A. What is Demutualization?

Demutualization is the term used to describe the transition from a mutual association of exchange members operating on a not-for-profit basis to a limited liability, for-profit company, accountable to shareholders. Essentially, demutualization separates ownership (and voting rights) from the right of access to trading.

In most advanced economies, exchanges historically predated securities regulation. Exchanges began as private clubs, or curbside meetings, that eventually adopted a formal structure. Eventually rules were developed setting time and place of trading, priority of trades, and price-setting mechanisms. Exchanges formalized their ownership structure by granting “seats” to members—a seat entitled the owner to trade on the floor of the exchange (or “sit” on the exchange) and each seat holder had an equal vote on the exchange’s affairs.⁶ Only those with seats were entitled to trade. The mutuality of this structure was generally reinforced by a prohibition on members trading elsewhere—that is, for the purpose of the securities traded on the exchanges, members pledged to trade only with each other and only through the exchange. Nonmembers could not trade on the exchange or with members.⁷ This arrangement made sense in a closed economy—the monopoly exchange was the most efficient means of pooling sufficient liquidity to support the capital-raising process.

Exchanges began taking on a regulatory function as a credit screening mechanism aimed at assuring other participants that the other side of the trade would settle. Restrictions on membership grew into a full range of regulation governing members. Many exchanges were granted special charter status under law—often governed by a special act of the legislature—and all were not-for-profit entities. Finally, exchanges began to be seen as institutions which served a public function, as well as, private clubs. Securities regulators, once established, and were granted authority to regulate exchanges.

Demutualization alters the governance structure of the exchange although its operations and services may remain the same. The exchange may still be regarded as serving a public function and may act as a regulator. Access to trading becomes a matter of contract with the exchange— dealers simply sign up as users or participants. Shareholders, a separate group, are entitled to the profits obtained from market operations. And whereas the exchange previously operated on a not-for-profit basis, with demutualization, it becomes a for-profit company, offering service to market intermediaries and listed companies. The corporate raison d’etre of the exchange alters completely—it is now organized around profit rather than as an extension of the business costs its members incurred as market intermediaries.

Demutualizations have generally occurred in stages, as illustrated by the examples provided later in the paper. The initial stage is an exchange of membership (or seats) for shares in the new corporation—usually current members receive shares equal in proportion to the voting rights they previously held as members (i.e., if a member owned 3 seats of a hundred, that member now holds 3 percent of voting shares). The exchange becomes a for-profit private corporation but ownership remains in the same hands. Some exchanges have created a private corporation through a private placement transaction that involves a wider group of shareholders—usually listed companies and institutional investors. A “full” demutualization requires a further step—a public offering of shares that are publicly tradable and widely held. Few exchanges have reached this stage.

A. The Market for Markets

Competition for liquidity comes from two sources: interlisting/cross border listing and the development of new exchanges and alternative trading systems. Both have been made possible by the appearance of electronic trading and the wide real-time dissemination of trading data which has broken down borders and allowed investors to access markets anywhere in the world.

Interlisting occurs when a single security is listed and traded on more than one exchange. Interlisting has become the norm for very large ‘blue chip’ companies—often the shares of companies are traded on their own national exchanges as well as the NYSE or Nasdaq (for example, Nokia and Nortel). This is a relatively new (and growing) phenomenon that relies on electronic trading, the real time dissemination of trading data to a wide area which enables the system to bring together investors from a very broad area (indeed, now the globe).

Exchanges, of course, mostly began as regional marketplaces, listing regional securities and providing investments to local people.¹⁰ In a closed economy, the exchange acted as the central liquidity pool for equity investors in that economy. Many exchanges now feel the pressure of competition for order flow since investors now have a wide range of choice and are most likely to direct order flow to the exchange that provides the deepest liquidity (and therefore cheapest and fastest execution of the trade).

Cross border listing is an extension of interlisting—now companies can interlist on their own national exchanges as well as on a larger foreign exchange. Most major exchanges (with the notable exception of the New York Stock Exchange and the Hong Kong Exchange) are now fully electronic and participation is no longer tied to location, which means that exchanges do not have a natural territory. Cross border listing allows liquidity to move across borders which has caused some exchanges to lose liquidity. This was true of the Stockholm Stock Exchange, for example, which before its demutualization in 1993 was consistently losing order flow to the London Stock Exchange—a turnover tax in Sweden made it cheaper to trade interlisted securities in London.

