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© CSI GLOBAL EDUCATION INC. (2010) 1•1

Chapter 1

The Capital Market



© CSI GLOBAL EDUCATION INC. (2010)1•2

1

The Capital Market

CHAPTER OUTLINE

What is Investment Capital?

• Characteristics of Capital

• Why Capital Is Needed

Who are the Sources and Users of Capital?

• Sources of Capital

• Users of Capital

What are the Financial Instruments?

• Debt Instruments

• Equity Instruments

• Investment Funds

• Derivatives and Other Financial Instruments

What are the Financial Markets?

• Auction Markets in Canada

• Stock Exchanges Around the World

• Dealer Markets

• Private Equity

• Trends in Financial Markets

Summary



© CSI GLOBAL EDUCATION INC. (2010) 1•3

LEARNING OBJECTIVES

By the end of this chapter, you should be able to:

1. Define investment capital and describe its role in the economy.

2. Describe how individuals, businesses, governments and foreign agencies supply and use capital in the

economy.

3. Differentiate between the types of financial instruments used in capital transactions.

4. Explain the role of financial markets in the Canadian financial services industry, distinguish among thetypes of financial markets, and describe how auction markets and dealer markets work.

5. Explain what private equity is, how it has grown and the different ways of investing in this market.

THE CAPITAL MARKET

The Canadian securities industry plays a significant role in sustaining and expanding the Canadian economy.

The industry grows and evolves to meet the ever-changing needs of Canadian investors, both from

domestic and international perspectives.

In some way, we are all affected by the securities industry. The vital economic function the industry plays

is based on a simple process: the transfer of money from those who have it (savers) to those who need it(users). This capital transfer process is made possible through the use of a variety of financial instruments:

stocks, bonds, mutual funds and derivatives. Financial intermediaries, such as banks, trust companies and

investment dealers, have evolved to make the transfer process efficient.

The first two chapters of this textbook focus on the three central elements of the securities industry:

investment markets, products and intermediaries. The emphasis throughout the course, however, is on

securities. The text examines the main types of investment products, how to analyze them, how they are

sold, and how they are used as part of a well-planned portfolio of investments.

For those new to this material, we offer a suggestion: stay informed about the markets and the industry

because it will help you better understand the material presented in this textbook. There are countless

sources of financial market information, including newspapers, the Internet, books and magazines. The

course material will be that much easier to grasp if you can relate it to the activity that unfolds each day in

the financial markets. Ultimately, this will help you achieve your goal of becoming an informed and effective

participant in the securities industry.





ONE • THE CAPITAL MARKET 1•5

© CSI GLOBAL EDUCATION INC. (2010)

WHAT IS INVESTMENT CAPITAL?

In general terms, capital is wealth – both real, material things such as land and buildings, andrepresentational items such as money, stocks and bonds. All of these items have economic value.

Capital represents the invested savings of individuals, corporations, governments and many otherorganizations and associations. It is in short supply and is arguably the world’s most importantcommodity.

Capital savings are useless by themselves. Only when they are harnessed productively do they gaineconomic significance. Such utilization may take the form of either direct or indirect investment.

Capital savings can be used directly by, for example, a couple investing their savings in a home;a government investing in a new highway or hospital; or a domestic or foreign company payingstart-up costs for a plant to produce a new product.

Capital savings can also be harnessed indirectly through the purchase of such representationalitems as stocks or bonds or through the deposit of savings in a financial institution. The indirect

investment process is the principal focus of this course.

Indirect investment occurs when the saver buys the securities issued by governments andcorporations, who in turn use the funds for direct productive investment – equipment, supplies,etc. Such investment is normally made with the assistance of the retail or institutional salesdepartment of the investment advisor’s firm.

Characteristics of Capital

Capital has three important characteristics. It is mobile, sensitive to its environment and scarce.Therefore capital is extremely selective. It attempts to settle in countries or locations wheregovernment is stable, economic activity is not over-regulated, the investment climate is hospitable

and profitable investment opportunities exist. The decision as to where capital will flow is guidedby country risk evaluation, which analyzes such things as:

• The political environment – whether the country is involved or likely to be involved ininternal or external conflict

• Economic trends – growth in gross domestic product, inflation rate, levels of economicactivity, etc.

• Fiscal policy – levels of taxes and government spending and the degree to which thegovernment encourages savings and investment

• Monetary policy – the sound management of the growth of the nation’s money supply andthe extent to which it promotes price and foreign exchange stability

• Opportunities for investment and satisfactory returns on investment when considering therisks to be accepted

• Characteristics of the labour force – whether it is skilled and productive

WHAT IS INVESTMENT CAPITAL?



CANADIAN SECURITIES COURSE • VOLUME 11•6


Because of its mobility and sensitivity, capital moves in or out of countries or localities inanticipation of changes in taxation, exchange policy, trade barriers, regulations, governmentattitudes, etc. It moves to where the best use can be made of it and attempts to avoid areas wherethe above factors are not positive. Thus, capital moves to uses and users that offer the highestrisk-adjusted returns. Capital is scarce worldwide and it cannot be increased synthetically or by government decree. It is in great demand everywhere.

