TSINGHUA UNIVERSITY COURSE ON FINANCIAL REGULATION Lecture 708

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TSINGHUA UNIVERSITYCOURSE ON FINANCIAL
REGULATIONLecture 7/08

• Demutualization of Stock Exchanges
• Business and Regulatory Issues
• by
• Andrew Sheng
• Adjunct Professor

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Outline

• Global Pressures for Change
• A New Business Model for Exchanges
• Demutualization Is this the Right Move?
• - Benefits
• - Conflicts of Interest
• - Policy Considerations
• Financial Outcome of Demutualization - Country
  Experiences

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Global Pressures for Change

• Global forces are transforming the exchange
  industry
• Technology Market deregulation Competition
• Changing investor demand retail, institutional
  quants
• Lower transaction costs leads to competition for
  liquidity
• Competition between Exchange and with Alternative
  Trading Platforms (cross-trades)
• Increasing consolidation of exchanges into major
  hubs

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East Asian Trends

• In the last 10 years, a number of exchanges in
  Asia (Australia, Hong Kong, Singapore, Malaysia
  and India) have demutualized to take on global
  competition
• All of them have succeeded to address the
  weaknesses that have affected emerging market
  exchange competitiveness viz. lack of depth and
  liquidity, efficiency and transparency.
• Competition for market share, including for IPO
  business, is coming from rise of Gulf exchanges,
  as well as other regional exchanges that have
  professed IFC status, e.g. Seoul.
• In Europe, consolidation of exchanges is
  accelerating, as threat of alternative trading
  platforms is rising

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Size and Competitiveness of East Asian Exchanges

• Although the East Asian equity markets have
  recovered from the 1997 financial crisis and are
  displaying strong fundamentals in recent years,
  individually they remain small and lack
  competitiveness when benchmarked against the
  world exchanges, especially in terms of
• Market capitalization
• Trading value
• Turnover
• Transaction costs
• Investor base
• Product range

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Source Srinivasa Madhur, Capital Market
Development in Emerging East Asia Issues and
Challenges, 26 February 2008
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Source Srinivasa Madhur, Capital Market
Development in Emerging East Asia Issues and
Challenges, 26 February 2008
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Source Srinivasa Madhur, Capital Market
Development in Emerging East Asia Issues and
Challenges, 26 February 2008
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A New Business Model for Exchanges

• The threats to domestic exchanges are due to the
  following-
• As exchange control declines, domestic investors
  can easily invest abroad and by-pass local
  exchanges or brokers
• Regional exchanges can use ETFs or derivatives to
  replicate local indices or even warrants on
  domestic shares that take liquidity away from
  domestic exchanges
• Liquidity begets liquidity, and shrinking
  liquidity means higher transaction costs, thus
  reducing competitiveness. Domestic exchanges
  must respond using three dimensions
• - products and services
• - technology and systems, and
• - corporate structure aligning performance with
  incentives

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The New Exchange Business Model is a Performance
Game

• The Traditional Game

• The New Performance Game

• Reliable trading and settlement systems
• Market transparency and fairness
• High liquidity and effective price discovery
• Reliable risk management systems
• Sound regulatory framework

• High IPO attraction rate
• Lowest transaction costs
• Most liquid in segment-specific market models
• Broad market access
• Most efficient risk management system
• Most innovative product range

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Overall Performance depends on Building a Robust
Institutional Infrastructure

• Performance Measure

• Enabling Factors

• High liquidity and price discovery
• Lowest transaction costs
• Broad market access

• Access to accurate and timely information
• Review explicit costs (taxes, commissions, fees)
  and indirect costs (red tape, bureaucracy)
• Wide investor base and openness to cross-border
  investors

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Overall Performance depends on Building a Robust
Institutional Infrastructure

• Enabling Factors

• Performance Measure

• Innovative productive range
• Market transparency and fairness risk management

• Knowledge and skills of market makers and
  regulators
• Corporate governance property rights,
  shareholder rights, disclosure standards and
  practices, accounting and auditing standards

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Three Key Choices
Tomorrow

• No collaboration with others
• Domestic market isolated if not on global
  technology platform
• Local brokers marginalised as markets stagnate

• Dwindling relevance?

• European and US exchanges become larger and tie
  up with regional competitors
• Local brokers absorbed into global players
• Liquidity drifts to other markets or ATS

• Cherry-picked ?

Today

• Clear Objectives and Strategy to Compete and
  Alliance
• Invest in global and regional platform and
  attract new liquidity
• Regional brokers emerge and thrive

• A new force in global markets?

