The Karachi Stock Exchange (KSE), Lahore Stock Exchange (LSE) and Islamabad Stock Exchange (ISE) are preparing for demutualization or conversion from not-for-profit membership based companies into for-profit companies limited by shares.

Internationally, demutualization is believed to bring significant improvements in economic efficiency and quality of governance of exchanges. However, a key concern involved in demutualization is the new conflict of interest it creates between the public interest role of an exchange as a front line regulator of listed companies and brokers and that as a for-profit shareholder- owned entity.

The objective here is to discuss forms of this conflict and measures that are used to address it. The conflict between regulatory and commercial role of a demutualized exchange can take many forms. Lets look at some of them.

First, as a regulator exchange is expected to maintain reasonably high standards for listing and corporate governance. It is expected to make its listing regulations such that unscrupulous individuals are not able to tap investor money.

It also shares responsibility with statutory regulator to ensure that investors are provided with adequate disclosure in offer documents and there is effective supervision of listed companies for compliance with corporate governance requirements.

On the other hand, as a for-profit company, a demutualized exchange has the incentive to relax its listing and corporate governance requirements because more listed companies mean more listing revenue. This conflict is given another twist when a demutualized exchange lists on itself because it might treat itself as more equal than other listed companies.

Second, as a regulator, an exchange is expected to facilitate competition among market intermediaries and listed companies for investor money. As a commercial entity, it would have the incentive to milk its customers to maximize profits. In situations where exchange is not subject to competition from other international and domestic exchanges, this conflict is intensified.

Exchange may also use its regulatory powers to stifle competition. For instance, it could cause difficulties for a brokerage company that may wish to compete with the exchange by electronically matching customer orders within the house.

Third, as a regulator, the exchange is required to carry out market surveillance to protect investors from market abuse such as price manipulation. As a commercial entity, exchange would have the incentive to commit minimum resources (such as staff, surveillance software, management time) to this function because these resources would cost much but not make any direct profits.

Moreover, investigations carried out as part of surveillance work could strain the relationship with revenue generating listed companies and brokers. Some surveillance actions, such as a halt in trading of a security, could cause a direct revenue loss.

Fourth, as a regulator, the exchange is entrusted with management of settlement risk. Exchange has to provide assurance to market participants that every trade executed shall be settled and there would not be any systemic threat to the market due to any defaults. Regulatory perspective requires being conservative in setting risk controls.

On the other hand, as a commercial entity, the exchange would be under pressure to maximize its revenue earned through service charges on trading volume. The tighter the risk controls such as margin deposits against outstanding positions, the lower would be the ability of brokers and investors to trade. Commercial considerations would demand that risk controls are eased, say by reducing margin levels, to help increase trading volumes.

Fifth, as a regulator, the exchange is required to levy fines on violations in a manner which is fair and in the best interest of the market. As a commercial entity, it would have the incentive to use its regulatory powers to maximize its revenues by levying large fines on minor violations. An exchange losing its conventional business revenues could be compelled to explore such options.

These examples show that the conflict of interest between regulatory and commercial role of an exchange is a serious one. Some, however, argue that commercial interest of a demutualized exchange and public interest have a lot in common.

To be successful in its business, an exchange has to be seen as a fair, efficient, and transparent market place by the investors. Therefore, commercial actions of a demutualized exchange should be inherently consistent with regulatory requirements and public interest.

This line of thinking may have some supporting international evidence, however, stakeholders in Pakistani exchanges would probably be deeply skeptical of the idea that a commercial entity shall be guided by such enlightened self- interest.

What stakeholders are likely to demand is a set of effective measures to address the conflict. Let's look at some measures that have been used in demutualization of exchanges in Asia Pacific.

First, board of directors is so structured that there is balance between interest of shareholders and other stakeholders. The present board of directors of Hong Kong Exchange and Clearing Limited (HKEx) consists of an equal number of shareholder elected directors and public interest directors.

The latter are appointed by the financial secretary of the government and they are mandated and protected by law to give priority to the interest of the general public.

In Malaysia, one-third of directors at Bursa Malaysia are nominated public interest directors, one-third are independent directors, and remaining third can be associated with stakeholders.

Second, regulatory functions are separated within the exchange and in some cases from the exchange. As a mutual, Australian Stock Exchange (ASX) had a Membership Department responsible for compliance with Business Rules and acting as a central point of contact for members for enquiries.

After demutualization, ASX separated its supervisory function associated with brokers from its customer relations functions. In Singapore, Monetary Authority of Singapore assumed a greater role in supervision and inspection of brokerage houses at SGX following its demutualization.

Third, the overall governance standards and expectations are raised after demutualization. ASX was required to maintain public registers of listing rule waiver decision and business rules disciplinary determinations.

Focus on news media on the exchanges also keeps them under pressure to maintain high degree of transparency and accountability. In Hong Kong, after an incident involving penny stocks in 2002, there was substantial outcry in the media. The listing function at HKEx was subjected to a review, its CEO had to quit, and there were significant changes in senior management.

Fourth, statutory regulator increases its supervision after demutualization. Where exchanges seek to list on themselves, the statutory regulator steps in the shoes of the exchange to supervise self-listing and on-going supervision of exchange as a listed company.

This has been done rather consistently where exchanges have self-listed such as ASX, SGX, and HKEx. In Australia, in addition to ongoing supervision, the Australian Securities and Investment Commission carries out an annual review of ASX's regulatory role.

Fifth, shareholdings are dispersed and made subject to regulatory thresholds to avoid concentration in ownership and control by any one stakeholder. Dispersion in shareholdings is often achieved through listing as in case of ASX and HKEx or listing with private placement and public offer as in case of SGX. Shareholding in demutualized exchanges by any one entity has usually been restricted to a 5 per cent threshold subject to necessary approvals.

In sum, the conflict of interest between the regulatory and commercial role of an exchange can take many forms. There are, however, a number of measures available to address this conflict.

It is expected that in demutualization of the KSE, LSE, and ISE, necessary checks and balances shall be built in the new structure by the Securities and Exchange Commission of Pakistan and the exchanges to safeguard the interest of all stakeholders.