Pamela S. Hughes


Ehsan Zargar

Blake, Cassels & Graydon LLP

May 1, 2006



List of Abbreviations ...................................................................................................................... 3 Introduction..................................................................................................................................... 4 PART I. EXCHANGE DEMUTUALIZATION....................................................................... 5 1. What Demutualization Means................................................................................................. 5 2. Historical Evolution of Exchanges ......................................................................................... 7 3. The Reasons to Demutualize ................................................................................................ 10 PART II. REGULATION OF A DEMUTUALIZED EXCHANGE ....................................... 15 A. Introduction........................................................................................................................... 15 1. The Need for Regulation....................................................................................................... 15 B. The Regulatory Challenges Surrounding Deregulated Exchanges ....................................... 17 1. Division of Regulatory Labour ............................................................................................. 17 2. Demutualization, Self-regulation and Conflicts of Interest .................................................. 19 3. DE Governance Issues .......................................................................................................... 24 PART III. THE DEMUTUALIZATION OF THE TSX AND ASX ..................................... 29 1. Background to the TSX’s Demutualization.......................................................................... 29 2. Rationale for the Demutualization of TSE............................................................................ 30 3. The Demutualization Process of the TSE ............................................................................. 31 4. Background to the ASX’s Demutualization ......................................................................... 34 5. Rationale for the Demutualization of ASX.......................................................................... 35 6. The Demutualization Process of ASX .................................................................................. 36 7. Post Demutualization: Changes in TSX’s and ASX’s Focus and Activities ........................ 39 PART IV. DEMUTUALIZATION OF EMERGING MARKETS ....................................... 42 1. The Extent of Demutualization............................................................................................. 42 2. What Drives Demutualization in Emerging Markets............................................................ 43 3. Who Drives Demutualization?.............................................................................................. 44 4. Demutualization and Stakeholder Issues .............................................................................. 45 5. Regulatory Obligations of a Demutualized Exchange.......................................................... 47 6. Conclusion ............................................................................................................................ 48 APPENDIX................................................................................................................................... 50



List of Abbreviations
Abbreviation Archipelago ASIC ASX ATS Blueprint CBOE CLA Act CME DE Deutsche Borse DTB Euronext NV Exchange Act Expert Committee FSR Act GEM HKEx HKFE HKSCC IOSCO IPO LSE MoU NASDAQ NSE NYSE OSC QTRSs RS SEC SEHK SES SFC SFCO SFE SFO SGX SIMEX SRO TSX Term • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • Archipelago Holdings Inc. Australian Securities and Investment Commissions Australian Stock Exchange Alternative Trading Systems A Blueprint for Success Chicago Board of Options Exchange The Corporations Act 2001 Chicago Mercantile Exchange Demutualized Exchange Operated on a for-Profit Basis Deutsche Borse AG Deutsche Terminbourse Euronext U.S. Securities Exchange Act of 1934 Expert Committee on Demutualization and Integration/Transformation of Stock Exchanges Financial Services Reform Act 2001 Growth Enterprise Market Hong Kong Exchanges and Clearing Limited Hong Kong Futures Exchange Limited Honk Kong Securities Clearing Company Limited International Organization of Securities Commissions Initial Public Offering London Stock Exchange Memoranda of Understanding NASDAQ Stock Market, Inc. Non-for profit Stock Exchange Owned its Members New York Stock Exchange Ontario Securities Commission Exchanges and Quotation and Trade Reporting Systems Market Regulation Services Inc. U.S. Securities and Exchange Commission Stock Exchange of Hong Kong Limited Stock Exchange of Singapore Securities and Futures Commission Securities and Futures Commission Ordinance Sydney Futures Exchanges Securities and Futures Ordinance Singapore Exchange Limited Singapore International Monetary Exchange Self-Regulating Organization Toronto Stock Exchange

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In the last twenty years stock exchanges have undergone several radical transformations. we will discuss what demutualization means. In Part II. we will discuss the 1234 . Some of these differences relate to the role and powers of the exchange’s Board of Directors. we will discuss several issues relating to the regulation of a demutualized exchange. an examination of the demutualization process highlights a number of common themes which we will explore in this paper. the legal and regulatory frameworks vary considerably.-4- Introduction Capital markets play a vital role in fostering sustainable capital formation by channelling the savings of an economy into investments. the historical evolution of exchanges. However. As result. This facilitates the financing of various activities and helps to increase national output and economic expansion. the officers. In Part III. In Part I. Before we discuss the differences between the organizational structure of demutualized and nondemutualized stock exchanges. and the advantages of demutualization. as does the degree of oversight of each exchange by government or their designated regulatory authorities. and regulation. and continue to be. significant variation in organization. Further differences relate to the manner in which external bodies and public interest representatives have been able to influence the policies of the exchange. Demutualization has generally involved conversion of an exchange from a not-for-profit member owned organization to a for-profit shareholder owned corporation. One such transformation is the demutualization of stock exchanges. it is important to note that within each organizational structure there have been. the Chair of the Board of Directors. operation. stock exchanges play a significant role by creating an organized market where issuers and investors are brought together. Also. In this paper we will provide a broad overview of four issues central to understanding of stock exchange demutualization. the specific circumstances of demutualization. In this process. and the various committees and subcommittees. the powers of the chief executive officer. the potential issues and regulatory responses to such issues will require a careful context specific analysis.

the ability of members to influence the decisions of the exchange is not related to the members’ level of economic interest in the exchange. “Issues Paper on Exchange Demutualization”. F. or “NSE”). 2 3 4 1234 . L.3 Although this has not always been the case. at 3. Donnan. on a one-member. Technical Committee of the International Organization of Securities Commissions. the close identity between owners of the organization and the direct users of its trading services. decisions are made democratically. available online: . the owners of NSEs are also its customers and share in the net gains of the enterprise in proportion to their ownership interest. we will discuss the extent of demutualization in emerging markets and some issues that are particularly important to such markets. PART I.” In this paper we will use term “TSE” to refer to the Toronto Stock Exchange during the period it was branded as the “TSE”. the ownership rights in most NSEs are not freely tradeable or exchangeable. Finally in Part IV. Self-regulation and the Demutualisation of the Australian Stock Exchange (1999) 10 Australian J. stock exchanges have been organized as mutual associations owned by their members (traditionally a national stock exchange. As a result. June 2001. at 5. 1. EXCHANGE DEMUTUALIZATION What Demutualization Means Traditionally. one-vote basis and often by committees of representatives of the firm’s members. 1 The Toronto Stock Exchange was originally branded the “TSE” this was later changed to the “TSX. NSEs are seldom able to raise capital from anyone other than their members. Traditional stock exchanging have typically limited ownership to brokers and have appointed a number of independent or public representatives to offset the self-interest of their member. Furthermore. and are often required to be forfeited on the cessation of membership. Corp. Generally. From 1802 until 1948 the London Stock Exchange was operated on a for-profit basis and paid large dividends to its members. that is. and term “TSX” to refer to the Toronto Stock Exchange thereafter. Usually. The most distinguishing feature of NSEs is their co-operative governance model.-5- demutualization experiences of the Toronto Stock Exchange (“TSX”)1 and the Australian Stock Exchange (“ASX”) as practical examples of the demutualization process. because most NSEs’ constating documents expressly or impliedly adopt a non-profit objective and prohibit the distribution of surpluses.2 Also.4 most NSEs have operated on a not-for-profit basis such that any earned profits are returned to members in the form of lower trading costs or access fees.

1234 . with immediate or eventual freely tradeable shares. As a result. some have demutualized and become public corporations by listing their stock on their own exchange. The emerging exchange’s governance structure 5 Technical Committee of the International Organization of Securities Commissions. some have limited the tradeablity of their shares post-public listing while others have permitted the immediate free exchange of their shares. Also most DEs separate ownership rights from trading privileges. and customers. In this manner. like other for-profit corporations are able to raise new capital from a variety of sources. then converting membership rights into shares. one share. and most have imposed share ownership restrictions.pdf. The board of directors in turn appoints officers to manage the day-to-day operations of the corporation. or “DE”).-6- In contrast. demutualization is the process of continuing an organization from its mutual ownership structure to a share ownership structure. DEs. which may be followed by public issuance and listing of the exchange. Therefore. one vote. most stock exchanges that have demutualized have operated as for-profit entities. at 3. it should be noted that most of the benefits associated with demutualization are generally thought to be associated with the publicly listed demutualized exchange with freely tradable shares. some have become subsidiaries of publicly traded holding companies. June 2001. As a result. While the appropriateness each of the various post-demutualization structures will be dependent on the circumstances.iosco. owners with greater economic interests are more capable of influencing decisionmaking. “Issues Paper on Exchange Demutualization”. decision-makers. first obtaining the appropriate regulatory and governmental consents. a quasi-governmental institution is transformed into a profit-oriented publicly traded company. most DEs have been comprised of three principal and generally separate groups: owners. the shareholders vest decision-making power in a board of directors who are subject to election and removal. organized as corporations with share capital which are listed publicly traded (a demutualized exchange. Most DEs are organized such that the voting rights of shareholders are proportionate to their economic interest in the corporation: that is.5 It should be noted that DEs have taken many forms post demutualization: some have remained private corporations. In This process often entails. available online at: http://www. In this structure.

Several other exchanges followed Stockholm’s lead: the ASX. the Singapore Stock Exchange and the Hong Kong Exchanges and Clearing Limited (“HKEx”) among them. has to this date not become a listed company. which was acquired by the OM Group in 1998. The TSX. On November 23. the TSX. However. transformed the exchange into a private limited company. an 1234 . The London Stock Exchange’s (“LSE”) path to becoming a DE began in 1986 with a series of market deregulation initiatives called the “Big Bang”. The HKEx was created in 2000 as result of the merger and demutualization of Stock Exchange of Hong Kong Limited (“SEHK”) and the Hong Kong Futures Exchange Limited (“HKFE”) and the Hong Kong Securities Clearing Company Limited (“HKSCC”). Singapore Exchange Limited (“SGX”) was Asia-Pacific's first demutualized and integrated securities and derivatives exchange. HKEx shares were listed on its own marketplace on June 27. The Deutsche Borse AG (“Deutsche Borse”) traces its roots to the Deutsche Terminbourse (“DTB”). 2000 a short three months after the merger. which among other things. 2. Deutsche Borse and Euronext are all public companies.-7- rests the ultimate control of the exchange in the hands of its shareholders. The ASX was one of the first stock exchanges to do a public offering and listing its shares on its own marketplace. In 2000. This effectively separates ownership from trading privileges as stockbrokers become the exchange’s customers and are no longer required to be owners. demutualized in 2000 and in 2002 became a public company by listing its shares on its own marketplace. which completed its demutualization in 2001 and is one of the largest exchanges in the world. 2000 SGX’s shares became listed on its own marketplace. although this is expected to occur by the end of 2006. Historical Evolution of Exchanges The Stockholm Stock Exchange. These two processes are discussed in detail in Part II of this paper. SGX was created on December 1. LSE’s shareholders voted to become a public limited company called the London Stock Exchange plc and in July 2001 the LSE became listed on its own marketplace. which is owned by the TSX Group. the major European exchanges including London Stock Exchange. was the first major exchange to demutualize in 1993. 1999. the Tokyo Stock Exchange. Similarly. following the merger of the Stock Exchange of Singapore (“SES”) and the Singapore International Monetary Exchange (“SIMEX”).

