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Section 1

The Canadian Investment


Marketplace

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Chapter 1

The Capital Market

THE CAPITAL MARKET

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

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: money market, stocks, bonds, mutual funds and others. Financial
intermediaries, such as banks, trust companies and investment dealers, have evolved to make the transfer
process efficient.

3 key components of the securities industry:


1. Financial instruments
2. Financial markets
3. Financial intermediaries

WHAT IS INVESTMENT CAPITAL?

Capital is wealth – both real, material things such as land and buildings, and representational items such as
money, stocks and bonds. All of these items have economic value.

- It represents the invested savings of individuals, corporations, governments and many other
organizations and associations.
- It is arguably the world’s most important commodity.

Capital savings

Direct Investment Indirect Investment

Examples of Direct Investment


- a couple investing their savings in a home;
- a government investing in a new highway or hospital;
- a domestic or foreign company paying start-up costs for a plant to produce a new product.

Examples of Indirect Investment


- Purchase of such representational items as stocks or bonds or through the deposit of savings in a
financial institution.

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Characteristics of Capital

Capital has 3 important characteristics:


- It is mobile
- It is sensitive to its environment
- It is scarce.
Therefore capital is extremely selective.

The decision as to where capital will flow is guided by country risk evaluation, which analyzes:

WHO ARE THE SOURCES AND USERS OF CAPITAL?

The only source of capital is savings.

 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, which they retain
in their businesses. These internally generated funds are usually available only for internal use by the
corporation and are not normally invested in other companies’ stocks and bonds. Thus, corporations are
not important providers of permanent funds to others in the capital 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 at a surplus are “savers” and able to invest their surpluses. Other
governments are “dis-savers” and must borrow in capital markets to fund their deficits.

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

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Sources of Capital

Retail, institutional, and foreign investors are a significant source of investment capital.

Users of Capital
Users can be both Canadian and foreign users. They can be:

1. INDIVIDUALS

Individuals may require capital to finance housing, consumer durables (e.g., automobiles, appliances) or other
types of consumption. They usually obtain it in the form of personal loans, mortgage loans or charge accounts.

2. BUSINESS

Canadian businesses require massive sums of capital to:


- To finance day-to-day operations,
- To renew and maintain plant and equipment
- To expand and diversify activities.
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A substantial part of these requirements is generated internally (e.g., profits retained in the business), while
some is borrowed from financial intermediaries (principally the chartered banks). The remainder is raised in
securities markets through the issuance of short-term money market paper, medium- and long-term debt, and
preferred and common shares.

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3. GOVERNMENTS

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

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WHAT ARE THE FINANCIAL INSTRUMENTS?

Securities have many advantages:


- Securities are formal, legal documents, which set out the rights and obligations of the buyers and sellers.
- They tend to have standard features, which facilitates their trading.

1. Debt Instruments (also referred to as fixed-income securities)


- The issuer promises to repay the loan at maturity 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.
- Examples: Bonds, debentures, mortgages, treasury bills and commercial paper.

2. 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 investor participates 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, the company may distribute part of its profit to shareowners in the form of dividends. Unlike
interest on 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.

3. Investment Funds
- An investment fund is a company or trust that manages investments for its clients.
- The most common 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 investors receive part of the money made from the fund’s investments.

4. Derivatives
- 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 or an index.
- The most common derivatives are options and forwards.

5. Other Financial Instruments


- In the past few years, investment dealers have used the concept of financial engineering to create
structured products that have various combinations of characteristics of debt, equity and investment
funds.
- Two of the most popular are linked notes and exchange-traded funds (ETFs).

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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. Long term returns on private equity typically exceed most other asset classes. But in
exchange for these returns, private equity also exposes investors to far higher risks.

A good example is venture capital. Venture capital finances businesses at a time when they produce little or no
cash flows, invest most or all revenue in more or less unproven technologies or production processes, and have
little or no assets to offer as collateral.

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

SIZE OF THE PRIVATE EQUITY MARKET

Investment minimums in the private equity market tend to be relatively high compared to the general retail
market. As a result, investments in private equity cater mostly to individuals and organizations with sizeable
portfolios and resources. For this reason, private equity investors are typically:

• Public pension plans


• Private pension plans
• Endowments
• Foundations
• High net worth investors

Its role is one of return enhancement and to a certain extent, of portfolio diversification. Return enhancement is
the reward for accepting much lower liquidity typical of private equity, particularly when compared to investing
in the common shares of highly liquid stocks like large banks or oil companies.
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WHAT ARE THE FINANCIAL MARKETS?
A well-organized market provides:
- speedy transactions and low transaction costs
- a high degree of liquidity
- effective regulation

A securities market provides a forum in which buyers and sellers meet. In the securities markets, buyers and
sellers do not meet face to face. Instead, intermediaries, such as investment advisors (IAs) or bond dealers, act
on their clients’ behalf.

Unlike most markets, a securities market may not manifest itself in a physical location. This is possible because
securities are intangible. 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.

