The Impact of Demutualization on the Performance of Stock. Exchanges

MAASTRICHT SCHOOL OF MANAGEMENT

____________________________________________________________

The Impact of Demutualization on the Performance of Stock

Exchanges

A paper submitted in partial fulfillment of the requirements for the degree of Master of Philosophy (M.Phil.) awarded by the Maastricht School of

Management (MSM), the Netherlands

By

Arwa M. Morsy

Cairo – Egypt

Doctoral Supervisor (Promoter)

Dr. Islam Azzam

Assistant Professor of Finance

The American University in Cairo (AUC)

Arab Republic of Egypt

Doctoral Reader:

Prof. Eno L. Inanga

Professor of Accounting and Business Finance

Maastricht School of Management (MSM)

Netherlands

TABLE OF CONTENT

1.2 CONCEPTUAL ISSUES OF DEMUTUALIZATION... 8

1.3 FORMS OF DEMUTUALIZATION... 10

1.4 MOTIVES /FACTORS FOR DEMUTUALIZATION... 10

1.4.1 The Impact of Technology ... 10

1.4.2 The Impact of Competition ... 11

1.4.3 Need for Improved Governance... 12

1.4.4 Investor Participation... 12 1.4.5 Raising Capital ... 13 1.4.6 Consolidation ... 13 1.5 THE TREND TO DEMUTUALIZATION... 13 1.6 THE DEBATE ON DEMUTUALIZATION... 15 1.6.1 Arguments For... 15 1.6.2 Counter Arguments... 16 1.7 PROBLEM DEFINITION... 17 1.8 RESEARCH OBJECTIVE... 17

1.8.1 Major Research Question ... 17

1.8.2 Minor Research Questions ... 17

1.9 SIGNIFICANCE OF THE RESEARCH... 18

1.10 ORGANIZATION OF THE STUDY... 18

CHAPTER 2: REVIEW OF LITERATURE ... 20

2.1 THE THEORY OF THE FIRM AND THE EMERGENCE OF THE FINANCIAL FIRM.... 20

2.1.1 Transaction Costs ... 20

2.1.2 Property Rights... 21

2.2 GOVERNANCE STRUCTURE... 21

2.3 ORGANIZATIONAL AND OWNERSHIP STRUCTURE OF EXCHANGES... 24

2.4 DEMUTUALIZATION AND REGULATORY ISSUES... 26

2.4.1 The Importance of Regulation ... 26

2.4.2 Regulatory Models... 27

2.4.3 The Regulatory Challenges Facing Stock Exchanges under the Demutualized Structure. ... 28

2.5 EMPIRICAL STUDIES ON THE IMPACT OF DEMUTUALIZATION ON THE PERFORMANCE OF STOCK EXCHANGES... 35

2.6 EMPIRICAL RESEARCH ON THE IMPACT OF TRANSFORMING OTHER OWNERSHIP STRUCTURES OF ENTERPRISES ON THE PERFORMANCE OF ENTERPRISES... 38