The emergence of new marketplaces has been made possible by cheap technology (lower barriers to entry) and by the huge increases in volume of trading which has rendered the operation of markets profitable, causing competitors to enter the market and compete head on with exchanges. These new marketplaces are both new exchanges and alternative trading systems (ATSs). An ATS can be described as an automated system other than an exchange that brings together buyers and sellers of securities in a way that results in an irrevocable contract of trade.¹¹ ATS do not regulate users (except to create trading rules specific to their systems) and do not carry out a listing function.

Alternative trading systems have threatened the traditional role of exchanges as providers of liquidity¹² by offering cheaper trade execution. In response to competing exchanges and ATS, some exchanges have been forced to reduce their trading costs in order to maintain competitiveness for order flow. In some cases, ATS also provide alternative and faster execution methods, which have caused the exchanges to alter their traditional methods—for example, by providing extended trading hours, or alternative price discovery mechanisms.

The extent of the ATS competitive threat to exchanges is not yet clear. Most ATS currently operating rely on exchanges as the major market in a security while providing adjunct services and rather than presenting themselves as a wholly alternative market. The exception to this might be ATS that specialize in bond trading. In any event, ATS do present a different business model (limited liability companies without a regulatory function) and have been the first serious competition to exchanges and much of the debate over demutualization at exchanges has centered on the threat posed by ATS.

B. Increasing Divergence of Member Interests

Historically, members of stock exchanges were dealers with a similar model of business. The brokers were either trading specialists (proprietary traders or speculators) or full-service brokers with a combination of trading, underwriting, retail and institutional businesses. These firms offered more or less the same client services, with more or less similar profit margins. In fact, in many countries, commission levels were determined by regulation and there was little competition. The homogeneity of members lent itself to the mutual association structure.

The securities industry has, of course, changed enormously in the past 30 years. The automation of trading and the proliferation of electronic information have had a massive impact on the brokerage business. Trading volumes have soared, cash has flooded into the market and investors have an enormous amount of information available to them. Businesses have unbundled and rebundled services partially in response to unfixing of commissions—when commissions were unfixed in North America, for example, competition between firms began in earnest. Trading commissions may no longer subsidize advisory or research activities, for example, and dealers have had to market such services separately. New technology—most notably, client on-line access to trading and information—has also forced a re-examination of the business model. Some dealers have specialized in retail clients who don’t want advice, others in institutional clients only. New intermediaries, including banks, have also entered the market, increasing competition and forcing innovation.

As a result of these changes, the members of an exchange are increasingly less homogeneous. Further, consolidation and the emergence of huge financial conglomerates has fragmented members of some exchanges along the lines of size and global reach. Recurring conflicts between large and small members of exchanges has surrounded the future business direction the exchange should take—small firms may want more common technology where big firms don’t need it, big firms may want global alliances whereas small firms may see their business threatened by allowing cross border trading. Large global financial institutions have less stake in the mutual structure since the traditional structure often favours local intermediaries that have more stake in market making and specialist activity.¹³

The appearance of ATS has sharpened the divergence of member interests. Many, if not most, ATS are owned by financial conglomerates or by a consortium of brokerage firms (for example, EuroMTS, Archipelago and Tradepoint). Members may have different abilities to compete or fill niches not threatened by ATS. In any event, it is clear the members of the exchange “benefit or suffer from ATS competition differently”¹⁴ making the mutual association’s task of facing ATS competition quite difficult. Without demutualization, an exchange continues to be an extension of the interests of its broker owners. When those interests are not common, innovation and competition are impeded.

C. New Focus for Exchange Operations

The logic of the traditional member-run exchange has, therefore, been eroded and the business aims of the exchange have changed—exchanges have become technology providers, requiring expertise and skill that may be much different from that of running a brokerage business. Professional management is now required to an extent it has not been before and the expertise on a governing board consisting of brokerage firm members is not matched with the needs of the exchange. In order to remain competitive in the world of electronic market places, exchanges have struggled with this mismatch of expertise and the fragmentation of member interests. A greater role for professional management, without the need to gain consensus of the brokerage firm members or meet the needs of individual members, may improve the exchange’s ability to face competition with innovation or by entering into alliances with other exchanges or ATS.

