Canada’s Financial System
The Bank of Canada defines Canada’s financial system as “the channel through which savings become investments, and through which money and financial claims are transferred and settled”.
As a dealing representative, you are part of Canada’s financial system which consists of financial institutions, financial markets, and payment systems.
Types of Financial Markets
There are three main types of financial markets in Canada’s financial system:
- capital markets
- money markets
- foreign exchange markets
A capital market is a trading place for financial assets. Capital markets bring together organizations seeking capital, including corporations and governments, with investors and lenders.
The capital market has the following characteristics:
- trades mainly stocks and bonds
- trades derivatives, which base their value on capital market securities
- generally a long-term market (as opposed to the money market, which deals with short-term fixed income securities)
A money market is a trading place for short-term financial assets, typically those with a maturity of less than one year, but sometimes up to three years. Money market instruments are used for raising short-term capital or for investing cash surpluses for a short period of time.
Foreign Exchange Markets
Currencies are traded on the foreign exchange markets between various international and domestic banks and dealers.
Foreign exchange trading involves selling one currency and buying a different currency. In a currency market, the price of one currency in terms of another is called the foreign exchange rate.
The Bank of Canada is also involved in the foreign exchange market. Through Canadian chartered banks and investment dealers, the Bank of Canada buys and sells Canadian and foreign currency in order to regulate the Canadian dollar.
Jane wants to purchase a U.S. Growth Fund denominated in U.S. dollars. Currently, the exchange rate is $1.01 Canadian dollar/U.S. dollar. Jane has $10,000 Canadian to invest.
How much will she be able to purchase in U.S. dollars?
$10,000 Cdn / (1.01 Cdn/US) = $9,900.99 U.S.
After five years, Jane’s U.S. Growth Fund is worth $15,750 U.S. She wants to sell the investment and convert it back to Canadian dollars. The exchange rate is $1.01 Canadian dollar to U.S. dollar.
What will Jane receive in Canadian dollars from this redemption?
$15,750 U.S. x $1.01 Canadian/U.S. = $15,907.50 Canadian
Newly Issued Shares
Corporations issue new shares for many reasons such as:
- To go from a private to a public corporation by way of an initial public offering (IPO).
- To raise additional capital for expansion, research, and development, or for an increase in working capital.
- To raise funds in a private company for the sale of an owner’s share of the business.
A corporation issues new shares in what is called the primary market. To do this, it will usually hire an investment dealer to help bring the shares to the market. The dealer is a financial intermediary between the company and the primary market. The issuing company relies on the dealer’s distribution channels instead of selling the shares itself to the market.
The Underwriting Process
Underwriting is the process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities.
Primary and Secondary Markets
When investors purchase an issue of new shares, money flows from the investor, through an underwriter, to the corporation that issued those shares. This is the primary market.
Once these shares are purchased in the primary market they subsequently trade among investors, changing hands whenever a match can be found between people who want to sell their shares and those who want to buy them. These shares are said to be trading on the secondary market. The original issuing company has no further direct financial interest in the subsequent trading of these shares. The secondary market includes the many organized stock exchanges, as well as the over-the-counter markets.
A stock exchange is established for the purpose of trading shares between members of the exchange and their clients. Members of the exchange are regulated by a strict code of conduct to ensure that markets operate smoothly and investors are treated fairly.
Companies must apply to be listed on an exchange. If accepted, companies must obey its listing requirements, including rules concerning the disclosure of information.
Some of the benefits a company enjoys by listing on an exchange include:
- increased marketability of shares due to greater market exposure
- increased public confidence in the company due to the exchange’s disclosure rules
- an active secondary market that can broaden a company’s shareholder base
The shares of publicly traded companies that are not listed on a stock exchange may still be traded on the (OTC), sometimes referred to as the unlisted market. Unlisted securities trade in the OTC market through a network of dealers. There are many reasons a company might consider listing in the OTC market including:
- unwillingness to abide by the disclosure rules of an exchange
- low volume of trading in its shares
- low investor interest
- inability to meet the requirements to be listed, usually because it is a small company
The OTC market also plays a part in the primary market. Many new stock issues that are underwritten by securities firms are first sold over the counter before becoming listed on a stock exchange.
Large blocks of outstanding shares offered for sale by a single investor, whether listed on an exchange or not, are sometimes sold in the OTC market. Often a securities firm will underwrite the block itself and offer it for sale in the OTC market in the same manner as a new issue. This process is referred to as secondary distribution.
The disclosure standards for the OTC market are not as stringent as those imposed by an exchange. A corporation whose shares are listed on an exchange is generally not allowed to list or trade in the OTC market, with the exception of secondary distributions.
Secondary Debt Markets
There is a large and active market for bond trading. Except for a few exchange-listed debentures, bonds trade in the dealer market or over-the-counter (OTC). In other words, trading is conducted directly between financial institutions.
The Roles of Securities Firms
The trading of securities in the primary and secondary markets is facilitated by a network of securities firms, including securities dealers and stockbrokers.
A securities firm is any company that specializes in the trading of securities by performing one or more of the following functions:
- underwriting new issues and secondary distributions
- stock brokerage
- market research and the provision of investment advice
- portfolio management
A securities firm may be organized as a private corporation or partnership, or it may itself be a publicly-traded company.
Dealers and Brokers
When a securities firm underwrites a new issue or a secondary distribution, it purchases the securities from the issuing company or the selling investor at a fixed price and attempts to sell them in the market at a profit. This is called a bought deal. In this case, the securities firm is referred to as a dealer, which is a company that acts as the principal in a securities transaction, buying and selling for its own account. The securities firm is in a position where if the securities do not sell at the anticipated price, the firm will realize a loss. A securities dealer makes its money by purchasing securities and selling them at a profit, in addition to earning commissions charged on transactions handled by the firm on behalf of clients.
In some cases, a securities firm will agree to sell new issues only to the best of its abilities, meaning that it will try to sell as many shares as possible at a stated price, but it does not accept any responsibility if all the shares are not sold. This is called the best effort deal. In this case, the securities firm is acting as a securities broker or an agent on behalf of the issuer. A broker arranges for the purchase or sale of securities, handles the flow of cash, and may provide clients with investment advice. A brokerage firm makes its money on the commissions charged on each trade it handles on behalf of clients.
Most securities firms have their own research departments, which are responsible for gathering and analyzing information that will assist both themselves and their clients in making investment decisions. The research department may include people who specialize in technical and fundamental analyses, as well as analysts who specialize in particular industries such as mining or biotechnology. The information developed by the research department is usually distributed to clients and potential clients free of charge in the hope that the recipient will decide to become a client of the securities firm.
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