2.7 PERFORMANCE MEASUREMENTS OF ENTERPRISES... 40

2.7.2 Performance Measurement Systems ... 44

CHAPTER 3: CONCEPTUAL FRAMEWORK ... 47

3.1 INTRODUCTION... 47

3.2 LINKING THE LITERATURE TO THE RESEARCH HYPOTHESIS... 47

3.3 DIMENSION 1:MEASURES OF THE FINANCIAL PERFORMANCE... 50

3.3.1 Liquidity Ratios ... 51

3.3.2 Asset Management Ratios... 51

3.3.3 Debt Management Ratios ... 52

3.3.4 Profitability Ratios ... 52

3.3.5 Market Value Ratios ... 53

3.4 DIMENSION 2:MEASURES OFMARKET PERFORMANCE... 53

3.4.1 Market Size ... 54

3.4.2 Liquidity... 55

3.4.3 Concentration ... 55

3.5 DIMENSION 3:NON-FINANCIAL INDICATORS... 56

3.5.1 Corporate Governance ... 57

3.5.2 Regulatory Functions ... 61

3.5.3 Stock Exchange Services... 63

CHAPTER 4: RESEARCH METHODOLOGY ... 67

4.1 INTRODUCTION... 67

4.2 SAMPLE SELECTION PROCEDURE... 70

4.3 RESEARCH METHODOLOGY... 70

CHAPTER 5: DATA ANALYSIS AND DISCUSSION OF FINDINGS ... 74

5.1 INTRODUCTION... 74

5.2 DATA PROCESSING... 74

Data Collection and Processing ... 74

5.3 STATISTICAL ANALYSIS AND INTERPRETATION OF DATA... 86

5.4 RELIABILITY AND VALIDITY OF THE STUDY... 88

5.5 LIMITATIONS OF THE STUDY... 88

5.6 RECOMMENDATION FOR FUTURE WORK... 88

APPENDICES ... 89

PROPOSEDQUESTIONNAIRE ... 90

DEMUTUALIZED, BUT NOT PUBLICLY LISTED STOCK EXCHANGES... 99

PUBLICLY LISTED EXCHANGES... 99

ESTIMATED TIME SCHEDULE FOR THE COMPLETION OF THE STUDY... 100

ESTIMATED BUDGET... 101

REFERENCE LIST ... 102

LIST OF FIGURES

Figure 1: The Conceptual Framework………67 Figure 2: The Hypothetico-Deductive Approach………...69 Figure 3: Dubin’s Theory Building Method as an Eight-Step Theory Research Cycle. ……… 70

LIST OF TABLES

Table 1: Data Collection ………..75 Table 2: Testing Hypothesis ………86

PREFACE

The proposed study for the doctoral dissertation is carried out by the researcher Arwa M. Morsy, in partial fulfilment of the requirements for the degree of Master of Philosophy (M.Phil.) awarded by the Maastricht School of Management (MSM), the Netherlands. The proposed pioneer study assesses the impact of demutualization on the performance of demutualized stock exchanges in terms of financial performance, market performance, and non-financial performance.

Motivations

Motivated by the catalyst role the stock exchanges should play to promote economic development, recent concerns have risen with regard to current real impact of the international trend of demutualization of stock exchanges on relevant stakeholders (stock exchanges as organizations, government, investors, employees, etc). The impact a 14 years of demutualization of stock exchanges worldwide is still unclear. Though there are many studies that analyze the motivations for international demutualized trend of exchanges, very few empirical and academic literatures were found that assess the impact of demutualization. This is an empirical study that focuses on one of the key stakeholders of the program (exchanges). This study aligns financial and non-financial measures as well as market measures to assess the impact of demutualization on the performance of exchanges. The researcher recognizes that such study is more needed today than perhaps ten years ago. The international trend of demutualization has increased over the past seven years, and there are no enough records that show whether their impact is positive or negative.

Acknowledgements

I would like to thank very much Dr. Samir Makary from the American University in Cairo (AUC), who was instrumental in introducing me to Maastricht School of Management (MSM). I am indebted to Prof. Kami Rwegasira, from MSM and Dr. Khaled Wahba, Academic Advisor in RITI, Cairo, for the useful research methods and quantitative analysis courses that helped me a lot in this research. My sincere gratitude to Prof. Beatrice Van der Heijden, Director of Research and Doctoral Programs whose

encouragement and support are most appreciated. I also want to express my deep gratitude to my doctoral supervisor Dr. Islam Azzam, for his invaluable comments, advice and encouragement. I am so grateful to Prof. Eno L. Inanga for his review of the paper and his useful comments and suggestions. I also wish to thank Patrick Mans and Sandra Kolkman, from MSM and Nada Megahed and Mona Nasser, from RITI for their coordination efforts. Last, but not least, my deepest gratitude goes to my mother and the soul of my father, to whom I dedicate this study, and my friends for their encouragement and support.

