'Demutualization' is relatively a new concept and majority of the developed exchanges have changed their status from mutual to a for-profit entity


Aug 19 - 25, 2002

Domestic stock markets have incorporated dynamic structural reforms during last couple of years. Encouraged by Asian Development Bank (ADB) and guided by Securities & Exchange Commission of Pakistan (SECP), these reforms have helped build credibility and bring local bourses to the international standards. Now, bourses have been urged to submit proposal for their 'Demutualization', a move to do away with the member brokers from the management of the exchanges. 'Demutualization' is relatively a new concept and majority of the developed exchanges have changed their status from mutual to a for-profit entity. Strong new forces forces that are causing exchanges to re-examine their business structures in order to remain competitive, are influencing the global financial services industry. Globalization, advances in technology, a concentration of new investment capital, competitive pricing pressure and government deregulation are all contributing to the allure of demutualization.

The distinguishing features of mutually owned exchanges are that the owners of the enterprise, its decision makers and the direct users of its trading services are the same entities: the member firms. Decisions are usually made on a one-member, one-vote basis. Limiting its supply enhances value in membership. Members in general are unlikely to vote for any changes that would require them to put in additional capital, or threaten their customary way of doing business, or decrease the potential value of their membership. This form of exchange structure and governance tends to place members' interest above those of the market and the investors. It also inhibits the exchanges from responding quickly to changes brought by new technologies.

Demutualization liberates a traditional exchange from the constraints of such structure. In a traditional exchange, ownership rights and trading rights are one and the same and not easily transferable. Demutualization will segregate current members' ownership rights from their trading rights and create value in both of these rights. Members' ownership rights are transformed into shares, while their trading rights may be maintained. If the demutualized exchange becomes a listed company, its shares will also be freely tradable.

As a commercial organization, a demutualized exchange will have to be more customers oriented and profit-driven. It will have to focus on the business aspects of operating a marketplace, and will be able to raise capital from the public. This will enable it to invest in technology and systems.

Demutualization also introduces new elements into the environment. The common concern is that the commercial pressures for profit will undermine the exchange's commitment of resources to carry out its regulatory responsibilities in the public interest. In order to generate and maintain its business, a demutualized exchange may lower its listing standards or be less vigorous in compliance and enforcement matters. The performance of regulatory functions in these areas directly impacts on an exchange's profitability. This may result in lesser standards in the market in general.

Definition of an exchange is changing as increasing volumes of transactions are executed across electronic networks rather than on traditional trading floors. Advances in technology and strategic alliance among exchanges mean that markets will be linked across geographical boundaries. It will be possible to have a central, global electronic marketplace. So only those exchanges will be able to join hands that meet the high quality standards of services and competitiveness.

SECP chairman, Khalid Mirza has rightly pointed out that the main responsibility of domestic exchanges is to strengthen as an institution. The choice of going for the demutualization is with the exchanges, as they should evaluate the implementation of capital market reforms carried out by the SECP. Demutualization demands competitiveness. Do the management of our bourses have reached that level of efficiency and professionalism that they come out of the shadow of member brokers. During the past, all the blames and responsibility were easily put on the shoulders of brokers but the new status would demand skills to run the company in profit with shareholders, mostly be brokers, questioning the deeds of management. So exchanges should spend some more time in proving themselves as a profitable entity to attract investors.

Karachi Stock Exchange, the biggest exchange of Pakistan, now offers trading in 'Single Stock Futures' and plans to establish 'Commodities Futures Counter' soon. Diversification benefits would help the exchange not only to retain existing clients but also attract the fresh business too. However, shareholders may have a sustained pressure on it to continuously expand and improve the technology and services. Now the question remains, does Lahore Stock Exchange and Islamabad Stock Exchange has the capacity to attract that much business? The decision going for-profit status may demand considering the merger of exchanges. This option may be considered to attain economies of scale and synergy, avoidance of large number of committees and overlapping memberships. However, that may take ages to develop unanimity of views and convince the industry players.

Competitiveness has also changed the role of traditional brokers. Real time information on stock prices and other data are available anytime and anywhere. Complex analysis of the market may done with a click of investors' personal computers. Investors are now able to obtain customized reports on their portfolio through web-based networks. Deregulation of the banking industry in many jurisdictions has enabled banks and other financial institutions to provide customers with one-window financial services including cash management, portfolio management, direct online trading, receiving of dividend etc. Brokerage firms will have to add value by developing superior risk management systems and providing risk capital in order to compete for customers under such environment.

Investors will be the ultimate beneficiaries of all these changes in the market place. They will have more choices and information on investment products, easier accessibility to any market they wish to trade on, and better and cheaper services for intermediaries. The new generation of investors will become more increasingly sophisticated as market information becomes widely available. However, the complexity of the new markets also means that investors must know their own risk appetite before entering the market. With sophistication in the marketplace, the demand for improved corporate governance by public companies will also increase.

Securities regulator, as well, cannot be insulated from all these changes. Whether a demutualized exchange should be regulated as any other listed company, or as a utility, will be a challenge for the regulators. Regulators must also keep up with the sophistication in market technology and new market structure. Enforcement cases will become more complicated as market manipulation and other misconduct are now also conducted on the internet, making it more difficult to be detected.

Accelerated changes and developments in the marketplace, together with the new population of investors, mean that there will be an increased emphasis on investors' education. This is a task which, has only recently been undertaken by regulators. The regulator's role is not only to enforce the rules but also to facilitate market development. The challenge is to balance the pressure generated by market participants, with the regulator's desire to ensure stability and integrity in the market. Regardless of any changes, however, the regulator must ensure a fair and transparent market, and a level playing field so that there will be continued confidence in the market of the new era.