D. Alliances and Mergers

One response to increased competition—particularly cross-border competition from large exchanges that draw listings and trading globally—has been the formation of alliances and mergers between exchanges and marketplaces. A small exchange threatened by larger exchanges or marketplaces may see an advantage in forming a partnership with others—the alliance or merger can pool listings and allow members of one exchange access to a larger variety of instruments. The most successful example of this has been Euronext, the alliance of the Paris, Amsterdam and Brussels exchanges. Each of these exchanges faced stiff competition from the larger London Stock Exchange and Deutsche Bourse. The alliance has created a Europe-wide exchange which now effectively competes with the larger exchanges—Euronext, which came to be in 2000, now claims 25 percent of trading volumes in Europe.

Alliances and mergers are made possible by demutualization which creates a more streamlined, operations-oriented approach to the business of running a market and which can move beyond its members. It is unlikely that a traditional mutual organization could move quickly enough to capture merger or alliance opportunities even if the interests of members could be satisfied.

E. Capital

Demutualization, when it proceeds to the public offering stage, releases the exchange’s ownership value and raises capital for the exchange. It is notable that in advanced economy countries, capital raising has not been the main force in support of demutualization. This appears to be the case also in emerging markets where, as discussed below, demutualizations appear to be regarded both as a mechanism through which to rid the market of corrupt self- regulation and a spur to innovation in the exchange.

F. Regulatory Pressure

Demutualizations in advanced economies appear to have been driven by business considerations rather than by regulatory concerns—although in cases such as the NASD/Nasdaq, increased scrutiny by regulators has resulted in a re-engineering of governance structure that is compatible with the changes necessary to engineer a demutualization. However, in emerging market countries, regulatory concerns may be the impetus for demutualizations which seem, more often than not, to be driven by the authorities in an attempt to wrest control of a institution that serves a public role and as a regulator from a self-interested group of brokers—the traditional model fails to deliver an appropriate level of regulation or fails to sufficiently develop the capital markets because the exchange is controlled by the interests of the members which may not be the same interests as those of the capital market as a whole. Examples of emerging market demutualizations are discussed in detail below.

A. Streamlining Operations

Demutualization requires an exchange to focus its business differently—accountability to shareholders who are not all members and the for-profit nature of the exchange mean that operations will have to be tailored to meet market needs and therefore generate profits. No longer constrained by individual member expectations, the exchange can choose to streamline its operations or add new innovative services. For example, an exchange might sell off its money-losing derivatives operations and specialize in equity products—despite the objections of some members whose revenues depended on the derivatives operations. An exchange might offer direct access to institutional clients—a service that has growing appeal but which is in direct competition with the business of the members.

B. Streamlined Decision Making

Similarly, the demutualized exchange, because it is further separated from its members’ control, may have more professional management and may be more efficient in its decision making—allowing the exchange to respond quickly to change and to remain innovative and competitive. One of the drawbacks of the mutual organization has been the (real or perceived) cumbersome decision making process inherent in a mutual governance structure, which often involves discussion and consensus in member committees and at the board and through which, ultimately, a minority of members might successfully block decisions not in their individual interest.

C. Capital

A demutualization can provide an influx of capital that the exchange can use to improve technology, seek innovation in technology and services or acquire other markets. A year following its demutualization, the Toronto Exchange purchased the only other equity-trading exchange in Canada (the Canadian Venture Exchange) thus consolidating the Canadian market and eliminating a source of domestic competition. OM Gruppen, the holding company of the Stockholm Stock Exchange, has used its capital to expand both its trading technology business and its trading system business. It has purchased the Jiway trading system in London—after famously making an unsuccessful bid for the London Stock Exchange. An examination of demutualizations reveals, however, that raising capital has not been a driving force for demutualization.¹⁵

