New moves by Maple

The Maple bid raises a host of issues about the future control, governance and operation of the Canadian capital markets. Those issues are going to get a public airing in the months ahead, with the Big Four provincial securities regulators — Alberta, British Columbia, Ontario and Quebec — seeking public comment on Maple’s plans. Quebec’s Autorité des marchés financiers and the Ontario Securities Commission also are planning public hearings on the matter. The AMF has scheduled its hearings for Nov. 24 and 25 in Montreal; the OSC hearings are likely to happen shortly after that in Toronto in December.

Earlier this year, the OSC and the AMF had planned hearings into the proposed takeover of TMX by London Stock Exchange Group PLC. But those hearings ultimately proved to be unnecessary when that deal was abandoned because of lukewarm shareholder support.

But although those regulatory hearings never happened, a legislative committee in Ontario did hold its own public hearings, which had heard a host of objections voiced against the proposed LSE/TMX merger.

Some of the same worries that were raised against the proposed LSE/TMX merger — such as concerns about governance and the conflict between TMX’s listing and regulatory functions — persist in the Maple application, too. But many other objections are fundamentally different.

The common objection to the proposed LSE/TMX deal was the worry that listing business or regulatory control — or both — would migrate out of Canada. There are no such fears with the Maple bid, which had been put together largely in response to the prospect of losing local control of the trading business as a result of the LSE bid.

But Maple’s bid nevertheless creates its own set of fundamental questions for Canada’s securities industry to tackle. The OSC, for example, indicates in its submission on the Maple proposal that the bid “raises complex and novel issues for the capital markets.”

Many of these issues are based on concerns that the Maple deal would result in concentrated ownership of the exchange and clearing business (largely by the big, bank-owned dealers); and that the vital clearing and settlement function would convert from a cost-recovery into a for-profit venture.

These sorts of sweeping changes to the structure of the capital markets in Canada — creating a huge player in the trading business, with control over the clearing business — naturally lead to worries about conflicts of interest, fairness and costs for the rest of the industry.

Maple’s application attempts to address these concerns, arguing that all players in the Canadian capital markets will benefit from Maple’s plans to consolidate and vertically integrate its operations. The application also argues the proposal will put the Canadian markets in a strong position to compete on the global stage.

At the same time, the Maple application argues that the governance mechanisms it is proposing, along with competitive self-interest, will keep Maple from abusing its position as the dominant player in the capital markets: “Simply put, if Maple fails to sustain fair practices and produce these efficiencies, our vision will not be fulfilled.”

Yet, Maple will still have some work to do to convince regulators and the rest of the industry that its vision is in the public interest. For one, the merger of the Toronto Stock Exchange and Alpha would take away the already dominant TSX’s primary competitive threat and restore the TSX’s stranglehold on market share in trading.

Regulators have been encouraging competition in the trading business in recent years, and that has started to bear fruit with a proliferation of alternative trading systems in Canada, of which Alpha has been the most successful. The emergence of competition in the trading business is creating choice for traders and helping to drive innovation; there’s a fear that consolidation could snuff out this impulse.

And not only would the combination of Canada’s two biggest trading venues give Maple an overwhelming market share in that business, but the group would also take control of the clearing business.

Under Maple’s proposal, it would acquire CDS and convert it into a for-profit venture, which would then be married with Canadian Derivatives Clear-ing Corp. CDCC is 100%-owned by TMX, while CDS is two-thirds owned by the Big Six banks, 18.1%-owned by TMX and 15.2%-owned by the Investment Industry Regulatory Organization of Canada.

Anytime a monopoly exists — particularly one that’s designed to make a profit — there naturally are concerns that the lack of competition will tempt the monopoly to exploit its power at the expense of the rest of the industry and dull the impulse to innovate.

Even before Maple’s bid, the Investment Industry Association of Canada had been complaining about the ever-rising cost of market data in Canada and calling on regulators to intervene. Further consolidation and increased market power only strengthens the case for regulatory involvement.

Historically, this is the sort of intervention that Canadian regulators have been reluctant to do. Now, the OSC says, it’s considering whether increased fee regulation for exchanges and clearing agencies is necessary, suggesting this could include everything from enhanced fee disclosure to requiring an unbundling of fees for various services and regulating the fees for infrastructure services such as clearing and settlement.

There’s also the question of whether the trading and clearing businesses should be allowed to merge at all. Although trading is a somewhat competitive, for-profit business, the clearing function is part of the basic plumbing of the capital markets that is essential for the markets to operate.

In the hearings over the proposed LSE/TMX merger, Alpha had argued that TMX’s index and clearing businesses should be considered strategic assets and spun off in order to keep those assets out of foreign hands. In Maple’s current scenario, these assets would become part of a for-profit venture controlled by a small group of players in a fiercely competitive field.

The OSC’s submission observes there are various exchanges around the world that either operate with integrated models or don’t, and there’s no clear evidence that one approach is inherently superior. The OSC’s note does express some concern with both the fact that CDS would be transformed from an organization that’s owned by its users to one owned by shareholders that may not use its services and that the composition of CDS’s board would change as well.

The Maple proposal envisions an 11-member board for CDS (down from 15 currently) composed of five independent directors, five Maple nominees and one director from management. The proposed board also would change the definition of “independence.” According to the current OSC definition, only two of the directors on the proposed new board could be considered independent.

The OSC has similar concerns about the independence of the proposed Maple board, noting that nine of the 15 directors on that board would be controlled by Maple, which leads to a fear that shareholder interests will dominate that board.

These worries are exacerbated where CDS is concerned because the clearing operation will also have a new mandate to maximize profit. Says the OSC’s submission: “This raises concerns about the ability of CDS to fulfil its public interest responsibility and promote the objectives of its users.”

In particular, notwithstanding Maple’s promise to maintain an open architecture, the OSC is questioning whether additional measures are necessary to ensure access to CDS for other marketplaces. This could include requiring a higher percentage of user representation on the board and/or imposing an ownership restriction on CDS so that no single shareholder or a group of shareholders have significant control over it.  IE