The brawl on Bay Street

Canada’s big banks are preparing to launch a rival stock exchange to the TSX, setting up a battle that could shake up the industry and bruise investors


When executive egos and business interests collide in Canada, the Toronto Stock Exchange has traditionally been the battlefield on which conflicts are waged. But the latest corporate showdown on Bay Street pits the TSX itself against the most powerful financial institutions in the country.

Sometime in the next few weeks, Canadians will get their first look at what this country’s newest stock exchange could look like. That’s when Alpha Group, a company owned by the Big Six banks, Canaccord Capital, Desjardins Securities and the Canada Pension Plan Investment Board, will make public its application to become a full-fledged exchange. Jos Schmitt, CEO of Alpha, is tight-lipped about exactly how the new exchange will be structured and what services it will offer. But he’s not nearly so reticent about why he believes Canada needs another big exchange. “What we’ve had in Canada was a monopoly without any regulation of fees,” he says, referring to the TSX and its parent company, TMX Group. “We saw a lack of innovation, fees that were too high and a lack of investment. That’s why competition has kicked in.”
On buttoned-down Bay Street, those are fighting words. And competition is certain to get fierce. But this isn’t just a battle between rival exchanges for market share and fees. Some worry investors could end up getting bruised, too.

If Alpha gets the go-ahead from regulators, whom it first approached with the idea in April, the new exchange would be just the latest challenge TMX Group has faced in recent years. Since it transformed from a non-profit organization to a publicly traded company early last decade, a phalanx of rivals have offered low-cost ways for big investors to swap stocks listed on the TSX without paying fees to the exchange. Known as alternative trading systems (ATS), these electronic platforms, of which there are now seven, serve as markets for matching buy and sell orders. That was Alpha’s original business, and since launching in 2008 the company has grabbed 19.5 per cent of all the volume of equities traded on Canadian markets. The TSX and TSX Venture Exchange still account for a combined 70 per cent of trading volume, but it’s a far cry from the 98 per cent they enjoyed in 2008. Since Alpha’s formation, the fees traders pay to buy and sell stock have plummeted between 30 and 50 per cent.

TMX Group has also faced intense pressure lately over the fees it charges brokerages for market data, such as share prices. According to reports, the Investment Industry Association of Canada is preparing a study that will show the TMX Group charges excessive fees to brokerages. The organization plans to use the report to pressure regulators to cap how much markets can charge for data feeds. Such a move could hurt the company—selling market data generated $146 million in revenue for TMX Group last year, up nearly eight per cent from the year before.

On the exchange front, Alpha isn’t actually the first rival to launch here. In 2007, the Canadian National Stock Exchange (CNSX) set up shop targeting micro-cap companies. But with just $15 million worth of trades on the CNSX each month, versus $110 billion on the TSX, it’s not even a David and Goliath contest. With the Alpha exchange, it will be a more even match, though, say analysts. Schmitt plans to use the success of Alpha’s trading business to lure mid- to large-sized companies to list their shares on the new exchange, bypassing the TSX altogether. Shubha Khan, an analyst at National Bank Financial, says Alpha poses a “noteworthy threat” to the TMX Group.

Not so fast, says Kevan Cowan, president of TSX Markets, the exchange division of the TMX Group. For one thing, the company is far more diversified than it was a few years ago, when it relied exclusively on the listing and trading of equities for its revenue. Through its purchase of the Montreal Exchange in 2007, the TMX Group grabbed the primary market in Canada for trading derivatives, like options and futures. The company also now controls one of the largest trading platforms for fixed income and operates NGX, a large market for natural gas and electricity contracts—five exchanges in all. At the same time, having already faced pressure from rival exchanges in New York and London, the TSX regularly courts companies in the U.S., China and Australia. At last count the exchange boasted around 300 international listings.

