There are differences in the manner in which stock exchanges are operated and regulated. They differ in the terms of the role of the board and the staff of the exchange, the powers of the CEO and the chairman of the board and the composition and powers of the exchange committees.
The distinguishing feature of the traditional stock exchange structure is its co-operative governance model; the close identity between the ownership of the organization and the direct use of its trading services. Owners of the mutual enterprise are also its customers. Owner/customers may share in the net gains of the enterprise in proportion to their ownership interest. Decisions are often made on a one-member, one vote basis and often are made by committees of representatives of member firms. A mutually-owned stock exchange is seldom able to raise capital from any one other than its members.
It should be noted that all stock exchanges in Pakistan i.e., the Karachi Stock Exchange (Guarantee) Limited; the Lahore Stock Exchange (Guarantee) Limited and the Islamabad Stock Exchange (Guarantee) Limited, are mutual organizations and their demutualization is in the pipeline. There are different ways in which the external bodies and public interest representatives are able to influence the policies of a stock exchange.
The role of the apex regulator of the securities is undertaken by the Securities and Exchange Commission of Pakistan (SECP), stock exchanges being the front-line regulators. The SECP is duty bound to regulate stock markets for the benefit of the investing public and to see that the securities market is being run in an efficient and transparent manner.
The SECP has its nominees appointed to the boards of all stock exchanges and the CEO’s of these exchanges are selected by their boards of directors and are appointed after the SECP has given its consent to their appointment.
The mutually owned exchanges have now served their goals, and markets are now recognizing that modern corporate structures and governance are essential to attracting firms to raise their resource requirements and for investors to invest their funds. In the year 2000 it was reported that of the 52 exchanges present at the annual meeting of the Federation Internationale des Bourses des Valeurs (FIBV), 15 had demutualized, 14 had approval to do so, and 15 were contemplating doing so- that’s 44 out of 52, or around 85 per cent.
The annual report of the FIBV in 2001 shows that they were polled again in the annual meeting in Brisbane in October 2000. By then, 45 per cent had been demutualized; 16 per cent had approved plans to do it; 39 per cent planned to draw up a proposal for it - that adds up to 100 per cent. This trend towards demutualization is being driven largely by changes in technology and competition. New technology does not come cheaply, highlighting the access to broader access to capital. Increasing competition between the bourses and other trading systems requires exchanges to become more efficient in all activities, including their decision making process.
The first stock exchange to demutualize was the Stockholm Stock Exchange in 1993. Several other stock exchanges followed Stockholm’s lead: the Australian Stock Exchange, Toronto Stock Exchange, Singapore Stock Exchange and Hong Kong Stock & Futures Exchanges among them. In May 2000, the Pacific Exchange became the first US Stock Exchange to demutualize a part of its business. The Chicago Mercantile Exchange became the first US financial exchange to demutualize in November 2000, converting its membership interests into shares of common stock in the Chicago Mercantile Exchange Inc.
In following paragraphs are explained the concept of demutualization, rationale for demutualization, conflicts of interests and legal avenues through which demutualization may be achieved.
Meaning: For-profit entities are organized as corporations with share capital in which owners, principal decision-makers and customers are three separate groups. Shareholders vest decision making power in a board of directors who are subject to election and removal by shareholders and the decision making power is exercised by the board on a day to day basis by delegating it to the management of the corporation. The voting rights of shareholders usually are proportionate to their economic interest in the corporation; one share, one vote.
In case of stock exchanges, demutualization is literally a process of continuing an organization from its mutual ownership structure to a share ownership structure. The process entails first converting membership into shares, which step may or may not be followed by a public issue of these shares. In this manner, a quasi-governmental institution and/or a non-profit entity transforms into a profit-oriented, publicly traded company.
Rationalized governance: The mutual association model works well if an exchange is a provider of trading services with little competition and the interests of the members are similar in nature. However, if the competition increases and the interests of the members are no longer homogeneous, the said model ceases to function well. Consensus decision making becomes slow and cumbersome and the exchange is unable to respond quickly and decisively in the market.
A corporate model of a stock exchange operates in a more customer focused manner and easily and quickly responds to changes in the business environment and to meet competitive challenges. The management of a corporate exchange can take actions that are in the best interests of the customers and the exchange itself.
Investor participation: A demutualized exchange affords both institutional investors and retail investors an opportunity to become shareholders. In the recent years, the institutional investor has grown in size and number and its needs differ dramatically from those of the retail investor e.g. the institutional investor trades in large volumes and needs greater liquidity to trade in these volumes and also lays more emphasis on negotiating the lowest price.
Competition: An ATC or ECN is a privately operated computerized system which performs many of the functions of an exchange by centralizing and matching buy and sell orders and providing post-trade information. In Pakistan, recently an ECN has been registered with the SECP and many more may come up in the due course of time. These ATC’s or ECN’s will pose tough competition to the stock exchanges in Pakistan in the future.
The ATC’s and ECN’s lower cost structure will definitely attract volume from the traditional stock exchanges. As long as the stock exchanges remain competitive in terms of technology, price, variety and quality of service, they will be able to compete with the ECN’s.
Globalization: Strategic alliances and consolidations affect capital markets and exchanges globally. Mergers between stock exchanges and derivative exchanges in the US are redefining North America’s competitive landscape and creating super-exchanges. The merger of NASDAQ and the American Stock Exchange for instance, created an exchange with a market capitalization of $1.9 trillion offering an unprecedented variety of products. Similar alliances are also occurring
Resources: A competitive stock exchange must be able to respond quickly to global competitive forces and technological advances. With the capital raised through the profits and a heightened awareness of accountability to stakeholders, a stock exchange should have both the incentive and the resources to invest in the competitiveness of its information systems.
