Regulatory competition counterweight to securities industry concentration, Quebec study argues

(August 8, 2003) Perceptions not established facts drive the debate on securities regulation in Canada, says an academic study commissioned by Quebec’s securities regulator. The report is also highly critical of brokerage fees and the “extreme concentration” of investment dealers, as well as the Toronto Stock Exchange’s status as more than a “regional” small-cap exchange.

“From the beginning, discussions on the efficacity of the current securities regulatory regime have turned on statements that seem to rest more on perceptions than on facts,” Commission des valeurs mobileères du Quebec (CVMQ) president Pierre Godin said in a release earlier this week. “We wanted to call on independent university expertise to clarify the issues and put the debate on a factual basis rather than an a priori ideological one.”

The result is a 200-page report by professors Jean-Marc Suret and Cécile Carpentier at Laval University’s Centre interuniversitaire de recherche sur les organisations (CIRANO). They argue that the real threats to efficient capital markets are the oligopoly of the big bank brokers and the leakage of large-cap trading in interlisted stocks to the U.S., not the absence of a single regulator. The criticisms commonly advanced in favour of pan-Canadian regulation, they say, are “guided by myths put forward by pressure groups,” rather than factual analysis.

Far from facing 13 different provincial and territorial regulators, the authors note, the vast majority of stock issuers as well as listed companies reside in the four provinces with 85% of the population. They might deal with one or two regulators, at most four. As well, the Canadian Securities Administrators has already harmonized prospectus disclosure and exemptions through the mutual reliance system, while streamlining market surveillance and registration. National instruments that govern securities have mostly been harmonized while the uniform securities law is expected to eliminate remaining difference.

Cost data

The authors also note that there has been no rigorous analysis of regulatory costs in Canada. They divide costs into three components: direct costs to issuers, indirect costs to intermediaries and finally costs due to marketplace distortions. Even if regulatory costs are significant, however, the authors argue that they need to be put in perspective. Alongside regulatory costs, investors are confronted with the spread between bid and ask prices, market impact costs stemming from trading large orders, broker commissions, and finally clearing and settling costs.

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Based on U.S. estimates, brokerage costs amounted to $5.7 billion in 2001, while the expenses of the four securities commissions were $103 million, Suret and Carpentier note, adding that the U.S. data is uncertain. In addition, it’s cheaper and faster to do an initial public offering in Canada than it is in the United States. While regulatory costs eat up 1% to 2% of the gross proceeds, “brokerage commissions constitute the greater share of total direct costs,” so much so that, the authors argue, “costs imputable to undervaluation, unrelated to regulation but related to broker conduct, are on average much higher than total direct costs.” In other words, start-ups lose more to low-ball offering prices set by underwriters than they do to brokerage and regulatory fees.

Still, there are weaknesses in the Canadian model, the authors argue. “The increased number of initial offerings, in particular for venture capital, the high mortality and the weak accounting and market performance of new listed companies, leads us to believe that Canadian regulation gives start-up companies access to the stock market too quickly.”

U.S. no model

The authors argue that the centralized regulatory model of the United States is a response to a fragmented financial market. The Securities and Exchange Commission (SEC) oversees nine stock exchanges, the over-the-counter market and 70 alternative trading systems along with 12 clearing houses. “Securities regulation is segmented, with small local isssues being governed locally” by state securities commissions, say Suret and Carpentier. “The SEC may be considered a regulatory monopoly with respect to important securities, in the face of a competitive and fragmented industry.” Nevertheless, they add, “the United States is considered to have onerous, costly and strict regulation. This regulation applies to companies very different from those in Canada, where small issues predominate.”

By contrast, the Canadian financial system is highly concentrated, with the six big bank brokerages controlling 70% of the securities business. In the various self-regulatory organizations, they also hold the majority of seats on boards of directors. The structure of the Canadian securities industry is also different, with one exchange group, two clearing houses, one regulatory serve and a handful of alternative trading systems “which are mostly under the direct or indirect control of the large banks and their broker subsidiaries,” Suret and Carpentier note. “To our knowledge, no developed country presents such a high level of banking, financial and self-regulatory concentration.”

For the authors, adding a single securities regulator on top of this would be “dangerous.” Suret and Carpentier say “the establishment of a national commission would lead to a regulatory monopoly. Authorization of the mergers of banks, which own the main brokerage firms, and the growing concentration in this sector, seems to be leading Canada to oligopoly. According to the forecasts of regulatory theoreticians, a situation where a regulatory monopoly governs an oligopoly is potentially dangerous.” The theory they refer to is “capture theory,” whereby the dominant players in the regulatory process work to capture the benefits of regulation for themselves. Regulatory competition, the theory holds, would blunt the capture effect.

Trading volume

The authors also question whether multiple securities commissions limit capital market growth. They note that the Canadian market is basically a small-cap market, with only 600 issuers being potentially able to list on the 5,000-stock NASDAQ. They also argue that “Canada is unattractive for foreign corporations and the presence of foreign corporation is symbolic: more than 99.9% of the trading volume in such securities is outside the Canadian market.” In addition, they say, “the American market captures a significant share of trading in large Canadian inter-listed companies. More than one-third of heavily traded Canadian stocks are now traded in the United States rather than in Canada.”

It’s a situation they call worrisome, and Suret and Carpentier add that with the increase in upstairs trading among institutions — trades that don’t cross the TSX floor, but are reported on the consolidated data tape — only 30% of Canadian stock transactions now flow through the regular Toronto market.

Given these challenges, Suret and Carpentier conclude “a revision of the current regulatory structure is probably not an essential aspect of the situation.” While improvements can be made, the authors suggest that a European-style “passport” system might be the better solution.

Filed by Scot Blythe, Advisor.ca, sblythe@advisor.ca.

(08/08/03)