1. Primary Market
- New securities are sold by companies and governments to investors for the first time.
- Companies can raise capital by selling stocks or bonds to investors while governments raise capital by
selling bonds.
- In this market, investors purchase securities directly from the issuing company or government. When a
company issues stocks for the very first time in the primary market, the sale is known as an initial public
offering (IPO).

2. Secondary Market
- Investors trade securities that have already been issued by companies and governments.
- In this market, buyers and sellers trade among each other at a price that is mutually beneficial to both
parties. The security is then transferred from the seller to the buyer.
- The issuing company does not receive any of the proceeds from transactions in the secondary market -
the issuer received payment when the securities were first issued in the primary market.

Auction Markets in Canada

In an auction market, buyers enter bids and sellers enter offers for a stock. The price at which a stock is traded
represents the highest price the buyer is willing to pay and the lowest price the seller is willing to accept. These
orders are than channeled to a single central market and compete against each other.

There are a number of important terms:

 The bid is the highest price a buyer is willing to pay for the security being quoted.
 The offer (or ask) is the lowest price a seller will accept.
 The spread is the difference between the bids and ask prices.
 The last price is the price at which the last trade on that stock took place. This price can fluctuate back
and forth between the bid price and the ask price as buying and selling orders are filled. The last price is
also referred to as the market price. It is important to understand that the last price may not reflect the
price for which you can currently buy or sell the stock, and only reflects the latest price at which a
purchase or sale occurred.
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Let’s see how this terminology is used on the Toronto Stock Exchange.

CANADIAN STOCK EXCHANGES

A stock exchange is a marketplace where buyers and sellers of securities meet to trade with each other and
where prices are established according to the laws of supply and demand.

On Canadian exchanges, trading is carried on in:


1. Common and preferred shares
2. Rights and warrants
3. Listed options and futures contracts
4. Instalment receipts
5. Exchange-traded funds (ETFs)
6. Income trusts, and
7. A few convertible debentures.

A liquid market is characterized by:


• Frequent sales
• Narrow price spread between bid and ask prices
• Small price fluctuations from sale to sale

Canada’s stock exchanges are auction markets. During trading hours, Canada’s exchanges receive thousands of
buy and sell orders from all parts of the country and abroad.
Canada has 5 exchanges:

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

2. TSX Venture Exchange - trades junior securities and a few debenture issues.

3. Montreal Exchange (MX, also known as the Bourse de Montréal), owned by the TMX Group Inc -
trades all financial and equity futures and options.

4. Canadian National Stock Exchange (CNSX) - trades securities of emerging companies.

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5. ICE Futures Canada - trades agricultural futures and options.
CHANGES TO THE CANADIAN EXCHANGES

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There are over 80 stock exchanges in over 60 countries around the world. Including the auction markets in
Canada, North America has 10 exchanges, Europe has in excess of 35, Central and South America, around 10,
and the balance are in Africa, Asia and Australia.
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
computer network.
- Unlike auction markets, where the individual buyer’s and seller’s orders are entered, a dealer market is 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 are less visible
than the auction markets for equities, so many people are surprised to learn that the volume of trading
(in dollars) on the dealer market for debt securities is significantly larger than the equity market.

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

TRADING IN THE UNLISTED MARKET


- Over-the-counter trading in equities is conducted in a similar manner to bond trading.
- It can be seen 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.
- These market 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 securities from
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 makers to quote bid and ask
prices provides liquidity to the system (although the market makers do have the right to refuse to trade at
these prices). When an investor wishes to buy or sell an unlisted security, the broker consults the bid/ask
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quotations of the various market makers to identify the best price, and then contacts the market maker to
complete the transaction. The broker charges a commission 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,
which trade with other corporate clients and 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 designed by the
buyer and seller. As a result, these products tend to be somewhat more complex, as special features 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 the exception.
The Ontario Securities Commission (OSC) requires that trades of unlisted securities be reported through
the Canadian Unlisted Board Inc. (CUB).
- CUB was launched as an automated 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.

Other Trading Systems


Over time, different trading systems emerged to meet changing investor needs. Examples include:

1. QUOTATION AND TRADE REPORTING SYSTEMS


Quotation and trade reporting systems (QTRS) are entities, other than an exchange or registered dealer that
disseminate price quotations for the purchase and sale of securities and report completed transactions to the
applicable securities commission. A QTRS must be recognized by a provincial securities regulatory authority.

2. ALTERNATIVE TRADING SYSTEMS


Alternative trading systems (ATSs) are privately owned computerized trading facilities that match buy and sell
orders for securities traded outside of recognized exchanges. ATSs can be owned by individual brokerage firms
or by groups of brokerage firms.

These systems compete with the exchanges because a brokerage firm operating an ATS can match orders
directly from its own inventory, or act as an agent in bringing buyers and sellers together, thus bypassing the
stock exchange. Since there 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 costs
considerably and avoid the market impact of their trades if the orders were instead traded through a regular
exchange. Some non-brokerage-owned ATSs even allow buyers and sellers to contact each other directly and
negotiate a price.

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Alternative trading systems have the potential, however, to threaten market stability due to lessened market
transparency, cross-border trading issues and technological glitches such as insufficient 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.