ABSTRACT

This thesis seeks to address the question of whether demutualization of stock exchanges is an efficient mechanism towards improving the performance of stock exchanges.

The primary contribution this study seeks to make is in the sphere of analyzing the post-demutualization stock exchange development of a sample group of demutualized exchanges, and to assess whether these stock exchanges are becoming operationally performing well.

While many researchers have praised the demutualization of stock exchanges, others have been more sceptical and have tended to conclude that demutualization might cause greater problems related to conflict of interests.

However, since little academic and empirical work have been conducted on the impact of demutualization on the performance of stock exchanges and even no literature was found to examine in detail the post-demutualization development of stock exchanges in developing countries and small exchanges, the researcher examines in the present study the post-demutualization developments of stock exchanges all over the world andexplains the level of importance of demutualization to the performance of stock exchanges. The units of criteria employed in this study to assess stock exchange performance include: 1. financial measures related to the liquidity, asset management, debt management and profitability of the exchange, 2. market measures related to the exchange’s market size, market value, liquidity and concentration 3. Non-financial measures related to corporate governance (including shareholders rights, commitment to corporate governance principles, structure and functioning of the board of directors and transparency and disclosure), regulatory functions and the services that the stock exchange provides. The post-demutualization development of stock exchanges is discussed in light of these criteria, and each stock exchange is categorized into one of the following groups: A. Noticeably improved demutualized exchanges, B. Moderately improved demutualized stock exchanges and C. Non-improved demutalized exchanges.

The research should conclude whether it is right to sustain the argument that

demutualization always leads to an improvement in the performance of stock exchanges and when policy makers can undertake the decision to convert to a demutualized exchange.

CHAPTER 1: INTRODUCTION

1.1 Background

Stock exchanges have long been viewed as important catalyst of economic growth. They provide an organized market for the trading of securities to individuals and organizations seeking to invest their saving or excess funds through the purchase of securities. This market is regulated by established rules that promote and maintain fair, efficient, secure and transparent market and facilitate the orderly development of the stock exchange. A fair and efficient performance of a stock exchange is substantial benefit to the public. The stock exchange provides liquidity and price discovery that facilitates efficient raising of capital for businesses, benefits the wider corporate sector and the economy in general. Stock exchanges fulfil several roles in the economy. Some of the various roles that stock exchanges assume are; raising capital for businesses, mobilizing savings for investments, facilitating company growth, redistribution of wealth, corporate governance, creating investment opportunities for small investors and raising capital for the government to enable for carrying out development projects. Therefore, the movement of share prices and in general the stock indexes can be a good indicator of the general trend in the economy1_.

Trade in financial assets and contingent claims can be undertaken on a bilateral basis without any formal economic organization. However, explicit collaboration among the suppliers of financial services (Traders) helps reduce the cost of transactions in several ways. In particular, through the creation of standards, the reduction of information asymmetries, the protection of property rights in prices, the creation of a centralized trading facility and the enforcement of contracts. A formal organization such as the stock exchange can organize and coordinate such cooperation. Therefore, stock exchanges play a vital role in reducing transactions costs (Pirrong, 1995, 229-255).

Stock exchanges undertake a variety of responsibilities to assume the above mentioned roles. These include; devising rules of trading and monitoring them, setting conditions for listing or admission to trading, adopting and enforcing rules for the conduct of members of the exchange, setting qualification and financial standards for securities industry professionals, conducting surveillance of the market and its participants and monitoring and regulating the daily trading and the operation of the market to ensure its integrity (International Organization of Securities Commission (IOSCO) Discussion Paper, 2000, p.4).

Therefore, as Lee (2002, p.19-20) argued, it would be inadequate to think of the stock exchange as a black box. Approaches that analyze the stock exchange as a trading system and ignore its inner structure are not rich enough to explain the impact of its performance. Prior to 1990s, stock exchanges all over the world used to operate as mutual organizations. Early 1990s, stock exchanges started to undertake major organizational and operational changes. One of the most noted changes was the trend toward demutualization.

