Distribution Accessibilty Issues for third party deposits July 2014 final (2)

Distribution Accessibility Issues

for Third-Party Deposits

Competitive Issues for Small Bank Competition in Canadian Retail Deposits Markets

July 2014

Distribution Accessibility Issues for Third-‐‑Party Deposits • • •

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Distribution Accessibility Issues for Third-Party Deposits About This Response International Financial Data Services Canada is pleased to respond to the Canadian Government’s request for perspective on competition issues surrounding small banks, deposit gathering and third-‐‑party distribution access. This document builds on the analysis of “Third Party GIC Rate and Volume Characteristics 2006-‐‑2013” presented by IFDS last August.

This document attempts to present a balanced review of the complex issues impacting small bank access to dealer distribution for their deposit products. This third-‐‑party deposit market represents over $220 billion of Canadian savings. It is an important source of liquidity for both small and large banks in Canada.

Small banks refer to a variety of licensed trust, banking and credit union companies engaged in deposit and lending activities in Canada. Small banks constitute a diverse constituency. It would be a mistake therefore to suggest all small banks have the same agendas, challenges or competitive frameworks. By and large, small banks do share the challenge of competing for customers in an oligopolistic environment where entrenched large banks have the advantages of scale, distribution and integration of retail and wholesale capital control. Small banks are very reliant on these large bank competitors for distribution, capital structuring and infrastructure. The nature of “co-‐‑opetition” creates frictions as there are differing desires to cooperate and compete within the

Problem Statement • • •

Retail deposits balances gathered through investment dealers surpassed $220 billion in 2013.

Third-‐‑party deposits are highly cost-‐‑effective, elastic and efficient – benefits big and small banks.

Third-‐‑party CDIC deposits, because of elasticity and market size, have proven to be vital to all banks during liquidity during crisis events.

Global regulatory changes have increased the value of retail deposits – and increased the value of how those funds are raised.

Some – but not all – bank reactions to the proposed regulatory frameworks have been to exert influence over in-‐‑house dealers to favor proprietary deposit products thus restricting the market.

If this behavior became the norm, if the liquidity pool is not maintained in normal times, an important liquidity channel for small banks would be jeopardized.


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industry. Deposits distributed through dealer channels is one such area where those frictions are currently felt.

But the small bank view point, if indeed there is just one, is but one input to the problem. Various individual stakeholders – banks, dealers – will have unique objectives and agendas when looking at the issue of access for deposits. In order to drive a long-‐‑term solution for deposit access, efforts need to be taken to understand the needs of the dealer community and to address the cost and revenue opportunities that drive some of the behavior outcomes impacting their reaction to the small banks.

Our essential observation is that a vibrant and open third-‐‑party deposit market serves the public interests, by: providing choice and higher rates for investors; serving the interests of competition by enabling small bank funding; and, more importantly, by providing a proven liquidity pool in the event of crises. Therefore the discussion how much should the industry encourage the market in normal liquidity periods in anticipation of periodic crises.

About International Financial Data Services IFDS Canada is a Toronto based provider of technology and processing services to the global financial services industry.

IFDS is a Canadian technology success story. Employing 700 associates, IFDS Canada is a leading IT technology and operations specialist in the competitive Toronto financial technology sector. For over 30 years, IFDS has driven industry efficiency and innovation through its development of shared IT infrastructure. Our systems currently administer over 12 million customer accounts, and $260 billion assets. We service over 50 financial clients – including Canada’s largest banks, insurance companies and global mutual fund companies. Our systems also run global investment back-‐‑offices in Europe, Middle East and Asia. IFDS is a joint venture between global financial technology leaders DST Systems and State Street Bank.

IFDS is an innovator for the investment and banking industries. In 2006 IFDS was the first provider to offer savings account administration services to banks in order to facilitate deposit gathering in the Canadian dealer channel. In 2011, IFDS launched a service to improve GIC processing for issuers and thereby standardize the product for the dealer community. Through the application of technology and standardization, IFDS is positioned to bring new efficiencies and products to the Canadian banking and investment dealer markets.

IFDS is channel agnostic. IFDS is a founder and part owner of the FundSERV network and is an integration partner with the Cannex Financial Exchanges network – two principal networks impacting third-‐‑party deposit facilitation. IFDS, with our affiliate companies, are also leaders in the creation of controlled direct and facilitated order systems for deposit and investment instruments.


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Our objective is to facilitate the growth of a stable, efficient and effective deposits market in Canada through back-‐‑office processing and standardization.

Accessibility and Competition Objectives The following objectives are identified as desirable outcomes of the analysis and recommendations:

• Predictable and affordable issuer access to dealer desks

• Fair compensation and cost/risk mitigation for dealers

• Transparent dealer rules/activities related to proprietary and third-‐‑party deposits

• Responsible infrastructure and participation rules

• Stability of deposit market

• Investor/regulator stakeholder trust


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Deposit and Third Market Environment When many Canadians think about deposits – GICs, Savings, Chequing – they think about bank branches and bank accounts. Canada’s banking industry strength has been long built on their retail banking operations. Through their branches, the banks have extensive, stable and profitable loan and transaction revenues. Deposits are the base of that stability, they are the funding from which loan revenue is derived.

Deposit, Loan Mismatch Canadian banks lend more through consumer mortgages, loans, and credit cards than is available through purely consumer deposit sourcesi. This mismatch is made possible in part due to the successful investment alternatives in the Canadian market and the long success of bank treasurers to fund their retail and commercial lending book through alternative sources of deposits, borrowing, asset securitization, and other forms of funding.

