Stanley M. Beck, Q.C. Chairman, Ontario Securities Commission
REVOLUTION IN FINANCIAL SERVICES
February 20, 1986
The President, Harry T. Seymour, Chairman
Mr. Minister, Reverend Sir, distinguished guests, members and friends of The Empire Club of Canada: It is my pleasure to welcome as our guest speaker today Stanley Beck, Q.C., Chairman of The Ontario Securities Commission.
Those in the industry who know Stanley Beck say his skills as a listener and an administrator make him a natural for the job.
William Pidruchney, Chairman of The Alberta Securities Commission, says he is impressed with Beck's composure and his fluency with the issues.
Says Edward Waitzer, a lawyer with Stikeman Elliott: "He's a good administrator, and has written some of the leading articles on shareholders' rights. . .His articles have influenced the law."
Henry Knowles, Ontario Securities Commission Chairman from 1980 to 1983, describes Beck as quietly thoughtful but very determined.
"He is his own man... He is an independent thinker... and there's no question he will bring a new direction and new thrust to the Commission."
Stanley Beck assumed the leadership of the country's most powerful securities regulator at a time of tremendous change within the so-called four pillars of the financial world: banks, trust companies, insurance firms and investment dealers.
The lines traditionally separating the pillars are blurring, as each moves into the other's business. That process is being sped along by new technology that allows capital to jump anywhere in the world at the push of a few computer keys.
Beck's regulatory shopping list includes: first, a thorough look at the amount of information contained in annual reports and other financial statements; and, second, the implementation of Peter Dey's paper on the ownership structure of the securities industry.
Meanwhile, the recommendations in the Dey Paper include opening the brokerage business to foreign investors by allowing non-residents to hold up to 30 per cent of a securities firm.
The findings of the Dey Paper have been attacked by the Securities Industry Capital Markets Committee, which says the recommendations could result in the Canadian industry being dominated by large United States firms.
Although our guest says he agrees with the general thrust of the paper, he is on the public record as saying he is willing to discuss modifications before pushing for legislation.
As well as developing a scenario for Ontario, the ownership legislation has to fit with the federal government's position and with the recommendations of Ontario's Dupre Committee, which reviewed the whole financial services industry in its November 1985 report.
As a champion of shareholders' rights, Beck has more detailed disclosure high on his list.
While interim and annual reports and timely disclosure statements record either what has happened, or what is about to happen, within hours or days, should not investors be informed of industry developments and trends that will affect a corporation's performance in the future? Beck says. This form of disclosure is currently required by companies that are registered with The Securities and Exchange Commission in the United States. Financial analysts have expressed the opinion that this requirement is the single most useful thing that the S.E.C. has done in recent years.
After the thorough investigation now under way, The Ontario Securities Commission will ascertain whether it would be useful, in the context of requiring the best possible disclosure to our marketplace, to insert a similar provision in The Ontario Securities Act.
The challenge of disclosure of ownership then of rapidly growing international markets, multinational offerings, international over-the-counter trading, Eurobonds, Euroyens, and Euroequity markets, produces, as Beck has stated, the classic Canadian regulatory problem: How do you protect a small, sophisticated market in Canada and still go about "playing with the big boys" on the international markets?
Originally from Vancouver, Stanley Beck studied law at the University of British Columbia. His appointment as Chairman of The Ontario Securities Commission on May 1, 1985, followed an illustrious legal career that included teaching positions of increasing responsibility at the University of British Columbia, Queen's University and Osgoode Hall Law School, where he was Dean from 1977 through 1982.
Our guest, who plays a mean game of racquet sports, according to former Commission Chairman Peter Dey, and Stanley's wife Barbara, whom we are pleased to have with us today, live in Toronto with their two children, aged 13 and ten.
Ladies and gentlemen, it gives me great pleasure to introduce the overseer of the fourth-largest financial market in the world, Stanley Beck, who will address us on the subject "Revolution in Financial Services."