A. What Do Regulators Care About?

Regulators are mainly concerned about three things: (1) that the exchange remain a viable institution and that if it does not, there is an orderly winding up of the exchange; (2) that the exchange treat listed companies and market intermediaries fairly; and (3) to the extent that the exchange continues to carry out regulatory functions, those functions be well and fairly executed. Or as an Australian parliamentarian put it, during the debate over demutualization of ASX, the issue is:

whether the commercial pressure [or governance structure] of a for-profit entity will undermine the commitment of resources and capabilities of the exchange to effectively fulfill its regulatory and public interest responsibilities to an appropriate standard.¹⁶

Two elements weave through these concerns: first, how does the regulator go about supervising a demutualized exchange and how is that different than its supervision of a traditional exchange; and second, to what extent can the exchange maintain its role in regulation of the capital markets and, if it can no longer carry out regulatory functions, where will those functions be housed?

B. The Regulator’s Role in Demutualization

Regulators, by in large, have the authority to approve or disallow a demutualization transaction. Regulators may be granted the power to license or “recognize” an exchange under securities legislation or may be appointed supervisor of an exchange in another way.¹⁷ The Swedish Financial Services Authority, for example, has licensing authority over the exchange—the proposed merger of the securities exchange and the derivatives exchange that created Stockholm Stock Exchange was a material change to the terms of the license of both exchanges which therefore required regulatory approval. Regulators may have established criteria for recognition as part of their oversight of the exchange. Often regulators have the ability to delegate regulatory functions to the exchange and through this retain a certain authority over the exchange’s transactions and operations.

Demutualization has coincided with a trend among regulators to pay greater attention to the role of SROs and exchanges. It has been a global trend to grant securities regulators greater power (often in the form of self-funding and greater independence from government) and more powerful regulators have turned their attention to the regulation of market participants. Historically, securities regulation in advanced economy countries has tended to focus more on the regulation of public companies (disclosure) rather than on the market conduct of participants or marketplaces. This seems to have been due to the origin of exchanges, their special status under legislation and a general lack of innovation or change.

The situation has changed enormously in recent years as SROs and exchanges have become a very great focus of securities regulators. One of the watershed events in this respect in North America was the SEC’s enforcement action brought against the NASD. It is notable that the enforcement action did not begin as a result of the SEC’s own oversight program but as a result of a study by academic economists whose study of bid-ask spreads on the Nasdaq market concluded that they were artificially wide. For their part, the U.K. authorities undertook an examination of the state of financial services regulation in the 1990s and concluded that SROs are unworkable and stripped the SROs and exchanges of most of their regulatory responsibilities and handed those responsibilities to the Financial Services Authority. Since these events, oversight or supervision programs for the exchanges and SROs has been a hot topic among securities regulators. Many regulators have recently instituted oversight programs where none had existed before.

The history of regulator-exchange relations suggests that while many of the issues that have arisen in the context of demutualization did not arise with traditional exchanges, this may have been more a lack of focus on the part of regulators than the issues related to demutualization specifically. There are, however, unique regulatory issues that do arise and these are discussed below.

C. Regulatory Role of Exchanges

Self-regulation, of course, carries with it an inherent conflict of interest—those responsible for regulation are those being regulated. The management of the conflict requires active supervision by the government regulatory authority and appropriate mechanisms for oversight such as review and approval of rules by the regulator, onsite examination and access to books and records by the regulator, appropriate administrative procedures for hearings and other decisions and transparency and disclosure requirements.

The introduction of a demutualized or for-profit structure brings with it another set of conflicts—the conflict of shareholder interests and the interests of appropriate regulation. The first potential conflict of interest is that shareholders, who are interested in profit, may under fund the exchange’s regulatory function. While in theory, the exchange should only benefit from an adequate regulatory standards, exchanges may succumb to competitive pressure— especially those competing against ATS that have no such regulatory role or costs. The regulator must ensure that the regulatory function is properly funded. The regulator must also prevent cross-subsidization of the exchange’s functions.¹⁸ For example, if the exchange competes against other trading systems but is the sole self-regulator (and therefore has a monopoly on regulatory services) the exchanges should not be allowed to use its regulatory revenues to fund the trading system operation.

