Canadian capital markets are evolving to face the threat of US domination
It all began two years ago in Kuala Lumpur, Malaysia. Then, at an annual meeting of the world's stock market executives, the chiefs of Canada's major exchanges found themselves in the same room. The conversation inevitably turned to common challenges. No doubt the changing way Canadian investors trade was discussed; as well as their clamor for access to global markets.
Similarly, record numbers of Canadian companies – large and small – are going abroad in search of investors. These and other developments threaten to make Canada's capital market an annex to US markets and a minor regional player on the global stage.
For those in the room, the challenge was to ensure the liquidity in Canada's capital markets remained vested there. Far from Canadian shores, light bulbs turned on. Within days, they had constructed the broad outlines of a new future for Canada's capital markets. Today, the realignment of exchanges along market specialization lines is largely a reality. The Vancouver and Alberta exchanges were merged into the Calgary-based CDNX venture exchange, while the Montreal Exchange now focuses exclusively on derivatives, and the Toronto Stock Exchange assumed all trading in senior equities.
So far, the reorganization has worked out well. By centralizing trading venues, liquidity has indeed increased for many issues. One Montreal-based analyst has seen liquidity appear to double for his stocks formerly interlisted on the TSE and Montreal Exchange. 'While they are simply adding the numbers from the two markets together, it looks like twice the trading,' says the analyst. 'Perception is everything and since the perception is changing, these stocks will in fact become more active.'
Still, many Canadian companies continue to look beyond the border to raise money and trade their stock. In 1988, just seven Canadian companies issued new equity in the US raising only US$94 mn. Ten years later, 30 companies raised nearly US$2 bn on US markets in 1998.
'There has been a fair flow to the US in Canadian interlisted securities,' says Fred Ketchen, managing director of equity trading at ScotiaMcLeod and a former TSE chairman. 'To see our trading gravitate to the US is a grave risk. But when you ask an American trader about Canadian dollars they get glassy-eyed and scratch their head.'
The new regime at the TSE is quick to set the record straight on interlistings. Exchange president Barbara Stymiest says not only are listings by Canadian firms on US exchanges relatively insignificant; they are also declining.
In fact, of the roughly 1,500 Canadian companies listed on the TSE, only 13 percent also list in the US. And the percentage of Canadian firms listed solely on Nasdaq is equivalent to only 10 percent of the TSE's total listed company customer base.
Stymiest isn't against interlisting per se: 'We have some great success stories that require global capital. I don't disagree that companies graduate from the CDNX to the TSE,' she says. 'Nor do I disagree there are companies that will become global and graduate to the NYSE.'
Calgary's Suncor Energy is one. 'We listed on the NYSE to increase our international profile,' says John Rogers, director of investor relations at Suncor. 'For a company like ours, nationality doesn't matter. Whether you are the best in your industry does.'
However, it is the Nasdaq Stock Market that is perhaps the US market with the most looming impact on Canadian capital markets. Canadians, once bitterly determined to thwart a bid by Nasdaq to set up Canadian trading terminals, have changed their disposition. The province of Quebec has approached Nasdaq while Stymiest also says a possible TSE alliance is a 'priority to look at in 2000'.
Cross-border links have been tried before and order flow is invariably in a north-south direction. Still, a Nasdaq link could help some Canadian companies attain a higher US profile.
Meanwhile, the TSE remains one of the world's leading resource exchanges. Its technology component has more than tripled in the past five years and now makes up a quarter of all listings on the TSE 300 index. With volume and index performance hitting new records almost weekly, and demutualization planned for mid-February, the TSE appears well on the way to ditching the myth of a stodgy institution.
Farm teams
For its part, Canada's new venture exchange is keen to start with a clean slate. Forged from the Vancouver and Alberta exchanges, a top priority is to distance itself from the poor reputation of its predecessors. That helps explain why the CDNX's new president is a former securities regulator.
'Investors should expect to take business risk but not regulatory risk,' says Bill Hess, president of the CDNX. As a first salvo in the effort, the CDNX plans to audit brokerages that take companies public to cull firms doing poor due diligence.
The refocused CDNX has spurred investor interest. Volume and index performance numbers have bounced high since the exchange officially began trading November 29. Still, critical challenges remain. Among them, to attract eastern Canadian listings and boost liquidity by attracting more institutional investors.
Both efforts should be aided by the planned opening of a Toronto office this spring and by CDNX taking over the 400-odd companies now listed on the Toronto-based over-the-counter Canadian Dealing Network. In the meantime, Hess is lobbying those institutions with rules against investing in the CDNX, and plans to tier CDNX stocks. He hopes a focus on the 'top 300' board will sharpen institutional attention.
