Demutualisation: Flexibility, innovation in stock exchanges

Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring (OECD, 2004). European Journal of Economics, Finance and Administrative Sciences - Issue 23 (2010) portrays organisational and strategic routines by which firms achieve new resource configurations as 'markets emerge, collide, split, evolve, and die'. 
The resource-based theory and dynamic capabilities have a direct link with the demutualisation decision of almost all of the stock exchanges that have undergone demutualisation. Recent changes in the global environment required exchanges to maintain flexibility and innovation. Without them, stock exchanges will not be able to compete with new entrants such as electronic communications networks (ECNs). Innovation as defined by Rogers (1998) is the application of new ideas to the products, processes or any other aspects of firm's activities. It is concerned with the process of commercialising or extracting values from ideas; this is in contrast with invention which need not be associated with commercialisation. Domowitz and Steil (1999) find that under the mutual ownership structure, members may resist innovations that enhance the value of the exchange as this innovation threatens the demand on their intermediation services. For-profit stock exchanges run by for-profit investors are more likely to seek innovative ideas and processes in order to expand their commercial activities and provide better financing for the exchange. It is these innovative products, structures and strategies that will enhance and develop their position in the market and add to their comparative advantages. 
Efforts to innovate are usually associated with two levels of problems; those affecting a particular project, and those affecting the organisational context. At the level of developing a particular product, problems include positioning the product strategically in the market, developing production, marketing and sales, securing expertise, managing external relations, understanding new markets, sharing knowledge, and evaluating progress. At the organisational level, it is in most cases structures and strategies in mature organisations that reinforce existing practices, and according to Halvacek and Thompson, are hostile to creativity (Dougherty and Hardy, 1996). Innovation within the institution (organisation) itself requires the establishment of attitudes and systems that recognise and reward creativity (Mason, 1991).  What the demutualised exchange needs is to direct these attitudes and systems; i.e. to direct structures and strategies towards innovation. Innovation must be managed, and in order for this to take place, significant decisions must be undertaken. 
FINANCIAL PERFORMANCE OF STOCK EXCHANGES: With the beginning of the 1990s, many stock exchanges all over the world started to undertake the demutualisation programme which represented a major shift in their ownership structure.  Demutualisation is a process by which a member customer-owned cooperative or mutual organisation is transformed into a shareholder-owned company raising capital with shares issued and traded on the stock exchange and providing services to customers as well as returns to shareholders. This transformation also means that trading and ownership can be separated. 
Shareholders under the demutualised stock exchange provide capital to the exchange and receive profits but need not carry out trading on the exchange. Shareholders are profit-seeking investors who want to produce better-financed organisations with greater ability to respond quickly to the international competitive forces and the fast changing market place. Profit maximisation is a shared goal between the shareholders and the new management of the demutualised stock exchange. Thus decisions should be in the best interest of the exchange and ultimately its shareholders (Aggrawal, 2002 and Hughes and Zargar, 2006).  Did stock exchanges financially perform better after demutualisation? Empirical evidence is still not clear yet and the debate on the real impact of demutualisation is still open. 
Supporters to demutualisation argue that it can help the stock exchange to modernise its technology, obtain a governance structure that is more flexible in responding to industry and market conditions, avoid concentration of ownership power in a particular group of stock exchange participants and, ensure financial decision-making by ensuring that resources are allocated to business initiatives and ventures that enhance shareholder value. Opponents to demutualisation argue, however, that the aforementioned benefits of demutualisation may not in reality be achieved or can be obtained under a mutual governance structure. Therefore, any cost-saving that a demutualised stock exchange with direct investor access might result in is low in comparison to the benefits that can be obtained in the presence of brokers with ownership interests in the exchange. They also argue that in many developing countries, the creation of any financial institution is extremely hard, and the creation of investors is even harder than the creation of the brokers (Lee, 2002). Demutualisation may also allow for new risky businesses that usually do not take place when the stock exchange is under a mutual structure (Worthington and Higgs, 2006). 
Literature on transactions economics introduced by Coase (1937) explains that firms exist where it is profitable to establish them. According to him, the firm is in a series of contracts that reduce and economise on its transaction costs. There are costs to conducting transactions in the market and there are also costs relating to negotiating and concluding transactions for each operation. The firm can also be viewed as a relationship between factors of production where there is an authority with whom they all make a contract and by whom resources are directed. Under the mutual governance structure, we find that without financial firms, individuals have to bear the cost of finding someone to contract with, search for prices and invest in legal skills in order to be able to draw up a mutually agreed contract. 
As Williamson (1975) concluded, the importance of transaction costs increases when transaction specific investments are involved. Under demutualisation, there is no room for such opportunistic behaviour. The new changes in today's competitive environment  (with the introduction of new electronic systems) have led to lower transactions costs of trading for  investors, allowed for better price determination, and lowered the chance for market manipulation.  Literature on property rights explains why a particular form of ownership (like demutualisation) takes place. Highly complementary assets should be owned together and independent or non-complementary assets should be owned separately (Ames, 2002). Where assets are independent, there are no economies of scope (synergies) between them and thus joint ownership has no economic benefit. Literature on property rights tackles the ownership of assets and the right to residual income. Possession of control rights is so important for the integration decision, and ownership of profit is in practice linked to ownership of control (Hart and Moore, 1990). 