Fixed-Income Electronic Trading Systems

With the exception of a few debentures listed on the TSX and TSX Venture Exchanges, all bond and money
market securities are sold through dealer markets. Three fixed-income electronic trading systems launched in
Canada include:

CANDEAL
 CanDeal, a member of IIROC, is a joint venture between Canada’s six largest investment dealers, and is
operated by the TMX Group.
 It is recognized as both an ATS and an investment dealer. It offers institutional investors access to
Government securities and to money market instruments.

CBID
 CBID, also a member of IIROC and an ATS, operates two distinct fixed-income marketplaces: retail and
institutional.
 The retail fixed-income marketplace is accessible by registered dealers on behalf of retail clients.
 The institutional fixed-income marketplace is accessible by registered dealers, institutional investors,
governments and pension funds.

CANPX
 CanPX is a joint venture of Investment Industry Association of Canada (IIAC)/IIROC dealer member
firms.
 The CanPX system is an information processor for government and corporate debt securities that
provides investors with real-time bid and offer prices and hourly trade data.
 The service covers Government of Canada bonds, treasury bills, and provincial bonds, and a select list
of corporate bonds from major industrial issuers.

Trends in Financial Markets

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

 ATSs are taking market share away from traditional stock exchanges.
 Exchanges are merging and taking over other exchanges to meet the challenge of globalization. Ten
years ago, there were over 200 exchanges in the world; today there are fewer than 100.
 In addition to mergers and takeovers, exchanges are forming alliances, partnerships and electronic links
with exchanges in other countries to foster global trading.

Most of these changes were driven by increased global trading, aggressive competition, and 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 financial marketplaces are likely to
increase.

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Chapter: 2
THE CANADIAN SECURITIES INDUSTRY

 It is a regulated Industry.
 Provinces have the power to create and to enforce their own laws and regulations through securities commissions
(also called securities administrators in some provinces).
 Securities commissions delegate some of their powers to self-regulatory organizations (SROs).

SROs
 Establish and enforce industry regulations to protect investors and to maintain fair, equitable, and ethical
practices.
 SROs are responsible for setting rules governing many aspects of investment dealers’ operations, including sales,
finance, and trading.

The chart highlights the workings of the industry by showing the major participants and their relationships:

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Investors and users of capital trade financial instruments through the various financial markets (stock exchanges, money
markets, etc.). Brokers and investment dealers act as intermediaries by matching investors with the users of capital and
each side of a transaction will have its own broker or dealer who matches the trades through the markets. Trades and other
transactions are settled through organizations like CDS Clearing and Depository Services Inc. and banks. The SROs
monitor the markets to ensure fairness and transparency, and they set and enforce rules that govern market activity.
Organizations like the Canadian Investor Protection Fund (CIPF) provide insurance against insolvency while provincial
regulators oversee the markets and the SROs. Organizations like CSI provide education for industry participants.
 According to the Investment Industry Association of Canada, there were 201 firms at the end of 2011 in
the securities industry that were members of the Investment Industry Regulatory Organization of Canada
(IIROC). Together, these firms employed more than 40,000 people.

 Still, the industry is small compared to other segments of the financial services sector or even to some
companies operating within competing segments. For instance, Canada’s largest bank, Royal Bank of
Canada, employed over 68,000 people in 2011 and had total assets of $751 billion. The entire Canadian
securities industry is likewise eclipsed in size by several individual U.S. and Japanese securities houses.

 In spite of its comparatively small size, the industry has provided Canada with a capital market that is
one of the most sophisticated and efficient in the world. These qualities are measured in terms of the
variety and size of new issues brought to the market and the depth and liquidity of secondary market
trading.

 In 2011 alone, more than $320 billion in new financing was issued through Canadian securities markets,
including more than $201 billion in new federal, provincial and municipal debt securities, $77 billion in
corporate debt securities, and $42 billion in corporate equities. In 2011, more than $2,380 billion in
equity securities and more than $9,340 billion in debt securities changed hands in Canada’s secondary
markets (source: Investment Industry Association of Canada website, September 2012).

 Today the industry is highly competitive and becoming increasingly so. It calls for a high degree of
specialized knowledge about securities issuers, investors and constantly changing securities markets. An
entrepreneurial spirit of innovation and calculated risk-taking are among its hallmarks. Change and
volatility are frequently the norm.

WHAT ROLE DO FINANCIAL INTERMEDIARIES PLAY?

Intermediaries are a key component of the financial system. The term “intermediary” is used to describe any
organization that facilitates the trading or movement of the financial instruments that transfer capital between
suppliers and users.

Example:

1. Banks and Trust Companies - Concentrate on gathering funds from suppliers in the form of saving
deposits or GICs and transferring them to users in the form of mortgages, car loans and other lending
instruments

2. Insurance companies and Pension Funds - Collect funds and then invest them in bonds, equities, real
estate, etc., to meet their customers’ needs for financial security.

Investment dealers
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 acting on their clients’ behalf as agents in the transfer of instruments between different investors
 Acting as principals.

Investment dealers sometimes are known by other names, such as brokerage firms or securities houses.