With Basel III’s impending introduction changes are coming to how regulators rank different sources of funding in order of their perceived stability through times of financial stress means that Canadian banks must reconsider how they manage the mismatch between retail deposits and retail lending. As a result, the treasurers have become more focused and more aggressive on protecting and growing their liquidity sources; and notably through proprietary channels.

Small banks feel this competition more directly as they do not have the distribution resources to compete with larger banks for deposits, and indeed often pay bank-‐‑owned dealers sales commissions to source deposits through their channels.

The Third-Party Deposit Market It surprises many that over 18% of deposit funds are gathered through intermediaries outside of the branch. The $140 billion GICs held in investment channels are now the single largest category of fixed income investments in Canadaii. Investment-‐‑based savings accounts represent $65 billion in outstanding

Third-Party Deposit Market

• • •

• Over 80 banks/CU/Trust companies offer GICs and Savings accounts through dealers.

• Rates adjusted daily and listed publicly and with dealers.

• Highly liquid, elastic and rational ~$80 million a day bought.

• 90% volume is CDIC insured… 5% provincial … <5% not insured.

• Cannex is the primary order and settlement network for GICs; FundSERV for Savings Accounts.

• 75% of deposits sold through 5 bank-‐‑owned dealers… dealers and issuers make discrete distribution agreements.

• 22 dealers drive 90% of deposit sales volumes.

• Deposits compete with other investment products (rate, transaction cost, guaranty, redeemability).


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balances and are the fastest growing investment category in Canadaiii. A further $50-‐‑ $60 billion (advised-‐‑but-‐‑directly-‐‑held) deposits (i.e., funds held in direct savings accounts in President’s Choice Financial, ING Direct, ICICIB, et al.) may also be included in this channel according to some sources such as Investor Economics.iv

Through dealer listings and published rates, deposit issuers compete with other forms of investments (bonds, mutual funds, stocks, etc.) for deposit dollars that they use to fund loans. In exchange, investors receive access to high-‐‑yield, secure and flexible savings instruments for their investment, RSP/TFSA/RESP, et al., accounts.

Unique and Important System Canada has a unique system of gathering banking deposits through registered investment brokers, dealers and advisors (third-‐‑parties). No other country operates a retail focused deposit system for investment dealers. It is a critical component of systemic strength for the Canadian banking community. At any time, deposit institutions with CDIC coverage can quickly raise deposits, if required, through third-‐‑party channels, particularly dealers.

Third-‐‑party deposit investors are more affluent and sophisticated than branch investors. It is estimated that the third-‐‑party investor market represents less than 10% of the total Canadian households but 80% of deposit holdings. Average deposit investments are approximately five times larger than branch average account size (average third-‐‑party deposit is $59,000). Since 2006, average deposit interest rates in the third-‐‑party channel are approximately 40% higher than branch rates. Investors are charged no transaction fees or commissions when purchasing a deposit account.

The third-‐‑party deposit channel grew as a result of two forces. First, investment customers have increasingly desired deposit products (initially GICs, but recently savings accounts) as part of their investment portfolio holdings. Second, the introduction of branchless and specialist banks in the 1990s identified dealers as a potential sales channel and sought to develop the infrastructure to sell their products.

Deposit product holdings in the dealer channel are expected to grow, driven by competitive pricing trends and underlying needs of an aging Canadian investment population for flexible fixed income investment alternatives. Individuals who establish advice-‐‑based relationships with investment dealers are, in general, sophisticated and affluent. They look to diversify investment holdings with CDIC coverage and seek advisors who offer the best yielding products.

Dynamic Strategic Environment Dealers and the banks make active choices in defining their third-‐‑party distribution strategy. Dealers choose issuer-‐‑banks based on capacity to consistently drive rate offers to customers, on their operations sophistication, capacity to accept deposit flows and on issuer risksv. Issuers choose dealers based on


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their funding expectations, marketshare, and process/willingness to board new deposit products. If an issuer seeks to distribute its deposits through a particular dealer, the two parties endeavor to negotiate a bi-‐‑lateral agreement that sets out the terms and conditions under which the issuer’s deposits will be sold.vi Although the business model for distributing and settling deposits is substantially similar throughout the industry, each issuer/dealer agreement is negotiated individually. Negotiations with the largest bank-‐‑owned dealers are typically the most time-‐‑consuming and complex, even though the distribution process is no different from other dealers.

The dealer decision process impacts the issuer-‐‑bank funding strategies, costs and risks. Issuers compete and jostle for access to large dealers as a source of predictable funding. Furthermore, issuers are also concerned about over-‐‑exposing themselves to dealer deposit sales volumes as the current deposit model works without funding limits – issuers must accept the entire amount of daily purchases made for them at the rate they posted. This exposure creates a risk for smaller issuers who cannot lend or match deposit exposures appropriately, requiring them to choose to establish relationships with dealers whose sales volumes are an appropriate match to their needs. Lastly, dealers prefer issuers to maintain a constant competitive pricing strategy, not those who come and go from the market on an intermittent basis. If issuers cannot (or do not) match a dealer’s funding and rate expectations over time, the distribution relationship may be terminated.

Third-Party Deposits: Two Instruments The third-‐‑party GIC and Savings accounts operate quite differently and offer different funding strengths and weakness for issuer-‐‑banks treasurers.