ucdavis. stockbased holding company was approved in 2005 with an IPO conducted in October 2005. which completed its demutualization in 2000 was the first exchange to demutalize in the U. In 2002 Euronext acquired the London International Financial Futures and Options Exchange and the Portuguese stock November 6. The DTB was structured as a corporation with five German financial institutions as its controlling owners.6. pg.pdf. In early 2000 the NASD moved to separate from and take NASDAQ public.pdf. The NASDAQ Stock Market. included demutualization into a for-profit. The Deutsche Borse was established in 1991 to operate the Frankfurt Stock Exchange.4. The The Deutsche Borse completed its public offering in February 2001.”8 The CBOE has also announced plans to demutualize by the end of 2006. 8 9 1234 . March 2004. NASDAQ.-8- electronic futures and options trading system established in 1988. “Taking Stock in Stock Markets: The Changing Governance of Exchanges”. which then merged with the DTB. Available at: http://www. the CME conducted its initial public offering and listed its shares on the NYSE. 2005 NASDAQ acquired the Instinet Group Incorporated and sold Instinet’s Institutional Broker division to Silver Lake 6 7 Alfredo Mendiola and Maureen O’Hara. The “restructuring of the Chicago Board of Trade.msb. Inc. and became listed Euronext Paris on July 2001.7 In 2003. Reena Aggrawal and Sandeep Dahiya. (formerly known as the National Association of Securities Dealers) (“NASDAQ”) was once a wholly-owned unit of NASD. Ibid. The NASD restructured NASDAQ in 2000 by conducting a private placement and issuing warrants. 2002 shares of NASDAQ started trading on the Over-the-Counter Bulletin Board and eventually migrated to the NASDAQ Stock Market in February 2005 after NASDAQ issued shares in a secondary offering. Ibid. the Chicago Board of Options Exchange (“CBOE”).6. Brussels and Paris stock exchanges. On July 1.6 Euronext NV (“Euronext”) which is a Dutch public company with limited liability was formed in September 2000 from the merger of the Amsterdam. “The Demutualization and Public Offering of Financial Exchanges”.S. Some of the major American stock exchanges that have or plan to demutualize in the near future include: the Chicago Mercantile Exchange (“CME”).9 NASDAQ acquired the BRUT ECN in 2004 and on December 8. pg.gsm. Available at: http://faculty. 2005. and the New York Stock Exchange (“NYSE”). pg.

Ibid. 2005. pg. 20 per cent was from Asia/Oceania and rest from the Americas. was completed February 28. 2006 approved application of the NASDAQ to become a registered securities exchange. It should be noted that a small but significant portion of exchanges accounting for 18 per cent of world’s total stock market capitalization have demutualized but not listed their shares. 2006. 2006 the NYSE began trading on its own marketplace ending the exchange’s 213-year history as a member-owned (“Archipelago”). this trend is illustrated in Figure 1. It has been widely thought that the CBOE will demutualize by the end of 2006 or early 2007. “the total stock market capitalization of world’s exchanges was $37. and it is a key step in NASDAQ obtaining full independence from NASD and competing on a more even footing with other exchanges. This application was under consideration since 2001.7.3. (“NYSE”). 2006.S. 2005. NASDAQ owns INET ECN. The U. See “CBOE May not Complete Demutualization in 2006: CEO”. As a result of these available online at: http://chicagobusiness. Securities and Exchange Commission (“SEC”) on January 13.”10 With the addition of the NYSE as a publicly traded company on March 8. The first major step was the approval of the NYSE’s governing board to acquire Archipelago on December 6. As of March 7. January 11.2 trillion of which 30 per cent was from Europe. in a deal that was intended to create a new DE.11 Not surprisingly the overwhelming majority of demutualized and listed exchanges are concentrated across Americas and Europe. 2006 with the approval of the merger from the SEC. presently over 70 per cent of the world’s total stock market capitalization is comprised of publicly-listed exchanges. The final step towards the merger.12 Table 1 shows the largest stock and derivatives exchanges measured in terms of capitalization as of 2004 10 11 Ibid. creating the new entity NYSE Group Inc.-9- Partners. pg. the New York Stock Exchange announced its plans to acquire Archipelago Holdings Inc. including the NYSE. twenty two stock and derivative exchanges have become publicly listed corporations with a great likelihood CBOE will be added to this list in the near future. 12 1234 . On April 21. On March 8. Reuters. 2006. At the end of 2004.

366 seats. From the NSYE’s 1.16. However. a corporation that operates in a more bottom-line focussed manner and is more capable of acting decisively and rapidly to changes in the business environment facilitating a timely response to competitive challenges.) A DE is.. 3. big Wall Street Firms).14 As a result. If either of these conditions fails to hold true. a) The Reasons to Demutualize Rationalized Governance The NSE model functions well if the exchange is a provider of trading services with limited competition and the interests of its members are homogeneous. A similar pattern is also evident for the largest derivatives exchanges. the floor community had significant power over decision making. 464 were held by the specialists and another 317 by “two-dollar” brokers while only 565 seats were held by “upstairs brokers” (i. Consensus decision making becomes slow and cumbersome and the exchange becomes unable to respond quickly and decisively to changes in the market. This focus on cost and efficiency threatened profits of the floor community and made it difficult for the NYSE to implement changes that were good for the exchange but not necessarily so for its memberowners. who want the lowest cost and most efficient execution of their trades. The previous ownership structure of the NYSE underscores the tensions created by the NSE model. it is useful to canvass the advantages of demutualization. pg. To understand this rapid transformation of stock exchanges. 1234 .10 - for all the major geographic locations. driven by institutional investors. This result is facilitated by the separation of ownership and trading privileges of the members of the exchange. Ibid.e. the NSE model ceases to function well. its decision not to pursue derivatives trading in 1972 and not to allow IPO firms to be listed until 1984. the bulk of the NYSE’s business was.13 As indicated in Table 1 almost all of the largest stock exchanges have demutualized and listed their shares in the last decade. This conflict has also been frequently cited as reason for some of the strategic missteps of NYSE in the past (for example. The DE structure will enable management to take actions that are in the best interests of the exchange and ultimately its shareholders.. ideally. and continues to be. pg. 13 14 Supra note 7.7.

unlike the NSE structure. the interest of the owners of the exchange will be aligned with those of the exchange as both will seek to maximize the profits. A DE will have greater flexibility to accommodate the needs of the now more powerful institutional investors and as a result adapt to change. a DE affords both institutional investors and retail investors the opportunity to become shareholders. and institutional and retail investors. For instance. 5. b) Investor Participation In today’s competitive environment. They are often operated by exchange members or member-affiliates and are similar 15 The Toronto Stock Exchange: A Blueprint for Success (8 October 1998) at pg. In order to respond effectively to emerging trends. where often only broker-dealers may be members. 1234 . ATSs are privately operated computerized systems that perform many of the functions of an exchange by centralizing and matching buy and sell orders and providing post-trade information. including participating organizations. institutional investors require greater liquidity to accommodate block trading and place more emphasis on negotiating the lowest price. Another advantage of the DE structure is the greater degree of transparency. In particular. a stock exchange must be responsive to the needs of its many stakeholders.11 - This separation will permit the exchange to achieve greater independence. In contrast to retail investors the assets managed by institutional investors have grown significantly in recent years and the trading needs of institutional investors differ dramatically from those of retail investors.15 c) Competition from ATSs and Upstairs Trading The threat of competition from alternative trading systems (“ATSs”) has forced exchanges to examine their role as trading arenas and to take measures that facilitate more competitive future strategies. Separating exchange membership from ownership may be a politically and economically feasible way to effect such a shift and resolve conflicts both between the exchange’s members and between the exchange and its members.6. Demutualized exchanges will be forced to account to their shareholders not only regarding the bottom-line but regarding issues arising in corporate governance. exchanges need to shift power from one group of stakeholder to another. listed companies. As a result..

16 Although some ATSs have been in operation for many years. The most important are the regulatory changes in the 1970s and 1980s that permitted investment dealers to trade as principals and to internalize orders. particularly firms that internalize or purchase order flow.csa- 17 1234 .. CSA News Release.pdf. The U. rather than exposing the order to auction on the exchange.nasdaq. August 21.17 Exchanges have faced additional competition from the many broker-dealers adopting internal systems to automate the firm’s execution of customer orders. These systems are not generally considered ATSs as all trades are effected on internal systems involve only the operator of the system and not external parties – this is generally referred to as “upstairs trading”.html 2001. Smith et al. The Canadian Securities Administrators have also implemented rules governing ATSs which permitted their introduction into the Canadian markets effective December 1. available online at: http://www. NASDAQ Working Paper (24 August 1998) at 36. available online at www. The NASDAQ Stock Market: Historical Background and Current Operation. 16 Jeffrey W. The market only learns of the trading activity after the fact.S. as well as the systems capacity. integrity and security of acvm. SEC became concerned that ATSs would impair the fair and orderly functioning of markets. trading value increases and pressures on trading profits have enabled some of them to become serious competitors to exchanges. In Canada. 2001. technological advances. the SEC implemented Regulation ATS that permitted ATSs to continue to be regulated as broker-dealers but required them to comply with rules designed to improve transparency and surveillance. Upstairs trading occurs when a stock exchange member matches customer orders against other customer orders or against its own inventory position within the upstairs trading has been on the rise as a result of several factors.12 - to exchanges because they allow two participants to meet directly on the system and are maintained by a third party who also serves a limited regulatory function by imposing requirements on each subscriber. In December 1998.academic. and the consolidation of investment dealers and their willingness to commit capital to facilitate trades have improved the services offered.

In 18 Timothy Baikie.. and upstairs trading. brokers and exchanges were locally focussed.adb. “Toronto Stock Exchange – From Toronto Stock Exchange to TSE Inc. Consequently.: Toronto’s Experience with Demutualization” at pg. mergers among stock and derivative exchanges in the U.9 trillion offering an unprecedented variety of products. It is clear that at least with respect to certain services there is direct competition among the three systems. Thus exchanges that once were isolated find themselves in intense competition with global rivals. have been impacted. this challenge has been acutely felt in relatively small home markets in emerging countries. 1998 created an exchange with a market capitalisation of US$1. the growing success of ATSs and upstairs trading suggests that there is a growing role for speciality.18 Modern telecommunications have enabled capital to become more mobile as issuers and investors are more readily able to access foreign capital markets. have altered North America’s competitive landscape and created super-exchanges. However a DE will be more capable of remaining competitive in terms of 1234 . available online at: http://www.13 - The bundled services offered by exchanges provide the advantage of scale and liquidity. While all exchanges. For instance. global centers have grown in importance as locality and nationality has become less of a defining characteristic of capital markets. e) Consolidation Strategic alliances and consolidations are also impacting capital markets and exchanges. It is also clear that ATSs and upstairs trading will not be able to entirely replace the integrated services offered by exchanges. variety and quality of their services than the exchanges organized pursuant to the NSE model. For instance the recent listings of the NYSE and the Tokyo Stock Exchange are expected to have an enormous impact globally. 6 and pg. d) Globalization Historically. niche player exchanges. It is not entirely clear what the ultimate division of labour will be between exchanges. including those in Canada. ATSs. National exchanges developed when the telegraph and telephone made it easier to deal on a distant exchange. the merger of NASDAQ and the American Stock Exchange completed November 2. 11. In the past 5 years.

products and services must not only be timely and cost-effective. In order to introduce screen trading considerable capital investment was required to buy-out the interests of the traders and to modernize the information systems of 19 Supra note 7. both the TSX and NYSE have announced plans to expand their capabilities.. Once customers were able to have direct access to screens. DEs. a DE should have both the incentive and the resources to invest in the competitiveness of its information systems. the most interesting arena will continue to be Europe where one or two large exchanges are likely to emerge. To be competitive. given that North America is already dominated by the NYSE and NASDAQ.14 - the next 5 to 10 years major consolidation is expected in the financial exchanges industry. These changes in turn are likely to exert greater pressure on NSEs to demutualize and adopt a share ownership structure. 1234 . as shareholder owned entities.S. exchanges. This consolidation process will be greatly facilitated by the DE structure with publicly traded shares. With respect to derivatives. In equities trading. One of the early drivers of stock exchange demutualization was replacement of floor trading with screen trading. but also reliable. The publicly listed status of DEs makes for easier execution of such strategies. These exchanges will attempt to potentially be of scale comparable to the U. With the capital raised from an IPO or private investment and a heightened awareness of accountability to stakeholders. face more pressing demands to deliver performance which provides greater incentive for exchanges to seek revenue and cost-saving synergies. f) Resources for Capital Investment A DE is more capable to respond quickly to global competitive forces and technological advances. An illuminating historical example is the replacement of floor trading with screen trading.19 These changes should introduce greater geographical consolidation and mergers/acquisitions across product lines. One area of expected consolidation is in the leading derivative and equities exchanges. the economic value of exchange memberships declined and clearing firms rather than traders become a dominant force in exchange activities.

