The Capital Market: Unlocking Economic Growth

Introduction to the Securities Industry

The securities industry is a cornerstone of the Canadian economy, constantly evolving to meet the dynamic needs of both domestic and international investors. Its fundamental purpose is to facilitate the crucial transfer of capital from those who possess it (suppliers) to those who require it (users) (Page 3).

• Core Pillars: Three essential elements underpin the securities industry:

  • Financial Intermediaries: Entities like investment dealers, banks, and trust companies that bridge the gap between capital suppliers and users (Page 3).

  • Financial Markets: Platforms where capital is exchanged and financial transactions occur (Page 3).

  • Financial Instruments: Legal documents outlining the rights and obligations for capital transfer (Page 3).

Investment Capital: The Lifeblood of the Economy

Capital broadly signifies wealth, encompassing both tangible assets like land and buildings (real capital) and financial representations such as money, stocks, and bonds (representational capital). All these forms hold economic value, embodying the accumulated savings of various entities including individuals, corporations, and governments (Page 3).

Harnessing Capital: Direct vs. Indirect Investment

Representational capital gains its true power when deployed productively through investment.

• Direct Investment: Involves direct commitment of funds into tangible assets or specific projects.

  • Examples: A couple purchasing a home, a government funding a new highway, a company establishing a new plant (Page 3).

• Indirect Investment: Focuses on acquiring financial assets like stocks or bonds, where the issuer then uses these funds for productive purposes. This is the primary focus of the course (Page 3).

  • Examples: An investor buying stocks or bonds, a parent investing in an education savings plan, a couple depositing savings at a bank (Page 3).

  • Often facilitated by an investment advisor in the retail or institutional sales departments of securities firms (Page 3).

Characteristics that Define Capital

Capital possesses three fundamental traits that influence its global movement and allocation:

• Mobility: Capital can readily move across borders and sectors (Page 3).

• Sensitivity to Environment: It gravitates towards environments offering stable governance, less regulated economic activity, a welcoming investment climate, and profitable opportunities (Page 3).

• Scarcity: Despite its mobility, capital is finite, leading to high demand worldwide (Page 4).

  • Capital consistently seeks opportunities offering the highest risk-adjusted returns, moving away from less favorable conditions (Page 4).

Evaluating Country Risk: Where Capital Chooses to Go

When assessing where to invest, capital suppliers consider various components of country risk (Page 4):

• Political Environment: Stability and potential for conflict (internal or external) (Page 4).

• Economic Trends: Strength of GDP growth, inflation rates, and overall economic activity (Page 4).

• Fiscal Policy: Taxation levels, government spending, and incentives for savings and investment (Page 4).

• Monetary Policy: Soundness of money supply management and promotion of price and foreign exchange stability (Page 4).

• Investment Opportunities: Availability of profitable ventures and satisfactory risk-adjusted returns (Page 4).

• Labour Force: Percentage of skilled and productive workers (Page 4).

The Ecosystem of Capital: Suppliers and Users

A healthy supply of capital is vital for economic prosperity, driving industrial expansion, productivity gains, competitiveness, and innovation (Page 4).

Suppliers of Capital: The Wellspring of Investment

Capital's sole origin lies in savings, which occur when revenues surpass expenditures (Page 4).

• Individuals: Tend to save when compensation for postponing consumption is high (e.g., attractive interest rates or tax incentives) (Page 4).

• Non-financial Domestic Corporations: Generate substantial savings primarily from corporate earnings. However, these are generally retained for internal use and not typically invested in other companies' securities (Page 4).

• Governments: Can be suppliers when operating at a surplus. Conversely, deficit-ridden governments become users by borrowing (Page 5).

• Foreign Investors: Both corporate and individual, have historically viewed Canada as an attractive investment destination, providing direct investment and portfolio capital (Page 5).

Users of Capital: Driving Economic Activity

Capital users span individuals, businesses, and governments, both Canadian and foreign (Page 5).

• Individuals: Require capital for significant purchases such as homes, vehicles, and major appliances, typically obtained through personal loans, mortgages, or credit (Page 5).

• Businesses: Need vast amounts of capital for daily operations, plant maintenance, equipment renewal, and expansion. While much is generated internally (retained profits), they also borrow from financial intermediaries and raise funds in securities markets (Page 5).

• Governments: Are significant issuers of securities, borrowing to fund deficits or large capital projects, often via their Crown corporations (Page 5).

  • Canadian capital is appealing to foreign users when its value is low relative to their own currencies. This also benefits Canadian investors by offering diversification through foreign securities (Page 5).

Summarizing Capital Flow

Here's a breakdown of the primary sources and users of investment capital:

Figure 1: Simplified Flow of Capital from Suppliers to Users (Page 3, 5)

The Financial Instruments: Tools for Capital Transfer

Financial instruments, primarily securities, are formal legal documents that delineate the rights and obligations of both capital suppliers (buyers) and users (sellers). They are crucial for efficient capital distribution due to their standardized features, which simplify trading, and the wide variety available to meet diverse needs (Page 6).

