SHOULD there be only one or more than one stock exchange in the country? This is a fundamental question facing the market for a number of years. At the moment it seems that the market may be moving towards a two-exchange structure. There could be KSE and another exchange formed by the merger of LSE and ISE. Both of these exchanges should be demutualized.

However, due to a number of reasons it is not clear if and when the two exchange structure would materialize. Some of these reasons are (i) there is no enabling legislation for demutualization and merger of exchanges, (ii) SECP and exchanges are yet to reach agreement on some of the core issues in demutualization, such as treatment of trading rights, shareholding rations, composition of board of directors etc, (iii) option to merge with other exchanges remains open to KSE and (iv) legal window for licensing another exchange is also not closed.

Therefore, the number of exchanges after demutualization remains uncertain. The debate about the right number can be reduced to two alternatives, unification versus competition. Let’s discuss the arguments for both to see which one suits the investors better.

The core argument in favour of unification is that it would put an end to market fragmentation and provide more liquidity, better price discovery, wider market access, and reduced cost for all three core stakeholders - investors, brokers and listed companies. Moreover, by eliminating the complexity caused by three independent exchanges and pooling their resources, unification would speed up market development.

Technological developments are already integrating the exchanges. The Central Depository Company has integrated custody while the National Clearing Company has integrated clearing. The key function that needs unification is trading and technological capacity to link the trading platforms is also available. International experience also favours unification.

Developments in information technology and other factors have led to unification of local stock exchanges in many countries including Canada, Britain, Japan, Australia, Hong Kong, Malaysia, Korea Philippines etc. There are also a number of countries which only had one stock exchange such as Singapore, Thailand, Sri Lanka etc and are continuing with the same structure. On the other hand there are but few countries in which unification of local exchanges seems unlikely. In fact, due to technological developments and globalization, international exchange are now making alliances and contemplating mergers across countries.

The core argument in favour of competition is that unification of exchanges would create an inefficient and unruly monopoly that would over charge its customers. Competition is the ultimate regulator of any market and the driving force in a business and it is competition among exchanges that would provide the stakeholders with the best product and services at the lowest rates.

Moreover, having more than one exchange would also diversify the risk associated with the financial failure of any one exchange. Let investors, listed companies, and intermediaries choose the exchange that would serve them better.

Moreover, there are but few countries in which the law prohibits licensing of new stock exchange after demutualization or unification, implying that the door for competition is kept open. In Hong Kong, where exchange is a statutory monopoly, the monopoly status has come under criticism and some favour restoration of competition. There are also some examples, such as that of India, where competition has been successful in developing the market.

While arguments for both alternatives have their merits, a careful analysis shows that if demutualization is successful, the case for unification is stronger than that for competition. The apparent objective behind demutualization is to help address some of the core issues facing the exchanges, such as inadequate say of stakeholders other than stock brokers in the affairs of the exchange, constraints on accessing economic and human capital for development, and a perception problem.

The key test for determining the success of demutualization would be the degree of say that it gives to the investing public in the governance of the exchange because once interest of the investors is put into the driving seat, the rest of the developments should follow. If demutualization is successful, then little could be achieved by competition and it would be in the interest of the investors that stock exchanges should unify after demutualization.

The concerns about abuse by and inefficiency in a unified exchange could be addressed by a set of check and balances as done internationally, such as a balanced board of directors, capital requirements, and close supervision by the SECP.

The law may be amended to allow licensing of another stock exchange after a specified period, say five years, provided it is in the interest of investing public to do so and lay down some specific tests to this effect. This should also allay the fear that a new exchange may be licensed even if it is not justified and vice versa.

But if demutualization is derailed or done in form rather than substance, then the issues that it is suppose to address would remain unaddressed and the interest of investors would be best served by competition. It would be unrealistic to expect that the existing exchanges could compete with each other and develop the market. For more than 15 years, there are three exchanges in the country but investors have seen precious little competition among them.

Reality is that KSE is in a dominant position and LSE and ISE are unlikely to offer KSE significant competition even after a merger. According to market rumours, brokers at LSE and ISE are still keen to merge with the KSE and there are some at KSE who would also like to see unification. If the exchanges merge in this scenario, then due to the greater political clout of the merged entity implementing reforms could become ever more difficult.

Competition in local exchanges would be best brought about by licensing a new demutualized exchange that would not be subject to the conflicts and constraints faced by the existing exchanges. Indian experience may be of some use. In 1994, Securities and Exchange Board licensed a new demutualized entity, National Stock Exchange of India (NSE), which was backed by financial institutions. With its superior governance and better access to economic and human capital, NSE rapidly developed the Indian market by introducing new products and services and put pressure on other exchanges to improve their services.

In 2003-04, India had nine operational exchanges but NSE accounted for almost 90 per cent of combined traded value across all segments, equities, debt, derivatives etc. Over the years, the success of NSE substantially reduced the influence of the Stock Exchange of Mumbai (BSE) and other stock exchanges and paved the way for their mandatory demutualization that is currently taking place. If leading financial institutions, particularly banks, in Pakistan become willing to sponsor a new exchange, then we could also see a similar outcome.

Demutualization, unification, or competitions are fundamental restructurings and a lot has to happen before we can see any of them materialize. The most important next step is enactment of enabling legislation. Once the enabling legislation comes into force, it should help answer a number of questions, including how effective demutualization could be in addressing the issues facing the exchanges and how many exchanges the country is going to have.