Exactly one week ago today, I was startled to read the following headline on the front page of the Financial Times of London:
New York Stock Exchange ruled out as London Stock Exchange regulator
If I was surprised at that headline, I can only assume that many in the London financial world must have choked on their morning tea as they read it. The internationalization of financial markets has truly proceeded at a remarkable pace. But the idea of the New York Stock Exchange as a regulator of the London Stock Exchange is not only an astonishing suggestion, but it provides some indication of the extent of the revolution that is taking place in world financial markets.
I use the term `revolution' advisedly, for what is happening is not just a reorganization of financial markets, but is truly a fundamental change taking place, both within and across national borders. It is a revolution whose winds are being felt very strongly in this country, although the ultimate design of our financial markets remains unclear.
In typically Canadian fashion, we have commissioned a, seemingly endless series of reports to diagnose and to prescribe. The result is a babble of conflicting advice, with both provincial and federal governments yet to take any significant action. But financial markets do not wait upon dithering governments, and the structure of the Canadian financial market continues to change in response to international forces from which we are not immune.
The Federal Green Paper spoke of the need for greater competition and the creation of "C" Banks. Since the publication of the Green Paper, three Canadian banks have disappeared from the scene, two through failure and one through merger, and the idea of the "C" Bank appears, mercifully, to be dead. What then of increased competition , within the financial markets?
The Report of The Ontario Task Force on Financial Institutions, known after its chairman as the "Dupre Report," warned against concentration and the merger of large units, and the mix of commercial and financial institutions. Since the appearance of the Dupre Report, Canada's largest and fourth-largest trust companies, Canada Trust and Canada
Permanent Trust, have merged as a result of a take-over of Canada Trust by Genstar, a primarily non-financial conglomerate.
Genstar has also purchased a ten-per-cent interest in Cordon Capital Corporation, an investment dealer, and Cordon and Genstar have formed Gordon Investment Corporation to carry on merchant banking activities in the non-regulated segment of the securities industry. Gordon Investment thus joins Great Lakes Financial and Hees Corporation as major investment bankers dealing in the exempt market and controlled by commercial and financial entities.
The Dupre Report also was concerned about maintaining a degree of separation among the so-called four pillar-the banks, trust companies, insurance companies and securities dealers-and warned about the dangers of moving towards a German-style universal banking system. Yet while the Dupre Report was being written, the Toronto-Dominion Bank began sale, through its branches, of a TSE Index Based Mutual Fund, a service that will complement its TD Green Line Discount Brokerage operation. And the Royal Bank has recently announced that it, too, will enter discount brokerage operations.
At the same time, the Mutual Life Assurance Company of Canada has registered with the Ontario Securities Commission as a mutual-fund dealer and will be offering an inhouse managed fund through its sales force. It will be the first insurance company to do so. In Quebec, the Desjardins and Laurentian Insurance groups have each, as a result of Quebec's liberalizing Bill 75, purchased an interest in a trust company and a securities dealer.
I do not want to suggest that Canadian governments, either provincial or federal, are powerless to deal with the forces of change in the financial industry. But I do want to suggest that those forces of change are rooted in international economic and electronic reality and that the changes that are taking place within our borders are mirrored in every developed Western economy.
Accordingly, I suggest that we need to lift our sights beyond what is happening within our own borders and look at the global financial marketplace. We need to ask what lessons might be learned before we embark on a restructuring that fails to take account of the global reality and leaves us with a regulatory structure ill suited to the best interests of Canadian issuers and investors.
Before dealing more particularly with the Canadian scene, let me return to my opening theme and outline briefly, some of the major changes taking place internationally and suggest what they indicate for the Canadian capital market.
The New York Stock Exchange, as a regulator of The London Stock Exchange, arises from the fact that the doors of the United Kingdom financial markets have been thrown wide open. As of this coming October, international ownership of United Kingdom securities dealers and merchant banks will become the operating reality. The result will be a truly international market with the major international banks being the dominant force in the securities markets, with the likely survival of very few independent U.K. securities firms.