Why Capital Is Needed

An adequate supply of capital is essential for Canada’s future well-being. Enough new andefficient plant and equipment must be put in place to ensure expanded output capability,improved productivity, increased competitiveness and the development of innovative, sought-after new products. If capital investment is inadequate, the result will be insufficient output,declining productivity, rising unemployment, decreasing competitiveness in domestic andinternational markets – in short, lower living standards.

The securities industry attaches great importance to the savings and investment process. It isconstantly in touch with governments with a view to improving the saving and investment

process. The industry advocates changes, when appropriate, in both government policies and thetax system. These proposed changes are designed to encourage more saving and the investment of savings in productive plant and equipment.

WHO ARE THE SOURCES AND USERS OF CAPITAL?

The only source of capital is savings. When revenues of non-financial corporations, individuals,governments and non-residents exceed their expenditures, they have savings to invest.

Non-financial corporations, such as steel makers, food distributors and machinery manufacturers,have historically generated the largest part of total savings mainly in the form of earnings, whichthey retain in their businesses. These internally generated funds are usually available only forinternal use by the corporation and are not normally invested in other companies’ stocks andbonds. Thus, corporations are not important providers of permanent funds to others in thecapital market.

Individuals may decide, especially if given incentives to do so, to postpone consumption now in order to save so that they can consume in the future. Governments that are able to operate ata surplus are “savers” and able to invest their surpluses. Other governments are “dis-savers” andmust borrow in capital markets to meet their deficits. Most governments also own or controlCrown corporations or agencies that may generate retained earnings for investment. Both federal

and provincial governments, until recently, have been running deficits and, therefore, have notbeen significant suppliers of investment capital.

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

WHO ARE THE SOURCES AND USERS OF CAPITAL?





Sources of Capital

Retail and institutional investors are a significant source of investment capital. Retail investorsare individual investors who buy and sell securities for their own personal accounts, and notfor another company or organization. Institutional investors are organizations, such as apension fund or mutual fund company, that trade large volumes of securities and typically have

a steady flow of money to invest. Retail investors generally buy in smaller quantities than larger,institutional investors.

For example, by the end of 2007, individual Canadians had just over $500 billion in personalsavings deposits at the chartered banks alone. They had many more billions of dollars at otherfinancial intermediaries such as trust companies, credit unions and investment dealers. Canadiansalso have other substantial assets in the form of securities investments made either directly orindirectly through investment funds and pension plans, equity in homes and businesses, cashvalues of insurance policies, retirement plans, etc.

Over the past ten years, Canadian investors’ holdings of securities have doubled to more than$600 billion today. Ten years ago, 22% of the average investor’s financial assets (bank accounts,registered retirement savings plans, pension, insurance, etc.) were stocks. Today, this share has

grown to 30%. Canadians are increasingly turning to the securities industry to ensure theirprosperity and future retirement security.

Foreign investors also are a significant source of investment capital. Historically, Canada hasdepended upon large inflows of foreign investment for continued growth. Foreign directinvestment in Canada has tended to concentrate in particular industries: manufacturing,petroleum and natural gas, and mining and smelting. There are many industries that are largely Canadian-controlled (e.g., merchandising, finance, agriculture, transportation, construction,utilities). Some industries also have restrictions with respect to foreign investment.

Canada’s use of foreign investment, while necessary, has its costs. Some Canadian economicnationalists feel that direct foreign investment implies control. They feel that foreign investment

leads to long-term outflows of interest and dividend payments, negatively affecting ourinternational balance of payments. They also fear that foreign owners may favour their owndomestic plants, or subsidiaries in other countries over their Canadian subsidiaries in the pursuitof export markets, research and development efforts, and in plant closings or layoffs duringrecessions.

The debate on the appropriate level of foreign investment in Canada will, no doubt, continue.But over the past 20 years there has been a significant swing in government policy away fromthe protection of Canadian businesses. The Canadian Government and the business community recognize that foreign capital continues to be needed and that foreign investors must be made tofeel that Canada is a safe and attractive country in which to invest.





Users of Capital

Based on the simplest categorization, the users of capital are individuals, businesses andgovernments. These can be both Canadian and foreign users. The ways in which these groups usecapital are described below.

INDIVIDUALS

Individuals may require capital to finance housing, consumer durables (e.g., automobiles,appliances) or other types of consumption. They usually obtain it through incurring indebtednessin the form of personal loans, mortgage loans or charge accounts. Since individuals do not issuesecurities to the public and the focus of this text is on securities, individual capital users are notdiscussed further.

Just as foreign individuals, businesses or governments can supply capital to Canada, capitalcan flow in the other direction. Foreign users (mainly businesses and governments) may accessCanadian capital by borrowing from Canadian banks or by making their securities available tothe Canadian market. Foreign users will want Canadian capital if they feel that they can accessthis capital at a less expensive rate than their own currency. Access to foreign securities benefits

Canadian investors, who are thus provided with more choice and an opportunity to furtherdiversify their investments.

BUSINESSES

Canadian businesses require massive sums of capital to finance day-to-day operations, to renew and maintain plant and equipment as well as to expand and diversify activities. A substantial partof these requirements is generated internally (e.g., profits retained in the business), while some isborrowed from financial intermediaries (principally the chartered banks). The remainder is raisedin securities markets through the issuance of short-term money market paper, medium- and long-term debt, and preferred and common shares. These instruments are discussed in detail in laterchapters.

