricing and Trading 7 3 INTRODUCTION 7 3 CALCULATING PRICE AND YIELD OF A BOND 7 4 The Discount Rate 7 5 Calculating the Fair Price of a Bond 7 8 Calculating the Yield on a Treasury Bill 7 9 Calculating the Current Yield on a Bond 7 9 Calculating the Yield to Maturity on a Bond 7 12 TERM STRUCTURE OF INTEREST RATES 7 13 The Real Rate of Return 7 13 The Yield Curve 7 16 FUNDAMENTAL BOND PRICING PROPERTIES 7 16 The Relationship between Bond Prices and Interest Rates 7 17 The Impact of Maturity © CANADIAN SECURITIES INSTITUTE (2017) xii CANADIAN SECURITIES COURSE | VOLUME 1 7 17 The Impact of the Coupon 7 18 The Impact of Yield Changes 7 18 Duration as a Measure of Bond Price Volatility 7 20 BOND MARKET TRADING 7 20 The Sell Side 7 20 The Buy Side 7 21 Buying Bonds through an Investment Dealer 7 21 Mechanics of the Trade 7 22 Clearing and Settlement 7 23 Calculating Accrued Interest 7 24 BOND INDEXES 7 25 Canadian Bond Market Indexes 7 25 Global Indexes 7 26 SUMMARY 8 Equity Securities: Common and Preferred Shares 8 3 INTRODUCTION 8 3 COMMON SHARES 8 4 Beneﬁts and Risks of Common Share Ownership 8 5 Capital Appreciation 8 5 Dividends 8 7 Voting Privileges 8 8 Stock Splits and Consolidations 8 9 Reading Stock Quotations 8 10 PREFERRED SHARES 8 10 The Preferred Shareholder’s Claim to Assets 8 11 Why Companies Issue Preferred Shares 8 12 Why Investors Buy Preferred Shares 8 12 Preferred Share Features 8 13 Straight Preferred Shares 8 14 Convertible Preferred Shares 8 15 Retractable Preferred Shares 8 16 Floating-Rate Preferred Shares 8 17 Foreign-Pay Preferred Shares © CANADIAN SECURITIES INSTITUTE (2017) TABLE OF CONTENTS xiii 8 17 Other Types of Preferred Shares 8 18 STOCK INDEXES AND AVERAGES 8 19 Canadian Market Indexes 8 21 U.S. Stock Market Indexes 8 21 OTHER U.S. STOCK MARKET INDEXES 8 22 International Market Indexes and Averages 8 23 SUMMARY 9 Equity Securities: EquityTransactions 9 3 INTRODUCTION 9 3 CASH ACCOUNTS AND MARGIN ACCOUNTS 9 3 Long Positions and Short Positions 9 4 MARGIN ACCOUNT TRANSACTIONS 9 4 Long Margin Accounts 9 7 Short Margin Accounts 9 11 Risks of Short Selling 9 12 TRADING AND SETTLEMENT PROCEDURES 9 12 Trading Procedures 9 13 HOW SECURITIES ARE BOUGHT AND SOLD 9 14 Types of Orders 9 17 SUMMARY 10 Derivatives 10 3 INTRODUCTION 10 3 THE ROLE OF DERIVATIVES 10 4 Features Common to All Derivatives 10 4 Derivative Markets 10 5 Exchange-Traded Versus Over-the-Counter Derivatives 10 7 TYPES OF UNDERLYING ASSETS 10 7 Commodities 10 7 Financial Assets © CANADIAN SECURITIES INSTITUTE (2017) xiv CANADIAN SECURITIES COURSE | VOLUME 1 10 8 THE USERS OF DERIVATIVES 10 8 Individual Investors 10 9 Institutional Investors 10 10 Corporations and Businesses 10 10 Derivative Dealers 10 11 OPTIONS 10 12 Options Terminology 10 15 Option Exchanges 10 16 Option Strategies for Individual and Institutional Investors 10 23 Option Strategies for Corporations 10 25 FORWARDS AND FUTURES 10 25 Key Terms and Deﬁnitions 10 27 Futures Trading and Leverage 10 27 Futures Exchanges 10 27 Futures Strategies for Investors 10 28 Futures Strategies for Corporations 10 29 RIGHTS AND WARRANTS 10 30 Rights 10 32 Warrants 10 34 SUMMARY SECTION 4 | THE CORPORATION 11 Corporations and their Financial Statements 11 3 INTRODUCTION 11 3 CORPORATIONS AND THEIR STRUCTURE 11 4 Advantages and Disadvantages of Incorporation 11 5 Private and Public Corporations 11 7 The Corporate Structure 11 8 FINANCIAL STATEMENTS OF A CORPORATION 11 9 Statement of Financial Position 11 16 Statement of Comprehensive Income 11 19 Statement of Changes In Equity 11 20 Statement of Cash Flows © CANADIAN SECURITIES INSTITUTE (2017) TABLE OF CONTENTS xv 11 22 THE ANNUAL REPORT 11 22 Notes to the Financial Statements 11 22 The Auditor’s Report 11 23 PUBLIC COMPANY DISCLOSURES AND INVESTOR RIGHTS 11 23 Continuous Disclosure 11 24 Statutory Rights of Investors 11 24 TAKEOVER BIDS AND INSIDER TRADING 11 25 Takeover Bids 11 25 Insider Trading 11 27 SUMMARY 11 28 APPENDIX A – SAMPLE FINANCIAL STATEMENTS 12 Financing and Listing Securities 12 3 INTRODUCTION 12 3 GOVERNMENT AND CORPORATE FINANCE 12 3 Investment Dealer Finance Department 12 4 Canadian Government Issues 12 5 Provincial and Municipal Issues 12 6 Corporate Financing 12 8 THE CORPORATE FINANCING PROCESS 12 8 The Dealer’s Advisory Relationship with Corporations 12 10 The Method of Offering 12 11 BRINGING SECURITIES TO THE MARKET 12 11 When a Prospectus Is Required 12 12 Preliminary Prospectus 12 13 Permitted Activities During the Waiting Period 12 13 Final Prospectus 12 14 The Short Form Prospectus System 12 15 After-Market Stabilization 12 15 The Bought Deal 12 16 Securities Distributions through the Exchanges © CANADIAN SECURITIES INSTITUTE (2017) xvi CANADIAN SECURITIES COURSE | VOLUME 1 12 16 OTHER METHODS OF DISTRIBUTING