The second conflict of interest is the disincentive to regulate market participants (who represent order flow and are a direct source of revenue for the exchange) and listed companies (who provide the listing and pay listing fees, another source of revenue) when both of these groups could withdraw liquidity from the market. The increase in available marketplaces allows market participants and listed issuers to take their business elsewhere—creating a disincentive for the exchange to regulate these entities. Competition for listings is fierce and many exchanges have begun to argue that the listing function is not a regulatory function but rather a “branding” function. Regulators who rely on exchanges for all regulation of issuers should be especially

concerned.¹⁹ Neither the standards for participants or issuers nor the enforcement of those standards should be permitted to erode as a result of demutualization.

The last conflict of interest is the regulation of competitors. An ATS can be participants on the exchange and therefore be regulated by the exchange. A brokerage firm owner of an ATS might also be directly regulated by the exchange. Intense competition might be an incentive for the exchange to impose rules and regulations that are anti-competitive or to enforce rules against the competitor differently. The ASX, for example, recently bid for the Sydney Futures Exchange at the same time a rival bid was made by a technology company listed on the ASX. The potential for conflict was obvious—as the regulator of the listed company the ASX would have access to confidential information and the right to make decisions binding on the company that could affect the bid. The Australian Securities and Investment Commission (ASIC) had to step in to directly supervise the handling of the technology company’s listing matters for the duration of the bid.²⁰

This conflict of regulator competitors may be the most pressing of the conflicts of interest. It may be an issue that regulatory oversight cannot resolve and may result in exchanges giving up regulatory power.

D. The Public Role of an Exchange

Exchanges play a key role in the functioning of the financial sector and can have an important impact on the functioning of the overall economy. Should an exchange cease to open for trading as a result of financial insolvency, the economic impact might be great indeed—investors rely on the exchange to establish liquidity for their investments; companies need the exchange to value their shares and provide a forum for investment.

The viability of an exchange was not a topic much discussed in advanced economy countries prior to the advent of new trading technology and ATS. Most exchanges were the sole trading platform for the local/national brokerage industry; most investors relied on the national or local exchange for a location to trade. Little thought was given to the possibility that they might fail. If, for some reason, there was a threat of insolvency, contributions could be expected from members who were liable for the exchange.

Once an exchange becomes a limited liability company facing competition and, therefore, is more threatened financially, the viability of the exchange might be an issue for the authorities. Questions of regional or national interests may arise as cross-border operations threaten local exchanges—many countries will be reluctant to allow an exchange to wind-up.

E. Approving a Demutualization: Specific Issues

Corporate governance: The public interest responsibilities of the exchange—its regulatory role and its place as a part of the financial structure—create special corporate governance needs. Particularly, the composition of the board and key committees (for example the audit and regulation committees) should be carefully considered. In North America, the strong trend has been to move toward exchanges (and SROs) with 50-50 boards—that is, to have equal numbers of shareholder or industry representatives and independent non-industry representatives. This governance structure has been installed at the NYSE, NASD and the Canadian exchanges. Even though not all of these bodies are demutualized strong concern over self-regulation has led to these requirements. Regulators have also required audit committees to have 50 percent independent representation. The board of governors of the new SRO for market regulation created after the demutualization of the Toronto Stock Exchange is also required to have 50 percent independent representation. The demutualization of the Singapore Exchange (SGX) was approved on the condition that the appointment of the Chair and CEO of SGX must be approved by the Monetary Authority of Singapore and a nominating committee, whose members are approved by the Monetary Authority, must be constituted to recommend all board appointments.

In addition to board and committee composition, regulators have considered reporting and financial filing requirements for the exchanges—including annual financial filings, annual reporting or self-assessments made to the regulator and additional disclosure to shareholders regarding regulatory activities. Regulators have also begun to include corporate governance issues in on-site examinations.

Financial viability: The concern that an exchange remain financially viable is perhaps a concern generated more by the advent of competition rather than by demutualization itself. However, as mentioned, the viability of an exchange as a key institution in the financial sector has become an issue in demutualizations. In many countries, the winding-up of an exchange is likely to be intolerable to authorities, particularly if the exchange is regarded as the national exchange although it should be noted that where an exchange is not independently viable, a range of options including international alliances could be considered. In the event, it will fall to the regulator to monitor the exchange’s financial condition—not only to inform the policy discussion on the future of the exchange but also to prevent market disruption in the event of a failure.