The $65 billion in third-‐‑party Savings product leverages FundServ mutual fund infrastructure. As a mutual fund, the Savings product is very cost effective as it leverages existing dealer operations and settlement infrastructure. There are also several providers of low-‐‑cost outsourcing solutions to enable the bank back-‐‑office savings solution, including services offered by IFDS, Citi, RBC Investor Services and CGI.

Issuers of savings accounts still require distribution agreements with dealers, but once online with FundSERV the savings account rates are accessible to all FundSERV participants. The product was initially designed to compete with Money Market Mutual Funds, and commissions and funding rules generally follow money market fund principles.

Savings products, however, are not generally seen as preferred funding by small banks because liquidity and capital rules penalize savings as “hot money” (that is money that can be withdrawn at any time, and that is subject to competitive pressures for returns). Savings products have had significant distribution restrictions placed on them by the big bank dealers, who were seeking to protect existing proprietary money market and savings balances. As of writing, the only dealers


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accepting new savings issuers were the small dealers, representing about 15% of the available deposit market.

The $140 billion third-‐‑party GIC market primarily relies on a network called Cannex for rate and order fulfillment – although there is no one standard for GIC order fulfillment and order and settlement information may flow through a variety of methods depending on dealer preferencevii. The Cannex network connects dealers to the various back-‐‑office systems of issuers on a virtual one-‐‑to-‐‑one basis driven by distribution agreements. Cannex is currently only used for GICs, therefore the operations, process and controls and people driving those are unique to the dealer operations environment.

In addition to the lack of formal network standards, the GIC environment is notable for the fact that each issuer-‐‑bank currently operates their own back office and product definitions for their GICs. As a result every issuer has small differences in how they process GIC interest, customer allowances, fees and processing window deadlines. This creates costs and risks for dealers in how they handle deposit accounts. And many dealers have argued that the revenues earned from deposit sales do not cover these extra costs. So addressing these cost issues are an important consideration for the dealer community.

These differences make GICs unique and opaque from a dealer perspective, further increasing costs, uncertainty and therefore risk. Risks associated with customer information, retention and disaster recovery protocols are also perceived as a risk for GIC dealer. The small bank industry often utilizes third-‐‑party banking software but is inconsistent with their outsourcing practices, data hosting and disaster recovery regimes. Given the investor reputation risk concerns by dealers, the transaction, operations and stability risks with issuers are not fully unrealistic – although dealer choices on implementation and processing are mostly at the root of these costs.

Following the example of the role of common outsourcing solutions to drive standardization in the third-‐‑party Savings market, IFDS launched a GIC focused processing solution in 2013. The outsourcing solution, together with innovations, and robust data center infrastructure address many of the dealer concerns associated with issuer-‐‑derived choices on GICs that create difficulties for dealers.

Outside of the nuances mentioned above, the products offered by third-‐‑party GIC issuers are generally standardized from an investor perspective, CDIC compliant and transparent. That means GICs are highly comparable on a rate basis. GIC pricing is set daily by bank treasurers. Approximately 50% of $84 billion in annual GIC transactions are issued by the large banks, mostly to their own dealer networksviii. The most common GICs are 1, 3 and 5 year non-‐‑redeemable, although other term, interest and redemption characteristics are also processed. Banks have different strategies on GIC pricing depending on their treasury needs and preferences. Generally small banks are pricing GICs as a spread to their loan book – while larger banks will have more complex pricing models and channel alternatives. The pricing is sent via Cannex to their dealers. Once rates are sent out, the issuer is obliged


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to fulfill all orders for those rates for 24 hours, which if banks are not careful can either generate not enough daily funding or too much funding.

Depending on the dealer, GICs may be issued in either Nominee (registered in the name of dealer in trust for client) or in Client Name (registered directly in name of client) form. Nominee represents 90% of the overall third-‐‑party GIC market. Client Name is the preferred form for dealing with small dealers, deposit brokers and others. This distinction, and impacts, will be discussed further below.

Positions on Deposit Access Deposit Access is a Public good: Positions Against increased Deposit Access:

• Third-‐‑party deposits pay substantially higher rates for deposits because of operations and channel savings (consumer benefit).

• Third-‐‑party deposits are a vital liquidity source during a liquidity crisis and therefore need to be maintained (systemic).

• Third-‐‑party deposit investors are wealthy, sophisticated and seeking deposit investments.

• Third-‐‑party deposits are a primary source of funding for loans, generally for underserviced elements of the society (consumer benefit).

• Deposits are a very low cost, generally insured investment (consumer benefit).

• Economic value for dealers through commissions of $330 million per year.

• Creates competition between branch-‐‑based advisory channels and investment advisors.

• Third-‐‑party deposit banks are regulated and insured.

• Unfairly subsidizes small banks at the expense of big banks (channel rent).

• Third-‐‑party distribution diminishes power of large-‐‑bank brand and service.

• Third-‐‑party deposits create operations costs and settlement risk for dealers.

• Third-‐‑party deposits artificially inflate deposit rates and cannibalize from other channels.

• Third-‐‑party deposits cannibalize investment assets from other proper investment alternatives like mutual funds and stocks.

• Small banks are riskier because of their lending activities and constitute a greater risk on CDIC and the bank because the bank has agreed to distribute them (preferred partner risk).

Costs are Driven by Distribution Choice Banks that raise deposits through dealers have a measurable cost advantage compared to banks that gather deposits primarily through physical branch networks or through direct channels. Branch systems are generally old and costly to maintain.

