What is Demutualization of Stock Exchanges

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.

Demutualization is a process of segregation of ownership, management and trading membership

in an exchange. Studies show that demutualization is a mechanism which minimizes the conflict
of interest by reducing the overbearing influence of the members on the affairs and
management of the exchange. The Government has initiated demutualization process in Pakistan
as part of the capital market reforms program. This paper studies the ongoing process of
demutualization in Pakistan and identifies its benefits and challenges. The benefits include better
corporate governance, access to economic and human capital, enhancement in listings and
international alliances. The study also identifies some challenges which are regulatory
framework, conflict of interest, ownership structure issues and agency cost.

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 Demutualization of Stock Exchanges- Position in Pakistan
 19 APR, 2016

Stock Exchanges are basically service provider where investor buy and sell shares and earn
profit. Prior to demutualization these stock exchanges were run by the person who bought
“seats” and also called broker who charge commission on every transaction.

This system was not healthy for the investors because they didn’t have voice and could not
control the affairs of these Exchanges. Basically there was a great conflict of interest between
brokers who are also owner of these Exchanges and investor who buy and sell the shares. So the
need was felt to convert the basic structure of the Stock exchanges. This process resolved many
problem and at the same time also gave rise to other new problems.

Meaning of Demutualization

It can be defined “The process of converting exchanges from non-profit member-owned

organizations to for-profit investor-owned corporations”.

This process was not so simple because government consent is needed to convert membership
rights into shares, which will be followed by the initial public offer and then listing of the
exchange with transferable shares.

Exchange became a limited company for profit. In this way access to stock exchange is not
restricted anymore to membership. The first converted stock exchange was Stockholm Stock
Exchange in 1993 afterwards this trend became popular.

There is often misconception relating to the demutualization. This concept is often linked with
for-profit exchanges, but this is not the only difference. There are many exchanges which give
profits to its owners but these are not demutualized. The core difference lies in the segregation of
ownership and membership.

The more correct definition is given by the World Federation of Exchanges. Which is “The
demutualization of an exchange is a process in which non-profit member-owned organization is
transformed into a for-profit shareholder corporation. Ownership is somewhat open”.

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Position of Stock Exchanges in Pakistan

In our country the stock exchanges corporatization, demutualization, integration act was passed
in 2012. Prior to this act the position was same as in 1990 in rest of the world.

The three main exchanges Karachi, Lahore and Islamabad stock exchanges were running as no
for profit entities. In that structure there were flaws such as, conflict of interest between members
and investors. This resulted in lack of transparency and fairness in the market.

The act gave 119 days to convert them into for profit entities owned by the shareholders.

Factors Affecting Demutualization

The change in the structure of any organization depicts the change in business environment. The
important factors which drove the exchanges to change its structure were the global competition
and technological advances.

The impact of competition

Invention and new technology lead to the rise of new competitors. Off floor trading system
introduced in the exchanges started to compete with traditional stock exchanges and damaged
their liquidity. With these changes the old structure became less applicable.

Another issue was the ability to raise new capital. As the competition between exchanges started,
the investors were looking to pay less commission fees and more profit with fast trading system.
[6]

The Impact of technology

With the advancement in the telecommunication, trading is moving towards electronic platforms
which are not available in certain places. Now the investors can trade without going in the
exchange and without physical interaction, such as Central Depository Companies are providing
such facilities. This system caused lower transaction cost of trading and better price.

With the advent of this, there is now minimal chances for those who wrongly manipulate market.

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Investor participation

Stakeholder like listed companies, institutional and retail investors have become very important
in new system. Under new structure power is shifted from one stakeholder to another by
separating the members from ownership. The new system makes investors as shareholders which
increases the liquidity.

Consolidation

Another factor which leads to demutualization was strategic alliances and consolidation. Stock
exchanges are in competition. That is the reason most of the world’s exchanges have gone
through this conversion to deal with the problem.

Challenges to Demutualization in Pakistan

There are groups which are in favor of this process yet there are also those who objects it. Their
arguments are as follows:

Argument in favor of Demutualization

The demutualization responds to the needs of investors and issuers. It has converted the
perception about financial intermediaries satisfying the market participants.

Now stock exchange is more transparent with the restriction on the market with less bureaucracy
involvement. With the involvement of intermediaries, it resulted in cost saving to investors and
improved access to market.

Self-listing on exchange also helps it to engage in other commercial activities.

Argument Against Demutualization

Major concern of demutualized stock exchanges is to develop and enforce appropriate listing and
disclosure standards, which enhances the surveillance, discipline, and fair and equal treatment of
the customer.

There is also a conflict of interest in running the stock exchange as commercialized entity and as
a self-regulatory organization.

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Then again there is a need to impose more regulation in order to curb the anti-competitive
practices.

In the words of Ruben Lee, the CEO at Oxford Finance Group, “Being demutualized entities,
they will seek profit maximization. They are expected to behave the same way as monopolistic
enterprises, raise price and reduce output”.

Stock Exchanges Regulatory Models

Basically, stock exchanges are regulator and they are mainly concerned about maintaining
balance between maximization of profit and shareholders value of stock exchanges. To
accomplish this objective there are three main models which are running.

Firstly: There is a model in which stock exchange continues to carry out its regulatory function
even after demutualization.

Secondly: The exchanges are set up as separate entity which will carry out only regulatory
functions. This way conflict of interest can be avoided.

Thirdly: The exchanges can outsource its regulatory function to a completely independent third
party, which are governed by the government and subject to accountability hence will avoid the
conflict of interest.

Disadvantages of Demutualized Stock Exchange

Demutualization is a multi-disciplinary issue. These exchanges became profit entities it will

contradict with its role as public entities as service provider. This process raises certain
challenges some of the important ones are as under:

Self-Regulation

Conversion from non-profit to for profit organization is not purposeful unless they put the
interest of investor, issuers and other stake holder first.

Because demutualized exchanges will mainly focus on profit, as a result it will lose its role as
self-regulatory.

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Self-Listing

Another conflict may arise is the listing its own shares on stock exchange. Because it can derive
advantages in this way, but this issue can be adequately resolved if more safeguards are evolved.

Transferability of Shares

In this new structure shares can be easily transferred. But what will happen if hostile takeover
happens and interest of new shareholders are not protected.

Governance

New governing structure is needed in which directors on board will be included from outside.
They will serve to check and promote the integrity in the decision making. It will reduce the risk
of delayed decision.

Conclusion

Stock exchanges are continuously looking to carry out their function as for-profit organizations,
using business polices which are capable to face competition challenges posed by other
competitors and new electronic trading platforms.

Demutualization has also played a pivotal role in the emergence of stock exchanges. It has also
given confidence to investors to invest their capital because now situation has changed and
members are no more the owners.

This separation of ownership and right to trade has put a positive impact in the perspective of
investor’s protection. Apart from the challenges like self-regulation, self-listing, governance,
transferability of shares. It can be said that demutualization is a good step toward the investor
protection.

After reviewing the demutualization process of Pakistan, here are few potential benefits and
challenges.

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