Key Types of Financial Instruments

• Fixed-Income Securities (Debt Securities): Formalize a lending relationship where the issuer commits to repaying the loan at maturity and making interim interest payments to the investor. The loan term varies (Page 6).

  • Examples: Treasury bills, bonds (Page 6).

• Equity Securities (Stocks, Equities, Shares): Represent an ownership stake in the issuing company. Investors can realize capital gains if the company's value increases (Page 6).

  • Examples: Common shares, preferred shares (Page 6).

• Derivatives: Products whose value is derived from an underlying instrument, such as a stock or an index. They are generally more complex and suited for sophisticated investors (Page 6).

  • Examples: Options, forwards (Page 6).

• Managed Products (Investment Funds): Pooled capital from multiple investors, managed according to a specific investment mandate to acquire other securities (Page 6).

  • Examples: Mutual funds, exchange-traded funds, private equity funds (Page 6).

• Structured Products: Financially engineered products combining characteristics of debt, equity, and investment funds (Page 6).

  • Examples: Principal-protected notes, index-linked guaranteed investment certificates (Page 6).

The Financial Markets: Where Transactions Happen

Financial markets serve as forums where buyers and sellers meet to conduct financial transactions. Rather than direct interaction, intermediaries like investment advisors and bond dealers act on behalf of their clients (Page 7).

• Core Function: Facilitate the efficient transfer of capital from suppliers to users, benefiting both parties (Page 7).

• Key Characteristics of Well-Organized Markets: Speedy transactions, low transaction costs, high liquidity, and effective regulation (Page 7).

• Nature of Markets: Often lack a physical location, with trading increasingly occurring via electronic platforms (Page 7).

Categorization of Financial Markets

Financial markets are diverse and can be classified in several ways:

• By Instrument Type:Stock markets, bond markets, and money markets (Page 7).

  • Money Market: Exclusively trades short-term fixed-income securities with maturities of one year or less (Page 7).

• By Issuance Stage:Primary markets and secondary markets (Page 7).

• By Trading Mechanism:Auction markets and dealer markets (Page 7).

Primary vs. Secondary Markets: The Life Cycle of Securities

• Primary Market: The arena for newly issued securities sold directly by companies and governments to investors. This is where companies raise capital by issuing stocks or bonds, and governments issue bonds (Page 7).

  • Key event: Initial Public Offerings (IPOs) (for stocks) (Page 7).

  • The issuing entity receives the proceeds from these sales (Page 7).

• Secondary Market: Where already-issued securities are traded among investors. Buyers and sellers transact at mutually agreed prices, and ownership is transferred (Page 7).

  • The issuing company does not receive funds from these transactions (Page 7).

  • Example: Trading stocks on the Toronto Stock Exchange (Page 7).

Auction Markets: Centralized Competition

In an auction market, investors buy and sell securities through intermediaries, typically investment dealers acting as agents. Orders are channeled to a single, central market where they compete (Page 7).

• Mechanism: Buyers submit "bids" (highest price willing to pay), and sellers submit "offers" or "asks" (lowest price willing to accept) (Page 7).

• Execution: A trade occurs only when a bid matches an offer (Page 7).

Understanding the Bid-Ask Spread

• Bid Price: The highest price a buyer is prepared to pay for a security (Page 8).

• Ask Price (Offer): The lowest price a seller is willing to accept (Page 8).

• Bid-Ask Spread: The difference between the ask price and the bid price (Page 8).

  • $ \text{Bid-Ask Spread} = \text{Ask Price} - \text{Bid Price} $

• Last Price: The price at which the most recent trade occurred. This is historical and does not necessarily reflect the current executable price (Page 8).

Figure 2: Example of Bid-Ask Matching in an Auction Market (Page 8)

Stock Exchanges: Hubs of Auction Trading

A stock exchange is a prime example of an auction market where securities are traded, and prices are determined by supply and demand dynamics (Page 8).

• Canadian Exchange Offerings: Primarily common and preferred shares, rights, warrants, exchange-traded funds (ETFs), income trusts, and some convertible debentures (Page 8).

• Liquidity: A crucial characteristic of efficient exchanges, characterized by:

  • Frequent trades (Page 8).

  • Narrow bid-ask spread (Page 8).

  • Small price fluctuations between trades (Page 8).

Key Canadian Exchanges:

• Toronto Stock Exchange (TSX): Lists equities, some convertible debt instruments, income trusts, and ETFs (Page 8).

• TSX Venture Exchange: Lists equities of emerging companies and a limited number of debentures (Page 8).

• TSX Alpha Exchange: Offers trading for securities listed on both the TSX and TSX Venture Exchange (Page 8).