Role of Investment Dealers (2 Main Functions)

1. First, investment dealers help to transfer capital from savers to users through the underwriting and
distribution of new securities. This takes place in the primary market in the form of a primary
distribution.
2. Second, investment dealers maintain secondary markets in which previously issued or outstanding
securities can be traded.

In today’s financial environment, most banks own a number of other corporations, such as investment dealers
and trust companies, as well as operating in the insurance market through subsidiaries. These activities are
becoming more and more integrated. An investor, for example, can walk into a bank today and receive advice
on purchasing mutual funds and other securities. In the same visit, a mortgage can be arranged, and life
insurance can be offered.

Overall, the expansion of chartered bank assets has been facilitated by several factors. These include:
- much greater international activity
- changes in the Bank Act permitting the banks to compete vigorously in new sectors of the financial
services industry
- the creation of more banks, notably the foreign-owned Schedule II and Schedule III banks
- the purchase of many major trust companies by banks

Types of Firms

Three categories of firms make up the Canadian securities industry:


1. Integrated firms,
2. Institutional firms,
3. Retail firms.

1. Integrated firms
 Offer products and services that cover all aspects of the industry, including full participation in both the
institutional and the retail markets.
 Most underwrite all types of federal, provincial, municipal and corporate debt and corporate equity
issues, actively trade in secondary markets including the money market, trade on all Canadian and some
foreign stock exchanges, and provide many ancillary services to securities issuers and large and small
investors.
 Such services include economic, industry, corporate and securities research and advice, portfolio
evaluation and management, merger and acquisition advice, tax counselling, loans to investors with
margin accounts and safekeeping of clients’ securities.

2. Institutional firms
 Many smaller securities dealers or “investment boutiques” specialize in such areas as stock trading,
bond trading, research on particular industries, trading only with institutional clients, unlisted stock
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trading, arbitrage, portfolio management, underwriting of junior mines, oils and industrials, mutual
funds distribution, and tax-shelter sales.
 More than 70 foreign and domestic institutional firms serve institutional clients exclusively. Foreign
firms account for about one-third of total institutional firms and include affiliates of many of the major
U.S. and European securities dealers.

3. Retail firms
 Retail firms account for the remainder of the industry. Retail firms include full-service firms and
discount brokers.
 Full-service retail firms offer a wide variety of products and services for the retail investor.
 Discount brokers execute trades for clients at reduced rates but do not provide advice. Discount brokers
are more popular with those investors who are willing to research individual companies themselves in
exchange for lower commission rates.

Organization within Firms


While the organization structure is flexible, a larger, integrated firm might be organized into the following
departments:

1. MANAGEMENT
Senior management usually include a chairman, a president, an executive vice-president, vice-presidents, some
of whom are also directors, and other directors, including, in a few firms, directors from outside the securities
industry. Most senior officers work at head office, but some may be in charge of regional branch offices in
Canada or abroad.

2. THE FRONT, MIDDLE AND BACK OFFICE


Structure of a securities firm is generally separated into three departments, the front, middle and back office to:
- To manage client portfolios
- Be in compliance with regulatory requirements
- Process trades efficiently

A) Front Office
- The front office usually includes all staff functions pertaining directly to portfolio management
activities. Accordingly, all portfolio management, trading, and sales and marketing staff would be part
of the front office.
- The primary objective of the portfolio management team is to earn a competitive rate of return on the
investor’s assets with an amount of risk that is acceptable to the investor.
- The primary responsibility of a trader is to execute effectively and efficiently the firm’s security trading
activities.
- The primary challenge for security trading is to buy or sell the requisite amount of securities at a price
that is as close as possible to the currently quoted bid or ask price.
- The success of a securities firm rests largely on profits generated by its sales department, which is
usually the largest and most geographically dispersed unit in a firm. Typically, the sales department is
divided into institutional and retail divisions.
- Institutional salespeople deal mainly with traders at major financial institutions and larger nonfinancial
companies. Working with their firm’s underwriting department, they help sell new securities issues to
institutional accounts. In co-operation with the firm’s trading department, they help generate day-to-day
trading in outstanding securities with such accounts.

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- The retail sales force serves individual investors and smaller business accounts and usually comprises
the largest single group of a firm’s employees. The activities of retail Investment Advisors (IAs) are
extremely diverse, reflecting the spectrum of investor types and needs.

To sell securities to the public, an IA must be registered with the provincial securities commission, be of legal
age, have passed the CSC and the Conduct and Practices Handbook exam, and participate in a 90-day training
program. IAs must also complete the Wealth Management Essentials Course within 30 months of their
registration.

B) Middle Office

The middle office provides functions that are critical to the efficient operation of the entire firm. The types of
duties middle-office staff perform have to do with compliance, accounting, audits and legalities. They are
responsible for ensuring that the firm’s products and services are designed and delivered in conformance with
industry best practices and pertinent regulations.

C) Back Office

The primary objective of the back office is to settle the firm’s security transactions in an efficient and effective
manner; this activity is otherwise known as the trade settlement function. Security trades are not complete until
they are “settled”. The trade settlement function fulfills the role of ensuring that all of the firm’s security

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transactions, both purchases and sales, are settled in the correct amounts, in the correct accounts (or
portfolios/funds) and at the agreed-upon time.