THE FEDERAL GOVERNMENT

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

Each year the Minister of Finance presents the government’s budget to Parliament. The budget details the government’s estimate of its revenues and expenses, which in turn results in aprojection of a budget surplus or budget deficit.

When revenues fail to meet expenditures and/or when large capital projects are planned, thefederal government must borrow. The government makes use of four main instruments: treasury bills (T-bills), marketable bonds, Canada Savings Bonds (CSBs) and Canada Premium Bonds

(CPBs). The characteristics of each of these instruments are discussed in detail in the material onfixed-income products.

PROVINCIAL AND MUNICIPAL GOVERNMENTS

Like the federal government, the provinces issue debt directly themselves and may guaranteeunconditionally the interest and principal of securities issued by their Crown corporations, suchas the Alberta Municipal Financing Corporation, Hydro Québec, and New Brunswick ElectricPower Commission.





When revenues fail to meet expenditures and/or when large capital projects are planned,provinces must borrow. They may issue non-marketable bonds (i.e., bonds that do not trade inthe secondary markets) to the federal government or borrow funds from Canada Pension Plan(CPP) assets (or the Québec Pension Plan in the case of Québec).

Alternatively, a province may issue debt domestically through a syndicate of investment dealers

who sell the issue to financial institutions or to retail investors. In addition to conventional debtissues, some provinces issue their own short-term treasury bills and, in some cases, their ownsavings bonds similar to CSBs issued by the federal government.

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

Municipalities are responsible for the provision of streets, sewers, waterworks, police and fireprotection, welfare, transportation, distribution of electricity and other services for individualcommunities. Since many of the assets used to provide these services are expected to last fortwenty or more years, municipalities attempt to spread their cost over a period of years throughthe issuance of instalment debentures (or serial debentures).

WHAT ARE THE FINANCIAL INSTRUMENTS?

Transferring money from one person to another may seem relatively straightforward. Why thendo we need formal financial instruments called securities?

As a way of distributing capital in a large, sophisticated economy, securities have many advantages. Securities are formal, legal documents, which set out the rights and obligationsof the buyers and sellers. They tend to have standard features, which facilitates their trading.Furthermore, there are many types of securities, enabling both investors (buyers) and users

(sellers) of capital to meet their particular needs.

Much of this text deals with the characteristics of different financial instruments. The followingbrief discussion of instruments is included here to remind the reader that financial instruments(products) are one of the three key components of the securities industry. The other twocomponents, financial markets and financial intermediaries, will be covered in subsequentchapters.

Debt Instruments

Debt instruments formalize a relationship in which the issuer promises to repay the loan atmaturity, and in the interim makes interest payments to the investor. The term of the loan

ranges from very short to very long, depending on the type of instrument. Bonds, debentures,mortgages, treasury bills and commercial paper are all examples of debt instruments (also referredto as fixed-income securities).

Bonds and debentures are among the most common forms of debt instrument. They are issuedby all levels of government, many corporations, and some educational and religious organizations.The term bond is sometimes used colloquially to refer to both bonds and debentures, but thesetwo instruments differ in terms of how they are secured. A bond is secured by specific assets

WHAT ARE THE FINANCIAL INSTRUMENTS?

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of the issuer, while a debenture is secured only by the general credit of the issuer and not by aspecific pledge of assets. These securities are discussed in more detail in the chapter on fixed-income securities.

Equity Instruments

Equities are usually referred to as stocks or shares because the investor actually buys a “share”of the company, thus gaining an ownership stake in the company. As an owner, the investorparticipates in the corporation’s fortunes. If the company does well, the value of the company may increase, giving the investor a capital gain when the shares are sold. In addition, thecompany may distribute part of its profit to shareowners in the form of dividends. Unlike intereston a debt instrument, however, dividends are not obligatory.

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

Ownership of a company’s common shares (or stock) usually gives shareholders the right tovote at the company’s annual meeting and also a claim on its profits. The company may issue a

dividend to common shareholders when business is profitable, but it is under no obligation todo so.

In contrast, owners of preferred shares generally are entitled to a fixed dividend that must bepaid out of earnings before any dividend is paid to common shareowners. As well, should thefirm wind up its affairs, preferred shareholders have a prior claim on the assets of the company before common shareholders. Unlike common shareholders, however, preferred shareholdersusually have no vote on the direction of management unless the company fails to pay preferreddividends.

Investment Funds

An investment fund is a company or trust that manages investments for its clients. The mostcommon form is the open-end fund, also known as a mutual fund. The fund raises capital by selling shares or units to investors, and then invests that capital. As unitholders, the investorsreceive part of the money made from the fund’s investments.

The key advantages of investment funds are that they are professionally managed and providea relatively inexpensive way to diversify a portfolio. For example, an equity fund may investin hundreds of stocks, which many individual investors could not afford to do directly. TheCanadian market offers a wide and ever-expanding range of mutual funds.

Derivatives and Other Financial Instruments

Unlike stocks and bonds, derivatives are suited mainly for more sophisticated investors.Derivatives are products based on or derived from an underlying instrument, such as a stock oran index.

