The Canadian investment landscape is undergoing profound changes. Some of these shifts are happening in response to global investment and economic trends, while others have been bred by new technologies that are redefining how people think about money and investment. In this special series of articles, we look at the good, the bad, and the ugly of trends that are arguably set to shape the future of finance.

For the Canadian securities industry, the turning point came in the late spring of 2011. As weak market conditions persisted in the post-financial crisis years and investor confidence remained low, Canadian equity markets sold off in spring 2011 and traded steadily lower throughout the following year, triggered by a deepening negative outlook for the global economy, a sluggish, uncertain U.S. economic recovery, with fiscal remedies held hostage by a dysfunctional political system, Europe’s sovereign debt crisis, and slowing growth in China.

The commodities markets mirrored the tumble. The resulting poor business conditions in the Canadian securities industry have continued and have even been made worse by rising industry-wide cost pressures, especially due to the impact of increased regulation brought on by the 2008 crisis. While deep stress has been felt across the industry by firms of all sizes, the effect on Canada’s small investment dealer firms—those lacking the size or scale to withstand these conditions— has been profound, and it continues to hamper the industry and markets today.

Falling share prices, particularly for resource companies, have undermined floatation of new securities offerings in both public and private markets. Share weakness has been reinforced by a widening heavy oil price differential, with Canadian crude prices in relative decline. The collapse in financing activity has been especially pronounced for small- and mid-sized companies due to investor reluctance to purchase speculative shares. It has remained at depressed levels, with virtually no initial public offerings (IPOs) for small companies since 2012. Given that IPOs are the traditional mechanism to transition venture investments out of a company, these tough conditions have also reverberated through angel networks and venture capital.

Longer-term structural developments have also complicated the issuance of small- and mid-sized business shares, given the greater flexibility managed funds have enjoyed since the removal of the foreign property rule in 2005. Sharply reduced financings have bitten heavily into the earnings of the approximately 60 domestic institutional boutique firms. Meanwhile, institutional trading revenue has collapsed as direct market trading access squeezed commission revenue and high-frequency trading activity interfered with market making. Moreover, these institutional firms have been hit with a double whammy: a ramp-up and layering of fixed costs before the financial crisis and a fall-off in operating revenues.

Small firms feel the squeeze

Since 2012, the profit squeeze has intensified, with revenues down and costs up due to expanded trading and research infrastructure to support investment banking, and an expanding regulatory burden, notably technology and compliance related to trading and dealing in multiple equity markets. As a result, institutional firms’ strategic need to expand scale through merger or acquisition, or the outright sale or windup of the firm, has taken on increasing urgency. The number of IIROC resignations has steadily increased, from six firms in 2010 to 13 in 2013.

Retail boutiques have not fared much better. Revenues recovered modestly in the past year or so in response to piqued investor interest in improving U.S. equity markets. However, low prevailing rates, perceived investment risk, and uncertainty about the outlook counsel caution.

Retail boutiques typically face proportionately higher fixed costs—reflecting the need to offer a full suite of wealth management services—coupled with the escalating compliance burden from the Client Relationship Model. As a group, retail firms have been losing money on an operating basis for nearly two years, with roughly half suffering net losses. Many recognize the need for scale and are seeking mergers and acquisitions, as well as adding new advisors to build business. But good advisors are increasingly expensive, given the demand from large bank-owned dealers.

Finally, the evisceration of net interest earnings, or the interest spread on idle client cash balances, has removed a key support to earnings. To alleviate the regulatory burden, some small firms look to jettison their IIROC registration for alternative options such as Exempt Dealer registration and Portfolio Manager registration, requiring modification in the business model. The larger wealth management firms fared comparatively better in this modestly improving market climate, reflecting greater reliance on fee-based advisory and discretionary accounts, a broad range of in-house products and financial planning services, and scale to carry the substantial increase in fixed costs.

Sharply reduced financings have bitten heavily into the earnings of the approximately 60 domestic institutional boutique firms.

What’s at stake?

The retail boutique sector is important, not just for the role it plays in ensuring competition in the domestic wealth management business, but also for providing customized wealth services for clients with portfolios in the $100,000 range and for offerings of small- and mid-sized corporate shares. Rising fixed costs are pushing the minimum account threshold higher, forcing smaller clients to mutual fund advisors and distributors of commoditized products and services.

Both the retail and institutional boutiques are vital to the financing, trading, and distribution of the shares of small listed companies. The venture markets are now caught in a vicious cycle, with weak financing and trading activity driving down the profitability of dealer participants in the market, and weak earnings handicapping their performance. Increased mergers and shuttered operations feedback negatively on the financing and trading trends in the venture markets. If the malaise continues, there is increased risk of negative structural adjustments in the marketplace, such as the withdrawal of legal and accounting expertise and market participants, including IIROC-registered firms and other registrants.

Ultimately, more capital-raising in the listed venture markets depends on improved business conditions. But there are interim solutions that must be considered, notably regulatory remedies, including greater flexibility to arrange exempt market financings and “post-implementation” review of the cost and effectiveness of the recently imposed regulatory framework. The future of Canada’s small dealers is on the line, as is the future of small and medium enterprises and venture financings that depend on them to drive our economy forward. The challenge is growing; the time to act is now.