There is no clear answer as to how the financial viability of an exchange should be monitored— or how the insolvency of an exchange should be handled. The regulator’s options can involve a number of alternatives and combinations. For example, most regulators require filing of annual financial statements. These financial filings give some insight into the exchange’s financial condition. Separate targeted financial reporting can also be developed to assist in the monitoring. Most securities regulators will have general powers to order an exchange to take an action and this could be relied on in the event of an impending insolvency. The Australian authorities opted for the establishment of a reserve fund, a capital cushion for the exchange. There were, however, no restrictions on the use of the reserve fund once the demutualized exchange was in operation.

The Canadian authorities required the Toronto Stock Exchange to enter into an early warning-style reporting system. The exchange developed some financial ratios for the measurement of the exchange’s financial condition. The exchange then has an obligation to report when the ratios are exceeded. The securities regulator then has broad authority to take action or request that the exchange do so. This would allow the securities regulator to prevent new capital expenditures or force the exchange to increase fees or something like this. If necessary, the securities regulator could force the wind-up of the exchange.

Ownership restrictions²¹: Because of the exchange’s unique position (in its role in the functioning of the markets and as a regulator), most demutualized exchanges have considered ownership restrictions. Control over the exchange has been an issue.

• (a) Restrictions by size: One concern is that a particular interest group not have a stranglehold on the exchange. This for example is the argument of small brokerage firms who do not want to be at the mercy of large financial conglomerates. By restricting the size of the ownership stake, no one group can control the exchange. At some exchanges, such a restriction has been the condition of member agreement to demutualize. Of course, there is usually a means of waiving the restriction. For example, Swedish law says that any one person can own only 10 percent of an exchange unless an exemption is granted by the regulator (which was the case for the OM purchase of the Stockholm Stock Exchange). Similarly, under U.K. law ownership in the LSE is limited to 10 percent but this did not prevent a bid for control by the OM group or merger discussions with the Deutsche Bourse.

  Restrictions on ownership are one way of controlling the exchange. However, given that demutualization is aimed at allowing the exchange to operate as an entity in its own right—rather than as an extension of its members/users business—continuing to restrict ownership to such small amounts as 10 percent or 5 percent (as in the case of the Toronto Stock Exchange) may defeat the purpose of demutualization. Indeed in the case of London and Toronto, those exchanges, although demutualized, have been unable to shake the conflicts between members who have different interests. For example, the LSE member-shareholders have not been able to realize a merger with the Deutsche Bourse, a business move that was supported by the larger brokers. If the future competitiveness of the LSE depends on its ability to make global alliances then the current ownership structure is a problem.

• (b) Restrictions by type: Some exchanges or their regulators have to consider the nature of ownership. If the exchange, for example, is seen as a national public institution, the regulatory authorities might prohibit foreign ownership. Or in a more positive sense, ownership of an exchange could be limited to those with some expertise in its operation.

Access: There are three ways in which the exchange, as a central part of the financial structure and the main source of liquidity, supplies access—to trading, to listing and to data.

• (a) Access to trading: From a regulatory perspective, access to trading on the exchange must be both fair (without anticompetitiveness) and responsible (an adequate level of protection to the system). Since exchanges are now in competition with ATS— which are often members of the exchange or owned by members of the exchange—they cannot be allowed to exploit their position either as the main pool of liquidity or as regulators to shut out competitors. Exchanges therefore must have a transparent process for entry to trading, transparent standards of membership and the decision denying access should be appealable to a regulator and/or a court.

  On the other hand, as the exchange competes for liquidity, it cannot open its doors to just anyone. This is particularly the concern where the exchange is the primary regulator of dealers. Dealers should meet a certain standard before access is allowed. The standard should include a prudential standard, so that the clearing and settlement of trades is not disrupted, and a business conduct standard (to ensure appropriate skill and ability to comply with trading rules).

