Understanding the Canadian Capital Market: Structure, Participants, and Instruments

Role and Characteristics of Investment Capital

  • Definition of Capital: Capital is synonymous with wealth, categorized into two types:

    • Real Capital: Material goods such as land and buildings.
    • Representational Capital: Money, stocks, and bonds that represent invested savings.

  • Economic Value: All forms of capital have economic value representing the savings of individuals, corporations, governments, and organizations.

  • Types of Investment:

    • Direct Investment: Occurs when capital is used for tangible assets. Examples include a couple investing in a home, a government investing in a new highway, or a company paying start-up costs for a new plant.
    • Indirect Investment: Occurs when an entity buys securities (representational items) which are then used by the issuer for productive purposes. Examples include an investor buying stocks or bonds, a parent investing in an education savings plan, or a couple depositing savings at a bank.

  • Three Core Characteristics of Capital:

    • Mobility: Capital can move easily between locations or countries.
    • Sensitivity: Capital is highly responsive to its environment and settles where conditions are favorable.
    • Scarcity: Capital is limited in quantity and is in high demand globally.

  • Country Risk Evaluation Factors: Capital flows toward locations with stable governments and profitable opportunities. Factors considered include:

    • Political Environment: Presence or likelihood of internal or external conflict.
    • Economic Trends: Strength of growth in Gross Domestic Product (GDP), inflation rates, and general economic activity.
    • Fiscal Policy: Levels of taxes, government spending, and incentives for savings/investment.
    • Monetary Policy: Management of the nation’s money supply and stability of price/foreign exchange.
    • Investment Opportunities: Returns on investment relative to risk levels.
    • Labour Force: The percentage of the workforce that is skilled and productive.

The Suppliers and Users of Capital

  • Suppliers of Capital (Sources):

    • Individuals: Tend to save if the compensation to postpone current consumption (interest or returns) is high or if tax incentives are provided.
    • Non-financial Domestic Corporations: Generate large savings through corporate earnings. These are usually retained for internal use rather than invested in other companies' securities, making them insignificant providers of permanent funds to the external market.
    • Governments: Can be suppliers when operating at a surplus; however, they often become users when funding deficits.
    • Foreign Investors: Provide both direct investment in industries and portfolio investment in Canadian securities.

  • Categorization of Investors:

    • Retail Investors: Individual clients buying/selling for personal accounts.
    • Institutional Investors: Organizations like pension funds and mutual fund companies that trade in large quantities and have steady money flows.

  • Users of Capital:

    • Individuals: Use capital (loans, mortgages) to finance large purchases like houses, cars, or appliances.
    • Businesses: Require capital for day-to-day operations, plant/equipment maintenance, expansion, and diversification. While they generate capital internally through profits, they also borrow from intermediaries and raise funds in securities markets.
    • Governments: Major issuers of securities (bonds) to fund expenditures or large capital projects. They may issue debt directly or guarantee the debt of Crown corporations.
    • Foreign Users: Borrow from Canadian banks or make their securities available to the Canadian market, often when the Canadian dollar is low relative to their currency.

The Financial Instruments

  • Definition: Financial instruments are formal legal documents setting out the rights and obligations of buyers (suppliers) and sellers (users). They typically have standard features to facilitate trading.

  • Types of Instruments:

    • Fixed-Income Securities (Debt): The issuer promises to repay the loan at maturity and make interim interest payments. Examples include Treasury bills and bonds.
    • Equity Securities (Stocks/Shares): Represent an ownership stake in the issuing company. Investors may receive capital gains upon selling. Examples include common shares and preferred shares.
    • Derivatives: Products whose value is derived from an underlying instrument (e.g., a stock or index). Suited for sophisticated investors. Examples include options and forwards.
    • Managed Products (Investment Funds): Pools of capital gathered from many investors to buy securities according to a specific mandate. Examples include mutual funds, exchange-traded funds (ETFs), and private equity funds.
    • Structured Products: Financially engineered products combining characteristics of debt, equity, and investment funds. Examples include principal-protected notes (PPNs) and index-linked guaranteed investment certificates (GICs).