Demutualization can be defined as the ‘process of continuing an organization from its mutual ownership structure to a share ownership structure. This process often entails, first obtaining the appropriate regulatory and governmental consents, then converting

membership rights into shares, which may be followed by public issuance and listing of the exchange, with immediate or eventual freely tradable shares (Hughes and Zargar, 2006, p: 6-7)’. The conversion was not identical among stock exchanges. In some cases, – such as the Italian Borse – the stock exchange transformed from a government-owned utility through the implementation of the Investment Services Directive (1993/22) that allowed for privatizing the exchange, transforming it into a company that can gradually be listed on the exchange. In other cases - such as London Stock Exchange (LSE), the stock exchange was not a government-owned entity and transformed into a limited company. Access to the stock exchange is not anymore restricted to membership (Di Noia, 1998, p. 22).

The trend toward demutualization started in 1993 by the Stockholm Stock Exchange. It was followed by several others, including the Helsinki Stock Exchange in 1995, the Copenhagen Exchange in 1996, the Amsterdam Exchange in 1997, the Australian Exchange in 1998, and the Toronto, Hong Kong and London Stock Exchanges in 2000. 2005 figures show that about 60% of the World Federation of Exchanges’ (WFE) members were either demutualized or listed (WFE Cost and Revenue Survey 2005, 2006, p.9).

The remarkable change in the ownership and organizational structure of the demutualized stock exchanges was mainly motivated by some intense global competition and advances in technology. Decisions to demutualization, is based in essence on the recognition that the old member-owned organizational structure fails to provide the flexibility and the financing needed to compete in the global competitive environment. Demutualized stock exchanges are driven by profit-seeking investors who want to produce better financed organizations with greater ability to respond quickly to the fast changing market place. Some of the typical sources of revenues such as, listing fees, membership fees become less important. For the demutualized exchanges, transaction fees and new products and services are more important sources to expand their revenue (Aggarwal, 2002, p.11). By the end of 2006, the total stock market capitalization of world’s exchanges was $50.6 trillion of which about 45 percent from Americas, 23 percent from Asia-Pacific and 32 percent from Europe, Africa and the Middle East. The majority of demutualized and listed exchanges are concentrated across Americas and Europe. Currently, about 50 per cent of total revenues of members of World Federation of Exchanges (WFE) are comprised of publicly-listed exchanges. A small but significant portion of exchanges accounting for 20 per cent of WFE’s total revenue have demutualized but not listed their shares (WFE, 2006, p. 26 and 66). Almost all of the largest stock and derivative exchanges; measured in terms of capitalization have demutualized and listed their shares in the last decade (Aggrawal and Dahiya, 2005, p.3).

1.2 Conceptual Issues of Demutualization

‘The concept of ‘demutualized exchanges’ are often wrongly confused with ‘for-profit exchanges in informal discussions. However, for-profit exchanges are not necessarily

demutualized ones. Many stock exchanges can legally distribute profits to its owners, but they are not demutualized. The concept of demutualization is related to the separation of ownership and membership when there is a need to create a complete cultural change within the organization. Thus, the ownership structure of the stock exchange is central to the definition. There are several researches and discussion papers have defined the concept of demutualization. The following lines demonstrate these definitions.

- The World Federation of Exchanges (WFE): ‘The demutualization of an exchange is a process by which a non-profit member-owned organization is transformed into a for-profit shareholder corporation. Ownership is somewhat open (WFE, Cost and Revenue Survey 2005, annex 1, p.37).’

- IOSCO discussion paper on Stock Exchange Demutualization; “the

transformation of an exchange into a for-profit shareholder-owned company is referred to as demutualization”. In most cases, the demutualized exchange becomes a for-profit enterprise (IOSCO Discussion paper, 2000, p. 1).