• Montréal Exchange: Specializes in trading all financial and equity futures and options available in Canada (Page 8).

• ICE NGX Canada: Provides electronic trading, central counterparty clearing, and data services for North American natural gas and electricity markets (Page 9).

• Canadian Securities Exchange: Lists equities of emerging companies (Page 9).

• Cboe Canada: Offers listing services and facilitates trading for public companies, ETFs, Canadian Depositary Receipts™, special purpose acquisition companies, and closed-end funds. Handles approximately 15% of the volume in Canadian-listed securities (Page 9).

• TMX Group Limited: An integrated group encompassing the TSX, TSX Venture Exchange, TSX Alpha Exchange, and the Montréal Exchange, providing listing, trading, clearing, and market data for various asset classes (Page 9).

Dealer Markets (Over-the-Counter - OTC Markets): Negotiated Trading

Dealer markets, also known as over-the-counter (OTC) markets, are decentralized networks of banks and investment dealers. Unlike auction markets, they are negotiated markets where market makers quote bid-and-ask quotations via electronic platforms (Page 9).

• Principals:Investment dealers typically act as principals in OTC markets, trading from their own inventory (Page 9).

• Predominant Instruments: Almost all bonds and debentures are traded through dealer markets (Page 9).

• Volume: The dollar volume of trading in debt securities in dealer markets significantly surpasses that of the equity market (Page 9).

• Unlisted Markets: Also referred to as unlisted markets because the securities traded here are not listed on organized exchanges (Page 9).

• Mechanism: Trades are conducted via inter-dealer brokers' computer systems that facilitate transactions between investment dealers (Page 9).

The Unlisted Equity Market: A Niche for Specific Equities

While smaller in volume than exchange-traded equities, the unlisted equity market provides a venue for certain junior issues and even some industrial company shares that choose not to list on an exchange (Page 9).

• Characteristics: No minimum listing requirements or regulation of companies. Often more speculative and offer lower liquidity compared to listed securities (Page 9).

• Trading Process:Market makers (investment dealers holding inventory) quote their own bids and offers. An investor's dealer identifies the best quote and contacts the market maker to complete the transaction, charging a commission (Page 9-10).

Over-the-Counter Derivatives Market: Customization and Complexity

Dominated by large international financial institutions, the OTC derivatives market operates 24/7.

• Customization: A key advantage is the ability to custom-design derivative products with specialized features, making them complex (Page 10).

• Negotiation: Traders do not meet in person; transactions are negotiated electronically (Page 10).

Reporting Trades in the Unlisted Equity Market

• General Rule: In most of Canada, investment dealers are not required to report unlisted trades (Page 10).

• Ontario Exception: The Ontario Securities Act mandates reporting of unlisted securities and unquoted equity securities through the Canadian Unlisted Board Inc. web-based system (Page 10).

Alternative Trading Systems (ATS): The Digital Evolution

Alternative Trading Systems (ATS) are electronic marketplaces that provide automated matching and execution of trades for both equity and fixed-income securities (Page 10).

Equity Electronic Trading Systems: Competing with Exchanges

ATSs in equity markets automate trade matching and execution, a function traditionally performed by stock exchanges (Page 10).

• Regulatory Framework: The Canadian Securities Administrators allow ATSs to compete with recognized exchanges and each other, expanding trading options (Page 10).

• Requirements: An ATS must be registered as an investment dealer and be a member of the Canadian Investment Regulatory Organization (CIRO) (Page 10).

• Distinction from Exchanges: While subject to similar regulatory filings and offering comparable trading services, ATSscannot list securities themselves; they trade securities already listed on traditional exchanges (Page 10).

Fixed-Income Electronic Trading Systems: Modernizing Debt Markets

Most bond and money market securities are traded through dealer markets (with a few exceptions on TSX and TSX Venture Exchange). Canada has several specialized fixed-income ATSs (Page 10).

• CanDeal: A CIRO member and joint venture of Canada's six largest bank-owned investment dealers, operated by TMX Group Limited. Recognized as a debt ATS and investment dealer, it offers institutional investors access to government securities and money market instruments (Page 10).

• CBID and CBID Institutional: An ATS with two distinct fixed-income marketplaces:

  • Retail: Accessible by registered dealers on behalf of retail clients (Page 10).

  • Institutional: Accessible by registered dealers, institutional investors, governments, and pension funds (Page 10).

• MarketAxess: Provides market data and a trading platform with multi-dealer competitive pricing for a wide range of corporate bonds and other fixed-income instruments. A CIRO member operating in Ontario and Quebec (Page 11).

• CanPX: A joint venture between Canadian investment dealers and inter-dealer brokers. It aggregates digital feeds from participating dealers to display composite real-time bid and offer quotations (price, yield, volume) for Government of Canada bonds and Treasury bills (Page 11).