The Financial Markets

  • Market Function: A forum where buyers and sellers meet through intermediaries (investment advisors and bond dealers) to complete transactions. Well-organized markets provide speed, low transaction costs, liquidity, and regulation.

  • Market Classifications:

    • Money Market: Exclusively for short-term fixed-income securities with a term of one year or less (≤1 year\leq 1\,\text{year}).
    • Primary Market: Where newly issued securities (Initial Public Offerings or IPOs) are sold by companies or governments to investors. The issuer receives the proceeds.
    • Secondary Market: Where investors trade existing securities among themselves. The issuing company does not receive proceeds from these trades.

  • Auction Markets:

    • Involves buyers entering bids and sellers entering offers/asks.
    • Orders are channeled to a single central market where they compete.
    • A trade executes only when a bid price matches an ask price.
    • Bid Price: The highest price a buyer is willing to pay.
    • Ask Price (Offer): The lowest price a seller will accept.
    • Bid-Ask Spread: The difference where Ask Price−Bid Price=Bid-Ask Spread\text{Ask Price} - \text{Bid Price} = \text{Bid-Ask Spread}.
    • Last Price: The price of the most recent transaction, which can fluctuate between the bid and ask.

Stock Exchanges and Dealer Markets

  • Canadian Stock Exchanges:

    • Toronto Stock Exchange (TSX): Lists equities, convertible debt, income trusts, and ETFs.
    • TSX Venture Exchange: Lists junior equities and some debentures.
    • TSX Alpha Exchange: Trading platform for securities listed on the TSX and TSX Venture.
    • Montréal Exchange (ME): Trades financial and equity futures and options.
    • ICE NGX Canada: Electronic trading/clearing for North American natural gas and electricity.
    • Canadian Securities Exchange (CSE): Lists equities of emerging companies.
    • Cboe Canada: Facilitates trading in public companies, ETFs, Canadian Depositary Receipts™ (CDRs), and closed-end funds. It accounts for approximately 15 %15\,\% of all Canadian-listed trading volume.

  • TMX Group Limited: An integrated exchange group comprising the TSX, TSX Venture, TSX Alpha, and Montréal Exchange. Its shares trade on the TSX under the symbol X.

  • Liquidity Characteristics: A liquid market features frequent trades, narrow bid-ask spreads, and small price fluctuations between trades.

  • Dealer Markets (Over-the-Counter or OTC):

    • A negotiated market consisting of a network of banks and investment dealers.
    • Market makers post bid and ask quotations via electronic networks.
    • Investment dealers act as principals, holding an inventory of securities.
    • Almost all bonds and debentures trade here. The dollar volume of debt trading is significantly larger than the equity market.

  • Unlisted Equity Market: Smaller volume than exchanges. Often used for junior issues or companies that choose not to meet exchange listing requirements. These stocks are often more speculative with lower liquidity. In Ontario, unlisted trades must be reported through the Canadian Unlisted Board Inc.

Electronic Trading Systems

  • Alternative Trading Systems (ATS): Electronic marketplaces providing automated matching/execution. They compete with traditional exchanges but cannot list securities themselves. Must be registered as investment dealers and members of the Canadian Investment Regulatory Organization (CIRO).

  • Fixed-Income Electronic Trading Systems:

    • CanDeal: A joint venture between Canada’s six largest bank-owned dealers and TMX Group; offers institutional access to government securities and money market instruments.
    • CBID / CBID Institutional: Operates retail and institutional fixed-income marketplaces.
    • MarketAxess: Provides multi-dealer competitive pricing for corporate bonds and other fixed-income instruments in Ontario and Quebec.
    • CanPX: A joint venture providing a composite real-time display of bid/offer quotations and volume for Government of Canada bonds and Treasury bills.