Investment Dealers and their Principal or Agency Functions


Investment dealers facilitate the trading or movement of the securities that transfer capital between suppliers
and users. Investment dealers sometimes act as principals, and at other times act on their clients’ behalf as
agents.

- When acting as a principal, the securities firm owns securities as part of its own inventory at some stage
in its buying and selling transactions with investors. The difference between buying and selling prices is
the dealer’s gross profit or loss.
- When acting as an agent, the broker acts for or on behalf of a buyer or a seller but does not itself own
title to the securities at any time during the transactions. The broker’s profit is the agent’s commission
charged for each transaction.

UNDERWRITING/FINANCING SECURITIES
- In the securities business, underwriting or financing mean the purchase from a government body or a
company of a new issue of securities on a given date at a specified price.
- The dealers act as principals, using their own capital to buy the issue in anticipation of being able to
make a profit when later selling it to others in the primary or new issue market.
- The dealers also accept a risk since market prices may fall during the time the securities remain in their
inventory.
- The issuer normally incurs no liability or responsibility in the sale of its own securities since payment is
guaranteed by the underwriter regardless of its success in selling the securities to investors.

OTHER PRINCIPAL TRANSACTIONS


Dealers also act as principals in secondary markets by maintaining an inventory of already issued, outstanding
securities. Here the dealer buys securities in the open market, holds them in inventory for varying periods of
time, and subsequently sells them.

There is no central marketplace for most principal or dealer market activities. Instead, transactions are routinely
conducted on the over-the-counter market by means of computer systems of inter-dealer brokers which link
dealers and large institutions.

Generally, most secondary trading of debt securities is conducted with the securities firm acting as principal,
though occasional agency trades take place. For new money market issues, for instance, a dealer may sell the
securities as an agent or, alternatively, take them into inventory as principal for later resale. The dealer provides
several useful services:

 Its knowledge of current conditions in secondary markets tempers the advice it gives about terms and
features for new issues in the primary market.
 The relative ease with which transactions can be made from their inventory, rather than waiting for
simultaneous matching buy-sell orders from other investors, adds to the liquidity of the market.
 Investment dealers may act as market makers who have the responsibility of taking positions in some
listed stocks in order to enhance market liquidity and smooth out undue price distortions.
 Some firms buy listed stocks as principals in order to accumulate large blocks of shares to permit them
to be more competitive in serving their larger institutional clients.
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 Firms also trade for their own account with the intent of making a profit.

The liquidity that investment dealers add to the secondary market also enhances the primary market, since it
helps assure buyers of new securities that they will be able to sell their holdings at reasonable prices.
BROKER OR AGENCY TRANSACTIONS
- When acting as a broker, a securities firm is an agent in a secondary securities transaction.
- The broker’s clients who buy and sell securities are, in fact, the principals or owners of the securities,
and the broker acts only as an agent, never actually owning them itself.
- Both the broker acting for the seller and the broker acting for the buyer charge their respective clients a
commission for executing a trade.
- Commission rates are negotiated between clients and their brokers. By convention, however, the term
‘broker’ may be used interchangeably to describe an investment dealer acting as a principal or an agent.

The Clearing System

During a trading day, an exchange member will be both buyer and seller of many listed stocks. Instead of each
member making a separate settlement with another member on each trade during the course of a trading day, a
designated central clearing system handles the daily settlement process between members.

In Canada, securities are cleared through CDS Clearing and Depository Services Inc. (CDS). Marketplaces
(exchanges such as the TSX and TSX Venture) and alternative trading systems (ATSs) report trades to CDS’s
clearing and settlement system, CDSX. Over-the-counter trades are also reported to CDS by participants in the
system. Participants with access to the clearing and settlement system primarily include banks, investment
dealers and trust companies.

By using a central clearing system, the number of securities and the amount of cash that has to change hands
among the various members each day is substantially reduced through a process called netting. The clearing
system establishes and confirms a credit or debit cash or security position balance for each member firm,
compiles their clearing settlement sheets and informs each member of the securities or funds it must deliver to
balance its account.

WHAT ROLES DO BANKS PLAY AS FINANCIAL INTERMEDIARIES?

All banks operate under the Bank Act, which has been regularly updated, usually through revisions every five
years. The Act sets out specifically what a bank may do and provides operating rules enabling it to function
within the regulatory framework.

In March 2010, Canada had 77 banks, made up of 22 domestic banks, 26 foreign bank subsidiaries and 29
foreign bank branches. The largest six domestic banks control more than 90% of the approximately $2.9 trillion
in assets. The Canadian banking industry is one of the largest employers in the country, making it one of
Canada’s biggest industries. However, as a result of international consolidation, the largest Canadian banks are
becoming relatively smaller when judged against their international competitors.

Banks are designated as Schedule I, Schedule II or Schedule III. Each designation has unique rules and
regulations surrounding the banks’ activities. Most Canadian-owned banks are designated as Schedule I banks
and the foreign-owned banks are either Schedule II or Schedule III banks.