For example, an option grants the holder the right, but not the obligation, to buy or sell a certainquantity of an underlying instrument at a set price for a set period of time. Options and futuresenable investors to profit or protect themselves from changes in the underlying instrument’s price.The wide range of option-trading strategies makes them useful for many investors. Successfultrading, however, requires a high degree of knowledge.





In the past few years, investment dealers have used the concept of financial engineering to createhybrid products that have various combinations of characteristics of debt, equity and investmentfunds. Two of the most popular are income trusts and exchange-traded funds. Both of these typesof securities trade on stock exchanges.

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

WHAT ARE THE FINANCIAL MARKETS?

Securities are a key element in the efficient transfer of capital from savers to users, benefitingboth. Many of the benefits of investment products, however, depend on the existence of efficientmarkets in which these securities can be bought and sold. A well-organized market providesspeedy transactions and low transaction costs, along with a high degree of liquidity and effectiveregulation.

Like a farmers’ market, a securities market provides a forum in which buyers and sellers meet.But there are important differences. In the securities markets, buyers and sellers do not meet faceto face. Instead, intermediaries, such as investment advisors (IAs) or bond dealers, act on theirclients’ behalf.

Unlike most markets, a securities market may not manifest itself in a physical location. This ispossible because securities are intangible – at best, pieces of paper, and often not even that. Of course, some securities markets do have a physical component. Other securities markets, such asthe bond market, exist in “cyberspace” as a computer- and telephone-based network of dealers who may never see their counterparts’ faces. In Canada, all exchanges are electronic.

The capital market or securities market is made up of many individual markets. For example,there are stock markets, bond markets and money markets. In addition, securities are sold on

primary and secondary markets. The primary market is the market where a security is sold whenit is first issued and sold to investors. For example, a company will use an initial public offering(IPO) to sell common shares to the public for the very first time. It is on this market that the userof capital, such as a business or government, receives capital from investors. Subsequent tradingtakes place in the secondary market and it is here where individual investors trade amongthemselves.

The secondary market is extremely important. It enables investors who originally bought theinvestment products to sell them and obtain cash. Without secondary market liquidity – theability to sell the securities with ease at a reasonable price – investors would not buy securities inthe primary market.

Auction Markets in Canada

Markets can also be divided into auction and dealer markets. In an auction market , clients’ bidsand offers for a stock are channelled to a single central market and compete against each other.The bid is the highest price a buyer is willing to pay for the security being quoted, while theoffer (or ask ) is the lowest price a seller will accept. Brokerage firms usually act as agents for theirclients. The prices of all transactions on an auction market are publicly visible. Canada’s stock exchanges are auction markets.

WHAT ARE THE FINANCIAL MARKETS?





A stock exchange is a marketplace where buyers and sellers of securities meet to trade with eachother and where prices are established according to the laws of supply and demand. On Canadianexchanges, trading is carried on in common and preferred shares, rights and warrants, listedoptions and futures contracts, instalment receipts, exchange-traded funds (ETFs), income trusts,and a few convertible debentures. On some U.S. and European exchanges, bonds and debenturesare traded along with equities.

Canada has five exchanges: the Toronto Stock Exchange (TSX) and the TSX VentureExchange, the Montreal Exchange (MX, also known as the Bourse de Montréal), owned by theTMX Group Inc., the Canadian National Stock Exchange (CNSX), formerly the CanadianTrading and Quotation System (CNQ), and the ICE Futures Canada. Each exchange isresponsible for the trading of certain products.

• The TSX lists senior equities, some debt instruments that are convertible into a listed equity,income trusts and Exchange-Traded Funds (ETFs).

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

• CNSX trades securities of emerging companies.

• The Montreal Exchange trades all financial and equity futures and options.• ICE Futures Canada trades agricultural futures and options.

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

• Frequent sales

• Narrow price spread between bid and offering prices

• Small price fluctuations from sale to sale

During trading hours, Canada’s exchanges receive thousands of buy and sell orders from all partsof the country and abroad.





Table 1.1 provides the share volume and dollar value of listed trading on the TSX and the TSX Venture.

TABLE 1.1 TOTAL SHARE VOLUME AND DOLLAR VALUE OF TRANSACTIONS FOR ALL

TSX AND TSX VENTURE

Comparative Share Volumes (Billions)

Exchange 2009 2008 2007 2006

TSX 118.5 109.2 96.1 82.0

TSX Venture 46.8 44.1 53.1 37.7

Total Shares 165.3 153.3 149.2 119.7

Comparative Dollar Values of Transactions (Billions)

Exchange 2009 2008 2007 2006

TSX 1,398.4 1,853.2 1,697.2 1,415.5

TSX Venture 16.1 23.8 44.9 33.3

Total Value 1,414.5 1,877.0 1,742.1 1,448.8

Source: Bloomberg

EXCHANGE MEMBERSHIPS

When a stock exchange is founded, memberships are sold to different individuals. Historically, inorder to trade on an exchange, a firm had to own a “seat.” The term seat originated with the old

practice of brokers trading securities while seated around a table. Today, the term means a rightof entrance to a stock exchange. The seat itself is a valid and valuable asset that may be sold orleased subject to conditions in the exchange’s by-laws. There are currently two types of exchangeownership. One is the original not-for-profit membership, in which the firm must own a seat tobe a member.