CDNX's success suggests capital is increasingly starting to flow into early stage companies, while its drive to spark institutional appetite for smaller companies may be critical to the continued viability of Canadian capital markets. Canadian institutions have been concerned about the emerging company marketplace for some time. Poor commodity markets and the fall-out from the Bre-X scandal has discouraged participation. Excluding their direct investments, Canadian pension funds commit only about C$200 mn a year to independent venture capital fund managers. For their part, US pension funds commit some US$15 bn a year.
That partly accounts for Canada's wave of high-tech start-ups forced abroad for funding. 'We're definitely seeing an increase in specialized venture capital available in Canada,' says Mary Macdonald, president of Toronto venture capital research firm Macdonald & Associates. 'But it is not as much as in the US by a long shot. We're not seeing strong enough institutional support for venture capital funds.'
Fault lines
While Canadian institutional investors need to be tweaked toward younger companies, dealers too may consider reorienting their focus. Thomas Caldwell, chairman of Caldwell Securities, says there is a financing gap in Canada for smaller companies. He believes outmoded financing structures are hurting growth potential and the Canadian economy.
As Caldwell explains it, Canadian capital markets have developed market mechanisms focused on fundraising for resource and manufacturing enterprises. Meanwhile, consolidation in the Canadian financial sector has resulted in a few massive fundraising enterprises controlled by banks.
The resulting problem, says Caldwell, is that only a few firms can handle public financings in the C$5-50 mn range. 'We've adopted the German capital market model in which banks control major sectors of the economy. That is the wrong road if innovation and new enterprise growth are to be the goals,' says Caldwell. 'Their machines are too large. You need C$50-100 mn for them to even look at you.'
Despite the lack of dealers to feed it, Caldwell says the CDNX, is a 'last gasp hope' for Canadian capital markets. 'The old-line exchange – with its preoccupation with quality and order – has geared itself for a more static world and abrogated its role of developing a truly vibrant capital market.'
However, not everyone agrees with Caldwell's assessment. Ian Russell, senior vice president at the Investment Dealers Association of Canada, says there's more of a market for emerging growth companies than Caldwell credits. 'It's an oversimplification,' says Russell. 'There's plenty of small and mid-sized dealers actively involved in providing financing for high-tech small caps.'
'Most investment banks have significantly increased their presence in new economy industries,' adds Mitchell Greenspoon, executive vice president of Yorkton Securities. 'Analyst specialization is increasing.'
Environmental change
The Canadian securities industry has made a lot of money in recent years with total annual profits regularly nearing the C$2 bn range. But the investment environment is changing and new entrants are forcing competition, while the globalization trend is pushing Bay Street's corporate and investing clients toward the products and services of the major US and European banks. Last year, for example, Canadians pumped almost C$10 bn of new cash into foreign funds, while pulling C$1.3 bn out of Canadian equity funds. The trend is likely to continue.
That is because a 'fifth pillar' of Canadian finance may be scaled back or scrapped. For 28 years, Canadian pension funds and registered retirement savings plans were constrained to a 20 percent limit on foreign holdings. The government has made noises about gradually increasing it, but some, like Glorianne Stromberg, a former OSC commissioner, say it should be scrapped entirely.
'The fact the restrictions operate like a sieve would indicate they are not essential to Canadian companies or our economy,' comments Stromberg, pointing out that Canadian investors can readily avoid the restrictions with devices such as clone funds and segregated funds. The results, she argues, have been increased cost and risk for Canadian investors. 'Let the market regulate portfolio foreign content levels,' says Stromberg.
Meanwhile, Canadian companies appear on the verge of losing 'most favored nation' access to the US capital pool. The multi-jurisdictional disclosure system allows large companies listing stocks or bonds in Canada to tap the US market using Canadian documentation. The SEC wants to ditch the nine-year-old 'no review' system.
'In a perverse way, what would seem negative legislation, might actually benefit the Canadian investment community,' says one investment banker. 'We may have a further crack at deals that may have been lost south of the border.' Issuers on the other hand, may have a different opinion.
While dot-com issues may have made headlines in the US, the demutualization of Canada's insurance companies dominated Canadian markets in 1999. 'We have a new class of shareholders,' says Eric Slavens, public offerings service leader at PricewaterhouseCoopers. 'They are a major force in capital markets.' Underscoring the growing importance of retail investors, for the first time in years, their proportion of trading is up while the share of institutional trading is declining.
Investor communication outfits are gearing up to service the new wave of investors. SCC Canada, for instance, is opening a new call center in Toronto. 'The retail resurgence is changing the face of the market,' says Glen Keeling, president and CEO of SCC Canada. 'Retail investors are becoming a force at proxy time.'
Market watchers are bullish on Canada throughout 2000. Economists see a strong Canadian economy buoyed by continued US strength and rising commodity prices. It seems Canadian capital markets have turned away from the precipice. But work continues to build a financial infrastructure able to survive the changes a digital economy brings. The throttle on progress has been jammed forward.