SECURITIES TO THE PUBLIC 12 17 Junior Company Distributions 12 17 Options of Treasury Shares and Escrowed Shares 12 17 Capital Pool Company Program 12 18 The NEX Board 12 18 Crowdfunding 12 18 THE LISTING PROCESS 12 19 Advantages and Disadvantages of Listing 12 19 Withdrawing Trading Privileges 12 21 SUMMARY S Summary for Volume 1 G Glossary © CANADIAN SECURITIES INSTITUTE (2017) SECTION 1 THE CANADIAN INVESTMENT MARKETPLACE 1 The Canadian Securities Industry 2 The Capital Market 3 The Canadian Regulatory Environment © CANADIAN SECURITIES INSTITUTE (2017) 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 among 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 among the roles of the various Financial Intermediaries Other than financial institutions. Investment Dealer 5 | Discuss the trends affecting the financial Financial Market Trends services industry in Canada and globally. © CANADIAN SECURITIES INSTITUTE (2017) 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 mutual fund broker open-end fund Canadian Investor Protection Fund pension fund CDS Clearing and Depository Services Inc. primary market clearing primary market distribution closed-end fund primary offering consumer finance company principal discount broker retail firm financial intermediary robo-advisor fintech sales finance company firewall savings bank initial public offering schedule I bank institutional firm schedule II bank integrated firm schedule III bank investment dealer self-directed broker investment fund self-regulatory organization Investment Industry Association of Canada secondary market Investment Industry Regulatory Organization settlement of Canada underwriting market maker money market © CANADIAN SECURITIES INSTITUTE (2017) 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 (2017) 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 self-regulatory organizations (SRO) such as the Investment Industry Regulatory Organization of Canada (IIROC). The SROs establish and enforce industry regulations that protect investors and maintain fair, equitable, and ethical practices. In that capacity, SROs are responsible for setting the rules that govern many aspects of investment dealers’ operations, including sales, finance, and trading. 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 Organizations Clearing & Markets Investment Industry Regulatory Settlement Organization of Canada Mutual Funds Dealers Association 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 SROs set and enforce rules that govern market activity and monitor the markets to ensure fairness and transparency. The Canadian Investor Protection Fund and similar organizations provide insurance against dealer insolvency. Provincial regulators oversee the markets and the SROs. The Canadian Securities Institute and similar organizations provide education for industry participants. © CANADIAN SECURITIES INSTITUTE (2017) CHAPTER 1 | THE CANADIAN SECURITIES INDUSTRY 1 5 DID YOU KNOW? Industry Statistics According to recent statistics from the Investment Industry Association of Canada (IIAC), there are 163 IIROC firms in the securities industry. Together, these firms employ more than 39,000 people. THE CANADIAN SECURITIES INDUSTRY 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, login 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 (IPO). 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 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. © CANADIAN SECURITIES INSTITUTE (2017) 1 6 CANADIAN SECURITIES COURSE | VOLUME 1 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 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. © CANADIAN SECURITIES INSTITUTE (2017) CHAPTER 1 | THE CANADIAN SECURITIES INDUSTRY 1 7 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 from 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 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. © CANADIAN SECURITIES INSTITUTE (2017) 1 8 CANADIAN SECURITIES COURSE | VOLUME 1 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 account to make a profit. THE TWO 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. 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. 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. © CANADIAN SECURITIES INSTITUTE (2017) CHAPTER 1 | THE CANADIAN SECURITIES INDUSTRY 1 9 FINANCIAL INTERMEDIARIES OTHER THAN INVESTMENT DEALERS 4 | Distinguish among 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 sets out operating rules and restrictions for banks and updates them 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. According to the Bank of Canada, there are currently close to 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) Royal Bank of Canada (RBC) Scotiabank Toronto-Dominion Bank (TD Bank Group) National Bank of Canada 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 (2017) 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, Comerica Bank, and The Bank of New York Mellon. 