The second type of exchange ownership is a for-profit private company, where the exchange isowned by shareholders. All Canadian exchanges are set up as for-profit companies. Firms whohave access to the trading facilities are known as “Participating Organizations” or “ApprovedParticipants,” and do not have to be shareholders. The Toronto Stock Exchange became a for-profit private company in 2000. The TMX Group became the first North American exchange tobecome a publicly listed company.

Each exchange sets its own requirements for permitting access to trading facilities. Memberfirms may be publicly owned. There are requirements regarding the amount of capital necessary to carry on business, and key personnel (officers and directors and all others who deal with thepublic) must complete required courses of study.





GOVERNING BODIES

The administration and policy setting of the exchanges are the responsibilities of each exchange’sBoard of Directors. Each board is comprised of at least one permanent exchange official (e.g.,the president) plus some experienced senior executives from the member firms who serve asDirectors for stipulated terms of office. Included on each board are two to six highly qualifiedPublic Governors appointed or elected from outside the brokerage community. Public Governors

represent the interests of investors as a whole, as well as listed companies, and provide governingbodies with outside points of view and expertise.

The provincial securities acts allow the exchanges to exercise considerable self-regulation. Theseexchanges define acceptable standards of behaviour for member firms and their directors,officers and employees. They also have established extensive rules for trading securities and any other approved instruments on the exchange. They set listing and reporting requirements forlisted companies, and they assist in the screening of statements of material facts or exchangeoffering prospectuses which are frequently accepted by securities commissions in lieu of standardprospectuses for some types of distributions on the exchanges.

HOW EXCHANGES ARE FINANCED

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

• transaction fees paid for each order executed on the exchange;

• fees paid by corporations when their securities are originally listed;

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

• fees paid by corporations subsequent to listing with respect to any changes in capitalstructure; and

• the sale of historical trading and market information.

Stock Exchanges Around the WorldThere are over 80 stock exchanges in over 60 nations. Usually a good gauge of a country’seconomy is the size and organization of its exchanges. North America has 10 exchanges; Europehas in excess of 35; Central and South America, around 10; and the balance are in Africa, Asiaand Australia.

The World Federation of Exchanges reports that the New York Stock Exchange (NYSE) wasthe largest stock exchange in the world in 2009 in terms of domestic market capitalization –a reflection of the comprehensive value of the stock exchange at that time. The TSX rankedeighth.





Table 1.2 shows the ten largest stock markets in the world by domestic market capitalization by along with total value of shares traded.

TABLE 1.2 THE TEN LARGEST STOCK MARKETS IN THE WORLD - 2009

(In Millions of U.S. Dollars)

Exchange

Domestic Market

Capitalization

Total Value

of Trading

1. NYSE Euronext (US) 11,837,793 17,521,119

2. Tokyo SE Group 3,306,082 3,704,009

3. NASDAQ 3,239,492 13,608,077

4. NYSE Euronext (Europe) 2,869,393 1,935,240

5. London SE 2,769,444 1,771,811

6. Shanghai SE 2,704,779 5,055,691

7. Hong Kong Exchanges 2,305,143 1,416,450

8. TMX Group 1,676,814 1,245,457

9. BME Spanish Exchanges 1,434,541 1,259,213

10. .BM&F BOVESPA (Brazil) 1,337,247 644,732

Source: World Federation of Exchanges, www.world-exchanges.org.





EXHIBIT 1.1 CHANGES TO THE CANADIAN STOCK EXCHANGES

Securities trading has existed in Canada since 1832. Over the years there have been many changes.

The late 1990s saw radical changes to securities trading in Canada. In March 1999, Canada’s four major

stock exchanges announced that they had reached an agreement to restructure along lines of market

specialization. The restructuring was intended to ensure a strong and globally competitive market

system, and this resulted in three specialized exchanges:

• The Toronto Stock Exchange became Canada’s senior equities market and gave up its participation

in derivatives trading and the junior equity market.

• The Alberta Stock Exchange, the Winnipeg Stock Exchange and the Vancouver Stock Exchange

merged to create a single, national junior equities market, called the Canadian Venture Exchange

(CDNX). This new market also consolidated the operations of the Canadian Dealing Network

(CDN) as of October 2000.

• The Montréal Exchange became the exclusive exchange for financial futures and options in Canada.

Responsibility for all equities once traded on Montréal transferred to the TSX or the TSX Venture

Exchange.

During the year 2000, the Toronto Stock Exchange also joined the Global Equity Market Alliance with

seven other stock exchanges to discuss the creation of a round-the-clock, global marketplace.

The Canadian Venture Exchange became a wholly owned subsidiary of the Toronto Stock Exchange

in 2001. In April 2002, the Toronto Stock Exchange rebranded its abbreviated name from the TSE to

TSX, while CDNX was renamed the TSX Venture Exchange. These changes were part of a rebranding

initiative as the TSX and its subsidiaries prepared to go public in the fall of 2002. Under the rebranding

program, the TSX, TSX Venture Exchange and TSX Markets Inc. (the arm of the TSX that sell

market information and trading services) are collectively known as the TSX Group of companies. In

November 2002, the TSX (now the TMX Group) Group Inc. went public, becoming the first listed

stock exchange in North America.