According to Ames (2002), those who have better management skills should also own the assets required for production. Management is viewed as an asset to the firm. It is variable by nature and affects the bundle of assets it seeks to complement and the quality of their usage. Thus, financial firms are heterogeneous in nature. Different financial firms produce different financial products as products are produced from different bundles of assets.  
Demutualisation is about changing the ownership structure of the stock exchange from a  mutual association with one vote per member and possibly consensus-based decision making, into a  company limited by shares, with one vote per share (with majority-based decision-making) (Aggarwal,  2002). In the business world, a change in the ownership structure usually reflects a change in the assets and the strategy adopted by the firm to respond to certain changes in the business environment such as globalisation, the rise of global competition and technological advances.  
Many studies and reports pointed out that the ticket to successful growth of stock exchanges in today's competitive environment lies in demutualisation.  The programme shifts the interest of the stock exchange from satisfying financial intermediaries to satisfying market participants. They argue that demutualisation and self listing can free up the ability of stock exchanges to engage in many commercial activities. In addition, demutualization can allow the stock exchange to modernize its technology, create a management structure that is more responsive to market conditions and, get an initial infusion of capital and allow for easier access to capital. It also enhances financial decision making by allocating resources to business initiatives and ventures that increase the shareholder value (Lee, 2002). Thus, demutualised stock exchanges are in general expected to bring better performance of exchanges.  
Of particular importance is the impact of demutualisation on the financial performance.  Shareholders (equity capital providers) provide money in return for a claim on profits. Since the return on the assets they provide (capital) is the residual earnings or profit of the firm, their return can not be guaranteed without ensuring that the firm's financial performance is strong. In other words, the firm's wealth must be created before it can be distributed to the various stakeholder groups (Boatright, 2006). In order to compete efficiently, stock exchanges must operate for profit. The new recent technological changes have made the members' ownership structure less appealing. As Hansmann pointed out, 'Exchanges must raise capital to compete efficiently and investor ownership is the obvious solution to solve '. 
Does demutualisation lead to better financial performance of stock exchanges? So far, there is only one previous empirical study - Mendiola and O'Hara - that examines the impact of demutualisation on the financial performance of stock exchanges. Mendiola and O'Hara (2004) study five general accounting measures of performance: return on assets, return on equity, profitability, asset turnover and financial leverage. Their study is faced with several shortcomings: first, it is restricted to exchanges that have been completely transformed into publicly listed companies. Second, there is a problem of having a control group of stock exchanges because almost all of the large stock exchanges are part of the sample. At the time of implementing the study, only the smaller stock exchanges were still member-owned. Third, most of the conversions - to the demutualised structure - happened in the last three years of applying the study. It was noted that this period witnessed difficulty for asset markets world-wide. 
Other previous empirical studies that examined the impact of demutualisation have studied that impact on one or more of the market measures. Examples of these studies include those of Serifsoy  (2005) who conducted an efficiency analysis that focuses on exchange governance, Krishnamurti,  et al (2003) who compared trading costs for two major stock exchanges in India, the demutualised National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), Treptow (2006)  who presents a detailed analysis on the impact of demutualisation of securities exchange on liquidity through examining securities that are listed on two markets simultaneously, Hazarika (2005) who examines the impact of demutualisation on trading volumes and costs, and considers this impact in two different situations in which competition plays very different  roles, and Worthington and Higgs  (2005/2006), who study market risk in four demutualised and self-listed stock exchanges by using a  bivariate MA-GARCH model to estimate time-varying betas for each stock exchange from listing until  June 2005.  
There are various studies that compare the performance of the firms in the pre- and post- privatisation periods. Studies that measure the performance of firms in the pre- and post- privatisation periods follow a very common approach; called the MNR approach, which has a reference to the first study, using this methodology for Megginson et al, (1994). Examples of other studies that follow this approach include those of: Boubakri and Cosset (1998), D'Souza and Megginson (1999), Verbrugge et al (2000), Boubakri and Cosset (1999), Dewenter and Malatesta (2000), and Boardman, Laurin and Vining (2000). To follow the above-mentioned approach and to compare the financial performance of demutualised stock exchanges in the pre and post demutualisation period. They used 11 financial measures to test whether demutualisation results in better financial performance of stock exchanges. 
Considering the theoretical foundation and economic rationale, the government of Bangladesh enacted the law to demutualise the stock exchanges that became operational three years back. Different stakeholder groups would, naturally, like to see the evaluation report of this new approach which has comparative economic and theoretical soundness and dynamism over other models of South Asian countries.   
Jamaluddin Ahmed PhD, FCA is a member of the Board of Directors, Bangladesh Bank and General Secretary-Bangladesh Economic Association.
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