The Capital Market



1 The Capital Market

What is Investment Capital? • Characteristics of Capital • Why Capital Is Needed Who are the Sources and Users of Capital? • Sources of Capital • Users of Capital What are the Financial Instruments? • Debt Instruments • Equity Instruments • Investment Funds • Derivatives and Other Financial Instruments What are the Financial Markets? • Auction Markets in Canada • Stock Exchanges Around the World • Dealer Markets • Private Equity • Trends in Financial Markets Summary



and describe how auction markets and dealer markets work. products and intermediaries. The emphasis throughout the course. and how they are used as part of a well-planned portfolio of investments. the Internet. The industry grows and evolves to meet the ever-changing needs of Canadian investors. we offer a suggestion: stay informed about the markets and the industry because it will help you better understand the material presented in this textbook. this will help you achieve your goal of becoming an informed and effective participant in the securities industry. In some way. such as banks. books and magazines. Explain what private equity is. For those new to this material. both from domestic and international perspectives. businesses. have evolved to make the transfer process efficient. how it has grown and the different ways of investing in this market. Differentiate between the types of financial instruments used in capital transactions. Explain the role of financial markets in the Canadian financial services industry. governments and foreign agencies supply and use capital in the economy. is on securities. The course material will be that much easier to grasp if you can relate it to the activity that unfolds each day in the financial markets. Define investment capital and describe its role in the economy. There are countless sources of financial market information. including newspapers. 5. you should be able to: 1.LEARNING OBJECTIVES By the end of this chapter. The text examines the main types of investment products. (2010) 1•3 . we are all affected by the securities industry. distinguish among the types of financial markets. Describe how individuals. how they are sold. 2. 3. Financial intermediaries. 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). however. This capital transfer process is made possible through the use of a variety of financial instruments: stocks. 4. © CSI GLOBAL EDUCATION INC. The first two chapters of this textbook focus on the three central elements of the securities industry: investment markets. bonds. Ultimately. THE CAPITAL MARKET The Canadian securities industry plays a significant role in sustaining and expanding the Canadian economy. mutual funds and derivatives. trust companies and investment dealers. how to analyze them.

(CUB) CanDeal Can PX Capital CBID Common shares Dealer markets Debt Derivative Equity ICE Futures Canada Institutional Investors Investment advisors (IAs) Investment fund Market capitalization Market makers Mutual fund Open-end fund Option Participating Organizations Personal disposable income Preferred shares Primary market Quotation and trade reporting systems (QTRS) Retail investors Secondary market Stock exchange Toronto Stock Exchange (TSX) TSX Venture Exchange 1•4 © CSI GLOBAL EDUCATION INC.KEY TERMS Alternative trading systems (ATSs) Approved Participants Auction market Bourse de Montréal Budget Canadian National Stock Exchange (CNSX) Canadian Unlisted Board Inc. (2010) .

capital is wealth – both real. Such investment is normally made with the assistance of the retail or institutional sales department of the investment advisor’s firm. and representational items such as money. All of these items have economic value. or a domestic or foreign company paying start-up costs for a plant to produce a new product. (2010) . which analyzes such things as: • • • • • • The political environment – whether the country is involved or likely to be involved in internal or external conflict Economic trends – growth in gross domestic product. Capital savings can also be harnessed indirectly through the purchase of such representational items as stocks or bonds or through the deposit of savings in a financial institution. Only when they are harnessed productively do they gain economic significance. It is mobile. corporations. Capital savings can be used directly by. stocks and bonds. sensitive to its environment and scarce. who in turn use the funds for direct productive investment – equipment. material things such as land and buildings. The decision as to where capital will flow is guided by country risk evaluation. etc. Indirect investment occurs when the saver buys the securities issued by governments and corporations. economic activity is not over-regulated. supplies. governments and many other organizations and associations. inflation rate. Such utilization may take the form of either direct or indirect investment. for example. a government investing in a new highway or hospital. a couple investing their savings in a home. levels of economic activity. The indirect investment process is the principal focus of this course. It attempts to settle in countries or locations where government is stable. the investment climate is hospitable and profitable investment opportunities exist. Characteristics of Capital Capital has three important characteristics. etc.ONE • THE CAPITAL MARKET 1•5 WHAT IS INVESTMENT CAPITAL? In general terms. Capital represents the invested savings of individuals. Therefore capital is extremely selective. Fiscal policy – levels of taxes and government spending and the degree to which the government encourages savings and investment Monetary policy – the sound management of the growth of the nation’s money supply and the extent to which it promotes price and foreign exchange stability Opportunities for investment and satisfactory returns on investment when considering the risks to be accepted Characteristics of the labour force – whether it is skilled and productive © CSI GLOBAL EDUCATION INC. It is in short supply and is arguably the world’s most important commodity. Capital savings are useless by themselves.