Currently, voting shares of large Schedule I banks must be widely held, subject to rules that restrict the control
of any individual or group and non-NAFTA (North American Free Trade Agreement) shareholders to no more
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than 20 per cent. In contrast, a single shareholder, including a company, can control a medium-sized bank
(shareholder equity of less than $5 billion) by owning up to 65% of the voting shares, provided that the
remaining shares remain publicly traded. A small bank (shareholder equity of less than $1 billion) can be owned
by one individual or organization.
Schedule I Chartered Banks

Schedule I banks are the giants of Canada’s capital market. There are 23 Schedule I banks, with six (RBC Royal
Bank, CIBC, BMO Bank of Montreal, Scotiabank, TD Bank Financial Group and National Bank of Canada) far
out-distancing the asset size of other Canadian-owned banks and most other non-bank financial institutions.

The major banks have achieved their present asset size largely by establishing a network of more than 9,000
retail branches throughout Canada, augmented in recent years with over 50,000 automated banking machines
(ABMs), thus attracting and centralizing the savings of Canadians. They have also become major participants in
the international banking scene. Most Schedule I banks are expanding their international operations through
acquisitions of, or investments in, U.S. and other international financial institutions.

While traditional banking such as retail, commercial and corporate banking services still exist, banks today
provide a variety of services through investment dealer, insurance, mortgage, trust, mutual fund and
international subsidiaries. In addition, banks have expanded their core services to respond to the increasing
demand for wealth management services. Canadian banks offer consumer and commercial banking products
and services, including mortgages and loans, bank accounts and investments. Banks also offer financial
planning, cash management and wealth management services, some directly and some through subsidiaries.

Wealth management products and services, including mutual funds and financial planning services, have been a
growing part of banking business in recent years, as demographics in Canada provide record numbers of
investors as potential clients. Banks have become more dominant players in this field.

Services such as investment dealer activities, discount brokerage accounts, and the sale of insurance products
are handled by subsidiaries within the banking group. While banks are permitted under current legislation to
take part in diverse sectors of the financial services industry, there are controls on how they do so and on the
sharing of customer information between subsidiaries. The controls that inhibit information sharing between
various businesses and business units are commonly known as “Chinese walls.”

Example: A bank may offer chequing accounts and mortgages through a local branch. If a customer wants a
discount brokerage account, the customer would be directed to deal with the investment dealer subsidiary and
would receive all further related correspondence from that subsidiary. The bank branch would not have access
to information about the customer’s brokerage account or trades, and the investment dealer subsidiary would
not have access to the customer’s bank account or loan balances. In this way, the operations of different
businesses within the same banking group are kept quite separate.

A major activity of the banks is to loan funds to businesses and consumers at interest rates higher than the rates
they must pay in interest on deposits and other borrowings. The spread between the two sets of interest rates
covers the banks’ operating costs (rent, salaries, administration, appropriations for loan losses, etc.), as well as
providing a margin for the banks’ profits.

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Schedule II and Schedule III Banks

Schedule II banks are incorporated and operate in Canada as federally regulated foreign bank subsidiaries.
These banks may accept deposits, which may be eligible for deposit insurance provided by the Canada Deposit
and Insurance Corporation (CDIC) and may engage in all types of business permitted to a Schedule I bank.

Schedule II banks, in practice, derive their greatest share of revenue from retail banking and electronic financial
services. Examples of Schedule II banks in Canada include the AMEX Bank of Canada, Citibank Canada, and
BNP Paribas (Canada).

Schedule III banks are federally regulated foreign bank branches of foreign institutions that have been
authorized under the Bank Act to do banking business in Canada. Schedule III banks, in practice; tend to focus
on corporate and institutional finance and investment banking. Examples of Schedule III banks in Canada
include HSBC Bank USA, Comerica Bank and The Bank of New York Mellon.

By allowing foreign banks to operate in Canada, the government has facilitated the expansion in the operations
of Canadian-owned Schedule I banks abroad. The presence of foreign-owned banks in Canada also provides a
conduit for investment of foreign capital in Canada as well as providing Canadian corporate borrowers with
alternative sources of borrowed funds.

WHAT ARE TRUST COMPANIES, CREDIT UNIONS AND LIFE INSURANCE


COMPANIES?

Trust and Loan Companies


Trust companies offer a broad range of financial services, which in many cases overlap services provided by the
chartered banks. For example:
- Accept savings
- Issue term deposits
- Make personal and mortgage loans
- Sell RRSPs and other tax-deferred plans.

However, trust companies are the only corporations in Canada authorized to engage in a trust business (i.e., to
act as a trustee in charge of corporate or individual assets such as property, stocks and bonds). They also offer
estate planning and asset management.

Credit Unions and Caisses Populaires

Early in the 1900s, many individual savers and borrowers felt that chartered banks were too profit oriented. This
led to the establishment of many co-operative, member-owned credit unions in English-speaking communities
in Canada (predominantly in Ontario, Saskatchewan and British Columbia), and the parallel caisses populaires
(people’s banks) in Quebec. Frequently, credit unions seek member-savers from common interest groups such
as those in the same neighborhood, those with similar ethnic backgrounds and those from the same business or
social group.