we consider some of the debates surrounding the regulation of DEs. (c) the development of standardized contracts to reduce transaction costs for investors in listed stocks. a regulator of a DE must balance the profit motives of the stock exchange with the greater goal of investor protection. (b) monitoring of trading patterns. 22. 1.15 - exchanges. particularly: 1) the desirability of dividing capital markets regulation between regulators and self regulatory organizations (“SROs”). Exchanges provide a bundle of services for listed firms. with particular attention to the questions of prudential regulation. The Need for Regulation Stock exchanges are firms that market transaction services to facilitate trading and generate revenue from listing and other transaction fees. 1234 . Legal Stud. and memoranda of understanding. Before embarking on this discussion however. PART II. continued investment in technology may serve as an effective means to meet competition from ATSs and upstairs trading systems.. it will be necessary to dwell for a moment on the need for regulation in this area. and (d) the provision of reputational capital to listing firms. A. pg. Regulating Exchanges and Alternate Trading Systems: A Law and Economics Perspective (January 1999) 28 J. share ownership restrictions. In this section of the paper. directors and officers of DEs. 2) the conflicts of interest that arise when a for-profit exchange also regulates certain dimensions of the primary and secondary market.20 20 Jonathan Macey and Maureen O’Hara. 17. REGULATION OF A DEMUTUALIZED EXCHANGE Introduction The process of demutualization from an NSE to a DE is a complex process that raises difficult regulatory questions. as well as justifying the scale of the typical integrated exchange model. dispute resolution and corporate governance of exchange-listed securities. Going forward. Demutualization was an efficient and rational means of infusing additional capital in order to finance both activities. Most broadly stated. specifically: (a) the provision of liquidity to compensate for temporary imbalances in order flow. and 3) the issues surrounding how to efficiently govern DEs.

the mechanisms for the enforcement of rules may become too costly in the absence of some centralized regulation. regulation may be required to address the certain effects of the functioning of the market on third parties or other externalities. 24. (b) the creation and maintenance of fair. The above mentioned three main objectives overlap to some extent and mutually reinforce each other. regulation is necessary to address the inefficiencies generated by economic activity. As a consequence. efficient and transparent markets. efficient and transparent. and isolates the risk to the failing institution.16 - Markets do not solve all the problems generated by economic activity within the financial manipulative.pdf. pg.. This requires regulation that ensures that markets do not favour some users over others and there is full and timely disclosure of all relevant information. Ibid. Regulation in the financial markets is necessary for three primary reasons. Ibid. 7. to prohibitive levels. “Objectives and Principles of Securities Regulation”. 6. Ibid. available online at: http://www. September 1998 at pg. 8. Generally.24 The risk reduction objective can only be achieved if regulation aims to reduce the risk of failure of market intermediaries. 23 24 25 1234 . The objective of investor protection is premised on the principle that investors must be protected from misleading. Pg. Second.iosco..25 21 22 Ibid. Third. competition between exchanges in the delivery of their products should be fostered as competition provides exchanges with the incentive to innovate and become more efficient in the delivery of products and services. another objective of securities regulation is enhanced competition. and (c) the reduction of systemic risk.22 In countries with multiple developed and sophisticated capital markets. incomplete contracts can prevent markets from proper functioning by increasing. pg. and fraudulent practices.23 In order to promote this objective markets must be fair. First.21 The three main objectives of securities regulation as expressed by the International Organization of Securities Commissions (“IOSCO”) are: (a) the protection of investors.. seeks to reduce the impact of that failure. the costs of certain transactions. International Organization of Securities Commissions.

S. For instance. The Regulatory Challenges Surrounding Deregulated Exchanges Division of Regulatory Labour The requirement to regulate markets does not necessarily mean that the responsibility for all aspects of the regulation and enforcement of securities law must rest with a single body. stock exchanges regulated their members and listed companies before the US government instituted regulation of the securities markets and the securities industry. Simon A. potentially greater compliance with mutually agreed rules set by peers than with externally imposed requirements. in the U. 1234 . Securities and Exchange Commission (“SEC”). their trading markets and their listed companies. but stock exchanges continued to have rulemaking and regulatory authority with respect to their members. pursuant to the U. 1.13.. and (d) greater flexibility and responsiveness. The principal advantages of a government regulator delegating responsibility for oversight of the market to SROs are: (a) (b) (c) the ability to utilize industry expertise. Romano. Pg. the potential for higher standards than may be imposed by law. “Self-Regulation in the Securities Industry-A Regulatory Perspective”.S.17 - B. 95 OSCB. has oversight authority over stock exchanges. Securities Exchange Act of 1934.. An SRO is an organization that exercises some degree of regulatory authority over market participants. or solely in the absence of government oversight and regulation. The ability of an SRO to exercise regulatory authority does not necessarily derive from a grant of authority from the government..S. As it stands presently. The regulatory authority of SROs could be applied in combination with some form of government regulation.27 26 27 Ibid. the U.26 There are several effective models in which responsibilities may be shared among several government or quasi-government agencies or where responsibility is shared with self-regulatory organizations (“SRO”).

. such as entry barriers and sub-optimal market structure. Ideally. such as the application of inconsistent standards or arbitrary penalties or the failure to respond promptly to problems. consistent implementation of regulatory standards. The government regulator and SRO must each commit to promote: (a) an improved understanding of the roles. the delegation of regulatory responsibilities to SROs also has a number of risks. (b) anti-competitive behaviour. and (ii) increased dependence of the government regulator on the SRO for policy input and expertise. including: (a) operational failures resulting from lack of resources or commitment.18 - However. (c) (d) self-serving regulation. heightened possibility of “regulatory capture” including: (i) through control of the information necessary to regulate properly. and (e) the chilling effect on dissent that may result from a well-organized interest group. a careful balance of regulatory responsibility between the government and the SRO must be crafted. 1234 . This will require establishing increased competency in each regulator. 28 Ibid. and creating effective oversight of the SRO by the government regulator. this balance will permit the SRO to act as the regulator of market participants and government as its supervisor. (b) (c) the exchange of expertise.28 In order to reap the benefits of regulation by SROs and minimize its potential risks. which favours the interests of members over those of investors. thus ensuring a sufficient level of oversight by each branch over the other. powers and responsibilities of each regulator. effectively arranging for co-ordination and the exchange of information.

For particular examples of how MOUs have been deployed to structure these relationships. although they are not typically binding. (c) (d) (e) adopting and enforcing rules of conduct for members of the exchange. Self-regulation and Conflicts of Interest General Concerns While incidence of conflict or potential conflict is not unique to a demutualized exchange their potential is heightened under the DE structure due to the exchange’s profit motives. 12. setting listing standards and ensuring continuous disclosure of material information by listed companies. setting qualification and financial standards for industry professionals. ‘ 2. 29 Frank Donnan. “Self-regulation and the Demutualisation of the Australian Stock Exchange”.19 - (d) access by each regulator to the information necessary to fulfil its responsibilities. 1999. 10. see the section entitled “Memorada of Understanding” below. co-operation between SROs and regulators can be effected by executing memoranda of understanding (“MoU”) which function to define the relationship between institutions. First.. a) Demutualization.29 As discussed more particularly later in this section. conducting surveillance of the market and its participants. Corp. Australian J. 1234 . Pg. L. Such memoranda can be useful in clarifying the regulatory roles of SROs and regulators. investigating violations of exchange rules and disciplining violators. The regulatory responsibilities of an SRO may include: (a) (b) developing trading rules and enforcing them. and (f) monitoring and regulating daily trading and the operation of the market to ensure its integrity. and (e) communication lines that will maintain and enhance each regulator’s ability to react to market activities in a timely manner.

conflicts of interest may arise if there are ongoing power struggles between the SROs and between the SROs and the government regulator or where the SRO is not independent of the exchange.31 The Australian Government passed The 30 Roberta Karmel. the SRO) has a certain level of independence from the business branch. Second. Third. A response to these arguments is that changes may be made to the organizational structure of the exchange to address concerns..aals. regulating duties are divided between the ASX.g. mechanisms have been established to ensure sufficient disclosure by the SRO of their regulatory duties and the process adopted in carrying out such duties ( limits have been placed on the level of ownership of the exchange. Thus permitting for sufficient oversight by the government in order to detect and address such problems. The model adopted in Australia provides an example of the utilization of each of these options. annual reports and press releases). 31 1234 .20 - commentators have argued that an exchange may sacrifice effective regulation to achieve the short-term goal of maximizing shareholder profits. particularly if several ATSs become exchanges and engage in self-regulation. December 2000. DE have divided their business from their regulatory branch and taken steps to ensure a that the regulatory branch (i. it increases its opportunities for conflict. available online at: http://www. commentators have expressed concern regarding the duplicative costs of creating multiple SROs. Second. it has been argued that a for– profit exchange and its management will be too preoccupied with profits and business development to dedicate sufficient resources to the regulation of the markets and its participants. Fourth. Supra note 29. 57..e. conflicts of interest may arise in the exchange regulating the dealer and providing a competing service.. First. Pg. as previously discussed steps have been taken to ensure that there is an efficient division of regulatory duties between the SRO and the government. In other words. Third. DEs have adopted four common structural changes to address these issues. Conflicts may lead to the denial of access to particular activities or failure to make changes to accommodate an entity providing a competing service.pdf. the Australian Securities and Investment Commission (the “ASIC”).30 Furthermore. “Turning Seats into Shares: Implications of Demutualization for the Regulation of Stock and Futures Exchanges”. as the for-profit exchange enters into new businesses. and the government. In Australia. If a dealer that operates an ATS is also a member of the exchange.