The idea of New York Stock Exchange regulation came from the suggestion that U.K. officials might be willing to accept New York Stock Exchange regulation and surveillance of its member firms dealing in the U.K. Although, as the Financial Times reported, that idea was "swiftly rejected" it does show the extent to which international trading has come to the securities markets.
In the same Financial Times, one reads about an agreement being reached between Reuters, an international news agency, and The London Stock Exchange to combine their competing electronic systems for displaying the share prices of leading international companies.
Reuters has some 53,000 terminals around the world. Initially, these terminals were used for information and later, currency trading. Now they are being broadened to include stocks and bonds. Reuters also owns 25 per cent of, and markets, Instinet, an American computerized screen-based trading system that offers both market information and automatic execution of trades up to 1,000 shares.
This is just a glimpse into the computerized networks that allow around-the-world trading of equities. In its May, 1985 issue, Euromoney lists 328 international equities that it defines as those having "active and liquid markets in at least one centre outside their home base." The equities include U.S., Canadian, Japanese, Australian, British and German issues.
Seven-day-a-week, twenty- four-hour-a-day global trading in the world's major equities will soon be a reality, and the trading will take place primarily through electronic networks. What then for national stock exchanges, and what role for national regulators? These are critical questions we are all beginning to face.
In addition to twenty-four-hour trading and the computerization of markets, another major- area of change is the linkage of exchanges and here, The Toronto Stock Exchange has taken the lead. The first truly international exchange is the link between The Toronto Stock Exchange and The American Stock Exchange, whereby interlisted securities are traded as if on one market, with the trade moving to the best market. Quotes are shown in both currencies with the appropriate conversion, so that there is a true international market. The second link is soon to be opened between the TSE and The Midwest Stock Exchange, thus bringing many New York Stock Exchange-listed companies within the international market concept.
The New York and The London Stock Exchanges have a committee studying possible linkages, and NASDAQ and The London Stock Exchange have recently reached agreement on a two-year pilot program that will see each Exchange display price quotes on stocks listed on the other Exchange.
Allied to international trading markets is the increasing use of multinational offerings. Indeed, offerings by Alcan Aluminium and Bell Canada in 1983 are often referred to as the first truly international financings. The Bell Canada issue of some $250 million was offered simultaneously in Canada, the Unites States and the United Kingdom.
The biggest international offering by far, and the biggest equity offering in history, was the British Telecom offering of last year, when some $4.7 billion in equity was offered simultaneously in Canada, the United States, the United Kingdom and Japan.
Since the British Telecom offering, we have seen international offerings, some part of which have been placed in Canada, by Britoil and Cable & Wireless in the U.K., and by the Union Bank of Switzerland.
The most remarkable of all the international securities phenomena has been the growth of the Eurobond market over the past twenty years. New issues of Eurobonds in 1985 totalled some $134.4 billion. Canadian issuers, government and corporation, tapped the Euromarket for some $8.7 billion. Since 1981, there has been close to a 30-per-cent increase in the volume of Canadian financing in the Euromarket.
Perhaps the most startling fact of all is that, in the first half of 1985, U.S. companies raised more money overseas than they did in the domestic market.
Every day, a computer system in the New York Clearing House called, appropriately CHIPS, processes debits and credits of London Eurodollar trading in a volume approaching some $200 billion. In the words of Walter Wriston, the former head of Citibank:
"This market is not just more of the same: it is something new in the world. It has changed the world."
While debt is by far the most prominent part of the Euromarket, there is a rapidly growing Euroequity market. The internationalization of equities is becoming a reality some twenty years after the internationalization of bonds.
It is important to note that the Euromarket is essentially unregulated. It is a market that began as an alternative to regulated, domestic markets. Financial intermediaries, issuers and investors came together and did deals that suited their needs.
Efficient ways were found to do business that transcended national boundaries, the restrictions of national financial markets, and the rules of national regulation.