The typical operating cost of a third-‐‑party deposit – including commission – is about 1/5 of the cost of a branch or direct banking operating cost according to industry analysisix. The savings in operating costs results in increased returns / interest for the deposit holder, and presumably better returns for the bank and its shareholders. Direct deposit channels are similarly costly to establish (marketing cost) and to maintain (systems, call centre, etc.). These operational savings allow third-‐‑party deposit issuers pay measurable higher interest rates and still have overall lower costs that traditional providers as


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illustrated below. It is not a surprise therefore, that many small banks have seized on third-‐‑party deposits to give them a competitive advantage in the market.

Figure 1 -‐‑ Example of Estimated Deposit Costs by Distribution Source (February, 2014)

Issuers pay third-‐‑party Dealers through commissions based on the annual value of deposits under administration. The standard industry deposit commissions is 0.25%/1$ per year (or $25 p.a. for a $10,000 deposit). This commission is equivalent to the commission earned through money market funds. The commissions are split by the dealer to also compensate the specific advisor and cover operating costs. The specific commission split varies by firm.

The commissions paid by issuers to dealers for deposits surpassed $500 million in 2013x.

Complex Operating and Regulatory Environment Various deposit taking institutionsxi – including banks, trust companies, insurance companies and credit unions – participate in this system through the issuance of GICs and savings accounts. Likewise, various dealers are involved – be it large national investment dealers, small investment dealers, mutual fund specialist companies, insurance agencies, deposit specialists, and recently even mortgage brokerages. As a result, depending on the province and registry of the organizations involved, there can be up to nine regulatory, supervisory or self-‐‑regulated organizations involved in a deposit sale.

A part of this regulator process involves the requirement for dealers to vet deposit issuers participating on their desks. The risk assessment is based on principals associated with the individual distribution agreement and the risk of appropriate investment recommendation to customers.

In reality, the risk of a deposit issuer – who is regulated and insured – is no different than any bank. This issue reflects both the competing regulatory overlaps inherent in the industry and of dealer self-‐‑defined risk cultures that has evolved since 2008.

A large component of potential costs for deposit issuers are the regulatory requirement to conduct thorough customer identification, validation and retention of information for purposes of Anti-‐‑Money Laundering and Know Your Customer compliance. Since regulated dealers perform this service, bank regulators allow banks to rely on dealers to execute this responsibility on their behalf, thus saving banks approximately $25 per transactionxii. This is a key factor that drives cost efficiencies in the third-‐‑party deposit distribution model. However, many dealers and non-‐‑dealer deposit brokers in Canada

Nominal(Yield((Rate)+Incentive(Yield(+

Channel(Cost(+

Origination(Cost(+

Servicing(Cost(+

Redemption(Cost(+ Total

Branch'GIC'w/Bank'1 90 30 100 45 5 5 275Direct'Bank 225 116 341Cannex'Nominee'w/Bank'1 155 25 4 0 0 184Client'Name'GIC'w/'Bank'1 145 25 10 20 5 205

(BPS)


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do not qualify for this regulatory allowance, and as a result, banks who offer deposits through this channel accrue higher costs – resulting in lower interest rates for those customers (and less compelling products compared to larger dealers).

Dealer Concerns: Profitability, Revenue, Growing Wealth Market The Canadian investment industry encompasses over 200 firms and 39,000 employeesxiii. Investment firms advise and facilitate customer investments in stocks, bonds, mutual funds, etc. Additionally there are other firms and individuals that provide similar financial advice/products in concert with other banking, mutual fund, insurance, financial planning and other related services, and these (while not strictly dealers) are of interest as distribution sources for third-‐‑party deposits.

Dealer management in general favors open desk policies that allow them to find the best investment product and rates for their customers. However, dealers are particularly concerned with the profit of those transactions both in both actual and opportunity cost forms as industry profitability is down significantly from the norms. Revenue and cost considerations have become paramount, as the industry has struggled with the financial market issues since 2008xiv. Dealers are facing escalation of costs associated with global regulatory changes and costs of legacy infrastructure. Furthermore, investor volumes and retail investor market growth have been relatively flat since 2008. Therefore dealer strategy has been to maximize revenues through addition of high volume advisors, focusing on high revenue investment products and driving down operating costs while minimizing investments. Complicating investment has been the legacy of many dealers evolving from or remaining in a partnership model, and due to lack of capital they have under-‐‑invested in technologies to lower costs.

The value of earnings from deposits pale in comparison to trailer fees from equity-‐‑based mutual funds of 1-‐‑2% ($100~$200 p.a. / $10,000); or, for buy/sell commissions on stocks and bonds ($29 <) per trade. As a result, there is a certain opportunity cost for dealers and advisors when an investor chooses to buy a GIC versus a mutual fund or bond. Add further the previous conversations about GICs being odd-‐‑ball product for many dealer processing environments – because they are essentially a “bank account” in a “securities” processing environment – and the dealer concerns about deposit profitability become clearer.

Dealer Concentration and Erosion of Chinese Walls The investment dealer industry is highly stratified and increasingly concentrated with over 80% of investable assets and earnings concentrated with the bank-‐‑owned dealersxv. These integrated organizations additionally provide services and influence investment banking, debt origination, stock issuance, mortgage backed bonds and other sophisticated services impacting investors, corporate and small bank participants. Increasingly, integrated investment dealer organizations working with retail accounts are evolving to become full service wealth managers, in concert with parent company growth strategies to serve the affluent investor markets.