(c) (d) (e) rigorous regulatory oversight. mechanisms to enhance exchange accountability to the government regulator and the public. remarks to International Organization of Securities Commission. The CLA Act and FSR Act impose a duty on the ASX to do everything necessary to ensure that the market operates in an orderly. ASX has also taken initiatives to enhance the transparency of its supervisory policies and procedures. 2004.21 - Corporations Act 2001 (“CLA Act”) and the Financial Services Reform Act 2001 (“FSR Act”) to designate the regulatory duties of the ASX. Theses acts clarify the statutory obligation and responsibilities of the ASX as an SRO.33 The ASX has transferred its regulatory functions to ASX Supervisory Review Pty Limited (“ASXSR”). a clear statutory statement of the obligation to provide a fair and efficient public trading market. “Mergers.pdf. May 20. fair. 33 1234 . Also the ASX imposed a maximum ownership limitation that capped the voting power held by any one person in the ASX to 5 per cent. enhanced transparency through requirements to publish rules and decisions. Full text of this MoU is produced in Exhibit B. and its accountability to the ASIC..”32 Further to this. 2004. Demutualization and Governance of Securities Exchanges”. b) Managing Conflicts of Interest Generally IOSCO commented that the challenge for exchanges is to create an environment in which conflicts are recognized. available online: http://iosco. This has included public consultation for rule development proposals. the ASX and the ASIC have attempted to clarify their respective roles by signing three MoUs. This environment involves: (a) (b) corporate governance requirements such as requirements for public directors. publication of waiver and disciplinary determinations. minimized and managed. and (f) separation of the commercial activities of the exchange from regulatory functions: from dividing lines of authority and accountability within a single firm to 32 Jeffery Lucy. this was later raised to 10 per cent. and transparent the latest of which was executed July 1.

the SEHK.34 An example of an attempt to put these principles into practice is the model adopted by the HKEx. open market for its securities. ownership in shares of the exchanges were separated from access to trading facilities. and the HKFE. operation under substantially the same management for three years. Qualifying requirements for listing applicants include an adequate track record. together with the HKSCC. Pg. HKEx shares were listed on its own marketplace on June 27. are not required to have a profit track record. The regulation of market participants is conducted by the SFC. 2003. 2000. which came into operation on April 1. The SFCO and nine other securities and futures related ordinances were consolidated into the Securities and Futures Ordinance (“SFO”).. GEM has been established as a market designed to accommodate companies to which a high investment risk may be attached. which is an independent statutory body established in 1989 by the Securities and Futures Commission Ordinance (“SFCO”). In Hong Kong no person may carry on a business of dealing in securities or futures contracts unless they have received a 34 35 Supra note 5. the SEHK and the HKFE demutualized and. merged to form the HKEx. 9. The Listing rules of the Main Board prescribe are more demanding than those of GEM. a short three months after the merger. unlike those of the Main Board. HKFE is also a wholly-owned subsidiary of HKEx. GEM listing applicants.22 - establishing a separate legal entity or transferring some regulatory responsibilities (such as regulation of the exchange as listed corporation) to the government regulator. SEHK is a wholly-owned subsidiary of HKEx. Shareholders of the new exchanges became holders of trading rights and trading members before the merger were deemed exchange participants. and meet minimum size requirements. It maintains a futures market in Hong Kong and is the primary regulator of Futures Exchange Participants with respect to trading matters. Its principal function is to operate and maintain the securities market in Hong Kong and to act as the primary regulator of stock exchange participants with respect to trading matters and companies listed on the Main Board35 and Growth Enterprise Market36 (“GEM”) of the Stock Exchange. In 2000. 36 1234 . The principal regulator of Hong Kong's securities and futures markets is the Securities and Futures Commission (“SFC”). As a result of this merger. profit requirements.

this section of the paper will go on to discuss more discrete instances of conflicts of interests. Further. which would result in more listing fees and transaction fees for the exchanges. 1234 . Jr.. a regulatory arm makes the exchange a less attractive candidate for an initial public offering (“IPO”). Coffee. c) Discrete Problems Respecting Conflicts of Interest Having discussed generally the problem of conflicts of interests and how to manage them. i) Supervision of Listing Some commentators have articulated the concern that the conversion of an exchange to a forprofit corporation would precipitate a “race to the bottom” in which exchanges would lower their listing and reporting standards to compete successfully for listings. “Privatization and Corporate Governance: The Lessons from Securities Market Failure”. fall within a relevant licensing exemption.23 - license from the SFC. since a regulatory function imposes additional costs. specifically those that may arise when a DE regulates the listing of its competitors and itself. a reply to this argument is that while some exchanges may choose to lower their listing standards in order to be more profitable for their shareholders.. 25 Journal of Corporation Law 1999. and have satisfied the requirements of the SEHK and HKFE. It has been argued that for-profit structures increase the scope and intensity of conflicts because revenues must meet expenses and generate a rate of return for investors. This would in turn undermine the investing public’s confidence in the strength and quality of the capital markets in general. It is argued that while competition among exchanges would probably result in a lowering of fees and other costs related to listing it would also be accompanied by a loosening of listing standards.37 However. This would permit more companies to list. In preparing for an IPO an exchange will seek to minimize costs and emphasize its potential for earnings thereby it is likely to spin off its regulatory arm. other exchanges will institute more stringent and rigorous standards in order to distinguish themselves and the service they 37 John C. The benefits of good regulation are hard to quantify and therefore a forprofit exchange may be unwilling to devote sufficient resources to enforcement.

the NYSE has adopted this approach to distinguish itself from other exchanges. As a result. Other alternatives raised are to 38 39 Exchanges supply reputational capital to the firms that list on them. DE Governance Issues a) Prudential Regulation A member-owned exchange usually has the right to assess its members and request a capital contribution. and (b) the risk to the exchange’s reputation. Capital and solvency requirements serve to reduce the risk of failure of a financial firm by requiring a capital cushion to absorb losses. Supra note 20. The IOSCO report cites two factors that act as controls against discriminatory treatment of competitors: (a) competition for listings among exchanges. at Pg. For example. at Pg. In addition to the issue of whether an exchange can function as its own regulator is the issue of whether self-listing increases the conflicts of overseeing competing entities that are also listed on the exchange. but gains the flexibility to raise capital from public or private sources.38 ii) Self-listing An exchange listing on itself presents a more fundamental conflict of interest than those inherent with the regulation of its competitors. 3. Regulators have raised the issue of whether capital requirements should be imposed on a demutualized exchange. Also ASIC supervises ASX’s listing and undertakes the day-to-day supervision to ensure that the ASX is subject to independent scrutiny.39 As previously discussed. 1234 . When the Stockholm and the Australian exchanges went public.24 - offer. 26. Supra note 5. Capital also provides liquidity to permit a firm to operate during an orderly wind down.. these potential conflicts are lessened by the governmental regulator’s oversight over the regulatory duties of the exchange. A demutualized exchange usually loses the right to demand that shareholders contribute additional capital. the government was assigned the task of overseeing the exchange’s disclosure its shareholders. companies seek to list on the NYSE partly because of the reputational capital that comes with listing on a exchange with a reputation for being one of the world’s premier exchanges. 8.

New business lines of exchanges may reduce financial risks by diversifying the exchange’s sources of income. An issue arises whether the public interest requires a limit on share ownership or prior regulatory approval for ownership above a threshold percentage. no person or combination of persons acting jointly or in concert was permitted to beneficially own or control more than 5 per cent of the outstanding shares without the prior approval of the Ontario Securities Commission (“OSC”). no one member exerts control over the decisions of the exchange. Persons who held more than 5 per cent immediately following demutualization were “grandfathered” from these provisions. 1234 . or for the regulator to monitor the financial condition of an exchange and take remedial action. Each person owning a TSE seat received 20 common shares of TSE Inc. Initially. firewalls to protect the resources necessary to run the exchange’s core activities or impose a requirement for prior regulatory approval. With demutualization.. ii) The Australian Securities Exchange 40 Ibid. Subsequently the permitted percentage of ownership was changed to 10 per cent. Pg. Concerns may arise if an exchange is controlled by one or more persons. may not vote in excess of 5 per cent without the prior approval of the OSC. if appropriate. A regulator could require segregation of core and non-core activities. ownership is broadened to include non-member investors. i) Toronto Stock Exchange The corporate structure that the demutualized TSX has adopted is similar to that adopted by several of the other demutualized stock exchanges around the world. with the TSX becoming the sole senior equity market. ASX and the HKEx.. meaning that persons who do own more than 5 per cent of TSE Inc.25 - require a demutualized exchange to establish a reserve to address shortfalls in capital. we will briefly discuss the share ownership restrictions of the TSX. In this section of the paper. In 1999. 13-14. Each common share carries one vote.40 b) Share Ownership Restrictions A mutual exchange is governed by consensus. Canada’s four major stock exchanges were streamlined into three specialized markets.

there is a prohibition on holding 5 per cent or more of the voting power of HKEx at any general meeting of the shareholders of HKEx. 41 Subsequently the permitted percentage of ownership of ASX was raised to 15 per cent. A memorandum issued to explain these restrictions in Australia justified the shareholding limits by offering two reasons: (a) the ASX has a critical role to play in the national economy and thus it is in the national public interest not to allow any one party to gain control of the Exchange. 41 42 43 Supra note 29.42 iii) Hong Kong Exchanges and Clearing Limited In the Merger Ordinance and in the articles of association of HKEx. 12. The consequence of share ownership restrictions is a prohibition on hostile take-overs of stock exchanges thereby removing disciplinary tool on management. An exchange provides liquidity and price discovery that facilitates efficient raising of capital for businesses. may give approval to a person to hold more than 5 per cent if it can be demonstrated to be in the interest of the investing public. The threat of take-overs forces management to use capital efficiently and focus on performance.. Ibid. and (b) such a limitation encourages diverse ownership of the ASX. benefiting the wider corporate sector and the economy as a whole. Ibid. Pg. the SFC in consultation with the Financial Secretary. 1234 . Economists argue that a healthy take-over market works efficiently and effectively to control costs imposed by the managers on the owners of the firm. The SFC will not give such an approval unless it is satisfied that it is appropriate to do so in the interest of the investing public or in the public interest.43 c) Directors and Officers The fair and efficient functioning of an exchange is of significant benefit to the public. However. This 5 per cent limit applies to both Australian and foreign persons.26 - The CLA Act in Australia also limits persons to owning or controlling no more than 5 per cent of the shares in the ASX.

The directors of a for-profit exchange must take into account the interests of all of its stakeholders if the exchange is to function effectively. d) Memoranda of Understanding MoU are used to define the regulatory relationship between institutions. its members that have trading privileges (the broker-dealers). IOSCO 45 raises the issue of whether there is a need for direct involvement of the government regulator in hiring decisions. MoU is useful as a means of clarifying in an explicit manner the regulatory duties of the parties. IOSCO raises the issues of whether a demutualized exchange still needs to have public directors and if so. Market demands will push the exchange to hire as competent people as possible. it is imperative that the investing public not lose confidence in the integrity of the stock exchange.. the senior management of the exchange are likely to be the decision makers on a day to day basis. Full text of the MoU between ASX and ASIC is produced in Exhibit B 1234 . In a demutualized exchange. Thus.27 - In recognition of the role of an exchange and the degree of conflict of interest in a member owned exchange. while a corporation exists to make profits for its owners. i) MoU between ASIC and ASX For example ASIC and the ASX put in place a number of MoU which consider46 44 45 46 Supra note 22.44 We would argue that given that the public interest in a fair and efficient exchange continues in a demutualized exchange. These are non-binding agreements that are used to delineate the regulatory responsibilities of the regulator and the exchange. exchanges are commonly required to have public directors on the board to represent the interests of the community. the need for public directors continues. which helps avoid duplication and promotes cooperation and efficiency. its owners (the shareholders) and the investing public. These stakeholders are its customers (the companies that list on the exchange and the securities information processors). Public directors monitor conflicts of interest in a SRO and promote integrity in decision making. Pg. Ibid. whether they should be given specific public interest responsibilities. 11.

a MoU dated August 22. HKEx and the SEHK sets out the way the parties will carry out their respective duties: (a) HKEx’s and other applicants and issuers’ compliance with the Listing Rules. consultation between ASIC and ASX as to: (i) the appropriate response to such cases and to other issues of mutual concern. HJKEx and SEHK Another example is the MoU between the SFC. (D) notification by each party of various matters in accordance with the statutory obligations of the parties.. Regulation by the SFC is imposed through two sets of provisions. (ii) (iii) the most appropriate party to conduct the response. Firstly. Chapter 38 of the Main Board Listing Rules and Chapter 36 of the GEM Listing Rules contain certain provisions relating specifically to the listing of HKEx and set out the requirements that must be satisfied for the securities of HKEx to be listed as well as the powers and functions of the SFC in the event of a conflict of interest. as a listed company on its own stock market. (E) the facilitation of information sharing between ASIC and ASX for the purpose of each fulfilling its obligations and. 1234 . HKEx and the SEHK. HKEx. including misconduct by listed reporting entities and participants. and the assistance (if any) to be provided by the other party. 2001 between the SFC. ii) MoU between the SFC.28 - (A) the referral of cases of suspected significant contraventions of ASX’s operating rules and of the Act. (F) agreement on joint strategic objectives and the identification of any areas of regulatory priority. is regulated by the SFC to avoid conflict of interest and to ensure a level playing field between HKEx and other listed companies which are subject to the Listing Rules of both the Main Board and GEM. (B) (C) ASIC and ASX keeping each other appropriately informed as to action being conducted (subject to legal constraints on information sharing). Second.