If capital investment is inadequate.1•6 CANADIAN SECURITIES COURSE • VOLUME 1 Because of its mobility and sensitivity. food distributors and machinery manufacturers. trade barriers. both corporations and private investors. These proposed changes are designed to encourage more saving and the investment of savings in productive plant and equipment. therefore. Both federal and provincial governments. 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. to postpone consumption now in order to save so that they can consume in the future. the result will be insufficient output. lower living standards. have long regarded Canada as a good place to invest. When revenues of non-financial corporations. capital moves to uses and users that offer the highest risk-adjusted returns. governments and non-residents exceed their expenditures. have been running deficits and. It moves to where the best use can be made of it and attempts to avoid areas where the above factors are not positive. Enough new and efficient plant and equipment must be put in place to ensure expanded output capability. declining productivity. Capital is scarce worldwide and it cannot be increased synthetically or by government decree. The industry advocates changes. WHO ARE THE SOURCES AND USERS OF CAPITAL? The only source of capital is savings. until recently. etc. exchange policy. individuals. rising unemployment. © CSI GLOBAL EDUCATION INC. capital moves in or out of countries or localities in anticipation of changes in taxation. improved productivity. regulations. The securities industry attaches great importance to the savings and investment process. when appropriate. corporations are not important providers of permanent funds to others in the capital market. government attitudes. Thus. Non-financial corporations. It is in great demand everywhere. they have savings to invest. (2010) . soughtafter new products. Thus. especially if given incentives to do so. Most governments also own or control Crown corporations or agencies that may generate retained earnings for investment. have historically generated the largest part of total savings mainly in the form of earnings. Canada has traditionally relied on savings for both direct plant and equipment investment in Canada and portfolio investment in Canadian securities. Governments that are able to operate at a surplus are “savers” and able to invest their surpluses. increased competitiveness and the development of innovative. It is constantly in touch with governments with a view to improving the saving and investment process. Why Capital Is Needed An adequate supply of capital is essential for Canada’s future well-being. Individuals may decide. have not been significant suppliers of investment capital. such as steel makers. Non-residents. decreasing competitiveness in domestic and international markets – in short. in both government policies and the tax system. which they retain in their businesses. Other governments are “dis-savers” and must borrow in capital markets to meet their deficits.

and mining and smelting. They feel that foreign investment leads to long-term outflows of interest and dividend payments. while necessary. registered retirement savings plans. Institutional investors are organizations. (2010) . etc. has its costs. Canadian investors’ holdings of securities have doubled to more than $600 billion today. Ten years ago. or subsidiaries in other countries over their Canadian subsidiaries in the pursuit of export markets. credit unions and investment dealers. individual Canadians had just over $500 billion in personal savings deposits at the chartered banks alone (Source: Bloomberg). retirement plans. continue. Foreign direct investment in Canada has tended to concentrate in particular industries: manufacturing.g. Canada has depended upon large inflows of foreign investment for continued growth. Some Canadian economic nationalists feel that direct foreign investment implies control.. 22% of the average investor’s financial assets (bank accounts. agriculture. and not for another company or organization. no doubt. such as a pension fund or mutual fund company. insurance. The Canadian Government and the business community recognize that foreign capital continues to be needed and that foreign investors must be made to feel that Canada is a safe and attractive country in which to invest. Retail investors are individual investors who buy and sell securities for their own personal accounts. by the end of 2007. They had many more billions of dollars at other financial intermediaries such as trust companies. They also fear that foreign owners may favour their own domestic plants. © CSI GLOBAL EDUCATION INC. construction.) were stocks. Historically. The debate on the appropriate level of foreign investment in Canada will. Canada’s use of foreign investment. Today. etc. Foreign investors also are a significant source of investment capital. equity in homes and businesses. Over the past ten years. Some industries also have restrictions with respect to foreign investment. Canadians also have other substantial assets in the form of securities investments made either directly or indirectly through investment funds and pension plans. pension. utilities). cash values of insurance policies. negatively affecting our international balance of payments. that trade large volumes of securities and typically have a steady flow of money to invest. Retail investors generally buy in smaller quantities than larger. petroleum and natural gas. research and development efforts. But over the past 20 years there has been a significant swing in government policy away from the protection of Canadian businesses. There are many industries that are largely Canadian-controlled (e. finance. institutional investors. and in plant closings or layoffs during recessions.ONE • THE CAPITAL MARKET 1•7 Sources of Capital Retail and institutional investors are a significant source of investment capital. this share has grown to 30%. transportation. For example. Canadians are increasingly turning to the securities industry to ensure their prosperity and future retirement security. merchandising.

and longterm debt. individual capital users are not discussed further. Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs). © CSI GLOBAL EDUCATION INC. Hydro Québec. The government makes use of four main instruments: treasury bills (T-bills). PROVINCIAL AND MUNICIPAL GOVERNMENTS Like the federal government. capital can flow in the other direction. marketable bonds. the federal government must borrow. which in turn results in a projection of a budget surplus or budget deficit. These instruments are discussed in detail in later chapters. Access to foreign securities benefits Canadian investors. Since individuals do not issue securities to the public and the focus of this text is on securities. consumer durables (e. BUSINESSES Canadian businesses require massive sums of capital to finance day-to-day operations.. When revenues fail to meet expenditures and/or when large capital projects are planned. businesses or governments can supply capital to Canada. medium.. either directly or through guaranteeing the debt of their Crown corporations. A substantial part of these requirements is generated internally (e. Each year the Minister of Finance presents the government’s budget to Parliament. businesses and governments. while some is borrowed from financial intermediaries (principally the chartered banks). THE FEDERAL GOVERNMENT Governments in Canada are major issuers of securities in public markets. The ways in which these groups use capital are described below. profits retained in the business). the provinces issue debt directly themselves and may guarantee unconditionally the interest and principal of securities issued by their Crown corporations. The remainder is raised in securities markets through the issuance of short-term money market paper.1•8 CANADIAN SECURITIES COURSE • VOLUME 1 Users of Capital Based on the simplest categorization. to renew and maintain plant and equipment as well as to expand and diversify activities. the users of capital are individuals. Foreign users (mainly businesses and governments) may access Canadian capital by borrowing from Canadian banks or by making their securities available to the Canadian market. The budget details the government’s estimate of its revenues and expenses. automobiles. mortgage loans or charge accounts. Just as foreign individuals. appliances) or other types of consumption. and preferred and common shares. Foreign users will want Canadian capital if they feel that they can access this capital at a less expensive rate than their own currency. and New Brunswick Electric Power Commission.g. who are thus provided with more choice and an opportunity to further diversify their investments. (2010) . INDIVIDUALS Individuals may require capital to finance housing. They usually obtain it through incurring indebtedness in the form of personal loans.g. The characteristics of each of these instruments are discussed in detail in the material on fixed-income products. such as the Alberta Municipal Financing Corporation. These can be both Canadian and foreign users.