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Small dealers themselves face extreme pressures in the post-‐‑2008 environment with escalating regulatory costs, diminishing revenues and complex/dated back office systems and aggressive competition for advisors and investors. Profitability for small dealers upcoming changes to trailer fees for mutual funds are also seen as a major threat, and could result in the hastening of large dealer concentration and/or loss of business to emerging financial planning models from bank-‐‑branch or insurance providers.

The nature of bank ownership of investment dealers is fairly recent (since the 1990’s). While the intent was to ensure “Chinese walls” existed between dealers and banks the informal separation of management and administrative strategies between banks and dealers has arguably diminished. Particularly since the 2008 global financial crisis, regulators, legislators and shareholders have demanded that bank leaders become more involved and integrated with dealer operations and activities.

Stakeholder Objective Analysis of the Third-Party Deposit Market Large Bank Small Bank

• Target Canadian wealth market with integrated solutions

• Global regulatory pressures

• Scarcity of Canadian retail deposits

• Minimize deposit costs/channel conflicts

• Maximize enterprise

• Shareholder demands for growth

• Grow niche lending businesses, by growing deposits

• Protecting deposit flows (too much, too little)

• Predictable and reasonable access to dealer deposit market

• Compensate for “last mile” access

• Cost effective distribution

• Regulatory pressure to diversify liquidity sources

Large Dealers Small Dealer

• Grow profit through efficiency of operations

• Grow revenues/profit

• Attract advisors (investor clients)

• Offer compelling/differentiated product

• Execute bank strategies

• Attract and retain advisors and customers through service and product offers

• Reduce costs of Client Name Accounts

• Manage cost of change/profit

• Risks to revenue due to trailer fee disclosure and change


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Small Bank Concerns: Access, Predictability, Fairness Small bank anxiety over access to large dealers has increased since 2007. Prior to 2007, access to dealer desks was seen (generally) as a formality. There were fewer small banks seeking deposit access. Dealers were open to new products, and deposit yields were not priced above competing fund and bond offers. Access to third-‐‑party deposits is not just a small bank issue – it is a critical issue to all deposit taking issuers in Canada regardless of their size.

Since 2009, the regulatory risks for banks and dealers have changed significantly. First, other sources of small bank liquidity have evaporated (i.e. uninsured mortgage securitization, changes in regulatory treatment capital treatment of lines of credit, off balance sheet assets, etc.). Second, the regulatory environment has emphasized the value of matching retail sources of deposits to retail loan portfolios; the matching of term of deposits to term of loans; and, further emphasizing the value of deposits originated through proprietary deposit channels. Lastly, there has been a marked increase in the number of companies seeking to apply for, and who have attained, a banking license in Canada – and therefore, there is more activity to access dealer desks than there has been in recent history.

The size of the market for insured third-‐‑party deposits has increased by 120% since 2007 because of the market environment and turmoilxvi. These funds have been cannibalized from other investment alternatives (i.e. mutual funds) and attracted into the investment channel from Branch and Direct sources, reducing revenues or, in the case of banks, driving up cost of funds in a very tight margin environment.

As a result, dealers and traditional banks are looking to the third-‐‑party market with concern. As a larger bank, one could look to the growth of the third-‐‑party market in one of three ways. First, one could ignore the market and leverage other channels to drive deposit growth. Second, one could choose to compete in the market. Third, one could try and foil – or more correctly limit the growth – of the market through actions of its dealer arms.

Lastly, Canadian banks as a strategy are increasingly focused on competing with each other for wealth management customers – arguably with indirect casualties being small banks and small dealers. This focus on product and services has further incorporated the retail investment arms of their dealer organizations – resulting in better product choices for customers. But it also means there is a tighter integration of large bank strategy with day-‐‑to-‐‑day dealer administrative and product choices – and viewing dealer operations as integral elements of the banks competitive strategies.

Recent Events that Cause Competitive Concern We have seen all three responses formally (senior management endorsed strategy) and informally (daily administrative decisions) espoused by banks, as evidenced by the following recent actual examples in the market:


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• Large bank decides to only sell its own Savings product through its dealer channel – cuts off pre-‐‑existing suppliers – other large banks follow suit.

• Removal of small issuer from dealer board based on dealer failure to win investment-‐‑banking contract from issuer for separate debt/equity deal.

• Dealer “cleans up” issuers from board who have not done enough volume with them.

• Threats to impede or/restrict access to large bank-‐‑sponsored CMHC bond agency programs if small bank escalates to regulators.

• Dealers lagging in technology enhancements – or forcing technology enhancements – to impede small bank dealer access.

• Direction to advisors by dealer leadership to use FCAC disclosure statements to overstate risk of buying small bank GIC in favor of large bank proprietary savings products.

• Passive resistance to discussing new issuer offers (i.e. failure to discuss, return calls).

• Fast tracking some issues / failure to follow own issuer boarding rules for some issuers, while others are admitted by informal process (CEO favors).

• Erratic legal and contract posturing.

It is important to note that not all dealers, (including bank owned dealers) acted in this fashion.

But the perception by small banks of arbitrary and high-‐‑handed behaviors at administrative levels of some bank-‐‑owned dealers are fact. Furthermore, there remains a concern by small banks that those large-‐‑banks that have provided access to date will continue to restrict access to their dealers in the near future.

Considering large bank dominance of the branch distribution system, acquisition of the primary dealers in the 1990’s, acquisition of the largest direct banking providers in 2011/2012 (ING Direct, Ally, MRS, AGF Trust), the importance of access to dealer deposit distribution takes on greater concern for many small banks. The concentration of power with bank-‐‑owned dealers has not gone unnoticed in the market or by regulator stakeholders. For example, the Minister of Finance addressed some of these concerns while consulting with senior bank leadership in 2011,although these discussions have had little impact on deposit access issues identified above.


