From little-known cog to centre stage role

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If you have ever traded a Canadian stock or received a dividend from one, you've probably done business, indirectly, with a Bay Street institution called the Canadian Depository for Securities Ltd.

CDS operates a crucial piece of financial machinery, known as "clearing." That means, behind the scenes, it does everything from tracking which investors own which securities, to ensuring that money from selling shares or dividend payments gets into the right hands. The company has also lived in near-total obscurity - until now.

The proposed takeover of TMX Group Inc. by a group of banks and pension funds has suddenly thrust CDS into the spotlight. The banks and funds, which are operating under the name Maple Group Acquisition Corp., want to take over CDS too and roll it into TMX.

The idea is that once integrated, the clearing business could help boost profits for the TMX, the parent company of the Toronto Stock Exchange. That would be a dramatic shift for a company that operates as a not-for-profit utility - much as the stock exchange itself once did.

CDS' cost-recovery business model has resulted in extremely low fees. And those fees are falling: in 2005 the cost per exchange trade was 18 cents, before discounts. In 2010, it was just 2.3 cents.

Bay Street firms have saved millions of dollars from those declining fees, which is why some have been caught off guard by the proposal to turn CDS into a money-maker.

"At the end of the day, it's the individual that's going to pay the cost," said Gary Reamey, head of retail brokerage Edward Jones Canada.

But change may be inevitable even if the Maple Group bid for TMX were to fail. Tom Kloet, TMX's chief executive officer, has made it clear that if his proposed merger with London Stock Exchange Group PLC goes through, he too wants to roll CDS into TMX.

"I think there are enormous efficiencies we can give the Canadian marketplace" by doing so, Mr. Kloet said in an interview. "The opportunity to cross-margin trades between CDS and [TMX-owned]Canadian Derivatives Clearing Corporation has enormous potential."

Yet CDS's 96 participants, ranging from the Big Six banks to smaller investment dealers like PI Financial Corp., are now left in the dark, unsure of what to expect.

Luc Bertrand, Maple's spokesperson, hasn't ruled out fee hikes, but he says that they aren't the cornerstone of his plan for CDS. TMX currently owns a separate clearing operation, Canadian Derivatives Clearing Corp., and he expects synergies to come out of merging it with CDS.

"If you can, picture some years out where the broker-dealer has one screen with all their exposures for all the different asset classes that they trade and clear through the TMX Group," he said. That could help Bay Street firms manage their risks better.

Mr. Bertrand repeatedly points out that the major exchanges in Germany Australia and Hong Kong are integrated with clearing, and their profit margins are higher because of it. Hong Kong's earnings before interest, taxes, depreciation and amortization are 80 per cent of revenues and Australia's are 77 per cent. TMX's are just 60 per cent.

But one fact Mr. Bertrand leaves out is that clearing fees on these exchanges are much higher. It costs domestic firms 66 cents to settle a trade on Deutsche Boerse, before any volume discounts.

Fee hikes would run counter CDS's current plans. The organization has set out to lower fees even more, and its latest annual report notes that "rather than provide returns on investment, CDS shareholders receive value through the efficiencies CDS provides to their operations."

Those efficiencies are why CDS was set up in the 1970s. At the time, banks, trusts and brokerages all paid enormous back-office costs to handle their trades. Eventually, they realized that by working together they could achieve economies of scale. To do that, they funnelled their trades through one central location, CDS. Today, the company has over $3.5-trillion of securities on deposit and handles over 360 million domestic and cross-border trades each year.

"It's a marvellous institution that every dealer needs and uses," said John Ing, president of Maison Placements Canada Inc.

While Mr. Ing said that "there's nothing wrong or dirty about making a profit," turning CDS into a profit-hungry business would contradict the organization's principles.

"When they set up the CDS, what they wanted and needed was all of the dealers' participation," Mr. Ing said. "Had [the fees]been exorbitant, CDS's function would have been a question mark."

If fees ultimately move higher, PI Financial chief executive officer Max Meier worries that smallest trading shops will be hurt the most, because they cannot benefit from the same volume discounts that bigger brokerage do.

But Mr. Reamey of Edward Jones stressed that it's too early to jump to conclusions, and that he isn't against the idea itself. "If by merging [CDCC and CDS]together, it improves service and reduces costs, I'm in favour."