July 14 - 20, 2008

Capital market plays a critical role in channeling savings of the economy into investments. This helps increase in country's employment and GDP level. In a developing country like Pakistan, the importance of capital formation through capital market can not be underestimated. So, it is imperative that capital market institutions are strengthened and made competitive to take full advantage of the available investment opportunities.

Stock Exchanges are centralized marketplaces where issuers raise capital through listing of securities and market participants buy & sell those securities. Stock Exchanges also provide primary mechanism for establishing price for securities through market demand and supply forces. Besides providing primary market for securities (i.e. listing), stock exchange is the principal stock market institution that facilitates trading in stocks in the secondary market. In addition to this, listed companies can enjoy different services offered by Stock Exchanges including liquidity, clearing of sale and purchase transactions, standardization of trading rules, monitoring of transactions to avoid coincidence of manipulations and insider trading. Generally, the attractiveness of an exchange for issuers & traders is directly linked to number of securities listed on the exchange and number of traders trading on the exchange.

In recent years, stock exchanges have undergone tremendous organizational and operational changes mainly due to 1) advancement in technology & consequent reductions in communication costs that facilitated alternative trading systems (ATS) including electronic communication networks (ECNs) 2) and competition spurred by globalization. These developments have blurred the distinction of geographic boundaries and capital can easily move from one country to another. Consequently the stock exchanges induced by the competition and technological advancements have been rethinking their business strategies and models to become more efficient, transparent and attractive for investors. Many of the stock exchanges adopted the strategy of demutualization to cope with the challenges of changing market scenario.

Demutualization is a process of converting stock exchanges from non-profit, member owned organizations to for profit organizations. Demutualization changes the legal status of the entity. Stock exchange is converted from mutual association of members with one vote per member into a company limited by shares where voting power depends upon the ownership of shares. Demutualization of stock exchanges is justifiable if its objectives change from serving a limited group of members to profit maximization by earning revenues for services provided to its customers (brokers & investors) in a competitive manner. In nut shell we can say that demutualization of stock exchanges should bring in efficiency in their process, otherwise it may not worth implementation.

In the year 1993, Stockholm Stock exchange was the first stock exchange that completed the process of demutualization. Thereafter, in a short span of time, most of the leading stock exchanges of the world followed the suit. As on March 2006, the total market capitalization of world's stock exchanges was around $ 44.4 trillion and demutualized exchanges accounted for around 89% of the total capitalization. Due to successful & profitable operations of demutualized stock exchanges around the globe, the stock exchanges of Pakistan, India, Sri Lanka, Brazil and South Africa have also announced their plans to demutualize and list their shares.



In traditional stock exchange structure, members are the owners and they have exclusive right to restrict entry of non-members to the trading floor. They also resist any change that can cause threat to their monopoly. However, the process of demutualization will restructure the corporate governance at stock exchanges. There will be separation of ownership from membership. It means disconnection of ownership rights and trading rights. It will help increase role of non-members in the affairs of the exchange.

The board of directors of stock exchange would also have representation of non trading members besides brokers. The role of board of directors will be restricted to policy making, monitoring of management and providing strategic direction to the exchange. Professional Management will be hired to run the day to day operations of the exchange that will take appropriate decisions in the interest of all stakeholders. Fit & proper criteria on the lines of commercial banks will be formulated for appointment of directors and management in the stock exchanges. This will lead to independent, transparent and efficient decision making. It is also important for the survival of profit oriented stock exchange that its decision making is perceived as fair and transparent for all stakeholders otherwise investors' capital may migrate to other exchanges.


Demutualization of stock exchange will require exchange to increase its profitability by bringing in efficiency in its processes. The exchange will introduce new products and services to increase its revenue. Thus a stock exchange will be converted into a securities market through introduction of new debt instruments and products. It will diversify investment opportunities available at demutualized exchange and will be helpful to attract more investors around the globe. Ultimately, it will generate a revenue stream for the exchange to grow and increase its profitability.


The profit oriented demutualized exchange will allow entry of new trading partners to have access to the services being offered. It will broaden the ownership base of the exchange that is of prime importance to raise funds to make investments in technological infrastructure. Such investments will help in making the exchange more competitive in future. Broader ownership base will also help absorb adverse swings in the capital base as compared to trading in limited number of shares only. Besides broadening ownership, the demutualized exchange can have access to capital through borrowing from banks, investments from institutions and individuals.


After demutualization the exchanges have opted for restructuring and revisited their business strategies to remain competitive in the international market. To become commercially viable, exchanges choose to merge, consolidate or integrate their domestic market. Merger of two or more exchanges can create synergic effects and exchanges can enjoy economies of scale. In this way, their administrative expenses are considerably reduced.