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What are the small bank issues in the third-party market? Bank-Owned Dealer Smaller Dealers Others Financial

Planners Deposit Competitive Issues

• Largest source of deposits

• Favour given to own bank deposits

• Arbitrary and high-handed approach

• Disconnect versus formal rules and administration

• Small funding flows • High origination costs

(“named accounts”) limit issuer pricing competitiveness

• Nascent market • Highly fragmented • Very high origination

costs due to replication of AML validation

Dealer Challenges • Perceived low revenue/profit from deposit products

• Assumed regulatory pressure for proprietary deposits

• Perceived treasury and channel conflict pressures to sell proprietary product

• Regulatory treatment and costs for “named accounts”

• Inconsistent access to order systems (Cannex/GICSERV)

• Cost of regulatory changes and decreasing market share

• Lack of common operating/back office environments

• Regulatory treatment and costs for “named accounts”

• Access to electronic order systems (Cannex/GICSERV)

Available Response • Standardize issuer application process

• Standardize issuer removal

• Standardize issuer operating, settlement and product environment

• Explore alternative commission/ transaction fee models

• Implement technology to reduce costs and increase profitability

• Enable Nominee remote KYC/AML by small dealers

• Standardize dealer/issuer back office

• Explore revenue model alternatives

• Regulatory rules to allow Nominee remote KYC/AML by small dealers

• Standardize dealer/issuer back office

• Explore revenue model alternatives


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Recommendations The challenge for the government to consider as it examines options for ensuring small bank competitiveness in the third-‐‑party deposit market is to understand decision complexities and ramifications of actions. The interests of the individual banks and dealers are not necessarily aligned by size or ownership. Therefore we would expect that a successful resolution of the question of bank access to the third-‐‑party market would involve several trade-‐‑offs between dealer revenues, regulator policy, bank cost and improvement of the underlying deposit instrument to make it friendlier to dealer systems.

The objectives at the start of the document were:

• Predictable and affordable issuer access to dealer desks • Fair compensation and cost/risk mitigation for dealers • Transparent dealer rules/activities related to proprietary and third-‐‑party deposits • Responsible infrastructure and participation rules • Stability of deposit market • Investor/regulator stakeholder trust

We have learnt that:

ü Canadian retail deposits are scarce and that there is significant competitive and regulatory pressure to attain them for all bank treasurers.

ü Dealers want deposit product offers as part of their retail investor offering to maintain assets in their portfolios and as part of a low fee/low risk investment alternative to bonds.

ü Dealers are essentially apathetic to deposits because they cannibalize other revenue opportunities, and of themselves are expensive to administer.

ü Dealers are generally in a period of economic and regulatory stress, their capacity to move independently from their parent companies are increasingly limited.

ü Small banks use deposits to fund loans that serve markets not generally served by large banks. ü Bank-‐‑owned dealers dominate the deposit market because of their size and because they

present issuing banks with a cost advantage associated with processing deposits more efficiently, because of favorable regulatory treatment of Nominee registry.

ü Not all dealers pose access challenges to small banks; that the problem of access is not with the majority of dealers but the informal/administrative actions of a few bank-‐‑owned dealers.

ü The deposit market is important to the Canadian banking market and consumers – and maintaining that trust is vital to everyone concerned.

ü The existing dealer deposit distribution model is seen by some small bank issuers as a competitive and funding risk advantage – while others view access as unfair, arbitrary and dealer actions in granting access high-‐‑handed.


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Response to Request for Consultation On June 25, 2014 the government issued a request for comment seeking a response from industry stakeholders on measures to require bank-‐‑owned investment dealers to distribute deposit products from non-‐‑affiliated deposit-‐‑taking institutions (DTIs).

It is IFDS’s understanding the government is seeking to implement measures that help small DTIs to enter and compete can improve competition in the market. It is further our understanding that small DTI entry and growth helps competition by introducing new and improved products and services, serving additional market segments, and motivating existing DTIs to improve their products, pricing, and service. Further, we have observed that a vibrant brokered-‐‑deposit market provides valuable and stable funding source for all participating DTIs, and acts as an important fire-‐‑wall in the event of a liquidity crisis.

We further understand and support the governments’ goal of encouraging DTI entry and growth and, by making brokered deposits a more robust source of funding, promote the safety and soundness of the financial sector. We further support the notion that Canadian investing consumers would benefit from greater choice, as this may provide better rates to savers. And with improved access, we would support the notion that existing brokered deposit arrangements between DTIs and investment dealers would continue on the same or better terms and that additional arrangements would occur as a result of the measure. In short, improved access should create a larger, more stable liquidity market – assuming arrangements create greater fairness, parity and transparency for all involved players.

Through our discussions with finance we have advocated that DTI entry and growth requires access to robust sources of funding distribution, among other things. For smaller banks, brokered deposit products are a significant portion of total deposits representing approximately $200 bn in balances in 2012. Brokered deposits are deposit products that are issued by a DTI and distributed by a third-‐‑party, principally through investment dealers, to investors. Brokered deposit products consist of Guaranteed Investment Certificates (GICs) and savings accounts and are eligible for deposit insurance by the Canada Deposit Insurance Corporation (CDIC). Small DTI deposit products typically offer higher interest rates to investors. Brokered deposits are also a compelling investment alternative for Canadian retail investors as they offer higher than government rates for low risk. It is no surprise therefore that GICs are the single largest product category in Canadian retail fixed income investment holdings.

