Economic rationale of stock exchange demutualisation - I

Prior to 1990s, stock exchanges all over the world used to operate as mutual organisations. In early 1990s, these started to undertake major organisational and operational changes. One of the most noted changes was the trend towards demutualisation. The demutualisation trend was started in 1993 by the Stockholm Stock Exchange. It was followed by several others, including the Helsinki Stock Exchange in 1995, the Copenhagen Exchange in 1996, the Amsterdam Exchange in 1997, the Australian Exchange in 1998, and the Toronto, Hong Kong and London Stock Exchanges in 2000. In 2005, about 60 per cent of the World Federation of Exchanges' (WFE) members were either demutualised or listed (WFE Cost and Revenue Survey 2005; 2006).  
Demutualisation can be defined as the 'process of continuing an organisation from its mutual ownership structure to a share ownership structure. This process may be followed by public issuance and listing of the exchange with immediate or eventual freely tradable shares (Hughes and Zargar, 2006).
In the business world, a change in the ownership structure usually reflects a change in the strategy adopted by a firm to respond to certain changes. Changes in ownership and organisational structures of stock exchanges mirror major changes in their business environment, such as globalisation and the rise of global competition and technological advances. In recent decades, there have been remarkable changes in competitive environment facing stock exchanges. The   European Journal of Economics, Finance and Administrative Sciences - Issue 23 (2010) highlighted the traditional role of a broker as an intermediary between the investor and the stock exchange which is getting minimised as a result of emergence of a number of electronic order routing and trading networks in recent years. These electronic communication networks (such as Instinet, Island, and Archipelago) serve as order-driven matching systems for participants seeking anonymity.
The new electronic systems have led to lower transaction costs of trading, allowed for better price determination, and reduced the chances for market manipulation. The new advances in technology have also facilitated cross-border trading and over time for development of inter-market trading systems (ITS). Strategic alliances and consolidations are driven by the competitive need to exploit massive economies of scale and network effects in trading (Agaarwal, 2002; Hazarika, 2005; Huges and Zargar, 2006; and Steil, 2002). With these changes in the competitive environment, many stock exchanges decided to demutulise. Decision for demutualisation was undertaken when the older mutual ownership structure failed to provide flexibility and financing needed to respond to the recent global competitive pressures. It was expected that the new investor-ownership structure will bring better financing and allow for more flexible decision mechanism and expand into new businesses (Aggarwal, 2002).  
Demutualisation is seen as facilitating a response to market and regulatory developments by: (i) separating rights of ownership from rights to trade and rights to manage; (ii) removing certain inefficiencies and conflicts of interest which impaired the decision-making process; and (iii) facilitating capital rising and alliances or mergers between exchanges (William Pearson , 2002).
TRADITIONAL STRUCTURES OF STOCK EXCHANGES: Internationally as well as nationally, stock exchanges have been the product of circumstance, or of design. These differences in the origins of stock exchanges have tended to lead to differences in perceptions of the role of stock exchanges and in views about what their relationship with the legal system should be. Stock exchanges have also been subject to limited competition from other firms. Historically, stock exchanges all over the world were mutual organisations owned by and run for common benefit of their members, with no member taking profits. They were more like 'clubs' where the dealers transacted business through the open outcry system.
DEMUTUALISATION: Demutualisation refers to conversion of an existing non-profit organisation into a profit-oriented company. In other words, an association that is mutually owned by members eventually converts itself into an organisation that is owned by shareholders. The company can take different shapes and forms, that is, it could be either a listed or unlisted company which may be closely held or publicly held. This process involves the segregation of members' rights into distinct segments, viz. ownership rights and trading rights. It changes the relationship between members and the stock exchange. Members while retaining their trading rights acquire ownership rights in the stock exchange, which have a market value, and they also acquire the benefits of limited liabilities.