The latest development in the Eurobond market is the opening of a Euroyen market. Euroyen bonds are Yen bonds sold outside of Japan. As the Japanese Government makes it easier to finance in Yen in international markets, there is growing pressure to ease entry into the Japanese domestic market.
That pressure resulted last month in the admission of six foreign firms to membership on The Tokyo Stock Exchange for the thumping price of $5 million per seat. The six firms were Goldman Sachs, Merrily Lynch and Morgan Stanley from the United States, and Vickers DaCosta, S.G. Warburg and Jardine Fleming from the United Kingdom. It is perhaps worth noting, particularly in the Canadian context, that Vickers DaCosta, a major U.K. dealer, is wholly owned by Citibank of New York, the world's largest commercial bank.
Clearly, Tokyo is taking its place as the world's third great financial centre alongside London and New York, and the world's major issuers are seeking listings on The Tokyo Stock Exchange. Bell Enterprises was the first Canadian company to list on The Tokyo Exchange, followed within the past few months by the Toronto-Dominion Bank, and the Canadian Imperial Bank of Commerce recently has announced that it, too, will seek a listing.
In two days, this Saturday, five million common shares of Bell Enterprises will be offered in the Japanese market. The offering, the first primary offering of equity by a Canadian ,issuer in Japan, is expected to realize some $200 million.
4. Let me turn for a moment from structural developments ` to two developments in financial products and services that are equally revolutionary. I refer to the growing securitization of debt and the swap market in currency and interest rates.
Securitization is just a fancy word for the turning of loans into securities. Put simply, what is happening is that banks, rather than playing their traditional role of risk takers, are now placing the risk directly to investors through securitization of their loan portfolios. Of course, as bank assets are securitized, the traditional distinction between commercial banking and securities dealing becomes blurred.
The securitization phenomenon is a direct result of the information revolution. From 1964 to 1985, the real cost of processing information has declined by 98 per cent and the cost of transmitting information has declined by about 95 per cent. These cost reductions have been one of the major factors in causing financial institutions to reconfigure the services they offer to the public. It is the decline in information costs that has promoted the direct placement of risk.
Reduced information costs make it easier and cheaper for investors to assess the risk of, and return on, direct obligations of issuers. Lower costs also make it easier and cheaper for these obligations to be subdivided into pieces small enough to enhance the diversification of even relatively small portfolios.
Let me give some recent examples of securitization. The prime example of securitization is the American mortgage market, but the trend is spreading to other kinds of loans and to other marketplaces. The first issue in the Euromarket of bonds backed by commercial real estate was an offering by Olympia & York Developments Limited of some $200 million of bonds this past November. The bonds were backed by a first mortgage and the assignment of long-term leases on a Lower Manhattan office building.
What is happening is that developers are, in effect, turning their buildings into bonds. The reason is that the capital markets provide a cheaper and more easily accessible source of financing than conventional mortgages, particularly for very large buildings. The story in the Economist on the
Olympia & York placement pointed out that the cost to an issuer on a double-A-rated bond backed by real estate could be V/a to P/2 percentage points lower than on a conventional commercial mortgage.
Another much noted example of securitization is the packaging of automobile loans and the issuing of securities backed by such loans. The potential for that market in the United States can be appreciated when it is realized that there is some $168 billion of outstanding car loans. Investors are eager to pick up securities backed by such loans where annual losses run at a mere 0.5 per cent.
As I have noted, as the trend towards securitization continues, and it is clearly going to do so, the line between commercial banking and securities dealing becomes even thinner.
The most significant development in services is the rise of interest rate and currency swaps. A swap is simply a way to exchange one kind of interest obligation, or one currency, for another. An interest rate swap, for instance, involves changing the nature of interest payments from fixed rate to floating rate, or vice versa. In the simplest case, two borrowers agree to swap the interest payments on identical amounts of debt to their mutual advantage. The principal does not change hands. There are many variations of an interest rate swap, but the advantages are cheaper, more flexible financing.