In 2004, the Canadian Trading and Quotation System gained recognition as a stock exchange by the

Ontario Securities Commission. The intent of CNSX is to provide an alternative market to the TSX

Venture Exchange for emerging companies.

CNSX is based on a combination of auction and dealer markets and liquidity is enhanced on a security-

by-security basis via market makers. Dealers accessing this marketplace are required to be members of

the Investment Industry Regulatory Organization (IIROC) of Canada (formerly the Investment Dealers

Association and Market Regulation Services Inc.) and must comply with CNSX’s trading and sales

practice rules. Trading on CNSX is also regulated by IIROC in the same way as the other Canadian

exchanges and must therefore follow the Universal Market Integrity Rules (UMIR).

CNSX also has its own trading rules and policies in addition to UMIR. The exchange also has minimum

quotation requirements for public float and business activity that are less stringent than those of theTSX Venture Exchange.

In 2008, the TSX and the Montreal Exchange merged to form the TMX Group.





Dealer Markets

Dealer markets are the second major type of market on which securities trade. They consist of a network of dealers who trade with each other, usually over the telephone or over a computernetwork. Unlike auction markets, where the individual buyer’s orders are entered, a dealer marketis a negotiated market where only the dealers’ bid and ask quotations are entered by those dealers

acting as market makers in a particular security. Almost all bonds and debentures are sold through dealer markets. These dealer markets areless visible than the auction markets for equities, so many people are surprised to learn that thevolume of trading on the dealer market for debt securities is 14 times larger than the equity market.

Dealer markets are also referred to as over-the-counter (OTC) or as unlisted markets - securitieson these markets are not listed on an organized exchange as they are on auction markets.

THE UNLISTED EQUITY MARKET

The volume of unlisted equity business is much smaller than the volume of stock exchange

transactions. The exact size of Canadian OTC dealings cannot be measured because completestatistics are not available. Many junior issues trade OTC, but so too do the shares of a few conservative industrial companies whose boards of directors have for one reason or anotherdecided not to seek stock exchange listing for one or more issues of their equities. The unlistedmarket does not set listing requirements for the stocks traded on its system (hence the term“unlisted market”) nor does it attempt to regulate the companies. Many of the stocks sold on theunlisted market are more speculative, and in most cases offer lower liquidity, than listed securities.

TRADING IN THE UNLISTED MARKET

Over-the-counter trading in equities is conducted in a similar manner to bond trading. Oneveteran described the OTC market as a “market without a market place.” In the OTC market,

individual investors’ orders are not entered into the market or displayed on the computer system.Instead, dealers, who are acting as market makers, enter their bid and ask quotations. Thesemarket makers hold an inventory of the securities in which they have agreed to “make a market.”They sell from this inventory to buyers and add to the inventory when they acquire securitiesfrom sellers. The market makers post their individual bid (the highest price the maker will pay)and ask (the lowest price the maker will accept) quotations. The willingness of the market makersto quote bid and ask prices provides liquidity to the system (although the market makers do havethe right to refuse to trade at these prices). When an investor wishes to buy or sell an unlistedsecurity, the broker consults the bid/ask quotations of the various market makers to identify thebest price, and then contacts the market maker to complete the transaction. The broker charges acommission for this service.

OVER-THE-COUNTER DERIVATIVES MARKET

Derivatives also trade in dealer or OTC markets. The OTC derivative market is dominated by financial institutions, such as banks and brokerage houses, who trade with other corporate clientsand other financial institutions. This market has no trading floor and no regular trading hours.Traders do not meet in person to negotiate transactions and the market stays open 24 hours a day.One of the attractive features of OTC derivative products is that they can be custom designedby the buyer and seller. As a result, these products tend to be somewhat more complex, as specialfeatures are added to the basic properties of options and forwards.





REPORTING TRADES IN THE UNLISTED MARKET

In most of Canada, there is no requirement for firms to report unlisted trades. Ontario is theexception. The Ontario Securities Commission (OSC) requires that trades of unlisted securitiesbe reported through the Canadian Unlisted Board Inc. (CUB). CUB was launched as anautomated system after the reorganization of the equity markets in Canada. It offers an Internet web-based system for dealers to report completed trades in unlisted and unquoted equity

securities in Ontario, as required under the Ontario Securities Act.

QUOTATION AND TRADE REPORTING SYSTEMS

Quotation and trade reporting systems (QTRS) are recognized stock markets that operatein a similar manner to exchanges and provide facilities to users to post quotations and reporttrades. Traditionally, a QTRS is a mechanism for dealers to post quotations indicating the pricesat which they are willing to buy and sell stock. The market itself does not match buy and sellorders; they are negotiated and trades are reported after the fact. This is the traditional model forNASDAQ.

ALTERNATIVE TRADING SYSTEMS

Alternative trading systems (ATSs) are privately owned computerized networks that matchorders for securities outside of recognized exchange facilities. Also referred to as Proprietary Electronic Trading Systems (PETS), they can be owned by individual brokerage firms or by groups of brokerage firms. Profits are made via revenues from the trading system itself and go tothe owner(s) of the system.