provinces must borrow. The other two components. (2010) . Bonds. and in the interim makes interest payments to the investor. debentures. payable in U.e. Securities are formal. They tend to have standard features. police and fire protection. there are many types of securities. some provinces issue their own short-term treasury bills and. The following brief discussion of instruments is included here to remind the reader that financial instruments (products) are one of the three key components of the securities industry. Complete the on-line activity associated with this section. a province may also issue marketable debentures. Debt Instruments Debt instruments formalize a relationship in which the issuer promises to repay the loan at maturity. The term bond is sometimes used colloquially to refer to both bonds and debentures. They may issue non-marketable bonds (i. bonds that do not trade in the secondary markets) to the federal government or borrow funds from Canada Pension Plan (CPP) assets (or the Québec Pension Plan in the case of Québec). and some educational and religious organizations. Since many of the assets used to provide these services are expected to last for twenty or more years. distribution of electricity and other services for individual communities. will be covered in subsequent chapters. currency in the American market or in other currencies in international markets. many corporations. mortgages. Furthermore. sewers. financial markets and financial intermediaries. Municipalities are responsible for the provision of streets. enabling both investors (buyers) and users (sellers) of capital to meet their particular needs. transportation. in some cases. their own savings bonds similar to CSBs issued by the federal government. sophisticated economy. welfare. treasury bills and commercial paper are all examples of debt instruments (also referred to as fixed-income securities). municipalities attempt to spread their cost over a period of years through the issuance of instalment debentures (or serial debentures). legal documents. which set out the rights and obligations of the buyers and sellers. A bond is secured by specific assets © CSI GLOBAL EDUCATION INC. Much of this text deals with the characteristics of different financial instruments. In addition to conventional debt issues. Bonds and debentures are among the most common forms of debt instrument.ONE • THE CAPITAL MARKET 1• 9 When revenues fail to meet expenditures and/or when large capital projects are planned. a province may issue debt domestically through a syndicate of investment dealers who sell the issue to financial institutions or to retail investors. waterworks.S. Why then do we need formal financial instruments called securities? As a way of distributing capital in a large. They are issued by all levels of government. The term of the loan ranges from very short to very long. securities have many advantages. WHAT ARE THE FINANCIAL INSTRUMENTS? Transferring money from one person to another may seem relatively straightforward.. depending on the type of instrument. but these two instruments differ in terms of how they are secured. Alternatively. As an alternative to domestic issues. which facilitates their trading.

Different types of shares have different characteristics and confer different rights on the owners. however. to buy or sell a certain quantity of an underlying instrument at a set price for a set period of time. which many individual investors could not afford to do directly. should the firm wind up its affairs. but it is under no obligation to do so. In general. such as a stock or an index. but not the obligation. For example. The Canadian market offers a wide and ever-expanding range of mutual funds. In addition. (2010) . The fund raises capital by selling shares or units to investors. Options and futures enable investors to profit or protect themselves from changes in the underlying instrument’s price. The most common form is the open-end fund. however. and then invests that capital. Investment Funds An investment fund is a company or trust that manages investments for its clients. requires a high degree of knowledge. preferred shareholders have a prior claim on the assets of the company before common shareholders. Unlike common shareholders. owners of preferred shares generally are entitled to a fixed dividend that must be paid out of earnings before any dividend is paid to common shareowners. For example. As unitholders. dividends are not obligatory. however. The key advantages of investment funds are that they are professionally managed and provide a relatively inexpensive way to diversify a portfolio. Equity Instruments Equities are usually referred to as stocks or shares because the investor actually buys a “share” of the company. As well. the investors receive part of the money made from the fund’s investments. If the company does well. the company may distribute part of its profit to shareowners in the form of dividends.1•10 CANADIAN SECURITIES COURSE • VOLUME 1 of the issuer. In contrast. while a debenture is secured only by the general credit of the issuer and not by a specific pledge of assets. The company may issue a dividend to common shareholders when business is profitable. Derivatives are products based on or derived from an underlying instrument. an equity fund may invest in hundreds of stocks. the value of the company may increase. there are two main types of stock: common and preferred. giving the investor a capital gain when the shares are sold. As an owner. The wide range of option-trading strategies makes them useful for many investors. derivatives are suited mainly for more sophisticated investors. Ownership of a company’s common shares (or stock) usually gives shareholders the right to vote at the company’s annual meeting and also a claim on its profits. also known as a mutual fund. Successful trading. © CSI GLOBAL EDUCATION INC. These securities are discussed in more detail in the chapter on fixedincome securities. thus gaining an ownership stake in the company. preferred shareholders usually have no vote on the direction of management unless the company fails to pay preferred dividends. the investor participates in the corporation’s fortunes. Derivatives and Other Financial Instruments Unlike stocks and bonds. Unlike interest on a debt instrument. an option grants the holder the right.

