CSA’s embedded commissions paper focuses on unique Canadian market

01 CSA consultation paper 81-408 on the option of discontinuing embedded commissions

In a paper published last month, CSA says it’s moving forward with a ban on embedded commissions. The paper discusses investor protection and market efficiency concerns arising from embedded commissions, and assesses the potential fallout from a ban. Ample evidence and research is provided to support CSA’s position.

Lynn McGrade, a partner at Borden Ladner Gervais in Toronto, appreciates the proposal’s in-depth research and analysis. “This is going to be a very Canadian discussion based on our unique Canadian market,” she says.

For instance, “the level of dependence that our households with investable assets less than $100,000 place on the deposit-taking institutions might be higher than in some other countries, like the U.K.,” says McGrade.

The CSA paper cites Ipsos Canadian Financial Monitor data from 2012 that show 83% of households with investable assets less than $100,000 purchased their investment funds solely through banks or insurer-owned firms. The data show banks and insurance firms dominate fund distribution across all households, regardless of investable assets.

Comparing that to the U.K. before it banned embedded commissions, Canada has more registered reps per capita, with most employed by banks or insurance firms (87% in Canada versus 21% in the U.K.).

“If Canada [were] to see the same post-ban decline [in advisors] that was experienced in the U.K.—a 23% decline, three years after the ban—we would still have a representative coverage rate close to four times the rate per capita in the U.K. pre-[ban],” the CSA proposal says.

Still, the proposal shows mutual funds “dominate the way many investors in Canada receive investment advice,” says McGrade. “The industry is going to want to examine [the advice gap] when they respond to this proposal, because one of the biggest concerns for all of us—for the Canadian investor, for capital markets in Canada—is that we are able to continue to service some of those households.”

Investors might move from mutual funds to riskier or otherwise inappropriate securities if they have to pay fees upfront, says Bernard Pinsky, a partner at Clark Wilson in Vancouver. Robo-advisors might fill that gap, but he questions whether Canadian investors have sufficient understanding of risks to use them effectively.

83%

The percentage of households with investable assets of less than $100,000 that purchased their investments solely through banks or insurance firms.

Source: CSA paper; Ipsos Canadian Financial Monitor data, 2012.

Small investors depend on mutual funds within their RRSPs, says Ian Russell, president and CEO of the Investment Industry Association of Canada (IIAC). Alternatives may not be readily available, as many firms would need time to develop online platforms and shift to fee-based advice. He further suggests segregated funds be included in such a ban to “level the playing field.”

Pinsky identifies another regulatory gap: the northwest exemption, applicable in B.C., Alberta, Saskatchewan, Manitoba and the Yukon. The exemption allows those “not registered in any form, shape or capacity to sell exempt products,” he says. “So a lot of the country is looking at people who are selling products [where] fees are paid by issuers, and there’s no advice given whatsoever to buyers.”

Ideally, advice and products would be separately regulated, says Ken Kivenko, president of Kenmar Associates, ruminating on the difficulty of regulating advice in a country with such a powerful banking industry.

“It’s very hard to go back to splitting insurance, banking and securities the way it used to be,” says Kivenko. “You would have to say, ‘If you want advice, go get advice. If you want to buy a product, go to a dealer to make a transaction for you.’” With integrated products and services, regulation may be unsolvable. “There may be a compromise. It’ll have to be a sub-optimal solution.”

The comment period ends on June 9, 2017.

02 Routing decisions influenced by spread between fees and rebates

Market liquidity rebates are a contentious industry issue because of concerns that they adversely affect liquidity allocation and allow high-frequency traders to profit from posting passive orders.

The rebates are the focus of a research paper, “Broker Routing Decisions in Limit Order Markets,” by David Cimon, a senior economist at the Bank of Canada, published in November 2016. Cimon’s finding: as the spread grows between trading fees and rebates, broker routing decisions are driven by rebates, and that’s not necessarily what’s best for clients.

He finds that routing decisions are also influenced by broker commissions: when commissions are high, relative to rebates, brokers switch to routing based primarily on fill rates.

When asked if the research supports a rebates ban, Andreas Park, associate professor of finance at the University of Toronto and a PhD advisor on the paper, says a ban would greatly lower the possibility of a conflict of interest for brokers.

While Park says empirical research shows passive orders in U.S. markets do indeed go to exchanges with the highest liquidity rebates, he hasn’t found similar research for Canada.

Further, there are bigger problems in the markets than this conflict for brokers, he says. For instance, Canada’s relatively small market is challenged by “the segmentation of order flow,” as market participants attempt to direct attractive retail orders through the use of explicit barriers or priority mechanisms, for example.

Canada’s small market also makes it hard to study rebate prohibition without U.S. collaboration.

In 2014, the OSC proposed such a pilot study but decided in April 2016 not to proceed because it wouldn’t be meaningful without including securities listed in Canada and the U.S.

And a pilot study using only non-interlisted securities would mean loss of liquidity to the U.S.

In June 2016, the SEC proposed a pilot study in which taker fees would be reduced, essentially capping liquidity rebates. But the proposal did not suggest prohibiting taker rebates, so potential conflict remains, as Cimon’s paper shows.

“The way to study this […] is to abolish any kind of rebate,” says Park. “If you allow taker rebates, you don’t get rid of the problem. You can’t study it meaningfully.”

by Michelle Schriver, assistant editor of Advisor Group.