Conflict: In a mutualized exchange which has been operating as a self-regulatory organization, the decision making process of the exchange may be conflicted, as the people making the decisions whether in the board or in the general body, tend to have an interest in what they decide. Technically under the law and on moral grounds, they should refrain from debating and voting at such a meeting and should instead declare that they are conflicted. Conflicts arise because the members are being asked to set rules in the public interest that may negatively affect their own commercial interests.
However, a major weakness of self-regulation is the inherent potential for it to favour the interests of broker members over those of the investing public. Because self-regulatory exchanges are in-charge of implementing the policy of the government and public policy, and is itself owned or controlled by the industry participants who are objects of regulation, self-regulation raises the distinct possibility of inadequate enforcement of rules and standards.
The demutualization of an exchange is not incompatible with self-regulation. The ability of the exchange to meet the standards set for it and deliver key regulatory and public interest objectives depends on a range of factors including the overall regulatory framework.
Demutualization may lessen some of the self-regulatory organization conflicts.It leads to a separation of the owners of an exchange from its members; the interests of the owners (shareholders) may act as a constraint on actions that would benefit only the interests of the members. The more the shareholder base looks like a public as a whole, the greater the effect is likely to be, as the shareholder interest and the public interest will arguably tend to converge.
However, it cannot be denied that even when an exchange is running for a profit basis, there can be a conflict of interest in retaining its regulatory role of the securities market. Some of these concerns are detailed hereunder:
* One concern is that in a demutualized exchange, the drive for profit increases both the scope and the intensity of conflicts. In a traditional exchange, the focus is on generating sufficient fees to meet the budget for expenses, capital investments and other outlays. In a for-profit exchange, the revenues must meet the budget plus produce an acceptable rate of return to the investors. As self-regulation is an incurred cost (outlay) and is not a profit and as the benefits of good regulation cannot be quantified, therefore the same may not be given a priority or full weight.
A self-regulatory organization, therefore may be unwilling to commit the resources that vigorous self-enforcement would require. Due to increased pressure to generate investment returns for shareholders, a for-profit exchange may be less likely to take enforcement action against customers or users who are a direct source of income for the exchange. By similar reasoning, a for-profit exchange may be less likely to suspend trading in the more liquid products listed on its markets where this may impact adversely on transaction fees such trading would otherwise generate. Conversely, the exchange may use its regulatory powers more vigorously to increase its competitive position or its revenue. This may arguably include a tendency to apply higher standards or take greater enforcement action than before to generate revenue from fines.
Once an exchange is demutualized, it may decide to list its own securities on the exchange, it has the ability to influence the actions of its competitors, specially, if it has a monopoly being a provider of a particular service. A for-profit exchange may want to enter into new businesses, thereby increasing the opportunities of conflicts between its regulatory role and those as a competitor in the market place.
A for-profit exchange may wish to lower listing (regulatory) standards in order to attract more listings and thereby increase its fee income. In a demutualized exchange, there are a few ways in which an environment may be created in which conflicts are recognized, minimized and managed effectively:
* Induction of “public directors” to the board of an exchange will increase the likelihood that the board takes its responsibilities for the integrity of the regulatory process seriously.
* A clear statutory statement setting out the obligations of the exchange can provide a fair and efficient trading market.
* Conflicts can be managed by a rigorous regulatory oversight by the exchange (front line regulator) and the SECP (apex regulator). However, considering the number of exchanges in Pakistan and the number of investors involved, the SECP may not be as affective as the exchanges.
* Decisions, actions, rules and regulations of the exchange as well as the apex regulator, if published, would enhance transparency.
* Certain mechanisms would have to be adopted to make the exchanges accountable to the public and the apex regulator. Currently, at the Lahore Stock Exchange (Guarantee) Limited, there is a process of claims settlement that are filed in the LSE by the investors against a member and it is likewise in the other exchanges in Pakistan.
These claims are verified and settled by the LSE. At times these claims are large in numbers and much time is spent on their settlement. In case a claim is decided against an investor, invariably, the investor goes out of the exchange with a feeling that the exchange was biased towards the member. This degenerates the public trust in the exchange. It would be proper if special statutory tribunals (maybe under the auspices of the SECP) be set up that should settle these claims. This will enhance the trust of the investors in the exchanges and make the exchanges and the members accountable for their actions or inactions.
In Pakistan, in order to convert a stock exchange into a demutualized exchange, it will have to go through a legal process that would convert it into a for-profit organization. There may be three ways to convert a mutualized exchange into a for-profit exchange:
1. A mutual stock exchange may opt for winding up and transfer its existing liabilities to another company limited by shares (the new stock exchange that shall be a demutualized body). The new company would then have to be registered with the SECP as a stock exchange as a demutualized entity
2. A new public company limited by shares may be incorporated and the mutual stock exchange be merged into the new company. This process will entail the indulgence of the courts and a grant of a new license to the new company as a stock exchange from the SECP as a demutualized entity
3. A mutual stock exchange may be re-registered as a company limited by shares with the SECP as a demutualized entity.
Any of the above mentioned ways have to be well thought out before they are carried out, since they would involve legal issues relating to corporate and taxation laws.
(The author is the in-house counsel of the Lahore Stock Exchange (Guarantee) Limited.)
