Ambitious reorganization plans are threatened by Quebec nationalists.

By Simon Boughey

Equity derivative products have made little headway in Canada: Products are few in number and lack sophistication, and volumes are often slight. Canadian business is divided between the Montreal Stock Exchange (ME), the Toronto Stock Exchange (TSE) and several smaller so-called “western exchanges” in Winnipeg, Manitoba, Calgary, Alberta and Vancouver. The diffusion of resources and liquidity within a relatively small equity marketplace has been to no one’s advantage.

But now there are plans to reorganize and streamline the whole structure—if the whole project isn’t stymied by the unique exigencies of Canadian domestic politics.

On March 15, the four biggest exchanges announced their intention to reorganize according to product lines: The TSE would trade only large-capital stocks and give up its derivatives business, the ME would trade only derivatives, and the Alberta and British Columbia exchanges would merge and concentrate on small-capitalization stocks. “We believe these changes will help ensure that the Canadian capital market system is streamlined and better able to perform in an increasingly competitive global marketplace,” said TSE president and CEO Roland Fleming at the time. The goal was to reduce competition, cut costs and allow the exchanges to concentrate on the things they do best.

The plan would have effectively turned the Montreal Exchange into the country’s only derivatives exchange. To be sure, it has often seemed more adventurous and innovative in its use of derivative products than the TSE, and has enjoyed considerably more success. Last tk/date, it introduced the popular three-month Canadian Bankers Acceptances futures (BAX), which are the Canadian equivalent to eurodollar futures traded at the Chicago Mercantile Exchange, and the Canadian Government Bond (CGB) futures. The ME now trades around 25,000 BAX futures contracts daily, and total turnover in 1998 was more than 6 million contracts, says a spokesman for the exchange. “There has been a greater level of creativity and a greater acceptance of derivatives in Montreal than in Toronto. They have a better attitude to these products,” notes Dave Pearson, head of derivatives sales at Toronto Dominion Bank.

Hedging a C$2.5 Billion Highway

The Canadian capital market is not the deepest or most liquid in the world; it can trade quite skittishly and erratically. Although these days this is not a feature unique to Canada, bid or ask prices can sometimes disappear completely, leaving the price of an instrument soaring or in free fall. So when Bank of Montreal Nesbitt Burns was faced with hedging 2.5 billion Canadian dollars of corporate debt earlier this year, it knew it had to tread warily. This mammoth offering of debt—the biggest corporate bond in Canadian history—was occasioned by the privatization of Highway 407 by the government of Toronto in mid-April. After a competitive bidding process, the road was bought by a consortium called BTR 407 International for 3.1 billion Canadian dollars. BTR 407 was composed of a Spanish company called Cintra and two Quebec-based firms called NC Labolin and Caisse des Depots. In July, BTR 407 came to the domestic market with the first stage of a 2.5 billion Canadian-dollar multitranche offering, with BMO Nesbitt Burns as chief underwriter. Over the next three months, the firm raised 1.5 billion Canadian dollars. To protect the borrower against an increase in yields between April and the time of issuance, BMO put in place a series of rate locks using both the swap market and the government bond market. It was assisted in this process by RBC Dominion Securities and Citibank, although BMO acted as “bookrunner” for the hedging group, thereby ensuring that the houses didn’t bump against each other in the market, explains head of Canada marketing Graham Watt. The rate lock guaranteed to BTR 407 that the cost of issuing debt would not increase over the coming months, no matter what happened to yields. The position was hedged both by paying fixed rate in the swap market and by putting on synthetic shorts in the government bond market. Both these trades have the same economic result: If yields rise, then BMO is compensated by the rise in the value of the hedge. When the bonds were printed, the swap hedges were taken off either by receiving fixed or by terminating the swap; the bond hedges were taken off by covering the short. Since BTR 407 has more debt to raise, some of these hedges are still in place, says Watt. More of the hedge was accomplished in the bond market than in the swap market; liquidity in the latter is notoriously thin and a trade of this size could have driven spreads through the roof. At the same time, BMO was aware that it had to be careful. It adopted a leg-in strategy, completing a portion of the overall size at a time over April and May, explains Watt. He declined to divulge what percentage of the trade was executed in the swap market and what percentage in the bond market. The results of the hedging “exceeded expectations from an execution standpoint,” he adds. In fact, yields did rise 130 basis points between the award of the concession to BTR 407 and the launch of the first bond, and the consortium did not have to absorb a penny of this increase. “The hedging strategy was a critical success factor in the overall financing of the issuer,” concludes Watt. Of course, everyone in the Canadian market knew this deal was imminent and that BMO would be setting up a rate lock. Consequently, some shops did position strategic shorts in the expectation of a drop in prices. Shortly after the announcement of the concession to BTR 407, however, bullish U.S. economic data were released and many of these shorts were flushed out with red faces. “Market participants who tried to benefit from knowledge of the hedging strategy were burned by bullish U.S. data quite early on,” says Watt, trying hard not to sound complacent. —S.B.

