Nationalism fights pragmatism in Canada's growing market

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06 October 2011

The proposed takeover of TMX Group by the Canadian Maple Group has been heralded by some as a bold move that will protect the sovereignty of Canada’s securities markets. But, as Wyn Jenkins found out, others condemn it as a backwards step towards inwards-looking parochialism that will stymie the competitiveness of the market’s burgeoning derivatives industry.

In June, Canada’s main securities exchange TMX Group, owner of the Toronto Stock Exchange and Montreal’s derivatives market the Bourse de Montreal was forced to abandon talks with the London Stock Exchange, which looked likely at one stage to lead to a merger. The decision cost TMX some a C$10m in the form of a break-up fee but it’s hand was forced. Although LSE’s shareholders had supported the deal, TMX had failed to convince sufficient numbers of its shareholders to accept LSE’s C$3.4bn bid.

National loyalties

This was largely because of a disruptive and last-minute counter bid that arrived on the table from Maple Group Acquisition Corporation, a consortium of 13 Canadian banks and pension funds, which offered more cash. The main motivation of Maple Group, which takes its name from Canada's patriotic maple leaf symbol, was to scupper the LSE bid. It has left those that use the market at odds about the best route forward for the exchange.

In the context of the number of high-profile mergers and pace of consolidation between global exchanges in recent years, many seasoned traders view the failed deal with LSE as a missed opportunity. Furthermore, they remain perplexed not by the motives of Maple Group, which seem transparently nationalistic, but by what a successful bid would really mean and what the Maple Group could bring to the table.

“The issue of potentially ceding control of a national stock exchange to a foreign entity in the LSE was clearly an emotive issue and one that became very political,” says Steve Grob, head of strategy at Fidessa. “Maple came out of nowhere and I wonder whether if the LSE bid had not been on the table then Maple would ever have emerged at all.

“Everything about the Maple bid, especially initially, seemed to be aimed at resonation with nationalistic feeling. But the idea of national retrenchment is inward looking and very much goes against the grain in terms of what other exchanges have been doing globally. It is increasingly difficult for any exchange to rely purely on its domestic market. This has now become a global business and it is not easy to see where TMX goes from here now in terms of finding another international partner.”

All eyes now rest on the discussions between TMX and Maple as observers speculate whether Maple will have the stomach to see its original bid – a C$3.6bn to buy between 70% and 80% of TMX shares – through. The TMX board has agreed to hold discussions until the end of September while the parties seek regulatory approval for the deal. Conversely, TMX will pay a further C$29m fee to LSE if it agrees a deal with Maple before the end of June next year.

If the deal does complete, Maple will be under pressure to rapidly set out a convincing strategic direction for TMX. The exchange has performed well according to its most recent results. For the six months to June, its turnover rose to C$344m from C$305m while net income before tax rose to C$166.7m from C$162.4m.

Its quarterly earnings grew thanks to increased derivatives trading, fees from new listings and information services. New listings rose 33% while turnover in derivatives trading rose 26 % to C$26.8m as the numbers of contracts traded rose to a record 16.3m.

The world has changed

Renee Colyer, a founder of capital markets consultancy Forefactor, says she foresees many challenges that Maple must overcome for the deal to go ahead. She believes the deal would create a quasi-monopoly dominated by the banks that would severely limit competition and potentially increase the cost of trading and other services. But her biggest reservation stems from the lack of what she believes Maple can offer in terms of future strategic assets and capabilities.

“Apart from deep pockets, I just don’t see what it brings to the table,” says Colyer. “To continue to grow, TMX must consolidate with other exchanges but I cannot see why another exchange would want to merge if it meant they would ultimately be owned by Maple.

“They might find another exchange to buy outright. Their other option is simply to reduce costs and turn it into another Canadian utility. But that would be a significant step backwards for Canada’s securities markets. It is very protectionist.”

She believes that support in Canada for the Maple bid is centered among some of the country’s big financial institutions, including a number involved in the consortium.

