Industry opposition to Maple’s bid

Maple — composed of large, mostly bank-owned investment dealers and some pension funds — says its proposals for consolidating trading and integrating clearing will create efficiencies that will benefit the Canadian markets. The consortium suggests that creating a dominant domestic firm also will put the markets in a better position to compete globally, thereby attracting more foreign issuers and investors, which also will benefit the markets overall.

Still, it’s not an argument that many players in Canada’s financial services industry are buying. “We believe the negative impacts of this transaction will far outweigh any potential benefits for the Canadian capital markets,” says Vancouver-based Canaccord Genuity Corp.’s comment regarding the proposed deal, adding that the promised benefits of Maple’s deal are overblown and that “the ultimate objective is to create an organization that will use its monopolistic powers for the benefit of its shareholders at the expense of its users.”

Indeed, the regulatory hearings to consider the proposals reveal some deep skepticism about the implications of the proposed makeover, from both market players that aren’t part of the Maple consortium and from investors. These concerns have been spelled out in written submissions to regulators in Ontario and Quebec, both of which had initiated consultations on Maple’s plans in early October, and at the first round of public hearings into the proposals held by the Autorité des marchés financiers in late November. (The Ontario Securities Commission is slated to hold its own set of hearings on Dec. 1 and 2, which is after Investment Executive’s deadline).

In these submissions, and at the AMF hearings, firms that are not part of the Maple consortium have highlighted their fears about allowing a small group of powerful financial services institutions to take control of most of the trading and listing business, as well as all of the clearing business, and operate it as a for-profit venture.

Contrary to Maple’s assertion that the consolidation and integration of the trading and clearing businesses will improve Canadian capital markets’ competitiveness, CNSX Markets Inc.’s submission says that Maple hasn’t produced any evidence that this will be the case: “We are aware of a contrary view among global market participants [that Maple’s plans] would lead to an environment that is closed to competition, domestically and internationally.”

At first blush, it appears that Maple’s biggest regulatory hurdle could come as a result of the concerns about the deal’s effect on competition in the trading business. The proposed acquisition of both TMX and its primary rival for trading volume, Alpha, would give the combined entity control of more than 85% of trading volume (on a pro forma basis). Questions have been raised regarding how this situation could pass muster with both the Competition Bureau, which also is reviewing the proposed transaction, and the securities regulators, which have tried to foster greater competition in this area in recent years by creating a regulatory framework for alternative trading systems.

However, it seems that there is relatively little concern about allowing greater concentration in the trading business — particularly now that there are alternative trading venues up and running that can compete for that business. Indeed, some industry players feel that the merger of TMX and Alpha will actually help to foster greater competition in the trading arena because Alpha’s focus may shift to generating profit and away from lowering costs, which would ease some of the pressure on rival trading systems to match Alpha’s low costs.

The bigger worries are over the plans to acquire CDS and convert it into a for-profit venture; and, more generally, how to structure the governance for an entity that will have overwhelming market power. Although there will still be competition in the trading business — even after the merger of the two biggest players in that arena — there is no real prospect of competition in the clearing business. CDS would remain a monopoly but would be run for profit and controlled by the industry’s largest firms, which has many other financial services firms deeply concerned.

Notes the CNSX comment: “An unprecedented range and depth of conflicts of interest are posed by the Maple application.”

Indeed, according to submissions from an industry committee that had been formed to advise the Investment Industry Regulatory Organization of Canada on Maple’s proposals, dealers that are not part of the consortium oppose the acquisition of CDS. These dealers are afraid of what could happen to the rest of the industry if regulators allow CDS to be acquired and turned into a for-profit venture.

Speaking on behalf of the committee at the AMF hearing, Jeff Kennedy, chief financial officer of Toronto-based Cormark Securities Inc., has indicated that there are three basic things that the rest of the industry is worried about if Maple is allowed to acquire CDS: the impact on fees; direct access to the clearing function for smaller firms; and governance.

Kennedy has suggested that the firms in the Maple consortium could aim to limit access to CDS for smaller dealers by altering CDS’s risk model and boosting collateral requirements that will be prohibitively expensive for smaller firms, which probably would have to turn to carrying brokers to handle the smaller firms’ clearing needs. (The two largest carrying brokers belong to Maple.) Moreover, Kennedy says, this would increase counterparty concentration, which could create firms that are too interconnected to fail, spawning a possible bailout risk in the future.

The submission from the Canadian Advocacy Council for Canadian CFA Institute Societies echoes this fear: “There is not a compelling case of how vertical integration would be in the public interest. Quite the opposite, the integration of the CDS with the TSX would introduce a higher level of the operational and systemic risk into the Canadian market.”

The CAC submission maintains that the current model is working well and that the possible benefits of integration don’t outweigh the potential new risks.

In addition, the members of the IIROC committee, along with several others submitting comments, are worried about the possible impact on clearing fees. Canada has some of the lowest clearing fees in the world, and there is a concern that this could change if CDS becomes a for-profit operation.

Although Maple has promised that its fees will be fair and equitable, and that it won’t adopt two-tier pricing, the lack of certainty in this area remains a concern for other dealers. At the AMF hearing, Maple and TMX indicated that they will be making an announcement about their plans for fees in early December, which they hope will soothe some of these concerns. It remains to be seen just what they’ll announce, and whether it will be enough to mollify the deal’s opponents.

Several firms point out in their submissions that CDS’s fees have been consistently declining, so even if fees aren’t raised, merely holding them steady would represent an effective increase compared with what firms have come to expect from CDS in its current form. And as the IIROC committee submission indicates, the Maple proposal is highly leveraged, so there may be an irresistible temptation to extract more revenue from CDS in the future in order to help service its debt.

The submission from the Ca-na-dian Foundation for Ad-vance-ment of Investor Rights (a.k.a. FAIR Canada), a Toronto-based investor advocacy group, says that if Maple is allowed to acquire CDS, regulators must control its pricing as if it’s a public utility.

Indeed, if regulators are reluctant to deny Maple’s bid to buy CDS outright, they probably will have to take a more active role in overseeing its fees in order to preserve access and ensure fairness.

Alternatively, the FAIR Canada submission suggests, the regulators should consider deferring their decision on the CDS acquisition in order to conduct further consultations on whether the clearing function should be converted into a for-profit entity: “CDS plays a crucial market infrastructure role in the Canadian markets and the [regulators] should not be rushed into making a decision with widespread implications for the markets to suit the timing of the Maple proposal.”

Conversely, the issue FAIR Canada doesn’t want to see deferred is the separation of the listing regulation function from the exchange. While the OSC submission states that transferring this responsibility to an independent self-regulatory organization — such as IIROC (something FAIR Canada has long recommended) — is not something that can be accomplished as part of this exercise, FAIR Canada disagrees and insists that steps could be taken to manage this transition.

In addition, FAIR Canada’s submission suggests the regulators place conditions on the Maple deal to manage the fundamental conflicts that will exist between the exchange’s for-profit status and its regulatory role, and between owner-dealer interests and the public interest. Specifically, the submission recommends that two-thirds of Maple’s board be required to be independent, including at least one-third representing investors; and the threshold for what constitutes “independence” for a director be reduced to 5% from 10%.

Indeed, several comments suggest that regulators are going to have to do more to ensure that the conflicts created by allowing increased consolidation and integration are managed effectively.

Although the Maple proposal has been pitched as a deal to benefit the markets overall, regulators will have to weigh those claims against widespread industry opposition and the profound issues this raises for the future of Canada’s capital markets. IE