Although the scheme to divide the marketplace according to specialty has been approved by Canadian regulators and all the exchanges concerned, the government of the province of Quebec has raised a red flag. It has expressed alarm about Montreal losing small-cap stocks, and has threatened to enact legislation that would “scupper the whole plan,” groans one Toronto banker. The relationship between the exchange and the government is explicitly arm’s length. But some observers fear the government of Quebec may pass a law that will force the ME to maintain small-cap trading in Quebec. “Three months ago, there was a 95 percent chance of this [plan] happening; now there is a 25 percent chance of it not going ahead,” declares a Canadian banker.

Quebec’s opposition derives from its long-term ambition to secede from the Canadian federation. “The ultimate objective of the government of Quebec is to be independent,” explains another Canadian banker. “And if it is to be independent, it needs its own stock markets.” In other words, it cannot afford to see all equity trading shift to Toronto.

Despite this, several steps have been undertaken to move the project forward. Montreal began trading options and futures on the Standard & Poor’s Canada 60 on September 7, and the TSE is to wind down futures and options contracts on the TIPS 35 index, which tracks 35 of the largest Canadian stocks, upon expiry of the December 1999 contracts. “In reality, can we undo this?” wonders one banker. “It is not practically possible for it to be derailed.”

“One of the problems with derivatives growth in Canada has been a fundamental lack of understanding of these products.” —Fred Ketchen Scotia Mcleod

A central Canadian derivatives exchange would be well-positioned to take advantage of a rebound in commodity prices, on which the economy is substantially dependent. In 1998, while the United States was experiencing boom-time equity growth, the Canadian market was in the dumps. But in 1999, the recovering Japanese economy resuscitated other southeast Asian economies that are big importers of Canadian resources. Base metal stocks, which declined 19.25 percent in 1998, are now up 27.3 percent; oil and gas stocks, which declined 30.38 percent, are now up 29.35 percent; forestry and paper products, which declined 11.08 percent, are up 36 percent.

Investors frustrated by sagging returns in the mature U.S. equity market may be attracted by the idea that the lagging Canadian stock market has quite a bit of catching up to do. And if inflation continues to rise, Canadian equities might attract other interest as a safe haven. As Toronto Dominion Bank’s Pearson asked, “If the world starts bailing out of financial assets, where will they turn?”

In this environment, Montreal could offer an array of derivatives products to meet burgeoning needs. In addition to the BAX futures, the CGB futures, and futures and options on the S&P Canada 60 index, options are also traded on individual stocks, the TIPS 35 and the TIPS 100. But equity options volume is less impressive than volume in the BAX and CGB. Between January 1 and September 30, the TSE’s entire equity options volume was slightly more than 1 million contracts and daily turnover was only about 4,000 contracts.

“At the moment, there is no easy instrument through which you can participate in the base metal sector without buying the individual stock.” —Subodh Kumar Cibc World Markets

The rebound in commodity prices this year offers a great opportunity for the ME to design a product for investors seeking exposure to this sector. Subodh Kumar, chief investment strategist at CIBC World Markets, believes that there is a particular need for a natural resources product to attract investors into the Canadian market. He sees the base metals sector as particularly hot. “At the moment, there is no easy instrument through which you can participate in the base metal sector without buying the individual stock,” he says.

However, Peter Haynes, an equity derivatives specialist at Toronto Dominion Bank, sees the way forward not through the introduction of new products but through the proper exploitation of existing ones. He believes that the number of single stocks on which options are available should be cut from the current 70 or so to only 30 or 40 to concentrate liquidity in the most active names. Customized flex options could be created by the ME to service interest in stock options that do not make the top 30 or 40 names.

The key, say many bankers, is to find a way to lure retail investors into the fold. “One of the problems associated with derivatives growth in Canada has been a fundamental lack of understanding of these products,” says Fred Ketchen, managing director of equity trading at Scotia Mcleod and an ex-chairman of the TSE. “There has to be a significant educational and marketing effort to the retail community to build up liquidity,” add Haynes.

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