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Demutualization - Is it the Right Move?

• Globally and in East Asia, demutualization of
  exchanges has been used as a means to overcome
  threats of marginalization in the face of intense
  global competition.
• Demutualization is commercialization of a stock
  exchange into a profit-oriented limited liability
  company and separates brokers rights to deal on
  the exchange from the ownership and management of
  the exchange. The new company may choose to be
  listed on its own stock exchange or remain
  unlisted.
• Structure follows Strategy.
• If Strategy is to Compete or Defend market share,
  then what is the right Governance Structure to
  obtain maximum competitiveness with right
  incentive structures?
• Think through Strategy, at level of broker,
  exchange and market

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Arguments in Favour of Demutualization

• Improve governance structures
• In a mutual company, there is inherent conflict
  between interests of mutual members and the
  market as a whole. The users, such as the large
  institutional investors and foreign brokers who
  are not members, may feel that their interests
  are not represented. If these views are not
  addressed, they may move to other markets or use
  new Alternative Trading Systems.
• Focused Objectives
• Demutualization and Listing lead to
  commercialization and for profit motivation, so
  that management and incentives are aligned to
  deliver greater efficiency and accountability.
  The exchange must compete more actively.
• Greater access to funds
• To compete, exchanges today need to invest
  heavily in technology and invest in strategic
  partnerships (through mergers and acquisitions).
  While member-owned exchanges have limitations to
  raising funds, publicly owned stock exchanges can
  tap capital markets to achieve their strategic
  goals.

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Pros of Demutualization

• Greater Flexibility of Operations
• A publicly owned company is more flexible in
  responding to changes and opportunities in the
  marketplace, since decision-making will be
  responsive to needs of market users and
  competitive threats.
• Widen international network and create value for
  the economy
• The exchange is a public utility network where
  Metcalfs Law applies The value of the network
  increases exponentially with the number of
  users. By listing and attracting more foreign
  investors, the exchange can be a star company
  and create value where none existed before.

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Perceived Downside of Demutualization

• Loss of Tax Benefits
• Mutual exchange would lose tax-free status or
  other privileges given to exchange, such as
  monopoly status.
• Loss of Social Corporate Responsibility
• Many mutual exchanges devote considerable
  resources to market development and investor
  education. Such focus could be lost if the
  demutualized exchange becomes totally commercial
• Loss of Regulatory Powers In several listed
  exchanges, the powers to regulate members and
  company listings were moved to independent
  bodies. This is seen as loss of power. On the
  other hand, loss of regulatory duties actually
  reduces costs and also regulatory liabilities.

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The Most Compelling Argument for
Demutualization - Unlocking Value of Exchange

• All stakeholders
• After demutualization, benefit from higher
  market capitalization, turnover, products and
  services
• Brokers
• Brokers benefit through higher commission earned
  on higher trading volumes and by capital gains on
  shares received on demutualization
• Creating a star company
• In several Asian experiences, demutualized and
  listed exchanges have become star companies
  with market capitalization, turnover and P/E
  ratios matching the larger blue chips (new blue
  chip)

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Potential Conflicts of Interest

• A demutualized for-profit exchange will face the
  broad issue of conflict between its regulatory
  responsibility and its desire to maximize profits
  for its shareholders.
• Examples
• Resources conflict Will a for-profit company
  devote sufficient resources and executive time to
  regulatory activities?
• Listings supervisory conflict Could there be
  temptation to relax listing requirements in order
  to boost profit from more listings? Because a
  Listed Exchange could own other businesses, such
  as registrars or corporate services, will
  Listings Division apply same standards for
  possible competitors? Perceived Conflicts need
  to be addressed.

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Conflicts of Interest and the Need for Regulation

• A demutualized exchange, which is
  profit-oriented, has to be properly regulated to
  discharge its public service and serve as a
  gatekeeper of the equity market
• Stock exchanges which have demutualised have
  adopted different ways of removing conflicts of
  interest
• Removal of activity option remove activity in
  question from the relevant division of the
  exchange
• Separation option separate the business
  activities from the regulatory activities of the
  exchange
• External oversight option subject regulatory
  activities of the
• exchange to external oversight
• Disclosure option disclose how an exchange has
  dealt with regulatory issues e.g in an annual
  report
• Restricting ownership or involvement option
  limit those who can control or influence exchange
  activities

