Demutualisation: Impact on performance of stock exchanges

Jamaluddin Ahmed | Published: February 08, 2017 20:03:07 | Updated: October 23, 2017 03:07:46

The decision to demutualise is initially undertaken because of several external and internal factors related to stock exchanges. While it is important to look at the external factors that may drive stock exchanges to demutualise, it is more important to look at the inner structure of the exchanges and how it can respond to these external factors through the demutualisation decision. It is important to link implementation of demutualisation programme to the nature of the stock exchange, including its existence, behaviour and its relationship with the market. This is explained thoroughly by the theory of the firm. As Arrow (1987) pointed out, the emerging economies of organisation becomes one of the most powerful and expanding fields in modern economics. It can be viewed as one of the broader attempts to inquire into the rationale and functioning of alternative institutions for resource allocation.
In economics, the new theory of the firm provides an explanation of the reasons for existence of institutions, its boundaries relative to the market and its internal organisation. The new theory of the firm comprises five theories of the firm and provides an answer for five important questions: 'How can organisations operate efficiently? The basic question of the behavioural theory of the firm, how can firms minimize costs? The basic question of transaction costs theory, how can firms align individual self-interest? The basic question of agency theory, how can resources be acquired, developed and deployed to improve the likelihood of survival and profitable growth? The basic questions of resource-based theory and more recently the dynamic capabilities and real options theories of the firm' (Huff, Ann)
TRANSACTION COSTS THEORY:  Literature on transaction costs provides an explanation of why firms exist. Pioneers of the theory argue that firms exist in order to reduce transaction costs and thus increase the volume of trade and economic value creation (Coase, 1937; Williamson, 1975; Williamson, 1985 and Coase, 1988).  The early work of Coase (1937) explains that firms exist where it is profitable to establish them as there are costs to conducting transactions in the market. There are also costs related to negotiating and concluding transactions for each transaction. The firm is in 'series of contracts' that reduces and economises on transaction costs. The transaction costs theory explains the worldwide move towards demutualisation. The new changes in today's competitive environment that resulted from the introduction of new electronic systems have led to lower transaction costs of trading for investors, allowed better price determination, and lowered the chance for market manipulation, which exist under the mutual structure of stock exchanges.
The new advances in technology have also facilitated cross-border trading and over time the development of inter-market trading systems (ITS) (Claessens et al, 2000). Therefore, the shift towards demutualisation of stock exchanges becomes a natural response to new technological advances, where the mutual structure becomes less appealing and more costly for investors. On the nature of transaction costs, Williamson (1975) also points out that the importance of transaction costs increases when transaction-specific investments are involved. Transaction costs come when the market is characterised by asymmetric information, uncertainty and when there is a room for opportunistic behaviour. This situation and behaviour exist under the mutual structure, where members of the exchange enjoy such opportunistic behaviour. In the past, without members of the exchange, investors had to search for prices and investment in legal skills in order to invest in the market. Such costs mean that only large amounts of transactions are made by the members because these were the only transactions that were economically viable. Under the mutual ownership structure of stock exchanges, people have to pay members of the exchange because it is usually only these members that know more about trading of the exchanges, have better knowledge of prices and have access to the services of the exchange. Such opportunistic behaviour is not justified anymore under the new worldwide technological advances.
Advances in telecommunications and the growth of Internet and wireless communication technologies are dramatically changing the structure and nature of financial services. Internet and related technologies have evolved as new different means for providing financial services (Claessens et al, 2000).
PROPERTY RIGHTS THEORY: Literature on property rights explains why a particular form of ownership takes place. Property rights come as a result of bargaining strength of those affected. Decision-makers usually want to adopt, or modify property rights to alleviate the harmful impact of economic losses of the common pool. The need for new property rights reflects the need to include new market prices and production possibilities that can not be attained under the old arrangement (Libecap, 1989; and Demsetz 1988 &1995). In Davis and North (1971), more clarification of this point can be found; 'It is the possibility of profits that cannot be captured within the existing arrangement structure that leads to the formation of new (or the mutation of old) institutional arrangements'. The ideas of Libecap (1989), North (1971) and Demsetz (1988) can be linked to the main reason for demutualisation.