These systems bypass the exchanges because a brokerage firm operating an ATS can match ordersdirectly from its own inventory, or act as an agent in bringing buyers and sellers together. Sincethere is one less intermediary, more of the commission charged to the client is kept by the dealer.Most client users of these systems are institutional investors, who can reduce transaction costsconsiderably. Some non-brokerage-owned ATSs even allow buyers and sellers to contact each

other directly and negotiate a price.In Canada, the development of an ATS network has been far slower than it has been in theUnited States. Only since 2001 has the regulatory framework existed for the creation of an ATSmarket (in contrast, ATSs have been operating in the United States since 1969). ATSs now inoperation in Canada include CNSX’s Pure Trading, Bloomgerg Tradebook Canada, OMEGA ATS, Chi-X Canada and Alpha Trading System, an ATS established by nine of Canada’s leadingfinancial institutions.

Alternative trading systems have the potential, however, to threaten market stability due tolessened market transparency, cross-border trading issues and technological glitches such asinsufficient system capacity. In Canada, ATSs are members of the Investment Industry Regulatory Organization of Canada (IIROC). The trading activity of ATS is also regulated by IIROC.

IIROC is discussed in more detail in Chapter 3.





ELECTRONIC TRADING SYSTEMS

With the exception of a few debentures listed on the TSX and TSX Venture Exchanges, all bondand money market securities trade OTC. In the past few years, three electronic trading systemshave been launched in Canada.

CanDeal, a member of IIROC, is a joint venture between Canada’s six largest investment dealers,

and is operated by the TSX. It is recognized as both an ATS and an investment dealer. It offersinstitutional investors access to federal bond bid and offer, prices and yields from its six bank-owned dealers, which represent more than 80% of the transactions in the bond market. CanDealintends to expand to provincial bonds, corporate debt and commercial paper.

CBID, also a member of IIROC and an ATS, operates two distinct marketplaces: retail andinstitutional. The retail marketplace, Canada’s first electronic fixed-income multi-dealer retailmarketplace, was launched in July 2001 and is accessible by registered dealers on behalf of retailclients. The institutional marketplace, launched in July 2002, is accessible by registered dealers,institutional investors, governments and pension funds. CBID currently has over 2,500 Canadiandebt instruments trading..

CanPX is a joint venture of Investment Industry Association of Canada (IIAC)/IIROC memberfirms. The CanPX system provides investors with real-time bid and offer prices and hourly tradedata. Issues include Government of Canada bonds and treasury bills, provincial bonds and somecorporate bonds..

Private Equity

Private equity is the financing of firms unwilling or unable to find capital using public means –for example, via the stock or bond markets. The term “private equity” is a bit of a misnomeras this asset class really encompasses debt and equity investment. Long term returns on privateequity typically exceed most other asset classes. But in exchange for these returns, private equity also exposes investors to far higher risks.

Private equity plays a specific role in financial markets, in Canada and in other markets worldwide. It complements publicly traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible. A good example isventure capital. Venture capital finances businesses at a time when they produce little or no cashflows, invest most or all revenue in more or less unproven technologies or production processes,and have little or no assets to offer as collateral. In such situations, firms must typically turn toinvestors that are ready to take substantially more risk against significantly higher profit prospectsif the venture is successful.

There are several means by which private equity investors finance firms.

• Leveraged Buyout – This is the acquisition of companies financed with equity and debt.

Buyouts are one of the most commonly used forms of private equity.

• Growth Capital – The financing of expanding firms for their acquisitions or high growthrates.

• Turnaround – Investments in underperforming or out of favour industries that are in eitherfinancial need or operating restructuring.





• Early Stage Venture Capital – Investments in firms that are in the infancy stages of developingproducts or services in high growth industries such as health care or technology. These firmsusually have a limited number of customers.

• Late stage Venture Capital – The financing of firms which are more established but still notprofitable enough to be self-sufficient. Revenue growth is still very high.

• Distressed debt – This is the purchase of debt securities of private or public companies thatare trading below par due to financial troubles at the firm.

THE HISTORY OF PRIVATE EQUITY

Private deals have always existed by definition (e.g., when one individual or company sells assetsdirectly to another individual or company). However, one source identifies 1901 as the first timea private deal in the modern sense of the word was struck. In that year, J.P. Morgan acquiredCarnegie Steel Company from Andrew Carnegie and Henry Phipps for the then tidy sum of $480 million.

Other sources identify an organized private equity market emerging in 1946 to stopgap

the inadequacy of financing for new businesses. The American Research and DevelopmentCorporation (ARD) was founded to create a private organization to attract institutional investors.

It is only in 1978, when the so-called ‘prudent man’ rule (tending to limit investments in smallercompanies and riskier instruments) was amended that venture capital began to grow rapidly. Additional support to venture capital was brought by a 1980 ‘safe harbour’ ruling grantinglimited partnership managers access to performance-based compensation.

SIZE OF THE PRIVATE EQUITY MARKET

The growth of private equity has been remarkable over the last 25 years. In 2007 there were133 buyout transactions in Canada worth $64.1 billion (Source: Bloomberg). This included

the proposed buyout of BCE by Ontario Teachers’ Pension Plan, Providence Equity Partners,Madison Dearborn Partners and Merrill Lynch Global Private Equity. Without the proposedBCE deal, $16.9 billion in buyouts were recorded year-to-date at the end of the 2007 thirdquarter alone, with $3.3 billion and 39 transactions in the third quarter itself, compared to$12.2 billion (and 107 buyouts) for all of 2006.

