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Issues in Demutualisation of Exchanges R Ramaseshan∗ Stock exchanges, traditionally, have been organised as not-for-profit mutual associations

owned by members, though the legal form differs across countries. trading in stocks started. Ever since stock trading commenced, till the advent of automation, an exchange implied a physical location. Members met at a specific place and at specified times to trade with one another. With it came the need to impose restrictions on access to the trading floor, given the limitations of space. This evolved into a system of seats or the right to trade, which was essentially a system of self selection based on high initial and yearly membership fees. Organisational profit making was never the motive; the exchange required funds only to the extent of meeting its expenses. Any surplus made by the exchange resulted in reduced access fees for members. The accepted norms of behaviour of members and their self imposed rules for trading governed the markets. Members were responsible for their conduct with one another, with users of the exchange and other stakeholders. With securities law in place, the concept of self-regulation under regulatory oversight emerged. This given order seems to be changing rapidly. Demutualisation and adoption of a different governance structure has caught the attention of exchanges. The first exchange to demutualise was the Stockholm stock exchange in 1993; since then over twenty exchanges have demutualised (Table 1). Many others, including commodity exchanges, are in the process of demutualisation. A mutual organisation, a remnant of the physical nature of the exchange, owes its origin to the manner in which

Secretary (Finance), Government of Karnataka. The views expressed in this paper are of the author and not necessarily of his employer or of NSE.

Table 1: Exchanges that have demutualised Name of the Exchange Stockholm Stock Exchange Tradepoint / Virt-x (never mutualised) Helsinki Stock Exchange Copenhagen Stock Exchange Amsterdam Exchanges Borsa Italiana Australian Stock Exchange Iceland Stock Exchange Athens Stock Exchange Stock Exchange of Singapore SIMEX LIFFE Toronto Stock Exchange Sydney Futures Exchange Hong Kong Stock Exchange London Stock Exchange Pacific Exchange (PCX) NASDAQ first phase Paris Bourse Deutsche Börse Oslo Exchanges Euronext Year of Demutualisation 1993 1995 1995 1996 1997 1997 1998 1999 1999 1999 1999 1999 2000 2000 2000 2000 2000 2000 2000 2001 2001 2001 Last year a survey of exchanges conducted by the London based BTA Consulting. All these have fostered competition Why is there a rush now to 2 . revealed that 79% of the exchanges were considering demutualisation. Both demutualised and mutual exchanges shared the belief that their future success lies in demutualisation. between securities markets. Access to trading is not restricted by geographical location and the frontiers between markets and investors have collapsed. the exchange as a physical location has lost its meaning. who can trade in foreign markets as easily as they do in their domestic markets. Multiple listing of securities in exchanges cutting across national boundaries and the near round the clock trading offer choice of trade execution to investors. representing over half the trading liquidity of the world. A conscious policy of fostering integration of financial markets as in Europe has liberalised market access for overseas competitors. demutualise? Drivers of Change Rapidly changing marketplace: With technological developments in information processing and transmission.

3 . exchanges have no motivation to do so. anonymity and convenience of time. even if such innovation would enhance the economic value of the exchange and cater to the larger interests of investors. Initially popular among institutional investors for trading among They provide access to trading at a much less cost with themselves. ATSs had cornered over 30% of the total share volume in NASDAQ securities and 3% of share volume of listed securities. The results of the BTA survey reaffirms this position. There is thus a pressure on exchanges to cut costs. Member owners who derive profits from non-member transactions may resist technological and institutional innovation that would reduce their intermediation role. This explains the changes taking place in NASDAQ. Choice of trade execution results in liquidity moving to the most efficient exchange amongst the same risk class. as 75% of mutual exchanges that responded believed that they are not free to pursue optimum commercial options. they have to offer value to investors. particularly from London. A case in point is the opposition of the market makers in London in adopting electronic auction. screen based trading received a fillip and exchanges adopted it only when competition became perceptible. And hence the emphasis is on separation of ownership and the right to trade and reducing the control of intermediaries over the management of the exchange. reduce the risk of trading and pass on the gains of efficiency to investors. exchanges not facing competition have been slow in responding to changes. As in 2000.1 Exchanges have to be efficient and be nimble footed to survive in this environment. especially in developed markets.Technology has also brought in competition from non-exchanges. Significantly. Do intermediary owned and operated exchanges impose additional costs on the investors? Trading costs are estimated to be 28 to 33% higher in the NYSE and the Intermediary owned 1 US Securities and Exchange Commission Special Study: Electronic Communication Networks and After-Hours Trading. They are no longer organisations to serve the interests of the intermediary. 2000. Alternate Trading Systems (ATSs) have become integral to the market and are competing with exchanges. which faced the threat of competition. Back home. while the NYSE has made little progress in this direction. June. It is not surprising that early initiatives for demutualisation came from the Nordic exchanges and Amsterdam.

