Traditionally stock exchanges have operated on a not-for-profit basis as mutual associations owned by their members in developed countries and as entities owned by the government in emerging economies. Since the early 1990s there has been a trend among exchanges to consider alternative governance structures to the traditional models. In most cases, stock exchanges have been transformed from not-for-profit to for-profit organizations driven by technological and competitive forces.
The process of conversion of an exchange from a not-for-profit to a for-profit organization is often described as “demutualisation” whereby its equity is opened up to public ownership.
 The three main objectives of securities regulation as expressed by the International Organization of Securities Commissions (IOSCO) are: the protection of investors; ensuring that markets are fair, efficient and transparent; and the reduction of systemic risk. In countries with multiple developed and sophisticated capital markets, another objective of securities regulation is enhanced competition. The two-fold regulation by governmental body and industry organization has continued within the U.S. and the principle has been exported to other countries as well. According to the two-fold regulation a Securities Commission generally has the decisive responsibility for regulating exchanges and their participants whereas Exchanges can play a significant role in regulating the markets. Exchanges are considered closer to the marketplace and serve as self-regulatory organizations (SROs).
The Securities and Exchange Commission of Sri Lanka (SEC) is the government regulator for the capital market in Sri Lanka whereas the Colombo Stock Exchange (CSE) is a self-regulatory organization. The CSE has a mutual ownership structure and is organized in the form of a company limited by guarantee and incorporated under the Companies Act of Sri Lanka and licensed by the SEC to operate as a Stock Exchange in Sri Lanka.
The distinguishing feature of the traditional stock exchange structure is its “mutual governance” model. As the CSE is a company limited by guarantee, where the liability of its members is limited to the respective amounts that the members undertake to contribute to the company if it is wound up, the demutualisation process entails converting membership into shares.
In other words the process of converting from a mutual member-owned company to a public company with a more diverse ownership is called demutualisation. The process requires first converting memberships into shares, which pace may or may not be followed by a public issue of those shares. In this way, a quasi-governmental institution converts itself into a profit-oriented, publicly owned/traded company. The first stock exchange to demutualize was the Stockholm Stock Exchange in 1993. It was followed by a wave of other exchanges, including major European Exchanges – London Stock Exchange in 2000, Euronext in 2000; major North American Exchanges - Nasdaq in 2001, New York Stock Exchange (NYSE) in 2006, Toronto Stock Exchange in 2000; and major Asian/Oceania Exchanges: Tokyo Stock Exchange in 2001, Osaka Stock Exchange 2001, Singapore Stock Exchange in 1999. The stock exchanges of Brazil, Sri Lanka, Pakistan, Philippines, and South Africa have announced plans to demutualize and list their shares. Sri Lanka’s SEC has recently invited suitably qualified parties for provisioning of independent consultancy services on demutualisation of the CSE.
Stock exchanges are demutualized for diverse reasons including: competition; technology innovations; internationalization of membership; and investor participation. One of the main reasons is to raise additional capital to expand and innovate. The increased complexity of the capital markets necessitates stock exchanges to invest in technological infrastructure that will speed up the processing of orders and reducing transaction costs for investors. A mutually owned stock exchange is barely able to raise capital from anyone other than its members. Further a demutualized exchange operates in a more customer-focused way and is able to take action more straightforwardly and speedily to changes in the business environment and meet competitive challenges. Responses from the IOSCO survey show that one of the main drivers cited for demutualisation in emerging markets that have chosen this path is the increasing competition for global order-flow.
However it is important to note that to compete successfully with each other for listings, exchanges would lower their listing and reporting standards in order to allow more companies to list thereby exchanges can obtain more listing fees and transaction fees. On the other hand, other exchanges will in fact put in place more stringent standards in order to differentiate themselves from other exchanges. For example, the NYSE has, in fact, adopted such a strategy to distinguish itself from other exchanges and companies seek to list on the NYSE because of the reputational capital that comes with listing on the world’s foremost exchange.
Emerging market jurisdictions such as Sri Lanka, Malaysia, Pakistan and India encounter different implementation concerns in the process of demutualisation. In emerging markets, the threat of competition from Alternative Trading Systems (ATSs) and Electronic Communication Networks (ECNs) was not a pre-dominant driver for demutualisation. The rare exception was Pakistan, where it was noted that members of stock exchanges showed considerable interest in demutualisation after the SEC of Pakistan granted a license to PEX Limited to operate as an ECN. One fascinating characteristic of demutualisation efforts in many of the emerging markets is that they are usually led by either the government or the regulator. In most emerging markets, there is only one (Thailand, India, Malaysia, Sri Lanka, Philippines and Turkey) exchange or, in cases where there are a few, only one dominant exchange (there are three stock exchanges in Pakistan, however the Karachi Stock Exchange is the dominant exchange).
An exchange which is limited by guarantee prior to demutualization like CSE may have difficulty in arguing ownership of the exchange belongs to its members. Often within developed market jurisdictions, demutualisation is discussed within the context of competitive pressures necessitating a restructuring of exchange operations.
Further, self-regulation also has a number of risks arising from the conflict between the interests of the members and the public. A for-profit structure increases the range and intensity of conflicts because revenues must meet expenses and generate a rate of return for investors. As a result a for-profit structure may be reluctant to allocate adequate resources to enforcement. In addition, as a regulatory function imposes additional cost, having a regulatory arm makes a corporation a less attractive candidate for an initial public offering (IPO). Therefore the government should supervise SROs so that regulatory responsibility is shared between the SRO, as regulator, and the government, as supervisor. |
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