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Demutualization of Stock Exchanges

The move towards demutualization of stock exchanges started in 1992 with the corporatization of Stockholm Stock Exchange. Today, all major regional and international stock exchanges are demutualized which include jurisdictions like India, Malaysia, Hong Kong, Singapore, Japan, Germany, Australia, the USA, UK etc.

If we see it in the historical perspective, stock exchanges globally were mutual entities where the members enjoy rights of ownership, decision-making and trading. Over time however, technological advancement, globalization, growing competition and concern for investors’ interests all put increasing emphasis on the need for stock exchanges to be cost-efficient, transparent and more widely accountable which led to the concept of demutualization. Demutualization of stock exchanges essentially refers to the process of converting a non-profit, mutually owned company limited by guarantee to a for-profit entity limited by shares.

Pakistan’s capital market has seen a number of significant reforms since year 2000 led by the Securities and Exchange Commission of Pakistan (SECP). The reforms were focused on governance, risk management, market development and investor protection with the objective to make the markets fair, efficient, and transparent and enhance its capacity for capital formation. The SECP as part of its reform process restructured the board of directors of the exchanges with appointment non-broker professional directors however, as self-regulatory organizations the decision making process at the exchange remain inherently conflicted. This is predominantly for the reason that members being owners have sole trading rights and dominant participation in various committees of the exchange which results in bias decision making, jeopardizing the interest of the stakeholders in particular the investors.
Also, due to lack of resources our exchanges have not been able to grow to the expectations of investors as trading activity is mostly concentrated in three buildings of these exchanges. Realizing this, the apex regulator initiated the process of demutualization of stock exchanges under the aegis of the Asian Development Bank Financial (nonbank) Markets and Governance Program 2002-2005. To facilitate the corporatization and demutualization process a separate legislation i.e Stock Exchanges (Corporatization, Demutualization and Integration) Act was drafted in consultation with the stakeholders. The Act has been promulgated after receiving the assent of the Presidential on May 7, 2012.- This is the beginning of a new era for capital markets in Pakistan!

The Demutualization Law

The Demutualization law provides a framework for corporatization, demutualization and integration of the stock exchanges. The stock exchanges shall be demutualized within 119 days of its promulgation.

The pre-defined timelines specified for completion of various milestones involved in the demutualization exercise are as follows:

Within 45 days of the promulgation of the law stock exchanges shall submit to the SECP for approval valuation and re-valuation reports, list of first four directors, memorandum and articles of the company, a detailed five years capital market development plan, plan for the segregation of the commercial and regulatory functions of the stock exchange and list of initial shareholders/members.

Within 30 days of receipt of these documents the SECP shall communicate its approval along with names of six SECP nominee directors to be appointed on the board.

Within another 30 days time period the exchanges shall allot 100% of its shares to existing members and deposit 60% of these shares in a CDC account with blocked status. The shares kept in blocked account shall be later divested to the strategic shareholder(s) and general public. The exchanges shall also issue trading right entitlement certificate to each initial shareholder/broker and through a special resolution of its general body approve bylaws of the company.

Within 7 days, the exchanges shall within submit to the Registrar of Companies documents evidencing completion of theses steps.

Within 7 days, the Registrar shall issue a certificate of re-registration to the exchange and the SECP will approve the first directors including SECP nominees to hold office.

The Demutualization bill allows 40% of the shares to be retained by existing members, 20%  to be issued to the general public through an IPO and the remaining 40% to be sold to strategic international investor(s) such as global stock exchanges, central depository , clearing company and/or financial institutions. The law allows the exchanges to be listed on their own floor where investors would have the opportunity of investing in the self-regulatory organizations and SECP to supervise such self listed demutualized exchanges.

The board of directors of a demutualized exchange shall initially comprise of four directors elected by the initial shareholder/members and six non-broker professionals nominated/appointed by the SECP. These six SECP nominated directors shall be replaced by representatives of strategic investor(s) and general public after divestment of shares to them.  Essentially, the trading right entitlement certificate holders or persons connected with these shall not hold majority on the board of any stock exchange with the Chairman of board being a non-broker/not holding trading right certificate.

Advantages of Demutualization

A wide range of merits of demutualization have been observed. Broadly speaking demutualization would lessen the conflicts visible in a mutualised set-up. It leads to improvement in the governance structure, segregation of regulatory functions from commercial functions and separation of trading rights and ownership rights. Demutualization/corporatization would also assist in attracting international strategic partners and good quality issuers. As such institutional investors prefer to invest in markets where the exchange demonstrates strong corporate governance, market surveillance and enforcement in the belief that such markets are less likely to experience endemic market speculation and manipulation or be threatened by systemic failure.

Also, greater competition among brokers, broader participation by investors, and rising turnover shall improve liquidity and price discovery without a parallel increase in trading costs. Strategic alliances and straight-through trading linkages will assist in enhancing outreach of market which is presently limited with a narrow investor base. Historically brokers and exchanges were locally focused. Exchanges did not face meaningful competition from exchanges in distance places. Through alliances, exchanges seek to attract more investors by harmonizing distinct trading environment and by offering greater product variety.

Demutualization will also facilitate consolidation of brokers leading to financially strong entities. As such demutualization serves in the interest of all stakeholders including the broking community who stand to gain from increased market liquidity that comes from better governance of the exchange and improved reputation.

Although there is long list of benefits associated with the demutualization of a stock exchange, however it needs to be borne in mind that demutualization will remain a means to the end and not the end itself. A demutualised entity may be exposed to a unique set of variables and challenges that need to be tackled in a planned fashion to term it as a success story!

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