We need an 'open sky' policy for Canadian investors
George Bragues The National Post Tuesday, June 01, 1999
There's no need to block access to cut-rate U.S. brokers and funds

Anyone who just briefly watches business news on CNN or CNBC can't miss it -- the onslaught of American Internet brokers advertising dirt-cheap commissions.

But try closing your higher-commission Canadian brokerage account to take advantage of these deals, and you'll be running afoul of provincial securities regulations, known as the blue sky law. Something is definitely wrong here.

The term "blue sky" reflects the law's intent to protect investors from the sale of securities a judge once called as worthless as "lots in the blue sky." First enacted in 1911 by the Kansas legislature, and brought to Canada a year later by the Manitoba government, the law has evolved to require that any securities offered for sale within a state or province, and any brokers doing business with its residents, be registered with local regulators.

The goal is to ensure public disclosure of all relevant information about securities. The rules are also meant to render brokers fully subject to jurisdictional authority, keep known stock swindlers away from investors, and restrict the brokerage business to individuals who have demonstrated satisfactory knowledge of the securities markets, as well as their duties to clients.

The problem is, U.S. online brokers are generally not registered to operate in Canada. Nor are the U.S.-based mutual funds that are available through these brokers. Still, the U.S. Securities and Exchange Commission doesn't prohibit foreigners from opening brokerage accounts. Online brokers execute trades only when adequate funds have already been deposited, so they don't have to worry much about the legal hurdles involved in collecting debts from someone in another country. Thus, according to the detailed listings at Norman Rothery's popular Directions Web site, Canadian clients are welcome at 29 American discount brokers. Accounts are easy to open, and no U.S. address is needed.

An increasing number of Canadians are signing up. Mr. Rothery has noticed a surge of interest among visitors to his site. The Ontario Securities Commission has had to post a warning about the illegality of the cheap Internet brokers on its Web site, and it is exploring whether U.S. state regulations bar foreign accounts. Canadian discounters are definitely worried about losing customers. They are lobbying securities regulators to relax the "know-your-client" (KYC) rule, which requires all trades to be monitored for their suitability with customers' circumstances and objectives, in order to better meet the American competition.

Those taking their money southward are not in sore need of legal protection. No one is being solicited to buy anything; most want to buy stocks they have researched on their own. Aside from being drawn by lower commissions -- $5 to $15 in the U.S., as opposed to $24 to $30 in Canada for the same Nasdaq and NYSE-listed issues (all figures U.S. dollars) -- investors prefer the faster trade executions made possible by the absence of the KYC rule in the U.S. For active traders, slow executions are costly because they exacerbate slippage, the difference between the price at which one plans a trade and the price one actually receives.

Long-term investors such as Bylo Selhi (a pseudonym) are attracted by U.S. registered mutual funds for the low management expense fees, which average 1.25% compared with 2.15% in Canada -- a small difference that adds up over time. Mr. Selhi particularly likes the large number of index funds offered by Vanguard, because these provide greater opportunities for diversification and track the indexes better than equivalent Canadian funds.

Consider, too, that U.S. discounters are members of the Securities Investor Protection Corp., which insures all customer accounts up to $500,000, and that like U.S. mutual funds, they operate within the most rigorous securities laws in the world. The only thing Canadians give up is the protection offered by the KYC rule, which hasn't done much to make brokers accountable for touting a risky mining play like Bre-X to the Canadian investing public.

The real beneficiaries of the blue sky laws are the regulators, who rely on them to preserve their power and garner registration fees, and even more, the Canadian brokers, who are shielded from competition. American firms shy away from registering in Canada, not just because of the costs involved, but because of the need to have staff take all the exams necessary to operate here.

Instead, why not institute a system in which North American regulators recognize a registration filed in any one jurisdiction? At a minimum, American discounters should be granted a registration exemption. And relax the KYC rule for Canadian discounters to give them an even playing field.

Then, watch as aggressive American players corrode the gentleman's code that keeps fees high in the Canadian securities industry. Expect lower transaction costs to increase the liquidity of domestic equity markets and make active traders excited about fast-moving growth stocks, enabling promising companies to raise capital more easily in Canada. Investors will also acquire additional incentives to educate themselves about the financial markets -- the best defence against fraud.

With the Internet already narrowing the information advantage traditionally held by brokers over investors, and rendering geographic boundaries meaningless, these changes will help keep securities laws in line with the times.

George Bragues is an economics and philosophy instructor at Toronto's Humber College.

 

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