The seap market, approximately six years old, is estimated to have grown into a $200-billion business. As noted, the advantages to swaps are cost effectiveness and flexibility, with the swaps being accomplished without buying or selling existing assets or liabilities.
Given the volatility of interest rates and currency fluctuations, one can appreciate the reason for the rapid growth of the swap market, and the major role that swap markets now play in commercial finance. It is interesting to note that in Canada, the largest player in the swap market is not an investment dealer or one of the Big Six Canadian banks, but is Citibank Canada, which has an estimated 25 per cent of the $3-$4 billion Canadian market.
So much for the description of the revolution in the financial markets. What lessons are there for the restructuring of the Canadian financial markets? My own area of responsibility is the securities markets. The Ontario Securities Commission, in its February, 1985 Report to the Government on Entry into and Ownership of Ontario Securities Industry, recommended major changes with respect to allowable limits of foreign ownership of Ontario securities dealers and allowable limits of ownership by Canadian financial institutions, that is, banks, trust companies and insurance companies.
The main recommendations of the Report were: 1. Non-residents, individually or in the aggregate, would be allowed to own up to 30 per cent of a registered dealer. 2. Financial institutions would similarly be allowed to own up to 30 per cent of a registered dealer.
3. Resident investors, other than a financial institution, would be allowed to own up to 49 per cent of a registered dealer.
4. A new class of registration, foreign dealer, would be created. A foreign dealer could be 100-per-cent owned by a non-resident. A limit of 30 per cent of the total capital employed in the securities industry would be placed in the aggregate amount of capital that would be permissible for foreign dealer registrants. An individual limit on any one dealer would be set at 1.5 per cent of the total capital of the industry. As the total capital of the industry was estimated at $1 billion, there would therefore be a $15-million limit on the capital of any one foreign dealer registrant.
In formulating its proposals, the OSC identified two primary public policy concerns whose importance necessitated some pulling back from a totally free market approach, and further necessitated the imposition of some competitive restrictions. The two overriding public policy concerns were: • Ownership of the securities industry must remain substantially Canadian.
• The Canadian financial system should remain segregated according to function, the so-called "four pillars" principle.
The recommendations contained in the OSC Report are intended to encourage, as far as possible, the development of efficient and competitive markets while preserving the two public policies. It is my firm belief that the OSC recommendations do that, and are minimum required to ensure that the Canadian industry is properly positioned to be a world player while, at the same time, offering the most efficient service to the Canadian investment community. Failure to keep up with innovations in other markets, in terms of regulatory structure as well as in products and services offered, introduces a significant risk.
One of the ways that economists measure what they refer to as the "vitality factor" is to determine how well a particular market is keeping up with its competitors. In this case, with the other financial centres around the world. Because one of the clear trends is toward increasing openness to foreign entry and ownership in every major market in the world, it can be expected that opening the Ontario industry will maintain its vitality relative to other markets.
Intermediaries will locate where business is found. If an advantage can be gained in another market, whether it is Montreal, New York or London, trading activity will move. The relative attractiveness of markets inevitably will affect their relative vitality over time.
The most important question facing the Ontario Government in the debate over foreign entry is one that has no empirical answer: If other markets are open to the international marketplace but Toronto is not, will that difference give rise to a competitive disadvantage for Toronto-based dealers?
The answer could be yes for two reasons. First, a protected market tends to be less vital, because fewer major players are present. Second, restricted entry could reduce access to capital, which would hamper Toronto-based dealers as they compete in the increasingly capital-intensive securities industry, especially for the business of large institutions engaged in international investment activities.
It is my opinion, and the opinion of my fellow Commissioners, that the risk to the Toronto-based industry, and to Canadian issuers and investors, of not opening the Canadian industry to significant foreign and domestic investment is substantial, and that the reality of international financial markets and global trading demands the kind of carefully staged opening outlined in the OSC Report.