Access Challenges Given the importance and size of the brokered deposit market, and bank general need for retail deposits, there is significant competition for DTIs to access dealer distribution. Large bank dealers control ~75% of the balances for third party issuers. Some large bank dealers have limited the distribution of deposit products from non-‐‑affiliated DTIs. These restrictions have taken the form of


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explicit product shelf reductions, negative regulatory and sales incentives, and artificial costs / technology charges that impede fair competition.

We generally support the government’s desire to ensure that non-‐‑affiliated DTIs can access the bank owned brokered deposit channel to seek funding and liquidity, but we are also concerned that the government’s actions put in place an equitable distribution and issuer landscape that would include access for provincially regulated DTIs and Dealers.

Legislative Actions To enact the policy objectives defined above, we understand that the government intends to amend the Bank Act to require DTIs that have investment dealer operations to offer certain deposit products (e.g. CDIC insurable) from non-‐‑affiliated DTIs. We further understand that this requirement could be based on whether financial institutions and deposit products meet certain criteria or standards

IFDS GIC and HISA offer IFDS currently operates brokered-‐‑deposit GICs and HISAs for Canada’s banking industry. Our customers include CIBC, Manulife, Home Trust, B2B Bank, ATB and Scotiabank.

The essential challenge facing the dealer and banking industry is that GICs are a bank account – while dealers desire a security to be compliant with their systems. IFDS’s operating thesis is based on the Mutual Fund industry framework of a shared services Transfer Agency acting as a standardized book of record for various investment funds operating in Canada. A transfer agency acts as both product technology platform as well as predictable operations environment, thereby reducing costs and risks for dealers. In effect, through IFDS the deposit issuing community can create GICs that are securities – thereby creating efficiencies and operational liquidity in the market.

Common technology and transfer agency for GICs / HISAs will make the industry more efficient by allowing dealers to hold GICs as securities rather than bank account. In theory, individual banks could enable much of the IFDS offer by recoding their back office choices and systems. However, this coordination between 50+ institutions is unlikely, making a industry shared solution preferable.

Our technology and services link to existing order and rate systems (CANNEX), banking back-‐‑office and accounting systems, and settlement functions to enable money transfer between organizations on a daily basis. We operate a 7/24 real time processing environment for multiple DTIs. Our data environment remains fully in Canada and we have class-‐‑leading business continuity resiliency.


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Response to Government Consultation Questions

International Financial Data Services Canada July 24, 2014

1. How should the policy measure be structured? In particular:

a. Which financial institutions (DTIs and bank-‐‑owned investment dealers) and deposit products should be included (e.g. CDIC insurable deposit products)?

IFDS Response

1) IFDS supports the access policy explicitly includes both brokered GICs and FundServ Savings accounts (so called HISA’s). The government may wish to consider opening dealer distribution generally to other deposit, savings, transaction and lending programs in order to further drive competition with this valuable market segment.

2) Ideally, we would counsel that the policy measures envisioned by the government would impact all DTIs and Dealers equally. The government may wish to consider the risk that the access measures the bank-‐‑owned dealer channels could become comparatively more cost effective than other smaller dealers – resulting, possibly, in similar concentration and competition issues that this measure is intended to correct. Therefore, the government should consider policy and regulatory options to encourage DTIs to drive efficiencies with all dealers to affect maximum liquidity stability goals.

3) We have no opinion of CDIC insurance versus other provincial insurance offers. By implication an OSFI regulated DTI will have CDIC coverage. The government has announced its intention to review deposit insurance in Canada. We would welcome further clarification and discussion of coverage related to broker deposits and the nominee instrument coverage model now in common practice with dealers.

b. Should financial institutions and deposit products have to meet certain standards and, if so, what should be the standards and what should be done to ensure transparency and fair outcomes?

IFDS Response

1) IFDS’s position is that DTIs have a responsibility to create products that are efficient and effective for the dealer environment. As discussed above, we believe that the essential paradox of the industry is that DTIs are systemically creating bank accounts for dealers and investors that want securities. DTIs that have pursued individual books of records, product choices and who have non-‐‑transparent and ineffective operations environments should be forced to upgrade their delivery systems over a period of time.


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2) IFDS would support minimum infrastructure requirements on to the industry as a requirement for connectivity to dealers. This would ensure that the dealers are not forced to assume additional costs or risks when supporting a broad range of deposit taking institutions.

3) The deposit market is a very low margin environment and increases in operating, system and/or product costs would impede investor objectives and could replace informal restrictions as a real barrier to access. Therefore, the government should consider monitoring bank-‐‑owned dealer infrastructure requirements to ensure that requirements are based on efficient operating needs and not of itself another barrier to competition.

c. How can a potential over-‐‑reliance on a single source of brokered deposit funding be avoided?

IFDS Response

1) There are two main policies that can prevent an over-‐‑reliance on a single source of brokered deposit funding; the first is to provide broad and unfettered access to the range of dealers for all deposit taking institutions that meet established infrastructure standards and second is to establish a system or processes to limit the daily originations for a given DTI from each dealer. By providing a DTI with a range of dealers to distribute deposits through and then ensuring that daily origination limits are established, deposit taking institutions will never become reliant on one dealer as a single source of funding.

2) In addition to the above, the government could consider expanding access policy guidelines in the future to include non-‐‑identified financial distribution channels including bank branches and proprietary insurance networks.