depend on the existence of efficient markets in which these securities can be bought and sold. This is possible because securities are intangible – at best. benefiting both. For example. however. investment dealers have used the concept of financial engineering to create hybrid products that have various combinations of characteristics of debt.and telephone-based network of dealers who may never see their counterparts’ faces. such as a business or government. a company will use an initial public offering (IPO) to sell common shares to the public for the very first time. all exchanges are electronic. buyers and sellers do not meet face to face. and other products. Instead. securities are sold on primary and secondary markets. Auction Markets in Canada Markets can also be divided into auction and dealer markets. Many of the benefits of investment products. act on their clients’ behalf. In Canada. a securities market may not manifest itself in a physical location. But there are important differences. exist in “cyberspace” as a computer. intermediaries. a securities market provides a forum in which buyers and sellers meet. The prices of all transactions on an auction market are publicly visible. equity and investment funds. It enables investors who originally bought the investment products to sell them and obtain cash. Without secondary market liquidity – the ability to sell the securities with ease at a reasonable price – investors would not buy securities in the primary market. © CSI GLOBAL EDUCATION INC. For example. Of course. In addition. These instruments. The primary market is the market where a security is sold when it is first issued and sold to investors. will be discussed in later chapters. Other securities markets. bond markets and money markets. receives capital from investors. Like a farmers’ market. A well-organized market provides speedy transactions and low transaction costs. along with a high degree of liquidity and effective regulation. It is on this market that the user of capital. The capital market or securities market is made up of many individual markets. In the securities markets. while the offer (or ask) is the lowest price a seller will accept. and often not even that. clients’ bids and offers for a stock are channelled to a single central market and compete against each other. such as investment advisors (IAs) or bond dealers. In an auction market. Both of these types of securities trade on stock exchanges. Canada’s stock exchanges are auction markets. Two of the most popular are income trusts and exchange-traded funds. WHAT ARE THE FINANCIAL MARKETS? Securities are a key element in the efficient transfer of capital from savers to users.ONE • THE CAPITAL MARKET 1•11 In the past few years. Brokerage firms usually act as agents for their clients. pieces of paper. Unlike most markets. The secondary market is extremely important. (2010) . there are stock markets. Subsequent trading takes place in the secondary market and it is here where individual investors trade among themselves. The bid is the highest price a buyer is willing to pay for the security being quoted. some securities markets do have a physical component. such as the bond market.

Each exchange is responsible for the trading of certain products.S. and European exchanges. Liquidity is fundamental to the operation of an exchange. A liquid market is characterized by: • • • Frequent sales Narrow price spread between bid and offering prices Small price fluctuations from sale to sale During trading hours. the Canadian National Stock Exchange (CNSX). CNSX provides an alternative equities market to the TSX Venture Exchange for emerging companies. trading is carried on in common and preferred shares. The Montréal Exchange trades all financial and equity futures and options. the Montréal Exchange (MX also known as the Bourse de Montréal). (2010) . More recently. exchange-traded funds (ETFs). On some U. income trusts. formerly the Canadian Trading and Quotation System (CNQ). Canada has five exchanges: the Toronto Stock Exchange (TSX) and the TSX Venture Exchange. owned by the TMX Group Inc. bonds and debentures are traded along with equities. • • • • • The TSX lists senior equities. The TSX Venture Exchange trades junior securities and a few debenture issues. the trading floors of the exchanges have been the focal points for trading in equities.1•12 CANADIAN SECURITIES COURSE • VOLUME 1 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. Canada’s exchanges receive thousands of buy and sell orders from all parts of the country and abroad. © CSI GLOBAL EDUCATION INC. The ICE Futures Canada trades agricultural futures and options. listed options and futures contracts. there has been a trend to use computerized systems for trading. and a few convertible debentures. instalment receipts. On Canadian exchanges. income trusts and ETFs. rights and warrants. some debt instruments that are convertible into a listed equity. and the ICE Futures Canada. Traditionally..

1 TOTAL SHARE VOLUME AND DOLLAR VALUE OF TRANSACTIONS FOR ALL STOCK EXCHANGES IN CANADA Comparative Share Volumes (millions) Exchange Toronto TSX Venture CNSX Total Shares 2007 96.41 2.9 37.00 Comparative Dollar Values of Transactions (millions) Exchange Toronto TSX Venture CNSX Total Value Source: Bloomberg 2007 1. The seat itself is a valid and valuable asset that may be sold or leased subject to conditions in the exchange’s by-laws. Historically.286.970. and key personnel (officers and directors and all others who deal with the public) must complete required courses of study.4 % 68.382.693.58 0.00 2006 82.29 0.742. © CSI GLOBAL EDUCATION INC.0 % 64.1 provides the share volume and dollar value of listed trading on Canada’s stock exchanges.8 1. TABLE 1.” and do not have to be shareholders.4 31.8 70.147. a firm had to own a “seat.648.3 100. Member firms may be publicly owned. 4 0. memberships are sold to different individuals.” The term seat originated with the old practice of brokers trading securities while seated around a table.0 53.5 % 97.448.7 149.0 1. There are currently two types of exchange ownership. Firms who have access to the trading facilities are known as “Participating Organizations” or “Approved Participants. in which the firm must own a seat to be a member.ONE • THE CAPITAL MARKET 1•13 Table 1.108.2 251.00 2006 1. The second type of exchange ownership is a for-profit private company.185.049. Each exchange sets its own requirements for permitting access to trading facilities.500.3 119. (2010) .4 381. All Canadian exchanges are set up as for-profit companies. The TMX Group became the first North American exchange to become a publicly listed company.857. One is the original not-for-profit membership. The Toronto Stock Exchange became a forprofit private company in 2000.00 EXCHANGE MEMBERSHIPS When a stock exchange is founded.415. in order to trade on an exchange.2 100.5 0.4 % 97.2 44.697.2 35.5 226.6 33. the term means a right of entrance to a stock exchange. where the exchange is owned by shareholders. Today.70 2.994.01 100.01 100. There are requirements regarding the amount of capital necessary to carry on business.

