The Market System

A process for making deals

A market system is any systematic process enabling many market players to bid and ask. It helps bidders and sellers interact and make deals. It’s not just the price mechanism, but the entire system of regulation, qualification, credentials, reputations and clearing surrounding the mechanism and making it operate in a social context.

A market system for securities

The term market system is used to describe all the various services that together make it possible to convert savings into productive investments. The system is the process that allows governments and businesses to access funds cost-effectively. It also helps investors buy suitable investments at the best price and sell them when the right time comes.

The system ensures there is no delay in the transfer of funds or securities from investors to users of capital or to other investors. It is also structured with built-in protection so that users of the system are all treated fairly.

The Market’s main players

Brokers, often called Investment Dealers, are the key players. They take orders to buy and sell securities from Investors. They also assist Users of Capital by finding investors willing to buy their securities. Securities are bought and sold in a Market by investment firm traders. The integrity of investment dealers and markets is monitored by Industry Organizations (Self-Regulatory Organizations) and by Government Regulators (Securities Commissions). Separate organizations called Securities Clearing Houses or Depositories keep track of securities for dealers and ensure their accounts are settled quickly. Transfer agents or Registrars keep a record of the owners of securities. If an investment dealer goes under, investors are protected from losses by an investor protection fund. Industry staff are trained and accredited by an industry educational institution to meet accepted standards. These are all the main players in the market.

Investment dealers and the market

Investment dealers help a company that needs capital decide whether it’s better to borrow through bonds or to sell ownership through equity or stock. They offer advice on factors in the marketplace that might affect this decision. They can also give a company an idea of what price and terms would be attractive to investors.

Once prices and terms are established, dealers may act as agents in finding markets for these securities. Different firms may get together to locate investors. Sometimes an investment dealer or group of firms may buy all the securities themselves and resell them to investors. When this happens, they are said to be acting as principal. The process of getting new securities to market through the use of an investment dealer is called underwriting or the primary market.

Dealers and the government

When the federal government decides to borrow by issuing bonds, it may consult with investment dealers and banks on how much it wants to borrow and on what terms. Then the government takes competitive tenders for the issue from a selected group of dealers and banks. These primary distributors tender a bid to buy some or all of the bonds at a price they think is competitive. The dealers that are successful then find investors to repurchase the securities at a slightly higher price.

Provincial and municipal governments tend to borrow more like businesses by choosing an investment dealer to underwrite and sell their securities.

The stock exchange. A market as physical space.

You’ve probably heard about stock exchanges, which are places where stocks are traded, especially stocks which have already been issued and which are now being bought and sold among investors (the secondary market). However, no market has to be a physical place. A securities market is really any network connecting brokers and dealers who have orders. In all markets, information is exchanged regarding prices and amounts so that dealers who want to buy or sell a security can find it at the best price for the right size of order. Today, securities markets are becoming more and more computerized. Computers are ideal for gathering and organizing complex information. With modern communication networks, this information can be relayed instantly. New technology has already changed the way trading in stocks has traditionally been done on a trading floor with traders calling out orders to buy and sell. On some Canadian exchanges, the computer is already the meeting place.

The investment firm trader

Investment firm traders do the actual buying and selling when an order arrives in a firm’s trading room from an investment advisor. Often an investment firm has two trading rooms – one for bonds and debt instruments and another for stocks. With stocks, investors’ orders may be traded by computer, over the phone, or on a stock exchange. If the order goes to the stock exchange, traders execute it there on your behalf.

Bonds are traded by phone in the trading room. Experienced traders are allowed to buy and sell bonds and stocks on behalf of their firm to build up an inventory. This means that the dealer always has a range of securities products to satisfy investors’ needs. If the dealer doesn’t have the security you are looking for, the firm will find it for you and obtain it as your agent.

Regulating the market

In Canada the securities industry has a lot of responsibility for regulating itself. This is done through the stock exchanges and the Investment Industry Regulatory Organization of Canada (IIROC) which are also called Self-Regulatory Organizations or SROs.* They have been delegated responsibility by provincial governments to ensure that the brokers and dealers which are their members meet agreed-upon standards. These standards are written into provincial laws governing securities.

The Self-Regulatory Organizations oversee markets and trading as well as member firms and their practices.

*IIROC is not recognized as an SRO in Quebec.

The role of securities commissions

The securities commissions play a very important role. They make sure that the capital markets work properly and that investors are protected. They do this in three basic ways. First, all the people and companies that trade securities have to meet certain requirements and be registered with the commissions. Second, the commissions set rules to make sure that all relevant information about securities and their issuers are available to the public. And third, the commissions have special powers to investigate and prosecute those who break the law.

Securities commissions are government bodies subsidized by taxpayers. To save money and time, much of the actual work in regulating the market is done by the Self-Regulatory Organizations. However, commissions pay very close attention to how well the SROs do this job.

The importance of clearing corporations

Often called depositories, play an important role. First, they ensure prompt payment for securities. Second, they speed up the movement of securities between buyers and sellers and minimize the chance of losing securities.

Today, you will find that most securities, especially shares, are locked up in huge concrete and steel vaults of a clearing corporation/depository where they are safe. That means you probably won’t receive a certificate when you buy a stock unless you ask for it. You own it and your account records are your proof of ownership, but you never see it. Instead of being registered to you, the securities are registered to your broker on your behalf. This is called registering your shares in street name. Bonds have recently come to be treated the same way.

A modern clearing corporation/depository uses computers to keep track of all purchases and sales of securities that are immobilized in its vaults. At the end of every trading day, transactions between firms are added up for every security. The depository sends a tab to each dealer of the total amount owed by every other firm. Dealers then settle by sending a cheque to the clearing corporation for deposit in other firms’ accounts. Securities are transferred by book or computer entry.

Firms in Canada have three business days to settle the day’s stock and most bond transactions. In turn, you also have three days to hand over your securities when you are selling (if you actually have them in your possession), or to pay for them if you are buying.

Clearing corporations you need to know about

In Canada, there is one clearing corporation: the Canadian Depository for Securities (CDS). It serves members of the Toronto Stock Exchange, the Montreal Exchange, the Vancouver Stock Exchange, the Alberta Stock Exchange and various banks and trust companies.

The transfer agent and registrar

A transfer agent is a trust company appointed by a corporation to keep track of its shareholders – who they are and where they live. This information is important should a company need to send out dividend payments and to make sure eligible shareholders know about annual meetings and their right to vote. The registrar checks on the accuracy of the transfer agent’s work and keeps track of the status of a company’s shares.

Alternatives to investment dealers

Investment dealers have a long history of assisting in financial transactions. For centuries brokers around the world have made markets by bringing together buyers and sellers. The central marketplaces where they worked led to better prices for everyone. With central marketplaces governments were also able to make sure the rules were being followed because the number of players with direct access to the market was limited without putting up barriers to public participation.

In the last decade or so, governments in Canada have allowed banks and other groups to buy investment dealers. This change in ownership will not affect how you work with a broker. Today, registered dealers still have sole access to the markets.

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