including other financial products such as warrants. Schatz futures contract. and Benn Steil. Decisions of the exchange could affect the trading interests of members. They pursued profit as a significant goal and in 1999 recorded more profits than other exchanges. etc. European trading costs are anticipated to fall by a whooping 70% if the exchanges adopt an ATS governance model. In Europe elimination of broker intermediation could reduce the cost of capital by 7. David G. for instance. used the demutualisation opportunity to return excess capital to members. The NYSE. and Richard R.). Victor. Nelson (eds. in Steil. is more likely a secondary aim.NASDAQ than through ATSs. members entrusted with regulation attempting to derive gains from their position are not uncommon. 2001. Ian. in fact. as many exchanges have no need for fresh capital. Annual Report. We have witnessed many such instances in the Indian capital market. Amsterdam. Traditional exchanges have to explore new funding avenues and hence demutualisation and the subsequent listing of shares gives them the market image and access to funds from a wide spectrum of investors. 2002. Benn. Worse still. convertible bonds. Princeton: Princeton University Press. This requires resources of a substantial magnitude. These exchanges were more customer oriented. individually or collectively. 2 4 .2 The Federation of International Stock Exchanges (FIBV) has reported that the operational cost of demutualised exchanges increased by 8% in comparison to 12% for other exchanges. The halving of trading cost documented between 1996 and 1998 resulted in a reduction of 8% in the cost of capital to S&P 500 companies. The willingness and ability of the members to fund expansion and technological upgradation in a mutualised exchange is rather limited. has Domowitz. it is argued. Innovation in Equity Trading Systems: the Impact on Trading Costs and the Cost of Equity Capital. the above argument has its detractors. Though compulsive. They offered the largest range of trading products. In sharp contrast. weather indices. electricity futures.8%. So their ability to protect investor interest and enforce rules is viewed with suspicion. Such instances are not uncommon even in developed markets. Raising capital. Conflict of interest: A mutualised exchange is subject to conflict of interest. demutualised organisations like ATSs take investment decisions faster and have access to funds from a large pool of investors. 3 FIBV Cost and Revenue Survey 1999. Technological Innovation and Economic Performance.3 Expansion and technology investment: Expansion and investment in technology are critical to survive in this environment.

the extent to which such an independent 5 . while the expenditure on regulation is. has also been mooted to overcome this apprehension.regulatory role seriously. A for-profit enterprise owned and operated by members distributing the surplus earned is no different from a mutual not-for-profit organisation. The Deutsche Börse and the Paris Bourse prior to the public offering in 2001 were structured as for-profit companies owned almost exclusively by members. Demutualisation can be successful only if the interest of investors. may contradict with its role as a public entity providing a service. A demutualised exchange with the management free to decide on operational issues is perceived to be effective and fair in enforcement. such exchanges are no different from a mutualised exchange. issuers and other stakeholders are of prime concern to shareholders. Institutional and foreign investors are weary of trading in markets where enforcement is perceived to be lax. As exchanges demutualise. The commercial nature of the exchange. may be compromised. Challenges of Demutualisation Demutualisation is not a legal project. Operationally. Over 90% of the shares of the Borsa Italiana are still owned by Italian intermediaries. Allocation of resources for self-regulation. many challenges come to the fore.been reported to have failed to enforce federal laws and NYSE rules against unlawful proprietary and discretionary trading by floor brokers. The benefits of effective regulation are not visible. A demutualised exchange. both human and monetary. If this indeed happens. However. may not take its self. Cross border alliances and mergers between exchanges are feasible only if the partners in the alliance feel that member interest in the other exchange would not override common interests and that issues would be dealt with in a fair and transparent manner. Divesting the exchange of its regulatory role and entrusting it to a separate organisation. either independent or a subsidiary of the exchange. namely profit maximisation. focused on profits. but is a multi-disciplinary issue. What are the challenges of demutualisation and the likely safeguards that are emerging? Self-regulation: A mere conversion from a not-for-profit organisational structure to a forprofit structure would neither ensure better regulation nor would it instill investor confidence. the fundamental objective of separating ownership and usage would be defeated.