The shareholders in a corporatised stock exchange may be a diverse group, as members may decide to retain their shares or to sell them. Demutualisation however, does not insulate them from competition. A stock exchange whose management does not effectively work to maintain its position in the market may soon become a takeover target. This term is not restricted only to corporatisation of stock exchanges. Any organisation that is a non-profit body (which is not the same as loss-making), and is not distributing its profits to owner-members but retains the same to develop infrastructure of the organisation, can demutualise. For instance, Australia's life insurer and funds manager AMP recently demutualised, as did Sun Life Assurance, the Canadian insurance firm. Recently, several stock exchanges like the London Stock Exchange and two US stock exchanges, New York Stock Exchange and Nasdaq, have demutualised.  
Thus recapitulating once again, demutualisation refers to the transition process of an exchange from a 'mutually-owned' association to a company 'owned by shareholders'. In other words, transforming the legal structure of an exchange from a mutual form to a business corporation form is referred to as demutualisation. The above in effect means that after demutualisation, ownership, management and trading rights at the exchange are segregated from one another. A demutualised exchange is different from a mutual exchange: three functions of ownership, management and trading are intervened into a single group in a mutual exchange. The broker members of the exchange over here are both the owners and the traders on the exchange and they further manage the exchange as well. A demutualised exchange has all these three functions clearly segregated.   Traditionally, stock exchanges have been mutual associations owned by their members. Demutualisation is not-for-profit basis so that any profits are returned to members in the form of lower trading costs or access fees, but this has not always been the case.
There are differences in the manner in which stock exchanges are operated and regulated. They differ in terms of the role of the board and the staff of the exchange, the powers of the chief executive and chairman and the composition and powers of exchange committees. Exchanges have a variety of voting structures and the balance of power among different users varies among them as well. There are various ways in which external bodies and public interest representatives are able to influence the policies of the exchange.  Legal and regulatory frameworks vary considerably, as does the degree of oversight of exchanges by government or their designated regulatory authorities.  Membership may be open to any person who satisfies stipulated requirements or it may be closed.  If membership of an exchange is acquired through seats on the exchange, the seats are usually not freely transferable.
Perhaps the most distinguishing feature of the traditional stock exchange structure is its cooperative governance model: close identity between ownership of the organisation and direct use of its trading services.  The owners of the mutual enterprise are also its customers. Owners/customers may share net gains of the enterprise in proportion to their ownership interest.  Decisions are usually made democratically, on a one-member-one-vote basis and often are made by committees of representatives of member-firms. The ability to influence the decisions of the exchange is thereby separated from the level of economic interest a member has in the exchange.
Ownership rights may not be freely tradable or exchangeable and on cessation of membership, those rights are forfeited. Since the organisation's constituting documents may expressly (or impliedly) adopt a non-profit objective and prohibit the distribution of surpluses, mutually owned exchanges are seldom able to raise capital from anyone other than their members. In contrast, most for-profit entities are organised as corporations with share capital in which owners, principal decision-makers and customers are three separate groups.  The shareholders vest their decision-making power in a board of directors who are subject to election and removal by shareholders and this power is exercised on a day-to-day basis by the management of the corporation.  The voting rights of shareholders usually are proportionate to their economic interest in the corporation:  one share, one vote.  Ownership rights are distinct from trading privileges.  For-profit corporations may raise new capital from a variety of sources.
Recently, the appropriateness of the mutual structure has been challenged. The first stock exchange to demutualise was the Stockholm Stock Exchange in 1993.  Several other exchanges followed Stockholm's lead: the Australian Stock Exchange (ASX), Toronto Stock Exchange (TSE), Singapore Stock Exchange and Hong Kong Stock and Futures Exchanges among them. In December 1998, the Securities and Exchange Commission (SEC) in the United States determined that a stock exchange could be registered with the SEC and operated on a for-profit basis.
Jamaluddin Ahmed PhD, FCA is a member of the Board of Directors, Bangladesh Bank and General Secretary-Bangladesh
Economic Association.
jamal@emergingrating.com