Members of the exchange were brokerage firms whose membership interests (or seats) in the exchange gave them access rights to trade in listed securities. where a conflict of interest arises.. a review of the experiences of other exchanges. In 1997. the TSE’s Board of Governors undertook a strategy development process that involved an assessment of the TSE’s capabilities and competitive position. not-forprofit corporation. and a consideration of governance alternatives. either as principal or on behalf of clients. TSE’s process of demutualization was self initiated. This process was motivated 1234 . market integrity. and (e) PART III. other applicants and issuers. Background to the TSX’s Demutualization The Toronto Stock Exchange was formed in 1852 as a mutual member-owned. In 1998. Like many of the stock exchanges in the developed markets. Trading originally occurred on the floor of the exchange with traders executing and completing trades using manual paper-based systems. The ASX did not delay in going public while the TSX remained private for two years before it went public. we now move on in this part of the paper to discuss the two distinct experiences of the TSX and the ASX. 1. The Toronto Stock Exchange closed the trading floor and became a fully electronic major exchange. (d) conflicts of interest which may arise between the interests of HKEx as a listed company and companies of which it is the controller. It should be noted that this discussion of the TSX and ASX are intended as practical examples of the demutualization process that illustrate some of the issues previously canvassed in this paper. (c) the SFC’s supervision and regulation of HKEx as a listed issuer and. and the interests of the proper performance of regulatory functions by such companies.29 - (b) the Stock Exchange’s enforcement of its rules in relation to HKEx’s securities and those of other applicants and issuers. a survey of the TSE’s constituents’ needs and attitudes. THE DEMUTUALIZATION OF THE TSX AND ASX Having discussed the regulatory challenges inherent in the demutualization process generally.

shareholder structure instead of member-seatholder structure. Since the TSE had historically attempted to resolve issues by consensus.30 - by the recognition that the TSE’s future was threatened and that a strategic direction was required to enable the TSE to succeed in the future. A sense of anachronism also motivated the TSE’s move from being an NSE to a DE. and initially designating at least half of the seats on the Board of Directors from outside the brokerage community. the TSE’s not-for-profit. Indeed. A governance structure that made sense years ago was no longer appropriate as members themselves no longer belong to a homogenous group. the existing governance model was becoming an 1234 . both the size of members and the markets in which they compete were becoming more diverse. demutualized company for several reasons. Rationale for the Demutualization of TSE At the time the Blueprint was published. which at one point had served it well. not the least of which was the fact that the TSE was facing real and growing competition for the products and services it offered both nationally and internationally.. The result of this process was a strategy blueprint. had become more of a hindrance than a benefit. which would assist the TSE in meeting its competitive challenges. The cornerstone to executing the strategic directions articulated in the Blueprint was a new ownership and governance structure for the TSE. It was thought that a for-profit entity with a business minded governance structure would allow the TSE to keep its mandate clear and accountability focused. In order to implement these initiatives. cooperative governance structure. entitled A Blueprint for Success (“Blueprint”). The TSE’s Board of Governors recommended that the TSE become a for-profit. the Blueprint recognized the need for a different governance model than the one that was in place and recommended a new ownership and governance model for the TSE with the following elements: (a) (b) (c) (d) for-profit instead of not-for-profit. separation of access from ownership.‘ 2.

and c) a short overview of the ramifications of the TSE’s demutualization on Canada’s capital markets more generally. aside from its power to impose levies on its seatholders. and restrictions on the number of seats reflected the limited real estate available for trading. Seats were exchanged for shares on the basis of 20 shares per seat. a for-profit corporation. At the time. b) a short discussion of how the TSE. Originally. Later. Members became shareholders and the Board of Governors was renamed the Board of Directors. The TSE no longer was a seat-based. member-owned company. what follows is: a) a brief chronology of the demutualization process.. a “seat” on the TSE was just that: a seat on the trading floor.31 - increasingly slow and cumbersome method of making decisions. Action was delayed by lengthy consultation. Lastly. making it difficult for the TSE to respond quickly and decisively to changes in the market. A business model of ownership would provide the TSE with the platform from which to meet these needs more effectively and would allow the TSE more opportunities to raise capital for itself.. and does not have to acquire more seats to increase its complement of trading personnel. In an electronic exchange. To that end. the notion of using “seats” as the basic governance structure of the TSE appeared outmoded and outdated. Further. the TSE had not been as flexible and proactive in responding to all of its customers’ needs. physical presence on the floor was the only means to trade on the TSE. 1234 . these concerns were no longer relevant. The Demutualization Process of the TSE The next section of this paper constitutes an overview of the different dimensions of the TSE demutualization process. Any member could have as many traders accessing the trading system as it has trading stations. As of April 1. with an eye to highlighting the specific regulatory challenges discussed in Part II of this paper. by limiting ownership to members. a) The History of the TSE Demutualization Demutualization required member approval that was easily obtained. 3. 2000 TSE became The Toronto Stock Exchange Inc. the Ontario government and various SROs dealt with the relevant regulatory challenges. a seat became an entitlement to have a certain number of traders on the floor.

the TSE had to submit a new recognition order to the OSC which set out the terms and conditions under which TSE was permitted to continue to operate as an exchange. 2002. under the Ontario Business Corporations Act on April 3. is obtained. the TSE imposed a seat restriction on itself following its demutualization. with its consolidated subsidiaries as the “TSX Group”). the Ontario Legislative Assembly passed legislation providing for the continuance of the Toronto Stock Exchange Inc. The demutualization process was effectively completed b) Responses to Regulatory Challenges In the Part II of this paper. we discussed concerns and criticisms that might arise if the ownership of any particular exchange became concentrated in the hands of a few shareholders. name and logo. As a result. TSX Group Inc.32 - Once demutualization was approved by the TSE’s shareholders approval was sought and granted by the regulator. a wholly-owned subsidiary of TSX Inc... The shareholders of TSX Inc. the TSX group of companies introduced the “TSX” brand. and Canadian Venture Exchange Inc. (incorporated under the Business Corporations Act (Alberta)). Immediately before closing its initial public offering of common shares. The original restriction stated that no person or persons acting jointly or in concert may beneficially own or control more than 5 per cent of the outstanding shares unless the prior consent of the regulator. on July 10. the Minister of Finance. was renamed as TSX Inc. was renamed as TSX Venture Exchange Inc.” but is not able to exercise more than 5 per cent of the votes outstanding. and its affiliates completed a corporate reorganization under a court approved plan of arrangement. TSX Inc. A member that received more than 5 per cent of the outstanding shares pursuant to the seat exchange was “grandfathered. and the Government of Ontario. were issued shares of TSX Group in exchange for their shares of TSX Inc. 2000. In order to address this issue. 2002 (referred to. newly incorporated under the Business Corporations Act (Ontario) on August 23. As part of the reorganization. This restriction on the number of outstanding shares permitted 1234 . the OSC. and became the holding company for the TSX group of companies. On April 2002. The Toronto Stock Exchange Inc. on July 26. the OSC. As part of the demutualization process.. 2002. acquired all of the outstanding shares of TSX Inc.

that is the actual buying and selling of securities on the marketplaces. interpretation and enforcement of a common set of market integrity principles applied to all regulated persons. TSE’s initial response was to restructure its operations and create a separate and distinct division to carry out its regulatory functions. Although those concerns also existed in the not-for-profit environment. RS’s mandate is to foster investor confidence and market integrity through the administration. in the Canadian marketplace.33 - to be held was later changed to 10 per cent. RS’s focus is on the regulation of equities trading. these restrictions were lifted once the TSE became a publicly listed company. shares of TSE could not be transferred unless the consent of the Board of Directors or of a majority of shareholders was obtained. TSX’s market regulation functions were transferred to Market Regulation Services Inc. including the TSX. buy-side institutions and the regions where RS regulates. RS is one of several regulators in Canada’s securities industry. including dealers. This branch of the TSE was to remain independent of its equities trading business.. the TSE imposed transfer restrictions such that for two years. Canadian Trading and Quotation System. As will be discussed. TSX Venture Exchange. Fifty percent of RS’s Board is made up of Independent Directors which includes representation from its marketplaces. The Board of Directors is responsible for the overall governance and strategic direction of RS. these firms believed that they would be exacerbated once TSE operated on a for profit basis. concerns arose over the perception of conflict of interest between the TSE’s role as a provider of trading services and a regulator following its demutualization. Some firms believed that TSE would use its regulatory powers to hinder business activities by firms it believed to be its competitors. As could be expected from our discussion of conflicts of interest previously in this paper. While RS is jointly owned by the TSX Group and the Investment Dealers Association of Canada. To more completely address concerns surrounding potential conflicts of interest. its structure ensures that the decision making power on its Board of Directors resides with its Independent Directors. self-regulatory organization funded through a transparent. In addition to seat restrictions. user-pay fee structure. Liquidnet Canada and Markets Securities Inc. (“RS”) in 2002. RS provides independent regulatory services to Canada’s equity markets. Bloomberg Tradebook Canada Company. RS is a not-for-profit. 1234 .

Under this agreement: ◦ TSX became the senior equity exchange by combining the senior equity securities businesses of the Toronto and Montreal exchanges. equities. Background to the ASX’s Demutualization ASX operates Australia’s primary national stock exchange for equities. 1234 . the company that is now TSX Venture Exchange. currencies 47 See: Figure 3 for a diagram of TSX’s inter-corporate structure.47 As part of this realignment and consolidation. Alberta and Winnipeg stock exchanges. Adelaide and Hobart. five equity securities exchanges operated in Canada. SFE provides futures and options on the four most actively traded markets – interest rates.. 4. TSX. Brisbane. Perth.34 - c) Ramifications of the TSE Demutualization Parallel with the demutualization process Canada’s securities markets have undergone significant market realignment in order to reduce the fragmentation of the markets’ liquidity and reduce costs for participants. ASX was formed by the amalgamation of six state-based exchanges located in Sydney. The Sydney Futures Exchange (“SFE”) is Australia’s other major exchange. and ◦ The memorandum of agreement prevents the TSX from providing trading facilities and services for exchange-traded derivative products. the junior listings from the Bourse de Montréal and the over-the-counter Canadian Dealing Network. Until 1999. Melbourne. other than natural gas and electricity products. ASX was created in 1987 by the Australian Stock Exchange and National Guarantee Fund Act 1987. options and fixed interest securities. comprising (without limitation) options and futures contracts. ◦ The exchange that is now TSX Venture Exchange (which the TSX acquired in 2001) became the junior equity exchange by combining operations of the Vancouver. and the Bourse de Montréal entered into a memorandum of agreement. which deemed the Exchange to be incorporated under Australian companies law and to be a company limited by guarantee. until March 2009.

comprised of ASX Board and Management representatives. which governed ASX. (b) (c) Vesting of the shares in ASX. ASX distributed a Notice of Special General Meeting to its members. between membership of ASX (as a corporation) and access to its trading facilities by. responsible and commercially focussed. Similar to the TSX and other stock exchanges in the developed markets. It was recognized that the future success of ASX required a new ownership and governance model with the following elements: (a) Conversion of the corporate status of ASX from a limited company by guarantee to a company limited by shares. and Breaking the nexus in the Corporations Law. market participants. including the recognition that a non-mutual structure would equip ASX better than a mutual structure to meet competition and that ASX needed to become more flexible. 1996. in its members.. ASX’s demutualization and listing process began in 1995 when the ASX Board formed a task force. 5. Rationale for the Demutualization of ASX On September 24. In the context of the ASX demutualization process. it was also acknowledged that members’ interests were diverging (and were unlikely to reconverge) and the same benefits were not 1234 . and capable of quickly taking up emerging commercial opportunities. The Note included a recommendation by the ASX Board for a demutualization proposal. The structure of the Corporation Law reflected a general assumption that membership of an exchange were limited to brokers or those with access to the securities-related services provided by the exchange. The reasons given by the ASX Board and Management for the recommendation were very similar to those given by the TSE in its demutualization process. together with an explanatory memorandum. and regulation of.35 - and commodities – and is the 10th largest financial futures and options exchange in the world by volume turnover. ASX’s process of demutualization was self initiated.