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Strategic Considerations

• Alan Cameron, while proposing that every exchange
  must now consider demutualization also reminds
  that demutualization is not an end in itself
  It is only a preliminary to the real issue of
  what is the desired future business of the
  exchange?
• IOSCO The key rationale for demutualization is
  to give the exchange the ability to raise funds
  through various means, including private and
  public offerings to a wide range of investors.
  Listing provides significant benefits to the
  exchange as a public company, its investors and
  the market as a whole.
• Ruben Lee Do not accept unconditionally that
  demutualizing a stock exchange is clearly
  beneficial undertake a realistic cost/benefit
  analysis of what its effects are likely to be

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Key Issues in Demutualization

• Legal constitution and ownership structure of the
  exchange prior to demutualization
• Composition of the governing boards before and
  after demutualization
• Merger of national stock exchanges prior to or
  after demutualization
• Ownership of assets prior to and after
  demutualization
• Transfer of assets upon demutualization
• Fiscal benefits prior to demutualization
• Enactment of any special legislation to
  facilitate the process of demutualization

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Some Guiding Thoughts

• The strategic decision is whether or not
  demutualization is beneficial to the national
  market and the domestic economy. So far, Asian
  experience suggests so.
• A related issue is whether the status quo is
  viable considering the global and competitive
  environment, not just for exchanges, but also
  local brokers
• How do we get consensus on the way forward?
• In the final analysis, it is a red ocean/blue
  ocean choice-
• For Broker
• For Exchange
• For Economy

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Financial Outcome of DemutualizationCountry
Experiences
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INTERNATIONAL EXPERIENCE TOTAL RETURN TO
SHAREHOLDERS FROM EXCHANGES HAS BEEN
OUTSTANDING(Compounded annual return to
shareholders since listing)
22
Yrs since listing
186
JSE
DB
Euro- next
Bursa Malaysia
NYSE Group
BME
SGX
HKEx
TSX
NSX
ASX
LSE
Athens
Nasdaq
Euronext from date of listing until merger with
NYSE NYSE Group thereafter. TRS data to Nov 1
2007 Source Datastream McKinsey analysis
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Financial Performance of ASX, SGX, Bursa and PSE
since Demutualization

• Market capitalization of the demutualized
  exchanges had been increasing since listing and
  peaked in 2007
• At their peaks in 2007, the increase in the share
  prices of the exchanges since their IPOs ranged
  from 4.5X for Bursa to 5.4X for the PSE, nearly
  12.2X for SGX and 14.3X for ASX.
• The companies P/E ratios were higher than the
  P/E ratios of their national market indices.
• Efficiency improved as reflected in the decline
  of the exchanges cost-income ratios
• Shareholders profits increased

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STOCK EXCHANGES Market Capitalization Since
Public Listing
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STOCK EXCHANGES Company Stock Price Relative to
Benchmark Index
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STOCK EXCHANGES Company P/E Ratio Relative to
P/E Ratio of Benchmark Index
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STOCK EXCHANGES Revenue, Expenses and
Cost-Income Ratio
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STOCK EXCHANGES Profit Cash Flow
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Experience of Hong KongHong Kong Process

• 1987 Merger of four Exchanges to form Stock
  Exchange of Hong
• 1997 - Stock Exchange chairman commissioned
  study on demutualization
• 1998 - Asian crisis Government intervened in
  stock market
• 1999 - Demutualization plan merger of stock,
  future and clearing house
• 2000 - Law passed and Listed at HK3.88 per
  share
• HKEx is today a major company by itself in Hong
  Kong, with wide public ownership.

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Hong Kong Exchanges and Clearing Limited Market
Capitalization since Public Listing
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Hong Kong Exchanges and Clearing Limited
Company Stock Price Relative to Benchmark Index
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Hong Kong Exchanges and Clearing Limited
Company P/E Ratio Relative to P/E Ratio of
Benchmark Index
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Hong Kong Exchanges and Clearing Limited
Company Revenue, Expenses and Cost-Income Ratio
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Hong Kong Exchanges and Clearing Limited
Company Profit Cash Flow
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STOCK EXCHANGES Market Cap Dollar Volume of
Trading Compared
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STOCK EXCHANGES Share Turnover Ratio Compared
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Key Lessons

• Demutualization is a strategic and structural
  reform to make financial infrastructure more
  efficient and competitive at global level
• So far, demutualization can raise
  competitiveness, reduce transaction costs and
  align exchanges with market/user needs
• Regulatory stance should separate market
  interests from regulation role to avoid conflict
  of interest.
• Clear trend towards network effect of winner
  takes all.

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Thank You
Questions to as_at_andrewsheng.net