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 consumers that 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 co-operative institutions. They can also provide administrative, educational, and other services to co-operative credit societies. © CANADIAN SECURITIES INSTITUTE (2017) 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: life insurance and 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 The largest aggregate premiums 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 (2017) 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. The Alberta Treasury Branches (ATB Financial), known as savings banks, were 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. Canada’s changing demographic landscape has focused public attention on the future viability of the Canada Pension Plan and Québec Pension Plan. THE ROLE OF THE BANKS AND OTHER 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 (2017) 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 2015, they had amassed $45 billion 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-2016. Many variations on 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 on 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. SHIFTING 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. There are also about 4.5 million Canadians who are older than baby boomers, most of whom are now in their retirement years. 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. An important trend to monitor is the growth of the segment of Canadians over age 65. As the leading edge of the baby boomer population reaches this milestone retirement age, advisors are expected to adjust their service offering to reflect the needs of their client base, which is increasingly made up of retired Canadians. © CANADIAN SECURITIES INSTITUTE (2017) 1 14 CANADIAN SECURITIES COURSE | VOLUME 1 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. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may ﬁnd answers in the online Chapter 1 FAQs. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 1 Review Questions. © CANADIAN SECURITIES INSTITUTE (2017) 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 (2017) 2 2 CANADIAN SECURITIES COURSE | VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. Aequitas NEO Exchange investment advisor agent investment fund alternative trading system last price ask price liquidity auction market MarketAxess bid price market maker bid-ask spread mutual fund Canadian Securities Exchange Montréal Exchange Canadian Unlisted Board Inc. Natural Gas Exchange CanDeal Nodal Exchange CanPX option capital over-the-counter market CBID preferred share CBID Institutional primary market common share retail investor dealer market secondary market debt securities stock exchange derivative Toronto Stock Exchange equity securities TSX Alpha Exchange fixed-income securities TSX Venture Exchange ICE Futures Canada unlisted market institutional investor © CANADIAN SECURITIES INSTITUTE (2017) 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 (2017) 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 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 riskadjusted 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 Individuals tend to postpone consumption by saving their money to spend it at an opportune time in the future. They become more inclined to spend when 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 (2017) 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 (2017) 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 securities Fixed-income securities (also called debt Treasury bills securities) formalize a relationship in which the Bonds issuer promises to 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, Common stock (also or shares) represent some form of ownership stake called common shares) in the company that issued them. For example, if the Preferred shares value 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) Mutual funds are typically pools of capital gathered from investors Exchange-traded funds to buy 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 Index-linked guaranteed an investment fund. investment certificates © CANADIAN SECURITIES INSTITUTE (2017) 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. 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 (2017) 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. STOCK 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 exchanges, trading is carried out in common and preferred shares, rights and warrants, exchange-traded funds, income trusts, and a few conve

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