Demutualized exchanges can also go for vertical integration with clearing, settlement and depository institutions. Such integration will diversify sources of income for exchanges. In addition to this, it will spur cost reduction for processing of clearing and settlement transactions thus lowering overall cost of transactions for investors.

Demutualized exchanges can be better able to make cross border alliances with other stock exchanges through equity swaps. This will increase investment opportunities for investors and cross listings of stocks/securities will be possible.


As earlier discussed that demutualization process of exchanges will improve level of corporate governance and ensure more transparency in the decision making process. It will create a better image of the exchange in the minds of the domestic and foreign investors and more capital can flow into the exchange for investment purposes.



The degree of conflict is present in both mutual and demutualized stock exchanges. However nature and intensity of conflict depends upon the structure of the exchange and its business. In a mutual exchange, the challenge is to resolve conflict between the interests of the members (owners) and the public interests (investors). In case of demutualized exchange, the challenge becomes keeping a balance between commercial objectives of the exchange and protection of public interests. The conflicts of interests at demutualized exchange may be as follows:-

1 Since the objective of a demutualized exchange would be profit maximization. Therefore, commercialization of exchange may inhibit its ability to commit adequate resources for self enforcement and performance of regulatory responsibilities.

2 Demutualized exchange may unfairly raise fee, service charges etc for rendering services to investors and brokers in pursuit of generating revenue to benefit shareholders

3 Standards for listing of securities/shares on exchanges may be relaxed to attract more and more listing of stocks in order to earn more revenue from listing.

4 Demutualized exchange may unfairly use its powers to impose heavy penalties for maximizing its revenue.

5 Risk Management standards may be compromised under the impression that tightening of risk management rules may cause decrease in volume of trade thus reducing revenues of the exchange.

6 There are apprehensions that while self listing of public issue on its own exchange, listing standards and their surveillance can be compromised.


After demutualization process when exchanges opt for merger in domestic market, it reduces competition among exchanges. So, a monopoly situation is created that can diminish benefits that may accrue due to competitive environment. This is another area of concern for decision makers to consider while devising strategies to overcome negative aspects of demutualization.


The demutualized exchanges have to be properly regulated in order to ensure efficiency, transparency and fairness of the market. This could only be achieved through supervision of the exchanges in order to ensure that:-

(i) Conflict of interest between owners of exchange and the business they offer are amicably resolved

(ii) Appropriate rules & regulations for primary and secondary market trading are formulated,

(iii) Standards for qualification, operational and ethical practices of market participants are defined

(iv) Rules for investors' protection are in place,

(v) Market transactions are conducted in a transparent manner.

The regulation of demutualized stock exchanges is a tricky job. On the one hand, it is important for regulators to ensure that regulations for securities market are properly implemented but one the other hand they must be cognizant of the fact that the rules and regulations should not inhibit development of the market and product innovation. The rules and regulations should be flexible enough to accommodate best market practices that are critical for success and survival of the demutualaized exchange. The regulations should be in line with the best international practices so as to avoid capital migration to other exchanges.

A law delineating criteria for operations of exchanges and entrusting powers to the regulators to issue license for establishment of an exchange should be formulated. The law should also prescribe definite guidelines to be followed by exchanges for making their own rules and regulations. It is also recommended that the regulator should also have the authority to revoke license of an exchange if it fails to fulfill prescribed criteria.


A lot of debate has been going on with respect to resolution of regulatory issues of demutualized exchanges. According to the principles laid down by International Organization of Securities Commission, regulatory supervision of exchanges and trading systems should be an ongoing process with an objective to ensure integrity of trading through fair and equitable rules that strike an appropriate balance between the interests of different market participants. To resolve regulatory concerns, demutualized exchanges all over the world have adopted different regulatory models according to their structure and business propriety. These models are briefly discussed below:-


One of the regulatory models is that a demutualized exchange continues to perform all regulatory functions by itself. It is argued that when regulators are themselves dealing with market issues and monitor conduct of market players, they are well aware of the market developments and show more flexibility /responsiveness and quickly react to any changes taking place in the market. However, Self Regulatory model is widely criticized on the grounds that how a demutualized exchange can take enforcement action and impose penalties on the investors and brokers who are a source of revenue for it. There are chances that monitoring and surveillance standards will be relaxed that can impair transparency and fair play in the market. Despite this concern with respect to regulatory point of view, the proponents of this model argue that in a competitive market environment, a demutualized exchange can not afford reputation risk because a reputation loss can hurt future viability of an exchange. So, even in the case of self regulatory demutualized exchange, implementation of a good regulatory and enforcement framework is critical for the commercial viability of the exchange in a competitive environment.