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Credit unions and caisses populaires offer diverse services such as business and consumer deposit taking and
lending, mortgages, mutual funds, insurance, trust services, investment dealer services, and debit and credit
cards.
The federal legislation governing credit unions is the Cooperative Credit Associations Act. The act generally
limits activities of credit unions to providing financial services to their members, entities in which they have a
substantial investment and certain types of co-operative institutions, and to providing administrative,
educational and other services to cooperative credit societies.

The act requires associations to adhere to investment rules based on a “prudent portfolio approach” and
prohibits associations from acquiring substantial investments in entities other than a list of authorized financial
and quasi-financial entities. It also sets out a number of limits designed to restrict the exposure of associations
to real property and equity securities.

Insurance Companies

The Canadian insurance industry, including agents, appraisers and adjusters, employs more than 200,000
people, divided more or less evenly between the life insurance industry and the property and casualty insurance
industry. Between the two industries, more than $400 billion in assets, either directly or indirectly, is managed
on behalf of policyholders.

PRODUCTS AND SERVICES


The insurance industry has two main businesses:
1. Life insurance
 Life insurance and related products include insurance against loss of life, livelihood or health, such as
health and disability insurance, term and whole life insurance, pension plans, registered retirement
savings plans and annuities.
 The chief sources of a life insurance company’s funds are premiums on whole life, term and group
insurance policies; premiums being paid for annuities, pensions, group medical and dental care
programs; interest on policy loans and mortgages; and interest and dividends on securities and
mortgages already owned. Life insurance products may be offered through either private or group
insurance plans, often those sponsored by employers.

2. Property and Casualty insurance


 Property and casualty insurance encompasses protection against loss of property, including home, auto
and commercial business insurance. The largest aggregate premiums are generated by automobile
insurance, followed by property insurance and liability insurance.

Life insurance companies act as trustees for the funds entrusted to them by policyholders and, therefore, they
must exercise extreme caution in selecting their investments. Safety of principal is most important. Contractual
obligations will have to be met in the future and certainty of principal repayment is their first investment aim.
Historically, life insurance companies have also tried, as far as market conditions permit, to invest as much as
possible of their funds in high yielding, longer-term securities, since many of their contracts are long-term in
nature, running for the lifetime of the insured. Life insurance companies, therefore, tend to be active in both
mortgage and long-term bond markets.
Underwriting operations are the most important aspect of the insurance business in Canada. Underwriting is the
business of evaluating the risk an insurance company is willing to take from a client in exchange for insurance
premiums, followed by the acceptance of the associated responsibility for fulfilling the terms of the insurance
contract.

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The other significant aspect of the insurance business is acting as agent or broker for other underwriters. Such
companies sell insurance policies underwritten by other firms. Reinsurance, the business of exchanging risk
between insurance companies to facilitate better risk management, is a relatively small part of the Canadian
insurance market, although it is an increasingly important business globally.
INSURANCE REGULATION

The key federal legislation governing insurance companies is the Insurance Companies Act. The bill
establishing the Act was proclaimed June 1, 1992.

The legislation permits life insurance companies to explicitly own trust and loan companies, and thus enter new
financial businesses through subsidiaries. Similarly, widely held institutions such as mutual insurance
companies would be permitted to own Schedule I banks. Insurance companies are also allowed to hold a range
of other types of corporations. While companies will have enhanced powers to make consumer and corporate
loans, the Act contains a number of restrictions on activities such as in-house trust services and deposit-taking.
It also continues the practice of allowing only life companies to offer annuities and segregated funds.

The Act also requires insurance companies to adhere to investment rules based on a “prudent portfolio
approach” which replaces the “legal for life” rules. Companies are prohibited from acquiring substantial
investments in entities other than a list of authorized financial and quasi financial entities. The Act also sets out
a number of portfolio limits designed to limit exposure to real property and equity securities.

A number of insurance companies are wholly owned by the Canadian Schedule I banks. Although these large
domestic banks have established their own insurance subsidiaries, the Bank Act does not permit the selling of
insurance through their branch networks, with the exception of insurance related to loans such as mortgage
insurance and loan insurance.

WHAT ARE INVESTMENT FUNDS, SAVINGS BANKS, SALES FINANCE AND


CONSUMER LOAN COMPANIES, AND PENSION PLANS?

The organizations described earlier are not the only intermediaries of financial products. These also play a
significant role in the Canadian financial services industry and can be categorized in the following ways:

1. Investment Funds: Investment funds are companies or trusts that sell shares (often called units)
to the public and invest the proceeds in a diverse securities portfolio. Closed-End Funds typically
issue shares only at start-up or at other infrequent periods, while Open-End Funds (or mutual
funds) continually issue shares to investors and redeem these shares on demand. Of the two
types of funds, mutual funds are much larger, accounting for close to 95% of aggregate funds
invested.

2. Savings Banks: The Alberta Treasury Branches (ATB) were formed in 1938 when chartered
banks pulled out their branches from many smaller towns. The ATB became a provincial crown
corporation in 1997 and became ATB Financial in 2002 providing a full range of financial services
to Albertans.