the members voted overwhelmingly to endorse alterations48 to the constitution of ASX. all members were treated equally for share distribution purposes.000 shares resulting in a total issued capital of 100. requiring the Board to seek the enactment of Australian Commonwealth legislation that would allow demutualization.50 48 49 Over 96% of members supported the recommendation. Members were entitled to one vote each. While ASX had both corporate and natural person members. To that end. a) The History of ASX Demutualization On October 18. 1996. with an eye to highlighting the specific regulatory challenges discussed in Part II of this paper.. Demutualization of ASX occurred two years later on October 13. ◦ There were no special restrictions placed on members concerning the sale of ASX shares.596.000 shares. what follows is: a) a brief chronology of the demutualization process. The issue of shares occurred on the following basis: ◦ Each of the 606 eligible former Corporate and Natural Person Members received 166. 6.36 - derived by all members from the services provided by ASX. and as part of the demutualization process former eligible members were issued shares in ASX. the next section of this paper constitutes an overview of the different dimensions of the ASX demutualization process. and b) a short discussion of how the ASX and the Australian government dealt with the relevant regulatory challenges. and there were no additional shares offered or funds raised by ASX. was inhibiting its ability to make rapid commercial decisions. The Demutualization Process of ASX As with our analysis of the TSX demutualization process. The mutual structure of ASX. including at least 500 individual members as well as large global participants.49 ◦ There was no “cash out” offer for members. 1998. 1234 . and to meet emerging business opportunities and threats.

Following demutualization. Listing of ASX and quotation of its shares occurred on October 14. Computershare has a major business in supplying market technologies. the ASIC reports about compliance with their supervisory obligations. Supra note 32. Australia introduced two sets of legislation to address some of the more important regulatory challenges highlighted in Part II of this paper. the initial wave of legislation introduced the following changes: ◦ Detail on the ASX’s obligation for market supervision including an express power to require it to do specified things to ensure it complies with supervisory obligations. and a substantial part of the share registry business in Australia and 50 There was however a 5% individual ownership cap imposed by the Government and contained in the Corporations Law. Importantly however. announced a rival bid for the SFE.. ◦ Requirements that the ASX at least annually prepare and give to the regulator.e. 1998. Computershare. ASX made an application to ASIC for admission to ASX’s own official list and for quotation of its shares. the role that ASX plays in relation to all other listed entities. Specifically. ASX announced a takeover bid for the SFE. to ensure that the ASX as a listed company complies with its disclosure obligations.. a public company listed on the ASX. ◦ Processes to require ASIC to act as the listing authority for ASX – i. this limit was ultimately raised to 15%. In December 1998.37 - ◦ There were no minimum shareholding requirements placed on members. at this time there was no legislative basis for regulating conflicts between ASX’s commercial interests and its obligations as market supervisor were introduced. b) Responses to Regulatory Challenges In anticipation of the demutualization of the ASX. In May 1999.51 The only conflict issue this wave of legislative reform law dealt with related to the ASX itself as a listed entity and not as a commercial rival of another listed entity. 51 1234 . and ◦ Share ownership of ASX for any single member was restricted to 5 per cent.

ASX would not make any substantive decision about Computershare without first consulting ASIC and acting in accordance with the advice provided by ASIC.52 A major conflict of interest had arisen. until the issue of the rival bids was resolved. a clearer regulatory environment emerged with the introduction of the Financial Services Reform Act 2001. This purely contractual arrangement was made public and details released to the market. However. its competitor. the Corporations Act 2001. the legislation had not dealt with this potential situation and a regulatory response was required. Accordingly. efficiency and transparency of ASX’s supervision of its markets. Pg. both parties entered into an agreement with ASIC which provided that. by having independent directors. a mandate approved by the regulator (ASIC). Incidentally. including by way of public reports. The Financial Services Reform Act is still based on a model where the market operator has “front line” regulatory responsibility. neither ASX nor Computershare succeeded in their bids and SFE remains independent today. 6. Pg. ASXSR is an ASX subsidiary that essentially operates as an arms length “process monitor” and “internal regulatory auditor”. 52 53 Supra note 32. as ASX was both an interested party in the commercial transaction and also the supervisor of Computershare. 5. 1234 . ASXSR distinguishes itself as a supervisory body that is separate from ASX. until recently there was no systemic structural separation of commercial and regulatory functions of the ASX. and provides its supervisory reporting of ASX to the ASIC. However. Subsequently. it also prescribes that: ◦ ASIC will undertake an annual assessment of ASX supervision.. structure and supervisory obligations. Its role is to ensure the integrity.53 On 11 March 2002. and in November 2000 created ASX Supervisory Review Pty Ltd. Ibid. As we stated previously. and the Corporations Regulation 2001. ASX recognized the importance of maintaining integrity in its own market.38 - elsewhere.

much of their decision-making prior to demutualization was by brokers on committees.39 - ◦ Market operators must have in place adequate conflict management arrangements to deal with conflicts between commercial interests and ensuring the market operates fairly and transparently. Australia’s new Regulation 7.16 has been reproduced in Exhibit A Supra note 32. Following demutualization most of the decision-making responsibility has been transferred to each exchanges’ management.. 54 55 56 Committees continue to exist. access to both exchanges’ market facilities were largely controlled by its existing market customers and the key criteria for admission to market participation was “membership”.56 Increased Flexibility in Decision-Making One of the most important changes that has accompanied demutualization is that both exchanges now have much greater flexibility in their decision-making. and Expansion of activities.2. Full text of Part 7.2.16 is important as it allows ASIC to intervene. both exchanges have experienced a number of significant changes in their focus and activities. or potential conflict. and ◦ The restriction on Share ownership of ASX for any single member is increased to 15 per cent. 5. and to take a supervisory role where there is a specific and significant conflict. between the commercial interests of ASX (or a subsidiary of ASX) and its market supervision obligations in dealing with a listed entity that is a competitor. Prior to demutualization. 1234 . Pg. These include: (a) (b) (c) (d) Increased flexibility in decision-making.54 Additionally. but their Ibid.55 7. and to respond to changing circumstances. Increased customer focus. at the request of a commercial competitor of ASX. Also. Post Demutualization: Changes in TSX’s and ASX’s Focus and Activities Since demutualization of the TSX and the ASX. These exchanges are therefore better equipped to make timely decisions for market users.

Bridge DFS subsequently listed on ASX. and (C) The acquisition of a 50 per cent stake in a company that provides an investor consultancy service. both the TSX and ASX have examined ways of enhancing profitability. the appointment of various account managers for key customers. as brokers were the owners of the TSX and ASX and a disproportionate amount of time was spent serving their needs. diversifying their revenue base. Management now has decision-making authority to admit new companies to the official list. decisions made in relation to admissions to ASX’s official list of companies used to be made by a Listing Committee comprised of some eight members. 58 59 1234 . decision-making authority was transferred to ASX Management. whereas there is a Listing Appeals Committee to hear appeals on Listing Rule decisions. each exchange has spent a great deal of time focusing on the needs of other customer groups such as listed companies and investors.40 - composition reflects competencies and experience required for the particular function and they are typically used for consultation. Prior to demutualization.57 a) Increased Customer Focus Another important change that has occurred is an increased customer focus. On 20 March 2000 ASX and Perpetual Trustees Australia Limited (Perpetual) announced that they had formed a joint venture. the majority of whom were brokers. while brokers remain an important and valued customer. Since demutualization. incorporating the operations of Perpetual’s share registry division. On 19 September 2000 ASX announced that it had agreed to take a 15% stake in Bridge DFS Ltd.60 57 As an example. including: (A) (B) A joint venture arrangement involving a share registry business. This has resulted in ASX expanding into new but related businesses.. b) Expansion of Activities Since demutualization. As part of the demutualization process. education and information dissemination.58 The acquisition of a 15 per cent stake in a company that provides trading and order management services to professional financial market participants59. This has resulted in changes in organizational lines to provide a better fit with customer groups. and more attention being devoted to marketing. and providing value-adding services to customers. Perpetual Registrars Perpetual is listed on ASX.

in addition to the acquisition discussed previously. NGX enables energy traders to trade and clear physical and derivative natural gas spot and forward contracts and derivative electricity forward contracts. which assists issuers to meet their corporate communication needs and to deliver time-sensitive information to their shareholders and other stakeholders. ◦ The purchase of NGX. The TSX. an unlisted company.. This transaction extended and diversified TSX’s position in Canada by broadening their product and service offering. CNX Marketlink provides publicly listed issuers with enhanced investor communication tools.41 - ASX has also announced a number of initiatives aimed at facilitating cross-border trading by investors. which owns and operates an electronic trading system for the institutional debt market and which is registered as an ATS.. (“CNW Group”). utilizing Bloomberg’s TradeBook system. and (B) A one-way trading link into the United States market.. NGX operates a Canadian electronic commodity exchange which trades and clears natural gas and electricity contracts. in the last three years has undertaken several initiatives to solidify its role at the centre of the Canadian equity market.. Marketlink offers webcasting and conference call Inc. This furthered TSX’s strategy to leverage their existing data capabilities and to deliver new services to their listed issuers. ◦ The creation of CNX Marketlink with Canada NewsWire Ltd. which is expected to be operational later this year. These have included: (A) A two-way trading link with Singapore Exchange Limited. This acquisition has diversified TSX’s business in the electronic fixed-income market. The most recent of these initiatives include: ◦ The acquisition of approximately 40 per cent (now 45 per cent) equity interest in CanDeal. while at the same time expanding their reach outside Canada. 1234 . now CNW Group Ltd. 60 ASX announced on 5 February 2001 that it had acquired a 50% stake in Orient Capital Pty Ltd.

42 - c) Post-IPO Returns Consistent with the well documented “IPO effect”. On their first day of trading the TSE and AST posted a 13% and 3% returns on investment. market capitalization is only 30-40% of GNP. PART IV. o illiquid. the TSE had reported a 302% increase in cumulative returns since its IPO. Although one cannot generalise the experiences across all emerging markets given their wide spectrum and level of development some of the experiences of emerging markets61 with demutualization will be instructive. respectively. The TSE and the ASX are not exceptions to this rule. 1. but increased by substantial margins. Typical characteristics of emerging stock markets: o relatively small. DEMUTUALIZATION OF EMERGING MARKETS In this part of the paper we will discuss some of the issues that are particularly important to emerging markets in the process of demutualization. activity. This represents almost 40 per cent of the membership of the 61 The term emerging market implies a stock market that is in transition. 2005. Most often the term is defined by a number of parameters that attempt to assess a stock market's relative level of development and/or an economy's level of development. large block holdings and parts of companies that are inaccessible due to foreign investment limits. Noninvestable-holdings include. 21 exchanges in developed market jurisdictions have demutualized. as compared to 70-80% of GNP in the developed markets o small investable-market capitalization relative to gross domestic product. while the ASX had reported an over 600% increase in returns. investable-market capitalization is a market's capitalization after removing holdings not truly "in the market" for foreign portfolio investors. In the time since the first exchange demutualization in 1993. The Extent of Demutualization The pace of exchange demutualization in developed market jurisdictions has been quite rapid. or level of sophistication. but are not limited to. DEs have tended to post significant returns on their first day of trading. increasing in size.. lower turnover o smaller market capitalization values o lower ”float” 1234 . As at September 30. What is additionally interesting is that these results have not only endured.