• (b) Access to listing: Competition for listings is the main source of competitive pressure for exchanges. Quality listings and liquidity are partners and liquidity is the lifeblood. However, this competition for listings cannot be allowed to reduce the regulatory quality of the exchange. While exchanges normally have a vested interest in the quality of an original listing (the branding of an exchange often depends on its quality) there can be a tendency to ignore violations of rules by listed companies since they are so important to the exchange. There is, in fact, a debate amongst regulators and exchanges as to whether listings are in fact a branding issue or a regulatory issue. One school of thought suggests that exchanges are not in fact the regulators of listed companies and should not perform that function—their incentive to attract quality listings is the incentive for original listing requirements, and for continuous requirements to ensure the quality is still there. Beyond that, it is argued, the job of regulating listed companies falls to the regulatory authority that regulates all issuers. However, in most countries, the securities regulatory authority relies heavily, if not exclusively, on the exchanges to regulate listed companies and may itself only regulate nonlisted issuers. This being the case, regulators will have a stake in the access to listings.

• (c) Access to data: While exchanges may operate with varying degrees of transparency (that is, more or less pre and post-trade information), in order to create an effective price discovery mechanism, all market participants of a similar class must have equal access to the data. The exchange cannot permit some participants to have more or less information or to receive information at different times.

Fee setting: Some regulatory authorities already become quite involved in the fee-setting at exchanges. It may not be the appropriate role of the regulator to participate in fee setting or to limit fee-setting practices. However, as with access, fee setting can be a source of anti competitive behavior and should therefore be monitored. This is particularly true vis-à-vis ATS. Fee setting policies, in general, should be reviewed by the regulator and the recognition criteria or recognition order should include an undertaking to ensure fee setting is fair.

The other aspect of fee setting is to ensure that the exchange does not cut fees so that it cannot support sufficient resources to operate the exchange. This may be an issue where competitive pressure for cheap trading is intense. Nor should the fees for trading be subsidized by regulatory fees—in situations where the exchange is the monopoly regulation services provider but competes for order flow, there may be a temptation to use the regulatory fees to subsidize the trading business.

Technology: Exchanges are quickly becoming technology businesses and this is a new source of challenge for regulators who generally lack expertise in systems technology. The reliance on technology to maintain a functioning market means that the state of technology at the exchange takes on a regulatory focus. Regulators have an obligation to ensure that the exchange is handling its technology properly. There could be a requirement that the exchange be subject to periodic audits, report outages etc.

F. Regulatory Structure

G. How Should the Regulatory Area Be Structured?

In addition to considering which regulatory functions must remain with the exchange, the arrangement for regulation should be considered. Several different structures have emerged. The regulatory function might remain part of the exchange as it has in the traditional exchange model. This is the structure that is currently used by the London Stock Exchange. Because the LSE’s regulatory functions are minimal, less separation is appropriate.

In Nasdaq’s case, while it retains some functions itself, the bulk of regulation is undertaken by the NASDR. Prior to the full demutualization of Nasdaq (which has not yet been completed), both NASDR and Nasdaq reported to separate boards. These boards, however, reported to the same parent board. Separation will be greater but not complete under demutualization. A last option would be to rely on another SRO or exchange for regulation. In the case of the Toronto Stock Exchange, all regulation has been moved to a SRO although the exchange remains involved in ownership and governance of that SRO.

In 2000, the U.S. SEC recognized the International Stock Exchange—a purely electronic for-profit options exchange. The ISE does not perform any regulatory functions having subcontracted those functions to the NASD.

Should regulators decide that some regulatory functions should remain with the exchange, additional supervisory structures might be required. For example, the ASIC is currently considering a separate review board, accountable to ASIC and consisting of a majority of independent representatives and a minority of exchange member representatives. This review board would act as an internal audit of the ASX’s regulatory functions, reporting to ASIC on a regular basis.