sustaining fees paid annually by corporations to keep listings in good standing. officers and employees. around 10. the president) plus some experienced senior executives from the member firms who serve as Directors for stipulated terms of office. The provincial securities acts allow the exchanges to exercise considerable self-regulation. Europe has in excess of 35. Stock Exchanges Around the World There are over 80 stock exchanges in over 60 nations. HOW EXCHANGES ARE FINANCED Sources of income used to meet operating and development costs include: • • • • • transaction fees paid for each order executed on the exchange. Included on each board are two to six highly qualified Public Governors appointed or elected from outside the brokerage community. and the balance are in Africa. Each board is comprised of at least one permanent exchange official (e. (2010) . down slightly from 2006. Central and South America. North America has 10 exchanges. Usually a good gauge of a country’s economy is the size and organization of its exchanges. The World Federation of Exchanges reports that the New York Stock Exchange (NYSE) was the largest stock exchange in the world in 2007 in terms of domestic market capitalization – a reflection of the comprehensive value of the stock exchange at that time.1•14 CANADIAN SECURITIES COURSE • VOLUME 1 GOVERNING BODIES The administration and policy setting of the exchanges are the responsibilities of each exchange’s Board of Directors. and they assist in the screening of statements of material facts or exchange offering prospectuses which are frequently accepted by securities commissions in lieu of standard prospectuses for some types of distributions on the exchanges. fees paid by corporations subsequent to listing with respect to any changes in capital structure. Asia and Australia.g. © CSI GLOBAL EDUCATION INC. Public Governors represent the interests of investors as a whole. These exchanges define acceptable standards of behaviour for member firms and their directors. and the sale of historical trading and market information. The TSX ranked eighth. They set listing and reporting requirements for listed companies. and provide governing bodies with outside points of view and expertise. as well as listed companies.. They also have established extensive rules for trading securities and any other approved instruments on the exchange. fees paid by corporations when their securities are originally listed.

198 1.069. Shanghai SE 7.650 3.ONE • THE CAPITAL MARKET 1•15 Table 1. Euronext 4.467. Hong Kong Exchanges 8.832 4. Deutsche Borse NYSE Group 2.685 4. Bombay SE Source: World Federation of Exchanges.760 15.136.634.333. © CSI GLOBAL EDUCATION INC. TABLE 1.909.851.2 THE TEN LARGEST STOCK MARKETS IN THE WORLD .910 1.485 Tokyo SE Group 3. Dollars) Domestic Market Capitalization 15.147 5.2 shows the ten largest stock markets in the world by domestic market capitalization and by total value of shares traded.650.550 2.705 3.105.101 Total Value of Trading 29.654.186.013.416 2.933 6.2007 (In Millions of U.928 343.S. www. TSX Group 9.891.775 Exchange 1. NASDAQ 5.869 4.348 2. (2010) .921 4. London SE 6.320.222.679 4.694.639.330.133 10.

the Toronto Stock Exchange also joined the Global Equity Market Alliance with seven other stock exchanges to discuss the creation of a round-the-clock. This new market also consolidated the operations of the Canadian Dealing Network (CDN) as of October 2000. Responsibility for all equities once traded on Montréal transferred to the TSX or the TSX Venture Exchange. and this resulted in three specialized exchanges: • The Toronto Stock Exchange became Canada’s senior equities market and gave up its participation in derivatives trading and the junior equity market. Canada’s four major stock exchanges announced that they had reached an agreement to restructure along lines of market specialization. The intent of CNSX is to provide an alternative market to the TSX Venture Exchange for emerging companies. the TSX (now the TMX Group) Group Inc. • The Montréal Exchange became the exclusive exchange for financial futures and options in Canada. These changes were part of a rebranding initiative as the TSX and its subsidiaries prepared to go public in the fall of 2002. During the year 2000. The restructuring was intended to ensure a strong and globally competitive market system. the Canadian Trading and Quotation System gained recognition as a stock exchange by the Ontario Securities Commission. called the Canadian Venture Exchange (CDNX). the TSX. went public.1 CHANGES TO THE CANADIAN STOCK EXCHANGES Securities trading has existed in Canada since 1832. The late 1990s saw radical changes to securities trading in Canada. Trading on CNSX is also regulated by IIROC in the same way as the other Canadian exchanges and must therefore follow the Universal Market Integrity Rules (UMIR). while CDNX was renamed the TSX Venture Exchange. Over the years there have been many changes. CNSX also has its own trading rules and policies in addition to UMIR. becoming the first listed stock exchange in North America. national junior equities market. In November 2002. The exchange also has minimum quotation requirements for public float and business activity that are less stringent than those of the TSX Venture Exchange. TSX Venture Exchange and TSX Markets Inc. the Toronto Stock Exchange rebranded its abbreviated name from the TSE to TSX. Under the rebranding program. The Canadian Venture Exchange became a wholly owned subsidiary of the Toronto Stock Exchange in 2001. global marketplace. (2010) .1•16 CANADIAN SECURITIES COURSE • VOLUME 1 EXHIBIT 1. In April 2002. (the arm of the TSX that sell market information and trading services) are collectively known as the TSX Group of companies.) and must comply with CNSX’s trading and sales practice rules. In 2004. the Winnipeg Stock Exchange and the Vancouver Stock Exchange merged to create a single. In March 1999. © CSI GLOBAL EDUCATION INC. CNSX is based on a combination of auction and dealer markets and liquidity is enhanced on a securityby-security basis via market makers. the TSX and the Montréal Exchange merged to form the TMX Group. Dealers accessing this marketplace are required to be members of the Investment Industry Regulatory Organization (IIROC) of Canada (formerly the Investment Dealers Association and Market Regulation Services Inc. • The Alberta Stock Exchange. In 2008.