3) The government should continue to drive the dealer industry to support prudent alternative capital arrangements from smaller banks such as asset securitization, syndication, bankers acceptances, et al.

d. Is a transition necessary and, if so, what should be the transition measures?

IFDS Response

1) We would counsel a 12 month transition policy for bank owned dealers with allowances for specific need extensions.

2) This period would allow the industry to come up with pragmatic private sector solutions to some of the sales, operational and dealer challenges identified in our conversations.

3) Longer time lines for transition could encourage higher costs through scope creep, solution over-‐‑engineering and infrastructure power plays.


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2. What is the expected impact of this measure on your organization (as a DTI and investment dealer, as applicable) and the financial services sector? In particular:

a. Are there any negative consequences on your business? How can this be mitigated?

IFDS Response

1) Increased access for DTIs should increase volumes and rational competition. IFDS welcomes the impact of this change.

2) The risks of this measure, as identified above, would be if: a. Provincially regulated dealers (therefore investors) were significantly disadvantaged

as a result of technology savings created specifically for large bank owned dealers, impacting largely smaller dealers in rural markets.

b. Provincially regulated DTIs were impeded from access to low cost deposit distribution.

c. That dealers reacted to this measure by seeking new barriers of entry by imposing high-‐‑cost and burdensome technology and operating requirements on small DTIs.

b. How important is brokered deposit funding?

IFDS Response

• IFDS estimates that $1 in $5 are originated through brokered deposit channels in Canada.

• GICs are the single largest class of retail fixed income product holdings in Canada’s investment market.

• Brokered deposit access was pivotal to the liquidity survival of at least 2 larger DTIs in 2008/2009 crisis.

• Brokered deposits are the lowest cost source of funding for small FIs.

c. How accessible is brokered deposit funding and how would accessibility improve?

IFDS Response

• IFDS does not directly source brokered deposits. We work with clients to identify distributors and process orders on behalf of the DTIs.

d. How stable is the brokered deposit market and how would stability improve?

IFDS Response

• Market stability of the GIC market would be improved through the following: o Reduced barriers to distribution access to investors (dealers);


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o Enablement of GIC secondary markets (fees, consistency of interest calculations, etc);

o Commoditization of compliance, deposit insurance and purchase eligibility rules across institutions, between regulatory bodies, and brokers.

o Common, consistent and standardized application processes, dealer boarding processes and DTI back-‐‑office processes.


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Notes i For example, in Q4 2013 all Canadian banks had individual loans outstanding for $2.1 trillion. Total individual deposits were $1.7 trillion. Or 78% retail deposit to retail loan coverage. Source: http://www.osfi-‐‑bsif.gc.ca/Eng/wt-‐‑ow/Pages/FINDAT.aspx. Consolidated Balance Sheets. Total All Banks.

ii Source: Investor Economics. 2013.

iii Ibid.

iv Investor Economics (www.investoreconomics.com) is a Toronto based market research firm specializing in investment dealers and wealth management. They provide an annual Deposits and Fixed Income Report that identifies market dynamics annually. v Dealer risks are nominally linked to the issuer bank capacity to remain solvent, as investor concerns about access to deposits and investment recommendations are intertwined. While real risks of insolvency are minimal, the perceptions of “hassle factor”, costs, and investment advice of dealing with a risky issuing bank and the CDIC process would impede dealer desire to list an issuer.

vi This model is consistent with how dealers and mutual fund companies contract for distribution, but different than how the stock and/or bond market works which is as an open exchange model. vii There is no formal industry standard for GICs. FundSERV has proposed a GIC order system GICSERV but this standard has yet to be adopted by the dealer and issuer market. As of writing, several large bank dealers facilitate orders through spreadsheets, faxed order forms and by retyping lists. There is also no agreed on protocol for daily financial settlements – with wires, direct deposit, net settlements and physical cheques in common use. Confirms and reconciliations are further dependent on dealer choices and issuer capabilities. This is a stark comparison to the highly regimented order, settlement and reconciliation process securities and mutual fund world.

viii Cannex Estimate. ix Third Party GIC Rate and Volume Characteristics 2006-‐‑2013. IFDS. August 2013.

x Third Party GIC Rate and Volume Characteristics 2006-‐‑2013. Assuming $220 bn in deposit assets and full commissions paid the value of commissions would be $550 million. However, depending on dealer and advisor preferences, commissions are frequently waived. xi Currently, only regulated Canadian financial institutions who are members of a deposit insurance program can participate. Depending on the issuer, deposits can be insured by CDIC. (http://www.cdic.ca/Coverage/Pages/default.aspx) or provincial deposit insurance plans. CDIC insures savings and generic GICs for up to $100,000 per person, per institution and is backed by the federal government. Some provincial plans have unlimited balance coverage – although the deposit insurance company may not be backed by the province. xii Costs for named transaction processing vary with issuer compliance rules and rejections due to field error rates in supplying information Client Name transactions have a 20-‐‑40% NIGO (Not in Good Order) occurrence. Additional costs for cheese, not-‐‑sufficient funds and special customer service has resulted in all but the most needy issuers to leave the Client Name environment for Nominee.


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xiii Securities Industry Performance. The Investment Industry Association of Canada (IIAC). Q3 2013.

xiv Securities Industry Statistics. IIAC. Q3 2013.

xv Securities Industry Statistics. IIAC. Q3 2013.

xvi $85 billion à $220 billion in 2013. Source IFDS and Investor Economics. 2013.

Documents

Distribution Accessibilty Issues for third party deposits July 2014 final (2)