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1: Capital Markets and Financial Services

Intro:
- vital function served by financial markets is the transfer of wealth from those who have extra wealth to
those who need capital (financial markets drive economic growth by transforming savings into
investments)

Suppliers and Users of Investment Capital:


capital - incorporates savings of individuals, corporations, govts and other entities
- scarce source and valuable; economically significant when properly utilized
uses of capital:
- direct investment – investment in real assets that directly generate wealth
- indirect investment - investment in financial assets
- allows issuers of securities funds to directly generate wealth

capital is scarce, mobile and sensitive - efficient allocation promotes growth, poor allocation constrains it
- tends to flow towards attractive economic environments
- flows in and out of countries in response to:
-political - investment opportunities
- economic trends - fiscal and monetary policy
- risk-return opportunities - labor force characteristics
- availability is critical – crucial to promote economic output, improve productivity & competitive position

- sources of capital – individuals represent significant source of investment capital in Canada

investment objectives – safety, income or growth of capital


- mutually exclusive (cant maximize two or more)
- secondary objectives – marketability, liquidity and tax minimization

users of capital
- individuals - consumption
- businesses - finance operations, purchase assets, and to finance growth
- mostly financed internally, also from bank loans and issuing securities

- govt – t-bills, marketable debentures, canada savings bonds and premium bonds

I. Financial Instrument
- legal formal documents that set out rights and obligations of parties involved
debt - legal obligation to repay borrowed funds at a specified maturity date and provide
interim interest payments as specified
equity - represents part ownership (common shares)
investment funds – company that manages investments (mutual funds / open-end funds)
derivative products – derive value from price of another underlying asset
others – income trust funds, exchange-traded funds, etc

II. Financial Markets


- efficient market to buy and sell (trade) instruments
- fast, low-cost, high degree of liquidity

- auction markets (stock exchanges) – all transactions coverage in one location


- member firms publicly owned, maintain capital adequacy, adequate key personnel
- finances by transaction fees, initial listing fees, sustaining listing fees, sale of information
- dealer markets: the unlisted market – otc (over the counter) markets
- network of dealers that trade directly with each, negotiated networks which maintain bid and ask
quotations received from the dealers acting as market makers in given securities, market makers
execute trades from their inventories
- almost all bonds and debentures are sold through dealer markets, however the volume of unlisted
equity trading is much smaller than the volume of exchange-traded equity transactions

- alternative trading systems – computerized systems executing orders outside exchange facilities matching
orders from own inventory or buy/sell orders – often owned by brokerage firms or groups of firms
- most institutional investors – cut costs, globalize (operate then exchanges are closed)

III. Financial Intermediaries


- improve efficiency by facilitating trading instruments between suppliers and users of capital
- 205 securities firms in Canada (7 larger houses accounting for 70% of total industry revenue)
- investment boutiques – smaller securities firms (focuses on segments of the market)
- industry is highly leveraged, and short-term funding is obtained through variety of arrangements

- primary or new issue markets


- investment dealers (ID) act as principals or agents
- underwriting / financing – purchase of new securities from issuer on given date and price then
resold to others – compensation results from the spread
- minimize risk by working closely with issuer
- underwriting syndicates – spread risk and enhance marketability
- best efforts basis – ID take role as agents – compensation by commission
- issuer assumes risk of securities not selling (private placements or smaller firms)
- secondary markets – enhance the effectivity of primary markets
- IDs transfer existing securities among investors
- principals – trading securities from own inventory, or trade with their own account
– earn from spread – assuming the risk
- brokers / agents – execute transactions taking commission
- discount brokerage houses – eliminate traditional services, reduced commission fees
- buying firm fund settle transaction or client provides funds by settlement date
- certificates must be delivered (now mostly held in Canadian Depository for Securities – CDS)

- Chartered Banks
- gather funds (savings / certificates of deposit)
- give to users as mortgages and other forms of loans – income from spread
- governed by bank act
- Schedule I banks – 90% - widely held (less than 20% per investor, 25% foreign holdings)
- Schedule II banks – incorporated – subsidiaries of foreign banks or financial institutions
- Schedule III banks – branches of foreign banks (diff is not subsidiary)

- large – 20%, medium (1-5 billion)– 65%, small – no restriction on ownership


- banks have moved into securities business – permitted to offer non-banking financial services

- Chinese walls – controls put in place to restrict flow of information between bank divisions

- Life Insurance Companies


- trustees for funds – safety of principal is primary investment objective
- long-term – active in both mortgage and long—term bond markets
- allowed to own “trust and loan” companies through subsidiaries
- follow rules on “prudent portfolio approach”
- demutualization – reorganization of ownership structure of life insurance companies
- owned by policyholders -> shareholders (providing appropriate shares)
- Investment Funds - either corporation or trust – sell shares / trust units to invest in portfolio of securities
- closed-end funds – issues shares at start-up / other times to invest with proceeds
- open-end funds – mutual funds – issue and redeem shares on a continuous basis – 95%
- vary in portfolio composition

- Other Intermediaries
- trusts and mortgage companies – trustees in charge of corporate or individual financial assets
- pension plans – focus on safety of principal and income (purchase govt debt)
- credit unions / caisses populaires – provide basic financial services
- sales finance and consumer loans companies
– direct cash loans and/or purchase sales contracts from retailers at a discount
- property and casualty insurance companies – provide insurance (much smaller scale)
- savings banks – take savings, but don’t lend
- business development bank of Canada – provide fixed term financing to small businesses

Regulatory Organizations:

OSFI – office of the superintendent of financial institutions


- combination of department of insurance and the office of the inspector general of banks
-regulates and supervises banks; insurance, trust loan and investment companies; cooperative
credit associations (anything chartered federally)

provincial regulators
- regulation of securities industry in Canada is a provincial responsibility
- work closely with CIPF – Canadian Investor Protection Fund and Self-Regulatory Org

CIPF – canadian investor protection fund – includes all IDA and exchanges members
- designed to protect investors from loss due to insolvency of a SRO member
- role is to anticipate and solve financial difficulties of member firms to minimize risk of
insolvency (orderly wind-down the business if not savable)
- coverage up to $1mil in losses related to securities holdings and cash balances combined

- MFDA – mutual fund dealers association – $100k


- CDIC – Canada Deposit Insurance Corporation – financial institution – $60k
- CUDIC – credit unioin deposit insurance corporation – varies about $100k

SRO – Self-Regulatory Organizations


- member regulation, listing and trading regulations
- IDA – national trade association of the investment industry and is self-regulatory org
- rep firms in securities business (only national SRO)
- foster efficient capital markets by encouraging participation in savings and investment
process by ensuring integrity of the marketplace
- industry regulator – monitor member firms for capital adequacy and business conduct
- international representative and public advocate of information

promote efficiency by serving as a regulator


- key role in formulation policies and standards for primary debt and equity markets
- monitoring activities of member firms and developing trading and sales practices for
fixed income markets

Arbitration
- compensation from dealers through court, west side allows investors to claim amounts below
$100k through arbitrations (direct solution)
- OBSI – Ombudsman for banking Services and Investments – investigates complaints against
financial service providers