1.4 Investment Capital, Financial Instruments & Financial Markets

Investment Capital: What It Is and Where It Comes From

Investment capital is money that is available to be invested in productive assets. It comes from savings: income that households, businesses and governments do not spend. Households save through bank deposits, pensions, RRSPs and TFSAs; businesses retain part of their earnings; governments that run surpluses add to the pool; and foreign investors supply capital when they buy Canadian securities.

The users of capital are governments (for infrastructure and deficits), businesses (for plants, technology and working capital) and individuals (mainly for mortgages). Capital is mobile: it flows toward places where the expected return is attractive for the risk and where taxes, regulation and political stability are favourable. Canada has long relied on foreign capital, so Canadian issuers compete with issuers around the world for investors' money.

The Financial Instruments

Financial instruments are the contracts that move capital from suppliers to users. They fall into a few broad groups:

• Debt instruments (money market securities, bonds and debentures): the issuer borrows and promises interest and repayment. Holders are creditors with a fixed claim.
• Equity instruments (common and preferred shares): investors buy ownership. Common shareholders have a residual claim on earnings and assets.
• Investment funds (mutual funds, ETFs and other managed products): investors buy a share of a professionally managed pool.
• Derivatives (options, forwards, futures, rights and warrants): contracts whose value is based on an underlying asset.

The Financial Markets

Instruments are created and traded in financial markets. The two most important distinctions are between primary and secondary markets, and between auction and dealer markets.

Primary vs. Secondary Markets

Financial markets are divided into two fundamental sectors based on whether securities are being distributed for the first time or traded among existing holders: the primary market and the secondary market.

The Primary Market

The primary market is the origin of capital formation. In this market, corporations, federal and provincial governments, and municipalities issue new debt and equity securities to secure new financial capital.

• Proceeds Flow to Issuer: The primary market is the only venue where the issuing entity receives net cash proceeds from the sale of securities (less underwriting commissions and legal fees).
• Types of Offerings:
  • Initial Public Offering (IPO): A private corporation offers equity securities to the public for the first time, transitioning into a publicly traded reporting issuer.
  • Follow-on / Additional Offering: An established public corporation issues additional shares from treasury to fund expansion, repay debt, or finance acquisitions.
  • Rights Offering: An offering allowing existing common shareholders the contractual right to purchase new shares at a discount directly from the corporation, preserving their proportional ownership.
  • Private Placement: Securities sold directly to institutional or accredited investors without a full public prospectus, relying on statutory prospectus exemptions.

The Secondary Market

The secondary market is the venue where previously issued securities are transferred between buyers and sellers.

• No Direct Corporate Capital: The original issuing corporation does not participate in secondary market transactions and receives no financial proceeds when shares trade.
• Economic Significance: While issuers do not receive capital directly from secondary trading, healthy secondary markets are essential to primary issuance. Investors would refuse to buy new issues in the primary market without the guarantee of an active, liquid secondary market providing continuous price discovery and immediate liquidity.
• Cost of Capital Impact: Secondary market prices reflect investor consensus regarding corporate performance, directly impacting the cost at which the company can raise future primary capital.

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Auction Markets vs. Dealer (Over-the-Counter) Markets

Secondary markets in Canada operate under two distinct structural models: order-driven auction markets and quote-driven dealer markets.

AUCTION MARKET (Order-Driven, e.g., TSX):
[Buyer A: Bid \$25.10] ──┐
[Buyer B: Bid \$25.08] ──┼──> [Central Limit Order Book] <──┼── [Seller X: Ask \$25.11]
[Buyer C: Bid \$25.05] ──┘    (Price-Time Priority Matching) └── [Seller Y: Ask \$25.12]

DEALER / OTC MARKET (Quote-Driven, e.g., Fixed Income):
[Investor] <────────> [Dealer Principal Inventory] <────────> [Investor]
                     (Quotes Bid: \$99.50 / Ask: \$99.80)

Auction Markets (Order-Driven)

In an auction market, buy orders and sell orders from public investors converge in a centralized order book. The prices at which trades execute are established through direct competition between buyers and sellers.

• Central Limit Order Book (CLOB): Bids (orders to buy) and offers or asks (orders to sell) are ranked electronically according to strict price-time priority:
  • Price Priority: The highest bid price and the lowest ask price execute before all other orders.
  • Time Priority: When two or more orders enter the book at the identical price, the order submitted earliest receives execution priority.
• Designated Market Makers (DMMs): On Canadian equity exchanges, specific dealers are assigned designated market maker responsibilities for specific stocks. The DMM is contractually obligated to maintain a fair, liquid, and orderly market by posting two-sided continuous quotes within defined maximum spreads and contributing capital to absorb temporary order imbalances.

Dealer Markets (Quote-Driven / Over-the-Counter)

Dealer markets (over-the-counter or OTC markets) are decentralized electronic networks where participants trade directly with investment dealers acting as principals from their own inventory.

• No Central Auction Book: Instead of public orders crossing against each other, investors buy directly from a dealer at the dealer's ask price and sell to a dealer at the dealer's bid price.
• Bid-Ask Spread: The dealer earns compensation through the spread (the difference between the price at which the dealer buys into inventory and sells out of inventory), assuming price risk while securities are held.
• Fixed-Income Dominance: Nearly all Canadian debt securities—including Government of Canada bonds, provincial debentures, municipal bonds, and corporate debt—trade in the over-the-counter dealer market. Corporate bonds are too heterogeneous (varying coupons, maturities, covenants, credit ratings) to trade efficiently on continuous equity auction books.