Given that investment minimums tend to be relatively high compared to traditional investing inthe retail market, these investments cater mostly to individuals and organizations with sizeableportfolios and resources. For this reason, private equity investors are typically:

• Public pension plans

• Private pension plans

• Endowments• Foundations

• Wealthy individuals and family offices

Given the features of private equity and the differences it shows with other assets typically heldin investor portfolios, its role is one of return enhancement and to a certain extent, of portfoliodiversification. Return enhancement is the reward for accepting much lower liquidity typical of private equity, particularly when compared to investing in the common shares of a highly liquidstock like Royal Bank or Encana. Recent annual reports of the largest pension fund managers,





such as the Caisse de Dépôt et placement du Québec, OMERS and the Ontario Teachers PensionPlan, have shown private equity returns well ahead of traditional portfolio asset classes.

Trends in Financial Markets

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

• Physical marketplaces (the trading floors) are becoming obsolete, while virtual marketplacesor electronic trading systems are reducing the need for human participants in the marketmechanism.

• Exchanges are merging to meet the challenge of globalization. Ten years ago, there were over200 exchanges in the world; today there are fewer than 100.

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

• To prepare themselves for accelerating competition, most exchanges have demutualized,

moving from not-for-profit organizations run by their members to for-profit corporations.Most of these changes were driven by increased global trading, aggressive competition, the ease of electronic communication, improved computer technology and the increased mobility of capital.The speed of innovative computer technology and the globalization and integration of financialmarketplaces are likely to increase. Some of the future trends may include:

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

• Consideration of “free trade” between stock exchanges to improve the flow of capital acrossborders. This proposal would allow institutional investors and brokerage firms to tradedirectly on each other’s stock markets.

• Despite the number of exchange mergers in recent years, new exchanges are emergingto focus on niche markets. In the summer of 2003, the TMX Group launched a secondboard of the TSX Venture Exchange called NEX, which provides a trading forum for listedcompanies that have fallen below TSX Venture’s listing standards.





SUMMARY

After reading this chapter, you should be able to:

1. Define investment capital and describe its role in the economy.• Investment capital is available and investable wealth (e.g., real estate, stocks, bonds and

money) that is used to enhance the economic growth prospects of an economy.

• In direct investment, an individual or company invests directly in an item (e.g., house,new plant or new road); indirect investment occurs when an individual buys a security and the issuer invests the proceeds.

• Capital has three characteristics: it is mobile, it is sensitive, and it is in short supply.

2. Describe how individuals, businesses, governments and foreign agencies supply and usecapital in the economy.

• Individuals generate investment capital through savings and use capital to finance majorpurchases or for consumption.

• Retail investors are individuals who buy and sell securities for their personal accounts;institutional investors are companies and other organizations.

• Businesses use capital to finance day-to-day operations, to renew and maintain plantand equipment, and to expand and diversify activities.

• Governments use capital when expenditures exceed revenue and to finance largeprojects.

• Foreign investors invest in Canada to access returns on investment not perceived tobe available in other countries. Foreign investors will use Canadian capital if they canborrow at a more advantageous rate in Canada than elsewhere.

3. Differentiate between the types of financial instruments used in capital transactions.

• Debt (bonds or debentures): the issuer promises to repay a loan at maturity, and in theinterim makes payments of interest or interest and principal at predetermined times.The term to maturity of a debt instrument can be either short (less than five years) orlong (more than ten years).

• Equity (stocks): the investor buys a share that represents a stake in the company.

• Investment funds (mutual funds, segregated funds): a company or trust that managesinvestments for its clients.

• Derivatives (options, futures, rights): products derived from an underlying instrumentsuch as a stock, financial instrument, commodity or index.

• Other investment products (income trusts, exchange-traded funds): investments thatare relatively new and do not fit into any of the standard categories.

SUMMARY





4. Explain the role of financial markets in the Canadian financial services industry, distinguishamong the types of financial markets, and describe how auction markets and dealer markets work.

• The financial markets facilitate the transfer of capital between investors and usersthrough the exchange of securities.

• The exchanges do not deal in physical movement of securities; they are simply thevenue for agreeing to transfer ownership.

• The primary market is the initial sale of securities to an investor.

• The secondary market is the transfer of already issued securities among investors.

• Dealer markets are network of dealers that trade with each other directly on anegotiated market with market makers. Most bonds and debentures trade on thesemarkets.

• In an auction market, clients’ bids and offers for a stock are channelled to a single

central market (stock exchanges) and compete against each other.

5. Explain what private equity is, how it has grown and the different ways of investing in thismarket.

• Private equity is the financing of firms unwilling or unable to find capital using publicmeans – for example, via the stock or bond markets.

• It complements publicly traded equity by allowing businesses to obtain financing whenissuing equity in the public markets may prove difficult or impossible.

• The growth of private equity has been remarkable over the last 25 years.

• Public and private pension plans, endowments, foundations, and wealthy individualsare the main investors in the private equity market.

Now that you’ve

completed this

chapter and the

on-line activities,complete this

post-test.



Documents

CSC_TXT Vol 01 Chap 01_2010_12_EN_V01