But Colyer says that while these institutions have significant sway in Canada among policymakers and regulators, they do not represent the average investor or trader who regularly uses TMX and has a better understanding of the rapid globalisation of securities trading.

“They see TMX as a kind of Canadian monument and they believe it should stay Canadian,” she says. “That view used to be fine but it was before the consolidation we have seen between exchanges around the world. Their view is that Canada doesn’t need anyone else: we have a steady economy, strong banks, low unemployment and low debt. TMX has also been successful in the past: it has been innovative and progressive and achieved many firsts compared with exchanges around the world.

“But just because you have got things right in the past doesn’t mean it will work going forward. The world has changed. TMX needs to grow and the only way it will do that will be through having a global perspective and looking at consolidation.”

Local consolidation

Not all agree that Maple’s proposal brings little to the table, however. A number of notable commentators have stressed its positives. John Carson, an international capital markets consultant and a former senior vice-president of the TSX, outlines several ways in which Maple’s proposal could add value to TMX but also notes that they raise as many problems as they do solutions.

“While Maple’s proposal would dispense with concerns over foreign control of TMX, it raises other issues that are at least as thorny as those raised by the proposed merger with LSE,” he says.

Two proposals central to the issue of whether Maple can add value to TMX is its desire to merge Alpha Group, one of Canada’s alternative trading platform and TMX’s biggest domestic rival, and the Canadian Depository for Securities (CDS), Canada’s not-for-profit securities clearing, settlement and depository, into the new TMX Group.

Successfully merging these entities into TMX would increase the value of Canada’s main bourse. The deal with Alpha would grow and protect its domestic market share, especially as Alpha’s current management has said it intends to launch listing services to expand from its current trading base.

Consolidation with CDS would also add great breadth to TMX’s overall offering. CDS processes both on and off-exchange trades in bonds and many other instruments, as well as offering a number of ancillary services.

Combining these operations with those of the Canadian Derivatives Clearing Corporation, Canada’s clearing agency for exchange-traded options and futures, which TMX already owns, would offer great added value to TMX’s services and its bottom line, especially if it could also swiftly convert CDS into a profit-making entity.

Competition concerns

However, several potential stumbling blocks remain. Firstly, both Canada’s Competition Bureau and Canadian securities regulators might have issue with the merger of Canada’s two largest providers of securities trading services, especially given that the country’s regulatory framework has been developed to encourage competition. Secondly, Alpha’s owners include two banks not part of Maple, which supported the original LSE bid and may attempt to block the deal.

The ownership structure of CDS also presents some problems as this combines several large banks with Canada’s self-regulating agency IIROC and TMX itself. CDS also operates as a neutral platform for clearing and settlement in many instruments, including over-the-counter government and corporate bonds and money market instruments. “It is regarded as a systemically critical institution for Canada’s capital markets,” says Carson.

As such, the Bank of Canada has some jurisdiction over CDS by virtue of the central role it plays in settling transactions in government debt as does the Ontario Securities Commission because of its location and role in the securities markets.

“The authorities would need to be persuaded that the changes – in particular changes in CDS’s governance and a move to a for-profit model – would not compromise its status as a neutral provider of clearing and settlement services across all securities markets, CDS’s rigorous standards of risk management, or the integrity of CDS’s operations,” Carson says.

The main problem Carson foresees stems from TMX’s ownership structure under Maple and where its priorities may lie as a result. He stresses that different shareholders will want different things: while those that use the exchange will want lower fees and profits ploughed back into improving services, its public shareholders will seek higher profits and growth.

“There would be a built-in conflict of interest between public shareholders and user shareholders,” says Carson. “The securities regulators must approve not only the overall takeover transaction, they also get to approve the details — the terms and conditions that apply to the TMX’s ownership, corporate governance system, management of conflicts of interest, and many other issues.

“Throw in the competition regulators and, last but not least, the politicians, and it becomes pretty difficult to figure out where this train is running. The potential for unintended consequences is high.”

Derivatives growth

The drama surrounding the future ownership of TMX is taking place against a backdrop of global consolidation among exchanges but also a bullish sentiment around its ability to attract business, launch new products and gain more of an established foothold derivatives.

