Demutualisation: Introduction of electronic auction trading

The investor-stock exchange relationship has changed to seek better liquidity and services. Members' interests become increasingly divergent and benefits of the cooperative structure are greatly reduced. Another issue is the ability of the cooperative structure to raise new capital and provide some motivation for the members of the exchanges. Again, considering the transaction costs point of view, the cost of organising the cooperative becomes greater than the benefits (Mendiola and O'Hara, 2004). It was initially hard for the traditional members of mutual stock exchanges to respond to competition. The mutual governance structure and the heterogeneity nature of members of the stock exchanges (local market makers, broker dealers, international banks, etc.) made it difficult for them to ignore their private cost-benefit evaluations and vote for policy change. It was noted that there was an initial resistance - by members of traditional mutual stock exchanges - to the introduction of automated trading as it would match the buy-and-sell orders and reduce their intermediary role.
But, with the global competitive pressures, some members of the stock exchanges realised the need to stop floor trading and the introduction of electronic auction trading (e.g. Amsterdam in mid 1990s). Moreover, they started to realise that without a change in the governance structure, the exchange's revenues could be largely reduced. Therefore, they put pressure on local stock exchange members and forced them to accept demutualisation (Hazarika, 2005). Considering the investors' reaction, we find that competition among stock exchanges has led them to seek the payment of lower commissions, and look for means to handle trades more quickly with anonymity on placed orders. Thus, the global competitive forces revealed that investors will only accept to be a part of the stock exchange only when the stock exchange adds to their personal interest.
To sum up, the behaviour of members of stock exchanges and investors towards the demutualisation decision is explained in March and Simon (1958) who argue that behaviour in organisations is highly routinised. But, the routine has the character of dynamic capability rather than a fixed programme. Routine-changing decision- makings are modeled as 'searches'. The lower the satisfaction of the organisational decisions, the more search will participants go through to look for alternative programmes. The more the search, the higher the expected value of reward will be.
AGENCY THEORY: Literature on agency relationship is very important to the study of corporate governance in strategic management. As Eisenthart (1989) noted, the theory was used by scholars in accounting  (e.g., Demski & Feltham, 1978), economics (e.g., Spence & Zeckhauser, 1971), finance (e.g., Fama,  1980), marketing (e.g., Basu, Lal, Srinivasan, & Staelin, 1985), organisational behaviour (e.g., Eisenhardt, 1985, 1988; Kosnik, 1987), and sociology (e.g., Eccles, 1985; White, 1985).  Eisenhardt wrote, 'The agency theory ideas on risk, outcome uncertainty, incentives, and information systems are novel contributions to organisational thinking, and the empirical evidence is supportive of the theory,  particularly when coupled with complementary theoretical perspectives'.
The theory views the agency relationship, in which one party the principal delegates work to another party (the agent), who performs that work.  This involves delegating some decision-making authority to the agent. The agency theory describes this relationship between the two parties through the metaphor of a contract (Jensen and Meckling, 1976).  The principal concern for the agency relationship is to solve two main problems. First, the agency problem that takes place when there is a conflict between desires/goals of the principal and those of the agent, and when it is hard or costly for the principal to monitor the agent in order to prove whether or not the agent is working in an appropriate manner. Second is the problem of risk-sharing which occurs when the principle and agent have different approaches toward risk; actions of the principal and agent may differ because of their different risk preferences (Eisenhart, 1989).
The agency theory started with the work of Berle and Means in 1932 that discussed the principal-agent relationship and explored the concept of the agency and their applications towards the development of large corporations. Berle and Means (1932) note that ownership of wealth without appreciable control, and control of wealth without appreciable ownership seem to be the logical result of corporate development. They address an answer to a question: "Have we any justification for assuming that those in control of the modern corporation will also choose to operate it in the interests of the owners?" The answer to this question will depend on the degree to which the self-interest of those in control may run parallel to the interests of ownership and, insofar as they differ, on the checks on the use of power which may be established by political, economic or social conditions (Berle and Means, 1932) ".  Berle and Means (1932) pointed out that though the corporation should be run for the economic benefit of its owners, the stockholders, a controlling group, may hold the power to transfer profits to their own pockets. Therefore, there is no certainty that the corporation will work for the interests of the stockholders (Berle and Means, 1932). How does the work of Berle and Means explain whether or not the interests of the investors be achieved under the demutualised ownership structure? Well, according to the work of Berle and Means (1932), that depends on how the interests of the directors and managers of the demutualised stock exchange differ from those of the shareholders (principals).
