FE Report (February 27, 2011)
After the hot topics like book building, share market efficiency, margin loan limits, implementation of Basel (II) and many other issues of finance, demutualization of stock exchanges is becoming a new issue.
Why demutualization? Is it something for which we can scream out loud "UREKA". No, actually it is not something for which we can do that. In 1993, the Stockholm Stock Exchange became the first exchange to demutualize. Since then, 21 exchanges in the developed markets have demutualized - representing almost 40% of the membership of the World Federation of Exchanges. (Source: World Federation of Exchanges Annual Report and Statistics).
The figure 1.1 shows the worldwide market capitalization of demutualized stock exchanges which is 52 %(data 2001) of the total. The figure 1.2 shows the total market capitalization of demutualized stock exchanges only in Asia which is 76%(data 2001) of the total. So it is not something new to the world but definitely it is something new to us. Let us start with what is demutualization? Demutualization can be defined as a process by which a mutually owned stock exchange is converted into a company owned by shareholders by transforming its existing legal structure as an into a business corporation. In contrast, a mutual stock exchange is a non-profit, mutual organization with monopoly power, owned by its members. Here, the owners are at the same time its clients who are the final consumers of its trading services. They share the profits of the company, based on their participation in the ownership.
A demutualized stock exchange will provide most of the same services as a mutual stock exchange but in a little bit different way. A mutual stock exchange is owned by the members and most of the time it tends to work favouring the interest of the members alone. This tendency sometimes undermines the rights of other stakeholders and participants. In a demutualized stock exchange, ownership is divided between members and outsiders. This is to some extent a balanced approach to remove conflicts of interest and enhancing management accountability.
A mutual stock exchange is unable to respond quickly and decisively (this point is much clear when we take the recent decision-making process of our stock exchanges into consideration as example). It acts well when the interests of all the stakeholders are homogeneous but undergreater diversity of stakeholders' interest and dynamic business conditions, the consensus decision making of a mutual governance model becomes slow and cumbersome. A demutualized stock exchange with a profit-oriented corporate model, will enable management to take actions that are in the best interest of customers and exchange itself. Above all, with the separation of ownership from its trading activities, there will be greater independence from its members regarding its regulatory functions.
Investor participation is another key advantage of a demutualised stock exchange. In a mutual structure stock exchange, only brokers/dealers may be the members; therefore, power shifting may not occur. A stock exchange has many stakeholders- participating organizations, listed companies, and institutional and retail/individual investors. A need to shift the power from one group of stakeholder to another group of stakeholder within the stock exchange may arise. Separating trading rights from ownership will make this shift to occur easily and in a way which is more feasible economically and politically. Most importantly, attracting institutional investors and retaining them by accommodating their needs will be much easier as shifting of powers will occur automatically in a more flexible demutualized stock exchange. We must not forget that in a demutualized stock exchange, institutional investors are not only customers but can be a potential investor too.
Finally, demutualization will also provide resources for investment. Many research papers have already identified the need for investment in our stock exchange infrastructure. As we all know an efficient capital market is defined as a market in which stock prices reflect all the information available to the market about future economic condition of the country and future profitability of the listed companies. To make this happen, an infrastructure of sound information system is essential which requires a large amount of capital investment. Capital that will be raised from an initial public offering (IPO) or a private placement of a stock exchange can provide an opportunity to invest in its information system and make its market more efficient.
All the possible outcomes (benefits) described above are already proven in many foreign markets, so there is no doubt about the benefits. On the other hand, we should not forget that demutualization is only a financial tool; it will not itself bring the benefits. It depends on how we use this tool. As proper use of this tool can bring benefits, its abuse at the same time can cause disaster. It is a knife, and the outcome depends on how we are using it. Are we going to use it like a doctor or we are going to use it like a killer?
Demutualization in the developed market is mainly market-led. In short, the objective is to be competitive and mainly initiative is taken by the exchange itself. By contrast, demutualizations in the emerging markets are largely policy-led and initiatives are mainly taken by the government, which is also applicable in our case.
Let us see what are going to be the main challenges for us if we go through this process of demutualization and what we can possibly do if we want it to be fruitful. There are two issues that are to be considered delicately to have fruitful result and they are regulations and financial stability.
Regulation: Stock exchanges usually act as a self regulator and their regulatory functions cover the areas of trading, market manipulation and members' activities. As after the demutualization, stock exchange will become a for-profit organization; so there remains a possibility that regulatory functions may be compromised with the goal of maximizing profit. After demutualization there will be no member, there will be either a customer or an owner or both, at the same time. Will a demutualized self regulated stock exchange be brave enough to conduct its regulatory functions precisely and to impose penalties on those who are its major provider of revenues? This is always a big question that needs to be answered. This problem of regulation even exists in a mutual stock exchange, which might not be as much severe as that of a demutualized stock exchange where drive of profit maximization can make it more severe, but it does exist even in a mutual one. Creation of a separate regulatory entity can be a solution to this problem. As in emerging markets, because the demutualization is policy led, a financial council can be formed which will be chaired by the ministry of finance. Another solution which will be costly but will bring more transparency is to outsource an independent third party regulatory body.
Financial stability: Financial stability is another big challenge which needs to be covered. Revenues earned by the stock exchanges are mainly from membership subscription fees, transaction fees, service fees etc., and if a mutual stock exchange has deficits, it enjoys financial coverage from its government and other donor agencies. As in emerging economies like Bangladesh, a mutual stock exchange is seen as an institution, serving national interest. But the question is: Who will guarantee the financial stability of a for-profit demutualized stock exchange? Its profitable existence is not granted by the for-profit demutualized structure itself. So what happens when a major or the only stock exchange with the demutualized for-profit structure faces financial difficulties and goes bankrupt? We cannot allow this to happen, it would be too big to let go. To avoid such occurrences, liquidity ratios and other financial ratios need to be closely monitored in a timely fashion to ensure a good financial health of a stock exchange with for-profit demutualized structure. To be more secure and keeping in mind that we are risk averse, a reserve fund can be created, which will act as a cushion against such a sort of financial shocks.
In conclusion, what can be said is that if we want to get to the other side of the river, we need to get into the water and swim; no one is coming with a boat for us, or even if someone comes, then it would not be for free. But without learning swimming techniques, jumping into the water would just be committing suicide. As we have set the goal to be on the other side of the river, let us learn the techniques and be well prepared first and if we can afford let us have a life jacket which will act as a cushion against risk and then jump into the river. To be more direct, demutualization is all good but let us not forget it is a tool which has a pre-requisite, it is just a knife and the output depends on how we use it.
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