3. Sales Finance and Consumer Loan Companies: Such companies make direct cash loans to
consumers who usually repay principal and interest in instalments. They also purchase, at a
discount, instalment sales contracts from retailers and dealers when such items as new cars,
appliances or home improvements are bought on instalment plans.

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4. Pension Plans: There has been a remarkable growth in the institutionalization of savings through
pension plans during the past 55 years. Canada’s changing demographic landscape has focused
public attention on the future viability of the Canada Pension Plan (CPP) and Québec Pension
Plans (QPP).

Chapter: 3
THE CANADIAN REGULATORY ENVIRONMENT

WHO ARE THE REGULATORS?

We will examine the regulatory role played by:


1. Federal Regulators
2. The Provincial Securities Regulators
3. The self-regulatory organizations (the SROs)
4. The various investor protection funds.

Federal Regulators

THE OFFICE OF THE SUPERINTENDENT OF FINANCIAL INSTITUTIONS

The Office of the Superintendent of Financial Institutions (OSFI) is a regulatory body for all federally regulated
financial institutions. OSFI is responsible for regulating and supervising:
 153 deposit-taking institutions including banks, trust and loan companies, and cooperative credit
associations
 284 insurance companies, including life insurance companies, fraternal benefit societies and property &
casualty insurance companies
 29 foreign bank representative offices that are chartered, licensed or registered by the federal
government
 1,200 federally regulated pension plans.

OSFI does not regulate the Canadian securities industry.

CANADA DEPOSIT INSURANCE CORPORATION (CDIC)

The Canada Deposit Insurance Corporation (CDIC) is a federal Crown Corporation that provides deposit
insurance and contributes to the stability of Canada’s financial system. CDIC insures eligible deposits up to
$100,000 per depositor in each member institution (banks, trust companies and loan companies), and
reimburses depositors for the amount of any insured deposits if a member institution fails.

To be eligible for insurance, deposits must be held with a member institution in Canadian currency and payable
in Canada. Term deposits must be repayable no later than five years from the date of deposit. The $100,000
maximum includes all insurable types of deposits you have with the same CDIC member. Deposits at different
branches of the same member institution are not insured separately.

Accounts and products insured by CDIC include:


• Savings and chequing accounts
• Guaranteed investment certificates (GICs) and other term deposits that mature in five years or less
• Money orders, certified cheques, traveller’s cheques and bank drafts
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• Accounts that hold realty taxes on mortgaged properties

These accounts and products must be held at a CDIC member and in Canadian dollars to be eligible for deposit
insurance.

CDIC does not insure:


• Mutual funds and stocks
• GICs and other term deposits that mature in more than five years
• Bonds and Treasury bills
• Debentures issued by governments, corporations, or chartered banks
• Deposits held in foreign currency

It is possible to have more than $100,000 in deposits eligible for CDIC coverage, provided the deposits are held
in more than one of CDIC’s six deposit insurance categories. These categories include deposits held:
• In one name
• Jointly in more than one name
• In a trust account
• In a registered retirement savings plan (RRSP)
• In a registered retirement income fund (RRIF)
• In a mortgage tax account

Example: If a depositor has $80,000 cash on deposit in her own name and in the same institution $120,000 on
deposit in a registered retirement savings plan, CDIC would insure her deposits in the amount of $180,000
($80,000 fully covered for the cash deposit in her own name and a maximum of $100,000 covered for her
registered retirement savings plan).

Since 1967, CDIC has provided protection to depositors in 43 member institution failures. As of April 30, 2011,
the CDIC insured more than $622 billion in deposits.

The Provincial Regulators

In Canada, the regulation of the securities business is a provincial responsibility. Each province and the three
territories is responsible for creating the legislation and regulation under which the industry must operate. In
several provinces, much of the day-to-day regulation is delegated to Securities Commissions. In other
provinces, securities administrators, who are appointed by the province, take on the regulatory function.

In Québec, the regulatory body is neither a securities commission nor a securities administrator and its power is
not limited to the securities industry only. The Autorité des marchés financiers (AMF) is responsible for
administering the regulatory framework for Québec’s financial sector, notably in the areas of insurance, deposit
insurance institutions, the distribution of financial products, financial services, and securities.

The 13 securities regulators of Canada’s provinces and territories joined together to form the Canadian
Securities Administrators (CSA), a forum to co-ordinate and harmonize regulation of the Canadian capital
markets. The mission of the CSA is to give Canada a securities regulatory system that protects investors from
unfair, improper or fraudulent practices and that fosters fair, efficient and vibrant capital markets.

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PROVINCIAL INSURANCE CORPORATIONS
In each province, one or more organizations exist to protect the deposits of credit union members. This
organization may be called a deposit insurance or deposit guarantee corporation or stabilization fund,
corporation, board or central credit union. Terms and maximum coverage may vary by province, so it is
important to check with your province to determine the specific coverage available.

OVERVIEW OF TERMS AND COVERAGE IN THREE CANADIAN PROVINCES

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