The demutualized exchanges can establish a separate entity to look after regulatory functions. This model reduces some of the issues relating to conflict of interest in the demutualized exchanges. However, it must be ensured that regulatory function is conducted in a manner that it permits its independence from commercial interests of the management and shareholders. For example, some for profit demutualized exchanges have established separate regulatory divisions to perform regulatory functions. Such divisions have no involvement in the commercial or business activities of the exchange. However, in some cases, the regulatory function is being performed by a subsidiary of the demutualized exchange which is run by an independent management. For example, this type of regulatory model was adopted by NASDAQ. During the process of demutualization of NASD in the year 2000, two subsidiaries were established, NASD Regulation Inc. (NASDR) and NASDAQ Stock Market. The former was the regulatory body and the latter was the commercial arm of the exchange. This arrangement has been quite successful in resolving issues relating to conflict of interest.


A third approach is to entrust the regulatory function to an independent third party. This model considerably diluted the perception of conflict of interest in a demutualized exchange. However, the independent regulatory body should be accountable for its actions. It must be ensured that the outsourced regulatory body should not stifle growth and development of the exchange by imposing too many rules & regulations with a purpose to have better risk management of transactions of the exchange. The regulatory body should also be accountable to perform its functions effectively so that the reputation and brand image of the exchange is not tarnished. For example, in United States, National Future Association is performing the regulatory function for several exchanges in futures market.


Globally, different research studies have been conducted in order to measure the performance of stock exchanges after their demutualization process. The view has been substantiated with few exceptions that demutualized exchanges outperform mutual exchanges in terms of profitability, revenue generation, efficiency etc.

Australian Stock exchange (ASX) was the first demutualized Exchange that went public in October 1998 through listing of its shares on its own exchange. One of the study conducted by Issac Otchere and Khaled Abou Zied "Stock Exchange Demutualization, Self-listing and Performance: The case of the Austrialan Stock Exchange", concluded that ASX after demutualization and self-listing has outperformed significantly when compared with its pre-conversion period performance. According to the study, ASX's after conversion Net Income Margin (27%), Return on Equity (30%) and Return on assets (31%) is considerably higher than its pre-conversion ratios of 15%, 12% and 7% respectively.

In August 2003, Alfredo Mendiola & Maureen O' Hara in their research paper titled "Taking Stock in Stock Markets: The Changing Governance of Exchange" conducted an analysis of a sample of 10 publicly traded exchanges and suggested that change in structure of exchanges from cooperative to corporate would allow for a corporate governance framework better suited to the exchange's competitive environment. They further opined that if an exchange is well positioned to compete then we expect improved performance and thus exchange's conversion should be a value enhancing strategy for the exchange's owners.

To ascertain the operating performance of demutualized exchanges that are publicly listed, Reena Aggarwal and Sandeep Dahiya conducted a study on a sample of exchanges by using measures like Return on Assets, Return on Equity and operating margin for the fiscal year 2004. The study concluded that demutualized exchanges performed well and their ROE and ROA was 17.6 % and 7.6% respectively while operating margin was 33.8%. Compounded annual growth rate (2000-2004) of sales and operating income was 10 % and 19 % respectively. The study also revealed another important feature of publicly listed demutualized exchanges that they do not rely on debt as their leverage ratio (debt to total assets ratio) was meager 0.4 %.


The factors like advancement in technology and competition that necessitated the process of demutualization of stock exchanges across the world are still relevant and most of the leading exchanges in the world have completed the process of demutualization. It is foreseen that in the next five to ten years the process of consolidation of exchanges through mergers/acquisitions etc will take a pace. The process has already commenced with a number of small regional exchanges are being merged into larger groups (e.g. OM Group, Euronext). The next phase would be geographical consolidation and mergers/acquisitions of exchanges across product lines (e.g. merger between stock & derivative exchanges).


Advancement in information technology and competition spurred by globalization has been the prime factors that prompted the process of demutualization of stock exchanges. The limitation of member owned exchanges with mutual zed structure to compete effectively with for profit demutualized exchanges has further accelerated the process of demutualization of stock exchanges around the globe. Demutualized stock exchanges enjoy benefits of better corporate governance, high growth rate due to profit orientation, access to more capital investment, economies of scale due to alliances & mergers with other exchanges and improved image building in the minds of investors and public at large. But at the same time, demutualization of stock exchanges poses some challenges to be dealt in a professional manner. The challenges include balancing of conflict of interests in a demutualized exchange. There are also strong apprehensions about implementation of an appropriate regulatory regime in a demutualized exchange that should ensure efficiency, transparency and fairness of the market. To resolve regulatory issues, different regulatory models have been adopted/proposed which include self regulatory model, Separation of regulatory function from commercial activities of the exchange & outsourcing of regulatory function to a third party. Despite propagation of concerns about demutualization, research evidence suggested that demutualized exchanges except with a few exceptions have been performing well. After the current wave of transformation of exchanges, it is foreseen that in the next five to ten years, the process of consolidation of demutualized exchanges through mergers/acquisitions will start.