Demutualization is the current trend among stock exchanges all over the world. It is the process of converting an organization from a mutual entity to a shareholder owned corporate body. Traditionally, stock exchanges operated as club-like mutual organizations where traders/brokers were the owners of the exchange as well as recipients of its services. Many stock exchanges operated on a not-for-profit basis; excess income was not distributed among the members as profit. The members were the owners of the exchange and also its customers. This is a distinguishing feature of traditional exchanges. On the other hand, in a profit making corporate body, the owners, decision makes and customers are three separate groups. By demutualization, an exchange’s mutual ownership structure is changed to a share ownership structure, therefore segregating ownership, management and functionalities. The first stock exchange to demutualize was the Stockholm stock exchange in 1993. Today, all major stock exchanges around the world such as exchanges in India, Malaysia, Hong Kong, Singapore, Japan, Germany, Australia, the USA, the UK etc are operating as demutualized exchanges.
This significant change in the business model of stock exchanges in the developed countries has sometimes been attributed to growing market competition and integration, globalization induced by cross-border listing, portfolio flows and migration of trading orders to overseas markets and concern for investors’ interests. Growing competitive pressure has sometimes resulted in restructuring, mergers and alliances for greater market reach, maximization of profit through economics of scale and accessibility. The Chicago Mercantile Exchange, Singapore stock exchange and others have formed global alliances with participants from all time zones, thereby creating around the clock trading facilities. However, the motivation for demutualization between developed and emerging markets seem to be quite different – the later being regulatory driven.
In our country, demutualization of both the exchanges is at the centre of the current reform initiatives taken by the government surrounding the capital market. In line with the government’s agenda, both the stock exchanges have made significant progress in this respect. Once demutualized, a stock exchange becomes fully exposed to market forces like any other business. Therefore the role of the regulator and the level of co-operation and trust between the regulator and the exchange being demutualized are absolutely vital. Measures taken without consensus between all the stakeholders seldom achieve as expected – specially for something as sensitive and complex as exchange demutualization. In order to succeed, policy-makers should adopt a consultative and consensus-seeking approach.
In many countries, the demutualization process was facilitated by legislative enactment. In some countries, comprehensive legislations have addressed the demutualization issue at the fundamental company or securities law level, e.g. the Australian Corporations Law and the Philippines Securities Regulations Code. In India, exchange demutualization has been embedded into the principle securities legislation. In our country, changes to existing law can be made to incorporate demutualization issues or a separate and independent Act can be enacted. However, a single new Act may not be enough to properly implement the process. Changes to some existing Acts, rules, regulations and other by-laws will be required.
The mode and process of demutualization varies considerably from jurisdiction to jurisdiction. Depending on the legal and regulatory framework, conversion can take many forms and routes. Mutual exchanges operate like clubs or associations. In that case the first step is corporatization; that is, the exchange is converted into a company limited by shares from whatever legal entity it was before. In common law jurisdictions, this process may become cumbersome without special law since company law usually does not address the issue of conversion to a company limited by shares from other forms of business entities. Demutualization should not in any way adversely affect the exchange’s continuity of operation, functions, undertakings or liabilities. The new law should address this issue specially if the exchange needs to be registered or re-registered as a company.
Once corporatized, a proper valuation of the exchange needs to be carried out, preferably by internationally reputed organizations for greater acceptability. Following valuation, other matters like the capital, number of shares, number of share allotments, mode of offerings, composition of the board of directors etc. will need to be determined. The memorandum and articles of association of the exchange is likely to go through major revisions to incorporate these changes. There are also issues like voting procedures, accounting, taxation and reporting requirements, dividend policy, rules and regulations for governance, future plans for commercial and regulatory functions etc. to deal with.
By demutualization, the ownership of the exchange is separated from the right to trade in the exchange. Thus trading rights entitlement becomes a distinct issue. Existing members essentially become trading rights holders irrespective of whether they own any shares or not. A major concern for traders in pre-demutualization is the protection of their interests. Members generally want to be adequately compensated if they give up their ownership of an exchange. This can be achieved by dilution of the ownership into shares. Members can choose to retain their shares – in which case they will own a stake in the exchange or they may choose to sell their shares in the market. Irrespective of this, a member’s right to operate as a trader in the exchange is managed by separate criteria. It would no longer be necessary for a trader to become a member of an exchange to be able to operate as a trader/broker. The trading services of the exchange will come under separate licensing mechanism as prescribed by the regulator and should not have any relation with ownership or management. A moratorium or suspension on granting of new trading licenses is sometimes applied. In such a case, new trading licenses are not granted during that time. The total number of trading license holders at any given time also can be fixed. These measures are taken to ensure that small brokers are protected against the competitive impact resulting from new entrants.
In line with profit-making organizations, a demutualized exchange will have separate and independent management body. This body will be diversified and in principle should not be dominated by traders/brokers as in the case of traditional exchanges, resulting in increased accountability and transparency – two of the expected benefits of demutualized exchanges. Ownership will shift from the existing members to the shareholders who will buy the shares of the exchange. Exchanges sometimes choose to enter into partnerships with big investors to boost growth by offering a certain portion of total shares. This can be a well reputed foreign exchange or other entities designated by the regulator. Stock exchanges in Bangladesh can greatly benefit from such an alliance if done properly. Many demutualized exchanges offer shares to the public through self-listing or through other exchanges. In case of self-listing, the main market regulator usually supervises the whole process. Enlistment on overseas exchanges is also a possibility.
Demutualized or not, all stock exchanges inherently exercise regulatory functions. Dealing with conflict of interests between an exchanges’ regulatory and commercial function is a major issue. This can be facilitated by creating new subsidies. This ought to be thoroughly thought out and planned before-hand. Another major challenge will be to make the exchange profitable and self-sufficient after demutualization. Unfortunately, it is not uncommon for demutualized exchanges in the emerging markets to show a tendency to resist growth after demutualization. This could be a major area of concern and stock exchanges in our country will need to address this issue. Diversification of services and attracting foreign investors could be a good starting point.
Stock exchange demutualization is a challenging issue, both from regulatory and business perspectives. Members’ participation in the process is vital, as is the cooperation of the regulatory authorities. A major challenge in the process is to balance different interests and objectives of the relevant stakeholders without compromising the purpose. Demutualization can take many shapes and forms and the experience varies considerably across the globe. There being no defined formula for success, considerable uncertainty must be taken into account. It should be borne in mind that demutualization is not the end in itself rather a means to an end. A proper understanding of all the issues, openness to new approaches and a high level of co-operation among the stakeholders is fundamental to any successful demutualization.