This market has no trading floor and no regular trading hours. these products tend to be somewhat more complex. individual investors’ orders are not entered into the market or displayed on the computer system. as special features are added to the basic properties of options and forwards. 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). (2010) . Unlike auction markets. who trade with other corporate clients and other financial institutions. Instead. such as banks and brokerage houses. TRADING IN THE UNLISTED MARKET Over-the-counter trading in equities is conducted in a similar manner to bond trading.” They sell from this inventory to buyers and add to the inventory when they acquire securities from sellers. The OTC derivative market is dominated by financial institutions. who are acting as market makers. Almost all bonds and debentures are sold through dealer markets. Many of the stocks sold on the unlisted market are more speculative. The broker charges a commission for this service. Many junior issues trade OTC. As a result. the broker consults the bid/ask quotations of the various market makers to identify the best price.ONE • THE CAPITAL MARKET 1•17 Dealer Markets Dealer markets are the second major type of market on which securities trade. 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. where the individual buyer’s orders are entered. © CSI GLOBAL EDUCATION INC. OVER-THE-COUNTER DERIVATIVES MARKET Derivatives also trade in dealer or OTC markets. THE UNLISTED EQUITY MARKET The volume of unlisted equity business is much smaller than the volume of stock exchange transactions. The unlisted market does not set listing requirements for the stocks traded on its system (hence the term “unlisted market”) nor does it attempt to regulate the companies. Dealer markets are also referred to as over-the-counter (OTC) or as unlisted markets . so many people are surprised to learn that the volume of trading on the dealer market for debt securities is 14 times larger than the equity market. dealers. usually over the telephone or over a computer network. 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. and then contacts the market maker to complete the transaction.securities on these markets are not listed on an organized exchange as they are on auction markets. One veteran described the OTC market as a “market without a market place. When an investor wishes to buy or sell an unlisted security. but so too do the shares of a few conservative industrial companies whose boards of directors have for one reason or another decided not to seek stock exchange listing for one or more issues of their equities. and in most cases offer lower liquidity. enter their bid and ask quotations. They consist of a network of dealers who trade with each other. The exact size of Canadian OTC dealings cannot be measured because complete statistics are not available. The market makers post their individual bid (the highest price the maker will pay) and ask (the lowest price the maker will accept) quotations.” In the OTC market. These market makers hold an inventory of the securities in which they have agreed to “make a market. than listed securities. These dealer markets are less visible than the auction markets for equities.

Perimeter Markets’ Blockbook. (RS) that became effective June 1. is scheduled to begin operation in 2008. ATSs have been operating in the United States since 1969). IIROC was established through the consolidation of the Investment Dealers Association of Canada (IIROC) and Market Regulation Services Inc. In Canada. cross-border trading issues and technological glitches such as insufficient system capacity. Alternative trading systems have the potential. to threaten market stability due to lessened market transparency. The trading activity of ATS is also regulated by IIROC. a QTRS is a mechanism for dealers to post quotations indicating the prices at which they are willing to buy and sell stock. Some non-brokerage-owned ATSs even allow buyers and sellers to contact each other directly and negotiate a price. These systems bypass the exchanges because a brokerage firm operating an ATS can match orders directly from its own inventory. In Canada. they are negotiated and trades are reported after the fact. Ontario is the exception. Project Alpha is a co-operative effort of Canada’s six largest banks and a well-established investment dealer. This is the traditional model for NASDAQ. more of the commission charged to the client is kept by the dealer. CUB was launched as an automated system after the reorganization of the equity markets in Canada. Most client users of these systems are institutional investors. ALTERNATIVE TRADING SYSTEMS Alternative trading systems (ATSs) are privately owned computerized networks that match orders for securities outside of recognized exchange facilities. as required under the Ontario Securities Act. ATSs now in operation in Canada include CNSX’s Pure Trading. Since there is one less intermediary. there is no requirement for firms to report unlisted trades. The market itself does not match buy and sell orders. however. It offers an Internet web-based system for dealers to report completed trades in unlisted and unquoted equity securities in Ontario. Also referred to as Proprietary Electronic Trading Systems (PETS). and Instinet’s Chi-X. ATSs are members of the Investment Industry Regulatory Organization (IIROC). they can be owned by individual brokerage firms or by groups of brokerage firms. Profits are made via revenues from the trading system itself and go to the owner(s) of the system. called Project Alpha.1•18 CANADIAN SECURITIES COURSE • VOLUME 1 REPORTING TRADES IN THE UNLISTED MARKET In most of Canada. (CUB). The Ontario Securities Commission (OSC) requires that trades of unlisted securities be reported through the Canadian Unlisted Board Inc. or act as an agent in bringing buyers and sellers together. A fourth ATS. 2008 – a topic we discuss in more detail in Chapter 3. QUOTATION AND TRADE REPORTING SYSTEMS Quotation and trade reporting systems (QTRS) are recognized stock markets that operate in a similar manner to exchanges and provide facilities to users to post quotations and report trades. (2010) . Traditionally. Only since 2001 has the regulatory framework existed for the creation of an ATS market (in contrast. © CSI GLOBAL EDUCATION INC. who can reduce transaction costs considerably. the development of an ATS network has been far slower than it has been in the United States.