But as the once-staid stock exchange business goes through upheaval, it’s prompting some observers to ask serious questions about what all this means for investors. For one thing, critics say the TSX suffers from a conflict of interest because it generates revenue from fees it charges to companies listed on the exchange, while also being responsible for regulating those listings. After the exchange became a for-profit company, it outsourced the job of overseeing trading activity to industry regulators. But the TSX continues to set and enforce its own rules governing stock listings. “They are the only exchange out of all the leading exchanges in the world who have not separated the commercial from the regulatory functions,” says Ermanno Pascutto, executive director of FAIR Canada, a shareholder rights group. In a recent report, FAIR called on regulators to force the company to hive off its own regulatory division.

With TMX Group on the hunt for profits, it’s not hard to see where the potential for problems could arise. In 2007, the company acquired Equicom Group, an investor relations business that, for a fee, helps promote publicly traded firms to investors. Take the case of one of its clients, Timminco Inc. The mining company saw its shares rocket from penny stock status to $33 in 2008 on the promise of its silicon production for the solar industry, but has fallen back to 39 cents amid doubts about those claims. TMX Equicom designed the company’s 2008 annual report and in a case study on its website said it educated investors about the solar energy “revolution.” Effectively, the TMX Group not only billed the company for its listing and regulated it, but helped promote it, too. “They’re being paid to make companies look good,” says Pascutto. “That is not something regulators are generally paid to do.”

Cowan says such concerns are unwarranted. Equicom, a small part of its business, works in a separate building and is not bundled with any other TMX Group services, as is the case with NASDAQ’s investor relations business—though as Pascutto notes, NASDAQ’s listing rules are handled by an independent organization. As for the exchange’s regulatory duties, he says the company’s business interests are aligned with its public service responsibility—otherwise investors would lose confidence. To that end, Cowan points to the success companies have had raising capital: last year, listed issuers in Canada raised $65 billion in equity, the sixth-highest level in the world. “We feel through 150 years of experience we’ve found a good balance between investor protection and the regulation of issuers and the access to capital,” he says. “The evidence seems to be the system is not only working well, but working disproportionately extraordinarily well compared to other exchanges in the world.”

But the TMX Group is hardly alone in feeling the heat. Some in the industry are disturbed that big banks and brokerages are getting back into the exchange business. Thomas Caldwell, chairman of Caldwell Financial Ltd., says he worries banks will use their clout as lenders and financiers to pressure companies to list on the new exchange. Just last week it was reported regulators are probing an agreement between Alpha’s owners to direct buy and sell orders to the upstart market. “Everybody says it’s for the customers but none of these guys care about the customer,” he says. “The banks want to dominate this industry again like they did in the old days.” Pascutto also worries that as competition between Alpha and the TSX heats up, they’ll ease rules to attract stock listings. “We’ll get a lowering of standards as people compete on less rigorous listing requirements.”

Schmitt says there will be no conflicts of interests at Alpha. The company’s governance model prevents the owners from meddling in day-to-day operations. Meanwhile, he says Alpha will hive off its regulatory duties as a separate entity once the exchange launches, which Schmitt hopes will happen during the first quarter of next year.

Regulators still have many other crucial questions to work out as financial markets transform at breakneck speed. The new entrants like Alpha are bringing with them innovations like dark liquidity pools, which let traders swap stocks anonymously, while the TSX and its rivals are all eagerly catering to computer-driven high-frequency traders who generate huge fees and now account for roughly 30 per cent of all trades in Canada—this despite the fact that both dark pools and high-frequency trading have come under increased scrutiny in the U.S. following the dramatic flash crash that roiled markets on May 6.

But all of this raises a more fundamental question. Does Canada really need so many exchanges? After all, in recent years many of the country’s biggest companies have imploded—like Nortel and JDS—or have been gobbled up—like Inco, Alcan, Falconbridge and perhaps, now, Potash Corp., too. Not everyone is certain to survive intact. In May, Peter Haynes of TD Securities predicted that in early 2011 a wave of consolidation will sweep the exchange business, and that the TMX Group may merge with an international exchange.

So don’t expect the war of words between the TSX and Alpha to die down any time soon. But as long as stock exchanges duke it out like the companies that list on them, investors need to make sure they don’t get KO’d in the process.

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