13. As Figure 2 turnover velocity. Pg.4 per cent. the pace of demutualization in emerging market jurisdictions has been relatively slower. Emerging markets as a group make up about 12. available online at: http://www.62 In contrast.5 per cent. Despite the numbers the individual size of these markets remain small. Ibid. Supra note 7. 62 Emerging Markets Committee of the International Organization of Securities Commission. an indicator of market liquidity. is extremely low in emerging market exchanges (although some exhibit very high turnover ratio). around 10 per cent of the global market capitalization.64 2. Overall market size is increased and cost of capital is lowered. As a result of globalization and technology. “Exchange Demutualization in Emerging Market”.. The AsiaPacific emerging markets represent. 63 64 1234 . Central and South American markets constitute 1. This permits order flow and liquidity to migrate quickly to major markets with adverse consequences for many smaller markets of emerging countries. the Middle-East and African region represents 1. as issuers have access to multiple per cent. The IOSCO Report63 on market demutualization stated that as of April 2005 (the date of the report) exchange demutualization had been completed in only 5 jurisdictions out of a total of 76 emerging market jurisdictions.7 per cent of the total global market capitalisation and individually many of these markets are less then 0. Although this pressure has also been one of the drivers of demutualization in developed markets.pdf.iosco. What Drives Demutualization in Emerging Markets The IOSCO’s Report found that one of the main drivers of demutualization in many emerging markets is the increasing competition for global order-flow. local and regional markets are forced into more direct competition regionally and particularly internationally. April 2005.43 - World Federation of Exchanges.5 per cent and the European emerging markets less than 0. it seems that this pressure is particularly pronounced in the smaller markets of emerging countries.

Who Drives Demutualization? One central difference of demutualization efforts in many of the emerging markets is that they are typically pursued by either the government or the regulator. It has become increasingly unacceptable that an exchange can function as a members club and operate without appropriate governance structures. legislation was specifically enacted mandating the exchange’s demutualization within a specified timeframe. This contrasts with the position in many of the developed markets where the process has been in most instances driven by the exchange or industry. is the pressure to reform the exchange’s governance structure as part of a broader trend reflecting increased domestic and international expectations for higher standards of governance.44 - Demutualization has been seen as providing the necessary catalyst to enable a transformation of the exchange business model to facilitate a more effective response to forces reshaping the exchange business and competition for investment capital. in the Philippines. In the IOSCO Report. a new stock exchange would be established to become the national exchange. 65 Section 32. the Expert Committee on Demutualization and Integration/Transformation of Stock Exchanges66 (“Expert Committee”) recommended that the Securities and Exchange Commission of Pakistan implement demutualization and integration of Pakistan’s three stock exchanges given the importance of integration and demutualization to the public interest. For example. The Expert Committee further recommended that if sufficient progress was not made towards the integration and demutualization of the existing exchanges within a year. Another pressure for demutualization. 1234 .2(a) of the Securities and Regulation Code (RSC) required the Philippine Stock Exchange.65 In Pakistan. Inc. to incorporate within one year from the date of coming into effect of the SRC. which has existed in developed markets but prevalent in emerging markets. 3.. all jurisdictions that had already completed demutualization of their exchange or were in the process of demutualization stated that the demutualization process was initiated by the government or the statutory regulator.

In order to succeed. where its ability to implement business strategies.45 - Even in instances where exchanges chose not to demutualize. in seeking to serve their own interests. 2004. then creating a for-profit exchange. We would argue that. policy-makers should adopt a consultative and consensus-seeking process. For instance. it was the Minister of Finance that appointed a steering committee to consider the demutualization of the Stock Exchange of Thailand. The tensions arising from a demutualization exercise could actually be more pronounced in emerging markets where the government and the regulator are the prime movers in the demutualization. if there is still a fairly closed and insufficiently liberalized capital market environment. in Thailand. 4. it is the existing stakeholders that. initiate change..pdf.67 In this regard. concerns have been expressed that this prescriptive approach could force a premature solution in an environment where the necessary preconditions for demutualized exchanges to thrive successfully may not be present. These trends indicate that the government and/or regulator in emerging markets will likely play a more significant role in initiating. including those across borders.lahorestock. available online at: http://www. in all markets the political will and support of the government is critical irrespective of who drives the efforts to 67 1234 . Demutualization and Stakeholder Issues In developed markets. policy-makers often have a lead role in the decision-making process. Policy-makers must be cognizant that the existing commercial stakeholders have substantial lobbying and other powers to delay 66 Report of the Expert Committee on Demutualization and Integration/Transformation. Also the government and/or the regulator may alleviate some of the potential problems that prescriptive solutions may impose by adopting a consensus building approach and pragmatic solutions to instituting the appropriate framework for balancing the commercial and regulatory considerations. “Demutualization and Integration/Transformation of Stock Exchanges. For instance. In some countries. September 2. in a more or less consensus basis. exchanges are owned by the government and therefore the demutualization exercise is really a privatization of a state-owned entity. are constrained would be leading the exchange to failure. overseeing and ultimately enforcing reform efforts in the demutualization of stock exchanges.

Typically. The process of demutualization can be implemented in a timelier manner once support from a broad group of shareholders has been obtained. including expediting the process for regulatory changes and approval. Exchange management perceived demutualization as opening up new opportunities and were major proponents of the demutualization process. Regardless of whether the decision-making process is driven by the public or private sector. ◦ Exchange management. the role of the regulator and the 1234 . it should be recognized that government or regulatory involvement can help in many aspects. Given the broad support from the major stakeholders. ◦ The government and regulator. This can be summarized as follows: ◦ Stockbrokers.46 - reform efforts. the obvious and direct stakeholders are the brokers who are members of the exchange in a mutual structure. about two years prior to the actual demutualization.. Extensive consultation was undertaken with the major stakeholder groups prior to making a decision to demutualize the exchange. Other stakeholders include the exchange management. to design and implement plans to restructure and streamline the organization to capture operational efficiencies. Indeed. considerable efforts were made early on. investors and listed companies. Sufficient “buy-in” measures should be instituted to align varied interests and converge expectations. The decoupling of broker membership from management of the exchange was not a major issue since the implementation of oversight rules in the mid-1980s. There was general support from the stock broking community as they saw benefits arising from the unlocking of value in the exchange through the demutualization process. The Malaysian demutualization experience provides a good example of how the interests and expectations of stakeholders can be carefully managed to ensure consensus and support for the demutualization process. it is critical to develop a robust strategic framework. exchange directors. Furthermore. outline a well-planned transformation process and have strong support from policy-makers for its implementation.

47 - government focused almost exclusively on public interest issues such as re-designing the regulatory role of the exchange as well as ensuring that effective governance mechanisms were put in place to prevent potential conflict of interest situations. According to this approach the potential conflict of interest situation discussed previously in this presentation would be minimized. ◦ Investors and issuers. Depending on the circumstances this may be achieved through MoUs which were discussed earlier in this paper. 5. While major institutional investors and issuers were not central to the process. Perhaps the optimal solution is a pragmatic one which would try to streamline. Regulatory Obligations of a Demutualized Exchange As in developed markets. Those agreements are advantages in that they extend the time to allow for the gradual minimization of the exchanges 1234 . nonetheless their opinions were sought as part of the process to ensure that decisions took into account a wide spectrum of views. It has been argued that this could be achieved either through a transfer of many of the regulatory functions conducted by the exchange over to the regulator. on an interim basis. and to the extent possible demarcate regulatory responsibilities. as has been the experience with the ASX and the TSX. This can prove to be a useful process in providing a mediating influence where there are divergent views between the different stakeholder groups. exchanges should be left to concentrate on their goal of building the business and enhancing the value of the exchange. Some have argued that following a demutualization. These non-binding agreements between regulators and exchanges can be used to delineate. or to create semi-autonomous entities where the regulatory functions can be separated from the exchange and bundled into a new entity. This approach is a more practical and gradual approach to defining regulatory arrangements by fine-tuning “as-is” arrangements. regulatory duties. regulatory responsibilities.. It could be argued however that demutualization is a massive exercise involving a substantial amount of legislative and organizational work as seen in my discussion of the ASX and TSX. a critical issue that arises in the context of demutualization in developing markets is what the regulatory role of the exchange be after demutualization.

such as the Philippines have been less successful. 2005. but failing to realize durable profitability. the Emerging Markets Committee of the International Organization of Securities Commissions has stated that it is too early to assess the benefits of demutualization of stock 1234 . These challenges include: • Differences in market conditions and private sector infrastructure that can influence the philosophies and strategies of market regulators. While certain DEs in emerging markets. • Constraints in domestic markets can narrow policy alternatives available. leading to conditions where it is necessary to shift post demutualization regulatory responsibilities gradually. 6. Unsurprisingly. • The overall strength of market reforms in some emerging economies may not be sufficient to support successful demutualization and may not be appropriate in all emerging markets These challenges have thus far been met with mixed success. Although the process of demutualization does not differ markedly from the experience of demutualization in developed economies. certain key challenges can be identified. While the reasons for these widely differing outcomes are still subject to debate. it is clear that there is no fixed formula for the success of demutualization in the emerging markets context. leading to the regulator taking the lead in the demutualization initiative as opposed to the market itself.. Conclusion The previous discussion attempts to highlight certain issues impacting stock market demutualization in emerging markets. reporting a first day trading return of more than 120%. they may end up imposing unnecessary constraints on regulatory powers – which shouldn’t be the intention because it is likely that further refinements to regulatory arrangements may be needed arising from the future changes in the exchange business model. such as the Bursa Malaysia have generated long-run returns in the 26% range. posting negative returns close to 74% as at September 30.48 - One cautionary note arising from this is the risk that if these MoUs are not carefully structured. others.

In this evolving context. markets that may not yet be in a position where demutualization in a viable option as a top-down policy initiative may find that market-led initiatives will lead to demutualization in the near emerging market regulators have made substantial progress in strengthening practices and infrastructure in their capital markets. “Exchange Demutualization in Emerging Markets”. it is evident that in general. available online at: http://www.. As a result. 1234 . it is important that regulators and exchange operators continue to work together to create policies and market conditions that are fair and efficient. as insufficient time has passed since the demutualization exercise was initiated68.49 - markets in an emerging market context. it is likely that there will be considerable debate on this topic as time passes and additional information is made available. April 2005. 68 Emerging Markets Committee of the International Organization of Securities Commission. Since this is the case.iosco. Nevertheless.pdf.

2005.50 - APPENDIX Figure 1 Source: Reena Aggrawal and Sandeep Dahiya. November 6. 1234 . “The Demutualization and Public Offering of Financial Exchanges”..

1234 . November 6. “The Demutualization and Public Offering of Financial Exchanges”.. 2005.51 - Figure 2 Historical Evolution of Major Stock Exchanges Source: Reena Aggrawal and Sandeep Dahiya.

52 - FIGURE 3: TSX’s INTER-CORPORATE RELATIONSHIPS Source: TSX Annual Information Form. May 29.. 2005. 1234 .

“The Demutualization and Public Offering of Financial Exchanges”. 2005.53 - FIGURE 4: POST LISTING PERFORMANCE OF MAJOR EXCHANGES Source: Reena Aggrawal and Sandeep Dahiya.. 1234 . November 6.

54 - FIGURE 5: AVERAGE ANNUAL TURNOVER RATIO IN EMERGING MARKETS. 1999-2003 Source: EMC of the IOSC. 1234 .. April 2005. “Exchange Demutualization in Emerging Market”.

55 - FIGURE 6: EMERGING MARKETS' SHARE OF WORLD MARKET CAPITALIZATION. 1234 .. “Exchange Demutualization in Emerging Market”. April 2005. 1994-2003 Source: EMC of the IOSC.