Positivist researchers focused on investigations of the governance mechanisms that solve the agency problem. Jensen and Meckling shaped the work of Berle and Means (1932) by arguing that corporations are structured to minimise the costs of getting agents to follow direction and interests of the principles. They found out that the agent will more likely follow the goals of the principal and work for his interest when the contract is outcome-based. And also when there is an established mechanism that enables the principal to verify the behaviour of the principal. It is then that the conflicts of self- interest between the principal and the agent can get minimised. Fama (1980) and Jensen (1983) looked at information systems as efficient tools to reduce agent opportunism. The availability of information systems ensures that the principal is informed with the actions that the agent is doing. The agent is aware that it is hard to deceive the principal.
Therefore, the agent's opportunistic behaviour is minimised. Fama (1980) examined the information effects of efficient capital markets on managerial opportunism. Fama and Jensen (1983) explored the useful role that the board of directors can play as information systems in order to allow stockholders to monitor the opportunistic behaviour of the top executives (Eisenhardt, 1989). The approach of positivist researchers suggests the importance for demutualised stock exchanges to maintain an efficient corporate governance system and enhanced transparency. The decision to demutualise is expected to bring a corporation that facilitates ownership and trading privileges of the members of the exchange and thus permit the stock exchange to achieve greater independence. It brings a management that should take actions that are in the best interests of the stock exchange and ultimately its shareholders.
Therefore, the interests of the owners of the stock exchange should be linked to those of the stock exchange as both parties will aim at profit maximization. Further, the demutualised organisational structure will allow for greater transparency because exchanges will be obliged to report to their shareholders not only regarding the bottom-line but also on issues regarding corporate governance (Hughes and Zargar, 2006).
Investors need implementation of rigorous corporate governance principles in order to assure improved performance of their businesses. That includes the composition of the board of directors and key committees, reporting and financial filing requirements for the exchange including annual reporting or self-assessments made to the regulator and additional disclosure to shareholders regarding the regulatory activities (2002).  It is important therefore to incorporate four core elements of corporate governance - when assessing the impact of demutualisation on the performance of stock exchanges; shareholder rights, commitment to corporate governance principles, board governance, and transparency.
Good corporate governance requires all shareholders to be equally informed and to be free to elect the management of their institution in an annual shareholders' meeting. All shareholders should have a clear understanding of the institution's policy and practice. Minority shareholders also need to have easy access to information and be treated fairly (Peralta, 2006, and IFC Corporate Governance Matrix, 2006). Demutualisation results in a complete change in the structure of the stock exchange; from an organisation that is basically owned by brokers to one that is owned by shareholders. The stock exchange should also work to adopt sound corporate governance policies and comply with the provisions of the institution's code of corporate governance. The basic principles of corporate governance are established in the exchange. The realisation of these principles needs a neutral corporate governance officer that assures compliance (Strenger, 2004).
Demutualisation entails a change in the management structure that should work in improving the commitment to corporate governance. Further, since shareholders depend on the board of directors in having effective governance of the institution, the institution needs to follow effective policies and practices in choosing the board of directors and ensure that they follow international best practices (Peralta, 2006). Finally, an enhanced transparency and disclosure system is required. As Peralta (2006) pointed out, 'Investors and shareholders expect the institution to provide them with adequate access to information, management analysis of financial results, and complete reports of annual shareholders' meetings. They also expect full disclosure of inter-institutional and related party transactions.'
RESOURCE-BASED THEORY:  Literature on the resource-based theory explains the ability of the firm to reach sustainable competitive advantage when different resources are employed and these resources can not be imitated by competitors. Wernerfelt (1984) in his article 'A Resource-Based View of the Firm' defines the resource-based view as an economic tool used to analyse a firm's resource position in order to look at some of its strategic options. That applies in particular to the relationship between profitability and resources as well as ways to manage the firm's resource position over time. The fundamental principle of Wernerfelt (1984) is that the basis for a competitive advantage of a firm lies in the application of the combined valuable resources that the firm owns. However, the resource-based approach does not adequately explain how and why certain firms have competitive advantage in situations of rapid and unpredictable change. In such situations, dynamic capabilities become the source of sustained competitive advantage.
Eisenhardt and Martin (2000) defined dynamic capabilities as 'the firm's processes that use resources - specifically the processes to integrate, reconfigure, gain and release resources - to match and even create market change.' Dynamic capabilities thus are the Corporate governance that involves a set of relationships between a company's management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance.
Jamaluddin Ahmed PhD, FCA is a member of the Board of Directors, Bangladesh Bank and General Secretary-Bangladesh Economic Association
jamal@emergingrating.com