There could be conflicts in the corporate objectives of the exchange and its regulatory role. Self-listing: An entirely new conflict arises if the exchange lists its shares on itself. A classic case was the bid made by the self listed Australian Stock Exchange (ASX) for the shares of the Sydney Futures Exchange. thought. its regulatory role of the primary market was transferred to the Financial Services Authority. 5 IOSCO. The Australian Securities and Invesments Commission has been made responsible for administering listing rules in the case of the ASX. self-listing would remain an area where adequate safeguards have to be evolved as experience with demutualisation is gained. Yet. September 1999. transparency and market discipline. Some attempts have been made in resolving this conflict. is another Statement of Richard A. 4 6 . any exchange that Thus in a competitive environment. Chairman and Chief Executive Officer. would the shares of the listed exchange be freely transferable? And if so. Issues Paper on Exchange Demutualisation. Transferability of shares: Like any other company. self-regulate itself? on the exchange? The conflict is apparent not only in satisfying listing requirements continuously. regulation is expected to be stronger. another listed company. NYSE before the Senate Banking Committee hearing on Public Ownership of the US stock markets. cast doubts about the obligation of the exchange to enforce listing rules. selfcompromises on self-regulation and which is perceived to be lax in enforcement may eventually lose the patronage of investors. if after a hostile But can an exchange Does this conflict with other competing companies that are also listed Such a move may weaken investor protection. The Monetary Authority of Singapore is authorised through a Memorandum of Understanding to monitor compliance with listing requirements of the Singapore Exchange. accountability. what would be the consequences. to name a few. With intense competition. Grasso.5 The exchange derives advantages by listing its shares – enhanced visibility and reputation. the efficacy of centralising regulation and the confidence that such an arrangement would generate among investors are issues of concern. A counter bid by Computershare Ltd.organisation would be subject to the authority of market regulator. When the London Stock Exchange decided to change its ownership structure in June 1999.4 The limited experience with demutualised exchanges has not revealed instances of sacrificing regulatory responsibilities. June 2001..

There could be conflict of interest due to Methods to deal with such conflicts and the internal segregation Statutory duties may be imposed on such public directors. commercial activities of the exchange should not expose it to financial risk. An appropriate governing structure balancing the interests of shareholders and the public at large is a possible remedy. In the meanwhile. If such norms are found necessary. Governance: Another concern is whether demutualisation and the drive for profits would compromise the position of stock exchange as a public entity. except the ASX where it is 15%. the shareholding limit is 5%. the risk of financial instability of the latter should not impact the exchange. Inclusion of outside Directors on Board to serve as a check and promote integrity in the decision making of the Board could reduce this risk. or made applicable also to the holding company owning the exchange is unclear.takeover. whether it is advisable to impose capital adequacy norms on the exchange is a critical issue. In most of the cases. It can also require any shareholder who has excess holding. the interests of the new shareholder are not aligned with the role of the exchange as a public entity? Exchanges that have demutualised have been sensitive to this issue. Other From this perspective. to bring his holding to less than 10%. While the corporate ownership structure may not justify imposition of such norms on the holding company. greater regulatory oversight may be necessary to spot such conflict situations. The Stockholm exchange does not prescribe any limit. excessive zeal to profit. but has the powers to assess the qualification of the proposed shareholder who intends to hold more than 10%. should it be applicable to the exchange per se. No firm view has evolved on this issue. 7 . Regulatory restrictions on the appointment of senior executives in the exchange may ensure that right persons are appointed and that they act in public interest. A wide ownership may also create public ownership and check between various business interests have to be evolved. Financial concerns: A demutualised corporate structure provides ample opportunities to diversify and set up other business operations. Continued financial viability of the exchange is of paramount importance. A limit on the shareholding has been imposed to prevent concentration of holding and the consequent transfer of control. apart from being responsible to shareholders. such diversification.

7% in 1997. thereby impacting the quality of regulation. A group set up by the SEBI is expected to deliberate on this issue. demutualised exchanges recorded the highest return with an average return of 45% in 1999. and could be the precursor for sweeping changes in the structure.4% return reached in 1998 and the 17. It is not clear if such a growth in profits is due to efficiency gains or the exchanges have taken advantage of their monopoly status. but logical. Events of conflict of interests and their impact on the market has led to the Union budget for 2002-03 laying emphasis on demutualisation of stock exchanges. its co-existence with other mutualised exchanges. Improving the market share may drive the exchange to price its service uneconomically. monopoly status or the lack of adequate competition and the pressure to generate profits may induce it to price the service at a high level. They would continue to do so. If it is the latter. efficiency 8 . Yet. many of the issues debated above may sound irrelevant in the Indian context today.Pricing decisions of the exchange in this scenario may be anything. With a distinctly different organisational structure. market position and management of stock exchanges in the country. designing a suitable market structure that would foster a healthy environment with adequate disincentives to prevent exchanges from taking advantage of their market position is the need of the hour. promoted and incorporated in 1990 by financial institutions as a non profit company under Section 25 of the companies Act. The subsequent setting up of the National Stock Exchange of India Limited in November 1992 as a tax-paying company unlike other stock exchanges in the country was another significant effort. was a pioneering attempt in separating ownership and membership of the exchange. This restructuring opportunity may have to be utilised to assess the competitiveness. With curbing of market abuse being the prime driver for demutualisation. sharply increasing over the 37. As per the FIBV. Indian Scenario Demutualisation has been experimented in India even before the concept came to be propounded internationally. was an interesting phase in the capital market history of the country. competition and institutionalisation and globalisation of the investor – have changed the Indian capital market. But the impacting factors – technology. The Over The Counter Stock Exchange of India.

??? 9 .and global aspirations and opportunities of the Indian market to position it as an important destination in the global financial scene.