via the stock or bond markets. firms must typically turn to investors that are ready to take substantially more risk against significantly higher profit prospects if the venture is successful.. Venture capital finances businesses at a time when they produce little or no cash flows. all bond and money market securities trade OTC. also a member of IIROC and an ATS. The term “private equity” is a bit of a misnomer as this asset class really encompasses debt and equity investment. Growth Capital – The financing of expanding firms for their acquisitions or high growth rates. invest most or all revenue in more or less unproven technologies or production processes. prices and yields from its six bankowned dealers. It is recognized as both an ATS and an investment dealer. Buyouts are one of the most commonly used forms of private equity. A good example is venture capital. It offers institutional investors access to federal bond bid and offer. Long term returns on private equity typically exceed most other asset classes. is a joint venture between Canada’s six largest investment dealers. In such situations. private equity also exposes investors to far higher risks. (2010) . • • • Leveraged Buyout – This is the acquisition of companies financed with equity and debt. provincial bonds and some corporate bonds. was launched in July 2001 and is accessible by registered dealers on behalf of retail clients.ONE • THE CAPITAL MARKET 1•19 ELECTRONIC TRADING SYSTEMS With the exception of a few debentures listed on the TSX and TSX Venture Exchanges. Issues include Government of Canada bonds and treasury bills.500 Canadian debt instruments trading. which represent more than 80% of the transactions in the bond market. launched in July 2002. and have little or no assets to offer as collateral. Turnaround – Investments in underperforming or out of favour industries that are in either financial need or operating restructuring. In the past few years. governments and pension funds. Canada’s first electronic fixed-income multi-dealer retail marketplace. © CSI GLOBAL EDUCATION INC.. Private equity plays a specific role in financial markets. CBID. operates two distinct marketplaces: retail and institutional. There are several means by which private equity investors finance firms. The CanPX system provides investors with real-time bid and offer prices and hourly trade data. CanDeal. CanDeal intends to expand to provincial bonds. corporate debt and commercial paper. institutional investors. The retail marketplace. It complements publicly traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible. The institutional marketplace. CBID currently has over 2. But in exchange for these returns. in Canada and in other markets worldwide. and is operated by the TSX. is accessible by registered dealers. CanPX is a joint venture of Investment Industry Association of Canada (IIAC)/IIROC member firms. Private Equity Private equity is the financing of firms unwilling or unable to find capital using public means – for example. three electronic trading systems have been launched in Canada. a member of IIROC.

Madison Dearborn Partners and Merrill Lynch Global Private Equity.P. J.1•20 CANADIAN SECURITIES COURSE • VOLUME 1 • Early Stage Venture Capital – Investments in firms that are in the infancy stages of developing products or services in high growth industries such as health care or technology. Providence Equity Partners. However. Morgan acquired Carnegie Steel Company from Andrew Carnegie and Henry Phipps for the then tidy sum of $480 million.2 billion (and 107 buyouts) for all of 2006.3 billion and 39 transactions in the third quarter itself. In 2007 there were 133 buyout transactions in Canada worth $64. It is only in 1978. For this reason.9 billion in buyouts were recorded year-to-date at the end of the 2007 third quarter alone. its role is one of return enhancement and to a certain extent. with $3. Return enhancement is the reward for accepting much lower liquidity typical of private equity. SIZE OF THE PRIVATE EQUITY MARKET The growth of private equity has been remarkable over the last 25 years. Revenue growth is still very high. Other sources identify an organized private equity market emerging in 1946 to stopgap the inadequacy of financing for new businesses. Late stage Venture Capital – The financing of firms which are more established but still not profitable enough to be self-sufficient. This included the proposed buyout of BCE by Ontario Teachers’ Pension Plan. (2010) . particularly when compared to investing in the common shares of a highly liquid stock like Royal Bank or Encana. © CSI GLOBAL EDUCATION INC. These firms usually have a limited number of customers. Additional support to venture capital was brought by a 1980 ‘safe harbour’ ruling granting limited partnership managers access to performance-based compensation. one source identifies 1901 as the first time a private deal in the modern sense of the word was struck. when the so-called ‘prudent man’ rule (tending to limit investments in smaller companies and riskier instruments) was amended that venture capital began to grow rapidly. $16. The American Research and Development Corporation (ARD) was founded to create a private organization to attract institutional investors. Recent annual reports of the largest pension fund managers.1 billion (Source: Bloomberg). when one individual or company sells assets directly to another individual or company). In that year. compared to $12. Without the proposed BCE deal. Distressed debt – This is the purchase of debt securities of private or public companies that are trading below par due to financial troubles at the firm. these investments cater mostly to individuals and organizations with sizeable portfolios and resources.. • • THE HISTORY OF PRIVATE EQUITY Private deals have always existed by definition (e. Given that investment minimums tend to be relatively high compared to traditional investing in the retail market. of portfolio diversification. private equity investors are typically: • • • • • Public pension plans Private pension plans Endowments Foundations Wealthy individuals and family offices Given the features of private equity and the differences it shows with other assets typically held in investor portfolios.g.