624 121.441.578 3. and Equity & Interest Rate Derivatives Equity. and Equity Derivatives Equity Equity.674 2.463 776. and Equity Derivatives Equity.779 141. and Equity & Interest Rate Derivatives Equity. and Equity & Interest Rate Derivatives Equity Equity Major North American Exchanges NYSE NASDAQ (including AMEX) Toronto Stock Exchange Instinet Archipelago Chicago Mercantile Exchange CBOT CBOE International Securities Exchange Major Asian/Oceania Exchanges Tokyo Stock Exchange Osaka Stock Exchange Hong Kong Stock Exchange Australia Stock Exchange Taiwan SE Corp. and Equity.517 940.TABLE 1 Year of Demutualization 2000 2000 2000 2001 2002 1997 1993 2001 1999 2006 likely 2001 2000 NA NA 2002 2005 2006 likely 2002 2001 2001 2000 1998 No Plans No Plans 1999 2004 2003 2001 2006 likely 2-Apr-04 27-Jun-00 14-Oct-98 No Plans No Plans 16-Nov-00 18-Mar-05 4-Jun-03 15-Dec-03 3.243 2. Currency.177.048 861.865. and Equity & Interest Rate Derivatives Equity Equity.673 826. Currency & Interest Rate Derivatives Equity.557. Commodity & Interest Rate Derivatives Equity.618 181. Commodity & Interest Rate Derivatives Equity.041 789.731 3.707. and Equity Derivatives Equity Equity Equity Equity Equity Equity Equity. Korea Exchange Singapore Stock Exchange Bursa Malaysia New Zealand Stock Exchange Philippines Stock Exchange 1234 .287.563 715. and Equity & Interest Rate Derivatives Equity. Commodity & Interest Rate Derivatives Equity & Interest Rate Derivatives Equity Derivatives Equity.436 389.615.931 1. Currency. and Equity Derivatives Equity.403 441. and Equity Derivatives Equity.194. and Equity & Interest Rate Derivatives Equity.518 NA NA NA NA NA NA 20-Jul-01 10-Jul-01 5-Feb-01 No Plans No Plans No Plans 1-Jan-93 28-May-01 28-Jul-00 2.657 7-Mar-06 1-Jul-02 12-Nov-02 18-May-01 12-Aug-04 6-Dec-02 19-Oct-05 2006 likely 8-Mar-05 12.473 217.921 IPO/Listing Date Domestic Market Capitalization (US $) Major Products Major European Exchanges London Stock Exchange Euronext Deutsche Boerse BME Spanish Exchanges Swiss Exchange Borsa Italiana OMX Group Oslo Bors Hellenic Stock Exchange Equity Equity.624 43.261 1. and Equity.

-2- Sydney Futures Exchange 2000 16-Apr-02 NA Equity. 1234 . 2005. November 6. “The Demutualization and Public Offering of Financial Exchanges”. Commodity & Interest Rate Derivatives Source: Reena Aggrawal and Sandeep Dahiya. Currency.

75 per cent 14-Oct-98 27-Jun-00 16-Nov-00 16-Apr-02 4-Jun-03 15-Dec-03 2-Apr-04 18-Mar-05 3.6 per cent 17.1 per cent 305.18 per cent 154.9 per cent 65.8 per cent -74. 2005 IPO/Listing Date 28-Jul-00 5-Feb-01 28-May-01 10-Jul-01 20-Jul-01 18-May-01 12-Nov-02 1-Jul-02 6-Dec-02 19-Oct-05 12-Aug-04 8-Mar-05 224.90 per cent 21.5 per cent 289.72 per cent 13.57 per cent 48.4 per cent 48.3 per cent 29.0 per cent 753.96 per cent 68.0 per cent -23.-3- TABLE 2 First Listing Returns & Cumulative Return for the Post-Listing Period Cumulative Returns Since IPO/Listing to Sept.40 per cent 11.3 per cent 41.8 per cent 151.26 per cent -8.33 per cent 21.6 per cent 4.7 per cent 43.5 per cent -30.70 per cent 17.4 per cent 80. 30.67 per cent Major North American Exchanges Instinet Toronto Stock Exchange Nasdaq*** Chicago Mercantile Exchange CBOT**** Archipelago International Securities Exchange Major Asian/Oceania Exchanges Australia Stock Exchange Hong Kong Stock Exchange Singapore Stock Exchange Sydney Futures Exchange New Zealand Stock Exchange Philippines Stock Exchange Osaka Stock Exchange Bursa Malaysia Median 1234 .80 per cent -3.9 per cent 21.9 per cent 2.3 per cent 15.9 per cent 223.5 per cent -14.4 per cent 385.8 per cent 602.5 per cent 102.02 per cent 16.4 per cent -6.12 per cent 23.7 per cent 58.67 per cent 120.1 per cent 12.0 per cent 6.5 per cent 302.10 per cent 0.3 per cent 65.40 per cent -5.7 per cent 22.8 per cent 343.70 per cent 6.9 per cent 17.8 per cent 206.7 per cent -58.1 per cent 65.2 per cent 149.20 per cent -31.4 per cent 120.2 per cent 48.0 per cent 705.3 per cent 33.0 per cent 83.7 per cent 663.6 per cent 53.6 per cent 26.9 per cent 69.2 per cent -13.85 per cent First Day Return (Offer to Close) Exchange Comparable Index Difference Major European Exchanges Hellenic Stock Exchange Deutsche Boerse Oslo Bors* Euronext London Stock Exchange* -35.40 per cent 25.29 per cent 78.8 per cent 231.4 per cent 163.3 per cent 0.7 per cent 17.00 per cent 22.3 per cent 26.8 per cent 88.1 per cent -25.89 per cent -52.7 per cent 38.

-4- (*Oslo Boerse is traded in OTC market is not liquid. 2001 but for almost a year earlier it trade on OTC market. November 6. “The Demutualization and Public Offering of Financial Exchanges”. 2005. 1234 . NASDAQ listed on the main exchange in Feb 2005. ****CBOT not enough data) Source: Reena Aggrawal and Sandeep Dahiya. **London Stock Exchange listed on the main exchange on July 20.

and (b) the need for ASX to ensure that the market operated by it operates in the way mentioned in paragraph 792A (a) of the Act. the conflict. having regard to ASX’s obligations under subparagraph 792A (c) (i) of the Act. exists —consider whether. this regulation applies in relation to specific and significant conflicts. exists as described in subregulation (1). or (ii) to require ASX to take action on ASIC’s behalf. and (c) decide whether (and to what extent): (i) to make decisions and take action. or (ii) a subsidiary of ASX is in competition. or potential conflict.2. As soon as practicable after receiving an application under subregulation (2). between: (a) the commercial interests of Australian Stock Exchange Limited (ASX) in dealing with a body (the competitor) that operates a business with which: (i) ASX is in competition.Exhibit A Corporations Regulation 2001 (Australia) Division 6 (1) The Australian market licence: other matters 7. If ASIC decides to make decisions and take action (or to require ASX to take action on ASIC’s behalf) as mentioned in subregulation (2). will make decisions and take action (or require ASX to take action on ASIC’s behalf) in relation to: (a) if the competitor is seeking to be listed — the compliance by the competitor with the applicable listing rules of the market operated by ASX. instead of ASX. The competitor may lodge with ASIC in the prescribed form. would be dealt with more appropriately and efficiently by a means other than taking the action mentioned in subregulation (2). or (iv) a joint venture (however described) to which a subsidiary of ASX is a party is in competition.16 Potential conflict situations For subsection 798E (1) of the Act. or potential conflicts that would be specific and significant. an application for ASIC to decide that ASIC. in relation to the matters mentioned in paragraphs (2) (a) and (b). or (iii) a joint venture (however described) to which ASX is a party is in competition. or potential conflict. and (b) if it considers that a conflict. ASIC must: (a) consider whether a conflict. ASIC: (2) (3) (4) 1234 . or potential conflict. or (b) if the competitor is listed on the market operated by ASX — the compliance by the competitor with the applicable listing rules of the market operated by ASX.

and must.69 If ASIC believes. and (iii) the extent to which action taken by ASIC is severable from the wider supervision of the competitor’s compliance with the listing rules. or not to grant. (7) 69 Note 1 It is expected that the listing rules of the market will support ASIC’s power to take a supervisory role in relation to compliance with some or all of the listing rules. and (ii) the desirability of treating the competitor consistently with other entities listed. on reasonable grounds. in writing. or in exercise or purported exercise of any power. as soon as practicable. If ASIC decides to make decisions and take action (or to require ASX to take action on ASIC’s behalf) as mentioned in subregulation (2): (a) the decisions made and actions taken have effect despite anything in the listing rules of the market operated by ASX. ASIC is not liable to an action or other proceeding for damages for or in relation to an act done or omitted in good faith in performance or purported performance of any function. and (iv) its consultations (if any) with the competitor and ASX. waivers of the listing rules. in writing. and (b) to impose conditions on which the grant of a waiver is made. (5) (6) ASIC must. Note 3 The powers available to ASIC include the power: (a) to grant. of its belief. and (b) the decisions and actions likely to be required are not adequately reflected in the listing rules of the market operated by ASX. or seeking to be listed. advise ASX and the competitor. as soon as practicable. having regard to: (i) the rationale for the listing rules of the market operated by ASX. on that market. 1234 . Note 2 Under section 246 of the Australian Securities and Investments Commission Act 2001. ASIC must notify ASX.-2- (a) (b) may consult with ASX and the competitor to identify the listing rules of the market operated by ASX for which ASIC needs to make the decisions and take the action. of decisions under paragraphs (3) (c) and (4) (b). and (b) decisions made and actions taken by ASIC (or action taken by ASX on ASIC’s behalf) have effect as if they were decisions made and actions taken under the listing rules. that: (a) the period during which decisions will be made and action will be taken in a particular case is likely to be more than 3 months. conferred or expressed to be conferred by or under the corporations legislation. decide the extent of ASIC’s role.

and (b) establish administrative and procedural arrangements for that purpose.-3- (8) (9) ASX must. and (b) notify ASX and the competitor of its decision. ASIC must cease to make decisions and take action (or must cease to require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict. as soon as practicable after being notified under subregulation (7).70 If ASIC decides that it is no longer necessary for decisions to be made and action to be taken in relation to the particular conflict or potential conflict. Paragraph (10) (b) does not prevent ASIC from: (a) reviewing a particular conflict or potential conflict. If ASIC is notified under subregulation (14). that it has again become necessary for ASIC to make decisions and take action (or for ASIC to require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict. ASIC must notify ASX and the competitor of its decision as soon as practicable. If ASIC decides to cease to make decisions and take action (or to cease to require ASX to take action on ASIC’s behalf). ASX must: (a) give ASIC the information and documentation that ASIC reasonably needs to make decisions and take action under this regulation. ASIC must notify ASX and the competitor of its decision as soon as practicable. (10) (11) (12) (13) (14) (15) (16) 70 Note Amendments of the listing rules are subject to procedural requirements. as soon as practicable: (a) decide whether it will cease to make the decisions and take the action (or cease to require ASX to take action on ASIC’s behalf). and (b) deciding. For this regulation. A competitor may notify ASIC that the competitor no longer wishes ASIC to make decisions and take action (or for ASIC to require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict. mentioned in sections 793D and 793E of the Act. or (b) ASIC has notified ASX under subregulation (9). at any time (with or without complying with paragraph (4) (a)). ASX may repeal any listing rule or amendment made for subregulation (8) only if: (a) the repeal or amendment is necessary or convenient to meet ASIC’s concerns more effectively. amend the listing rules of the market operated by ASX to the extent necessary to meet ASIC’s concerns. If ASIC makes the decision mentioned in paragraph (11) (b). ASIC must. including possible disallowance. 1234 .

-4- (17) If ASIC decides not to cease to make decisions and take action (or not to cease to require ASX to take action on ASIC’s behalf). 1234 . ASIC must continue to make decisions and take action (or must require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict.

-5- Exhibit B MoU Between ASX and ASIC 11966440.DOC 1234 .1.

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