A. Thailand

The Stock Exchange of Thailand (SET) is a mutual organization. Although it operates as a SRO, 5 of its 11 board members are chosen by the regulator (SEC). SET has a monopoly, as no other exchange can set up in Thailand and all trading in listed securities must be on SET. The government supports SET by granting various tax incentives to the exchange and to investors in listed companies. The SEC is currently considering demutualization.²² The monopoly and nonprofit status of the exchange has resulted in inefficient use of resources and a resistance to change-—with no incentive to modernize the exchange. As a result, there is a lack of quality of listing and the Thai equity market has been marginalized and with growing international competition this would only get worse. The SEC believes that changes to the governance structure (demutualization) will encourage innovation—and while it will not cure the ills of the exchange, it sets a necessary foundation for change. In the SEC’s view, demutualization would improve SET’s flexibility in operations and allow it to respond to more diverse stakeholders. Theirs is a development perspective. A proposed plan of demutualization will grant 45 percent of shares to members, 10 percent to listed companies and 55 percent to the public at large (with a 5 percent cap on any one individual’s holdings). The SEC believes that this demutualization will put the SET in a position to join an international alliance, which will boast its competitiveness and benefit the Thai market. At present, a SET committee is still reviewing the demutualization proposal.

B. India

India has a very large number of exchanges. One it of its largest, the National Stock Exchange (NSE) formed in 1992 is a demutualized exchange—it is owned by shareholders rather than market participants, is run for profit and is not tax sheltered. These shareholders are largely the state-owned banks. The other large exchanges, notably the Bombay Stock Exchange (BSE) and the Calcutta Stock Exchange (CSE) have, until recently, been mutual organizations. Under political pressure to respond to the latest in a series of stock market and financial sector scandals—this one causing severe market value drops and runs on banks—the Ministry of Finance imposed a form of demutualization on the remaining exchanges, all of whom are carrying out direct regulation of brokerage firms. This “demutualization” took the form of a Ministry of Finance decree that no broker would be allowed to sit on the board of an exchange. The brokerage representatives on the boards of the BSE and CSE resigned leaving behind representatives of SEBI and a few independent board members to govern the exchanges. The authorities have plans to continue the demutualizations but it is unclear how they will proceed.

As in Thailand, demutualization is approached in India partially as a cure for crippling self-interest. The authorities believe that if the mutual organization structure continues, the exchanges will continue to under-perform operationally or with respect to its regulatory obligations or both. While in the case of the SET there is minimal regulation being carried out by the exchange, in India the exchanges are relied on for almost all direct regulation of market participants. Because the Indian capital market is so large, it may be impossible for a government regulator to take direct responsibility for all its participants.

What then becomes of self-regulation under enforced demutualization? The benefits of self-regulation should be considered very carefully before a demutualization is finalized. The most obvious benefit of self-regulation, of course, is that regulatory costs are borne directly by the industry. It is unclear, for example, whether the Indian authorities can or will devote additional resources to regulation—in such an enormous market, it is difficult to foresee a regulator ever having sufficient resources to carry out all regulation of market participants. Another benefit of self-regulation is that it provides the industry with a connection to the regulator, allows for industry participation in rule making and in enforcement. This should lead to greater credibility with the industry. However, the Indian brokerage community has displayed a weak commitment to regulation—as witnessed by a string of scandals over the past ten years including a market disruption in spring 2001 that was the result of the exposure of wide-spread non-compliance with the law, and therefore the involvement of these brokerage firms in regulation is questionable. Solutions being considered by the Indian authorities include increasing the independence of the exchanges and allowing them to continue a role in regulation and/or strengthening the central government regulator.

C. Malaysia

Not all emerging market countries view demutualization primarily as a means of improving the regulatory functioning of exchanges. The Malaysian Securities Commission recently released its “Capital Markets Masterplan”—which makes a large number of recommendations aimed at strategically positioning the Malaysian capital markets in a globally competitive market. The recommendations include steps to improve the quality of market intermediaries and issues and to strengthen the regulatory framework. The masterplan also includes recommendations to “enhance the competitive position and efficiency of market institutions.” This would mean consolidating and demutualizing Malaysia’s exchanges. The Malaysian exchanges, like many in southeast Asia, face serious competition for order-flow and listings from the more developed Singapore and Hong Kong exchanges and are struggling to find a niche for themselves. The masterplan takes the view that demutualization would “facilitate broader representation of [the exchanges’] constituents’ interests in its management and decision-making process” as well as provide necessary capital for expansion and improvement of the marketplaces. The key to the masterplan’s competitive strategy appears to be the ability of demutualized exchanges to then enter into strategic alliances with global trading networks—a way to match the resources and ability of its competitors in Singapore and Hong Kong SAR.