As a new form of ownership, the previous mutual structures have failed to respond to the new advancement in technology and new changes in the global market. Investors wanted to have a new ownership structure that improves their exchange and as a result, can provide them with higher yields. In literature, there are few studies that have covered the process by which property institutions change and explained whether or not changes represent an efficient economic solution to address a certain social problem. Libecap (1989) argued that though certain property rights arrangement can lead to lower transactions costs, there are some economic challenges to change property rights. The distributional implications might lead the old influential parties to be against the new property rights arrangements. The inability to solve these conflicts can impede the new property rights arrangement to emerge or create a structure that in fact resembles the old property right arrangement. In real life, how far demutualisation succeeded to address the investors' need have not been thoroughly covered.
The European Journal of Economics, Finance and Administrative Sciences - Issue 23 (2010) used a few measures to study the impact of demutualisation on market. In addition, the samples used in prior literature were small in most of the studies based on Libecap's analysis. Mahoney (2004) noted that 'the greater the size of anticipated aggregate economic benefits of institutional change (or) the greater the economic losses of the common pool, the more likely the new property rights will be sought and adopted. Similarly North (1990) addressed an important question on why societies experience long-term stagnation or an absolute decline in economic well-being. North and Thomas (1973) considered institutions the determinants of economic performance and relative price changes, the main reason that accounts for institutional change. As North and Thomas explained, changes in relative prices provide an incentive to create more efficient institutions (Mahoney, 2004). These arguments can be related to the trend on demutualisation.
The remarkable change in the ownership and organisational structure of the demutualised stock exchanges was mainly motivated by some intense global competition and advances in technology. Decisions to demutualise usually happens when the old member-owned organisational structure fails to provide flexibility and finance needed to improve the stock exchange, which in turn affect the profit-seeking investors and might drive them to go to other stock exchanges. As Mendiola and O'Hara (2004) pointed out, updating trading platforms is capital intensive and this need had required many large and small stock exchanges to look for ways to finance such investments. Also, the lack of liquidity problem had posed a threat on smaller businesses to go out of business.
It was seen that the demutualisation programme and listing can allow the stock exchange to raise capital by selling shares in the public market and can also motivate the management of the exchange to seek more business initiatives. The ability to raise capital, IPO private investment and the increased responsibility to stakeholders, were viewed as convenient ways to respond to the global competitive pressures as it allows for the resources and incentives needed for investment in competitive products and information systems (Hughes and Zargar, 2006).The property rights theory also helps to understand another question: Can members of the exchange under the mutual structure protect their economic rights? Brazel (1989) argues that; 'legal rights are neither necessary nor sufficient for the existence of the economic rights'. Barzel (1989) looks at the concept of property rights to be closely related to the concept of transaction costs. He defined transaction costs as those costs that are associated with transfer, capture, and protection of rights. Because transactions are costly, property rights are never delineated (In Mahoney, 2004).
Under the mutual governance structure and with the arrival of competition, transaction costs are more costly in home exchanges or are cheaper elsewhere. Unless members can guarantee that investors will deal with them, there is no guarantee of income.
BEHAVIOURAL THEORY:  The behavioural theory of the firm can also be used to explain the reason behind stock exchanges' demutualisation. Barnard (1938) argues that little incentives lead to dissolution or failure of corporation. Incentives can be in the form of desirable physical conditions of the stock exchange, capacity of stock exchange to satisfy personal ideas, and the opportunity for enlarged participation (in Mahoney, 2004). Barnard (1938) and Simon (1947) argue that the decision to participate is central to what they call the 'organisational equilibrium'. Individuals will be willing to accept the organisation's membership when their activity in the organisation adds directly or indirectly to their personal goals. Their theory of organisational equilibrium is in essence a theory of motivation. That is, it provides the conditions with which the organisation can motivate its members to participate, and thus increase the chance of the organisation to survive.  Applying Barnard (1938) and Simon's (1947) ideas, it can be noted that with the aforementioned changes in the competitive environment, the mutual cooperative structure of the stock exchange corporate governance becomes less appealing.
[The third part of the article will appear on Saturday.]
Jamaluddin Ahmed PhD, FCA is a member of the Board of Directors, Bangladesh Bank and General Secretary-Bangladesh Economic Association


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