Certainly there are risks, and the entry of major American, U.K. and Japanese investment banks into the domestic market, as well as the entry of our own major financial institutions on a limited basis, is bound to change the nature of that market and is likely to change the makeup of our major investment dealers.
The risk of standing still, while dramatic change is taking place around us, is an even greater risk. What is at stake is Toronto's place as a major capital market at the very top of the second rank, just beneath the New York-London-Tokyo axis. The Government of Ontario has before it the OSC Report and the Dupre Report, which is more cautious than the OSC Report and asks the Ontario Government to assess very carefully the risk to the maintenance of a substantially Canadian industry.
I do not know what the decision of the Ontario Government is to be, but I have urged the Government to make a ~~ decision within the next few months as, in my view, delay would be injurious to all of the interested parties. Foreign dealers wish to enter this market and domestic financial institutions want to know what the rules are to be, so that they might plan accordingly. Domestic dealers similarly want to put the matter of industry structure behind them and get on with their primary business, whatever the rules are going to be.
The worst possible scenario, in my view, would be to adopt the view advocated by the Dupre Report and leave the entire matter to be negotiated as part of the services aspect of free trade negotiations. That suggestion would have the double disadvantage of postponing the decision for as much as three to five years, and would take the decision-making power out of the hands of the Ontario Government and put it in the hands of the Federal Government which, whatever the outcome of current Federal/ Provincial negotiations, will have the lead hand in the free trade negotiations.
Finally, let me turn to the OSC Report, the Dupre Report and the Federal Green Paper as they deal with the entry of Canadian financial institutions into the securities industry.
Part of the scenario of global financial markets that I have outlined indicates the need for world-scale units. The entry of Canadian financial institutions into the securities industry, along with the capital that will be supplied by limited foreign entry, gives the best chance of world-scale Canadian firms. I appreciate that this raises the spectre of concentration in the Canadian financial industry, but I think we have to pause to consider what our concern with such concentration is.
First, concentration has been a part of Canadian economic reality since Confederation. The size of our country and the thinness of our population and markets has always meant, and means today, that we require a small number of large-size economic units. The five major Canadian banks have always formed a major concentration of economic power, a concentration not the least lessened by widely held ownership, notwithstanding the banks' protestations to the contrary. It is a very naïve view of power to suggest that a major economic institution is any the less powerful for being widely held, as opposed to being closely held. The nature of the economic, political and social power is exactly the same, although the seat of the power is easier to identify if the institution is closely held. The important point is that the nature of the power is essentially the same, whether the institution is closely or widely held.
I agree that there is a good deal to be said for widely held companies, particularly in the financial sector, in terms of openness and accountability. In the current Canadian context it is, in my opinion, both politically possible and feasible, for closely held holding companies and/or their subsidiaries, to be required to sell at least a 35 per cent equity position to the public over the next three to five years.
Such a requirement, combined with sensitive rules with respect to self-dealing, independent audit committees, appointment and rotation of auditors and increased disclosure, would go a long way towards meeting the objections to the current control of financial conglomerates. The public would support such moves; what is lacking is political will.
If the six major banks, along with the very competitive "B" Banks, plus the five major trust companies and, say, five major insurance companies, were allowed to compete in the financial markets, although not necessarily to deal in each other's core function, then I suggest that we would have as competitive a financial sector as any country in the developed world. And, if those same institutions are allowed, in a limited way, into the securities industry, it can only lead to healthy innovation, greater access to capital and a more competitive environment.
In my view, that would be to the great advantage of Canadian capital markets, Canadian issuers and Canadian investors. Certainly such a scenario will bring change, and change always brings a certain amount of upset. But the reality, as I have tried to outline it, is not one simply of change, but of revolution in world financial markets. What is at stake is the positioning of our financial institutions to take their rightful place as major players in those markets.
Canada has been extremely well served by its capital markets, and the immediate challenge is to so position the players in those markets that we can be as well served in the future as we have been in the past.
The appreciation of the audience was expressed by Bredin Stapells, Q.C., a distinguised Past President of The Empire Club.