Now that regulators have discovered a small group of U.S.-based dealers operating in Canadian markets with less oversight than domestic firms, the Canadian regulators are trying to bring those U.S.-based firms onside instead of shutting them down. However, several domestic firms aren’t happy with the proposed compromise.

In September of last year, the Canadian Securities Administrators (CSA) said it had discovered that several U.S.-based firms (primarily brokers) are using their exempt-market dealer (EMD) registration to provide brokerage services to accredited investors in Canada. That was not what the CSA had intended when it created the EMD category.

The EMD category was created to provide increased oversight of firms operating in the exempt market, not to allow firms effectively to function as brokers while avoiding the added oversight and investor protection that comes with belonging to the Investment Industry Regulatory Organization of Canada (IIROC).

Not only are investors potentially exposed to added risk and less protection, but the EMD category also creates an unlevel playing field between these firms and dealers that belong to IIROC.

But regulators are reluctant to shut down this activity. An IIROC paper published this past summer says that the regulator believes Canada’s capital markets benefit from the participation of non-domestic firms and that IIROC doesn’t want to force these U.S.-based firms to abandon the Canadian markets (and their clients) altogether by curtailing the firm’s brokerage activities.

Instead, IIROC proposes creating a new registration category, to be called the “restricted dealer” (RD) category, which would exempt non-domestic firms from complying with IIROC’s financial operations requirements, although, in other ways, they would be subject to IIROC oversight. The idea is that the new RD category could serve as an interim step for applicable firms on their way to full IIROC registration without requiring them to comply with all of IIROC’s rules right away.

But some Canadian investment dealers argue that the regulators are effectively entrenching a competitive advantage for these U.S.-based firms doing business in Canada. The Investment Industry Association of Canada (IIAC) comment on the IIROC paper says the proposed compromise “would result in the creation of a structural competitive advantage for U.S.-based broker dealers” and that this is not justified by the purported benefits of the proposal.

The IIROC paper envisions that the new RD category would be open to only U.S. firms that belong to the U.S. self-regulatory organization, the Financial Industry Regulatory Authority (FINRA), and that RD-eligible firms would have to comply with FINRA’s financial operations rules. The RD category would not be open to Canadian dealers.

But the IIAC comment argues that this arrangement will give U.S.-based firms an advantage over Canadian firms, in that U.S.-based RD firms will be able to use “portfolio margining” (instead of margining based on individual positions), which means such firms may require less capital than Canadian firms to do the same business; this would allow RD firms to provide greater leverage to their clients than a Canadian dealer can.

(The potential advantage of portfolio margining also is being considered in Canada. In mid-September, IIROC published another consultation paper that looks at the possibility of allowing portfolio-based margining. That paper, which is out for comment until mid-December, suggests that a move to portfolio-based margining would: provide a better match among funding, collateral and risks; improve the ability of investors to make efficient risk-control decisions; and meet the demand from market players to allow portfolio margining.)

The IIAC comment on the RD proposal also points out that U.S. regulators aren’t offering to facilitate comparable access to their markets for Canadian firms: “U.S. regulators have shown little willingness to recognize firms outside their borders. We do not believe it is appropriate to provide FINRA firms with greater access to the Canadian market and Canadian investors when Canadian firms are not offered similar access to the U.S. market.”

The IIAC’s opposition to IIROC’s RD proposal is not unanimous among Canadian investment dealers, however. The IIAC’s position primarily reflects the views of firms that don’t also have an affiliate with an EMD registration. Such firms don’t see why firms that do have an affiliation with an EMD registrant should effectively be granted a competitive advantage.

A U.S.-based investment industry lobby group, the Securities Industry and Financial Markets Association (SIFMA), tilts in exactly the opposite direction to the IIAC. SIFMA is concerned that the RD proposal is too restrictive on U.S.-based firms.

SIFMA worries that the RD category will be used only to grandfather existing firms. The association’s comment argues that new firms won’t be able to enter the Canadian market this way and that certain registration exemptions won’t be available to firms in the RD category.

SIFMA’s comment argues that FINRA firms are well regulated and there’s no need to layer on additional oversight by IIROC, and that firms’ existing activities need not be further curtailed.

The SIFMA comment also states: “These factors could negatively affect how Canada’s capital markets operate and are perceived internationally and may impact the access that Canadian investors currently have to the capital markets generally.”

In particular, the SIFMA comment points to the fragmented provincial regulatory system, which recently has seen various provinces take different approaches to investment fund portfolio manager registration, as well as to the divergent treatment of issuers quoted in the U.S. over-the-counter market.

The SIFMA comment adds that the regulatory burden for international securities firms doing business in Canada has increased, and “there has been considerable confusion in the market because of non-harmonized rules.”

In the meantime, while the U.S. and Canadian industry lobbyists squabble over access to one another’s markets, investor advocates point out that Canadian clients are being left exposed to differing levels of investor protection.

The comment on the RD proposal from the Canadian Foundation for the Advancement of Investor Rights (a.k.a. FAIR Canada) points out that clients dealing with U.S.-based firms without full IIROC registration: access to dispute resolution through the Ombudsman for Banking Services and Investments; don’t have their accounts backed by the Canadian Investor Protection Fund; and their ability to sue in a Canadian jurisdiction is not clear.

The FAIR Canada comment recommends that the retail clients of U.S.-based firms be given explicit warning about the different level of protection clients may face in the case of a dispute with a firm or its insolvency. And that if the new RD category is created, eligible firms should be allowed to deal with only institutional investors and truly sophisticated retail investors, not so-called “accredited investors.” The comment criticizes that tag as a poor proxy for sophistication.

Regulatory loopholes often are very tricky to close. When firms find themselves with a particular competitive advantage, they will fight tooth and nail to preserve it. Their rivals will push just as hard to eliminate it, inevitably leaving regulators in the middle.

© 2012 Investment Executive. All rights reserved.