Volumes of derivatives traded on TMX’s derivatives exchange, the Bourse de Montreal, exceeded last year’s full year figure by mid-July.

While there have clearly been successes, however, Colyer at Forefactor issues a note of caution. “The volumes of derivatives traded here are still very small compared with other exchanges such as Chicago. TMX has focused on derivates in recent years and achieved some substantial growth. But it was from a pretty low base.”

Grob at Fidessa is also quick to put things in perspective. “Whatever successes the market may have seen in the short term, they are against a backdrop of increased fragmentation – a trend that is here to stay,” he says.

“We are seeing more dark pools being formed and there are so many exchanges all over the world competing internationally. If any exchange is serious about long-term growth in any sector, including derivatives, they must be outward looking and open to working with other exchanges and venue operators. The net result of all this for TMX appears to be fairly inward looking which seems at odds with the view in other geographies.”

Fragmented regulation

Canada’s other big issue, which could influence if not underpin, some of the regulatory decisions that will need to be made around the proposed Maple-TMX deal surrounds the country’s fragmented regulatory regime.

While Canada was one of the countries that instigated the financial reform process of global derivatives regulation undertaken by the G20, its own regulatory regime remains complex and persistently stubborn to change.

David Brown, the former chairman of the Ontario Securities Commission and now a regulatory consultant at Canadian law firm Davies Ward Phillips & Vineberg, says that laws need simplifying if Canada is to remain competitive. “Virtually every other country in the world has a single regulator,” he says. “In Canada, we have 13 commissions spanning 10 provinces and three federal entities.”

By virtue of the fact that the main exchanges, including TMX, are based there, Ontario has held the position of regulator of default for some time now. But the regulation of derivatives in Canada remains particularly complex as different regulatory authorities approach them – when they recognise them at all – in different ways.

Derivatives are regulated in Canada through securities regulatory authorities only in the provinces of Alberta, British Columbia, Manitoba, Ontario, and Quebec. Alberta and British Columbia take a similar approach, treating derivatives as ‘exchange contracts’.

Ontario and Manitoba have a common approach in that they govern derivatives under commodity futures legislation. Quebec has recently passed a new Derivatives Act that applies to both exchange-traded and OTC derivatives, which has introduced a third approach to derivatives regulation. It imposes recognition and registration requirements on intermediaries as well as registration requirements on dealers and advisors.

Brown says that while Canada will likely toe the line on any reforms agreed internationally, the situation and the implementation of such changes would be far easier were a single overarching regulator created with jurisdiction over the entire country.

Moves have been made in this direction in recent years – with a view to streamlining Canada’s fragmented regulatory regime. But they have also been opposed. The provinces of Alberta and Quebec have resisted such moves, even taking a formal legal challenge to the courts.

The courts initially sided with the provinces, agreeing that the federal government had no authority to implement such a regulator. A ruling from the Supreme Court on the matter is now expected any day now.

“My view is that this is such a global business now, the federal government must have some jurisdiction over it,” says Brown. “I also believe there is the political will in place for this to happen. As the securities industry gets ever more global, Canada risks being penalised for its higher regulatory burden.

“We are not without advantages, notably our close association in many senses with the US. But in terms of regulation it is a mess and what concerns me most is that if Canada ended up with an economic crisis on the scale other countries have experienced, we are not equipped to deal with that.”

Global exchange consolidation has proved to promise more than it can deliver. Nasdaq OMX, InterContinentalExchange, the Singapore Exchange, and the LSE have all be thwarted in their bids to expand their reach internationally. However, the LSE deal for TMX may be remembered as the greatest lost opportunity for the two exchanges.

Should Maple succeed in its bid, it will be faced with the momentous task of growing TMX into a globally competitive derivatives exchange without the benefits of the economies of scale that its rivals enjoy. Should it be successful in that goal, it will be praised for keeping the national monument in domestic hands, should it fail, it may well mark the end of Canada’s ambitions to compete on a global level in derivatives.

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