In addition to mergers. OMERS and the Ontario Teachers Pension Plan. exchanges are forming alliances. aggressive competition. most exchanges have demutualized. Ten years ago. • • • Most of these changes were driven by increased global trading. This proposal would allow institutional investors and brokerage firms to trade directly on each other’s stock markets. In the summer of 2003. have shown private equity returns well ahead of traditional portfolio asset classes. moving from not-for-profit organizations run by their members to for-profit corporations. Trends in Financial Markets There have been many changes to global capital markets over the last several years: • Physical marketplaces (the trading floors) are becoming obsolete. new exchanges are emerging to focus on niche markets. today there are fewer than 100. Despite the number of exchange mergers in recent years. Exchanges are merging to meet the challenge of globalization. Consideration of “free trade” between stock exchanges to improve the flow of capital across borders. which provides a trading forum for listed companies that have fallen below TSX Venture’s listing standards. the TMX Group launched a second board of the TSX Venture Exchange called NEX. • © CSI GLOBAL EDUCATION INC. there were over 200 exchanges in the world. partnerships and electronic links with exchanges in other countries to foster global trading. while virtual marketplaces or electronic trading systems are reducing the need for human participants in the market mechanism. the ease of electronic communication. Some of the future trends may include: • • Exchanges taking the next step from becoming a for-profit corporation to becoming publicly traded companies. (2010) . To prepare themselves for accelerating competition. The speed of innovative computer technology and the globalization and integration of financial marketplaces are likely to increase.ONE • THE CAPITAL MARKET 1•21 such as the Caisse de Dépôt et placement du Québec. improved computer technology and the increased mobility of capital.

you should be able to: 1. it is sensitive. The term to maturity of a debt instrument can be either short (less than five years) or long (more than ten years).. 3.g. Foreign investors will use Canadian capital if they can borrow at a more advantageous rate in Canada than elsewhere. and it is in short supply. new plant or new road). stocks. Retail investors are individuals who buy and sell securities for their personal accounts. futures. Define investment capital and describe its role in the economy. Derivatives (options. house. • • • • © CSI GLOBAL EDUCATION INC. segregated funds): a company or trust that manages investments for its clients. institutional investors are companies and other organizations. financial instrument. governments and foreign agencies supply and use capital in the economy. Businesses use capital to finance day-to-day operations. rights): products derived from an underlying instrument such as a stock. Differentiate between the types of financial instruments used in capital transactions. Describe how individuals. and to expand and diversify activities. an individual or company invests directly in an item (e. Capital has three characteristics: it is mobile.1•22 CANADIAN SECURITIES COURSE • VOLUME 1 SUMMARY After reading this chapter. commodity or index. • Debt (bonds or debentures): the issuer promises to repay a loan at maturity.. real estate. • • • • • Individuals generate investment capital through savings and use capital to finance major purchases or for consumption. bonds and money) that is used to enhance the economic growth prospects of an economy. to renew and maintain plant and equipment. Other investment products (income trusts. Equity (stocks): the investor buys a share that represents a stake in the company. • 2. Governments use capital when expenditures exceed revenue and to finance large projects. and in the interim makes payments of interest or interest and principal at predetermined times. In direct investment. (2010) . businesses.g. • • Investment capital is available and investable wealth (e. Foreign investors invest in Canada to access returns on investment not perceived to be available in other countries. Investment funds (mutual funds. indirect investment occurs when an individual buys a security and the issuer invests the proceeds. exchange-traded funds): investments that are relatively new and do not fit into any of the standard categories.

• • • • • The financial markets facilitate the transfer of capital between investors and users through the exchange of securities. Public and private pension plans. • 5. The exchanges do not deal in physical movement of securities. and wealthy individuals are the main investors in the private equity market. Most bonds and debentures trade on these markets. foundations. Explain what private equity is. distinguish among the types of financial markets. © CSI GLOBAL EDUCATION INC.ONE • THE CAPITAL MARKET 1•23 4. Now that you’ve completed this chapter and the on-line activities. how it has grown and the different ways of investing in this market. and describe how auction markets and dealer markets work. • • • • Private equity is the financing of firms unwilling or unable to find capital using public means – for example. Explain the role of financial markets in the Canadian financial services industry. complete this post-test. The secondary market is the transfer of already issued securities among investors. they are simply the venue for agreeing to transfer ownership. In an auction market. via the stock or bond markets. It complements publicly traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible. The growth of private equity has been remarkable over the last 25 years. endowments. Dealer markets are network of dealers that trade with each other directly on a negotiated market with market makers. clients’ bids and offers for a stock are channelled to a single central market (stock exchanges) and compete against each other. (2010) . The primary market is the initial sale of securities to an investor.