- Abdel Shahid 2002: Demutualization means restructuring the stock exchange and changing it from a nonprofit organization mutually owned organization by its members into a profitable company owned by various entities including the public. The shares of the exchange can then be distributed among members, financial institutions and the public. Done properly, a change in the status of the exchange could provide the needed capital to build the marketplace, lower costs to members and better serve investors” (Abdel Shahid, 2002, p.1).

- Aggarwal, Reena”, 2002: ‘Demutualization is the process of converting a non-profit, mutually owned organization to a for-non-profit, investor-owned corporation. The members of mutually owned exchanges--that is, broker dealers with “seats” on the exchange--are also its owners, with all the voting rights conferred by ownership. In contrast, a demutualized exchange is a limited liability company owned by its shareholders. Trading rights and ownership can be separated; shareholders provide capital to the exchange and receive profits, but they need not conduct trading on the exchange. And as discussed later, although

demutualized exchanges will continue to provide many if not most of the same services, they will have different governance structures in which outside shareholders are represented by boards of directors (Aggrarwal, 2002, 106).’ The above-mentioned definitions rest on bringing nonmembers (shareholders) as owners. Selling ownership stakes to outsiders allow the exchange to raise capital for expansion and technology investment. More importantly, demutualization enables to reduce the control of intermediaries over the decision making process. Intermediaries seek to maximize their own profits from trade intermediation and hinder the ability of the exchange to serve companies and investors with maximum efficiency. Demutualization helps to expand direct trading access to foreigners or institutional investors, or to merge with other exchanges. Thus, what is essential to successful demutualization is to have non-members free to buy equity stakes in the exchange from current owners and to help reduce demand for services of existing members (Steil, 2002, p.65-66).

Clearly, there are huge differences in the governance structure among demutualized exchanges. A demutualized exchange might allow members to freely sell their equity stakes in the exchange to non-members, but put some limitations to the maximum shareholdings. The demutualized Borsa Italiana is an one extreme example of this

definition, where 90 percent is owned by Italian intermediaries. At another extreme is OM Stockholm which listed itself and which has a highly diversified shareholder base

including foreigners (Ibid. 66-67). 1.3 Forms of Demutualization

A demutualized stock exchange might take different organizational forms. Some exchanges have demutualized and become public companies listed on their own

exchanges. Other exchanges have demutualized but remained private corporations. Others are subsidiaries of publicly traded holding companies. Empirical examples include the Australian Stock Exchange which is a public company listed on its own exchange, the Amsterdam Exchange and the Toronto Stock Exchange which are presently private corporations, the London Stock Exchange arranged for an off-market trading facility for its shares and the Pacific Exchange in the United States converted its equity business into a wholly owned subsidiary of the exchange and the OM Stockholms börsen AB is a wholly owned subsidiary of a listed company (IOSCO 2000, p. 1).

1.4 Motives / Factors for Demutualization

In business world, a change in the ownership structure usually reflects a change in the strategy adopted by the firm to respond to certain changes. Changes in the ownership and organizational structures of stock exchanges mirror major changes in their business environment such as, the globalization, the rise of global competition and technological advances. Decisions by stock exchanges to demutualize are undertaken when the existing member-owned structure fails to provide the flexibility and financing needed to respond to today’s competitive environment. For-profit stock exchanges run by for-profit investors are expected to provide better financing, allow more flexible decisions mechanism and to expand into new businesses (Aggarwal, 2002, p.11).

1.4.1 The Impact of Technology

Advances in telecommunications, and the growth of the 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, p.2). Trading is moving toward electronic platforms that are not attached to a certain location; a centralized physical location became less important (Ibid. p.12).

A number of electronic order routing and trading networks have emerged in recent years. These networks serve as order-driven matching systems for participants seeking

anonymity (Ibid. p.14). Examples of such electronic communications networks (ECNs) include Instinet, Island, and Archipelago which provides since 1997 trading platforms that can match customer orders anonymously without the interference of middlemen. Some ECNs like Island have succeeded to obtain retail order flow. ECNs have currently

emerged as a factor of success in Europe as most stock exchanges in Europe are electronic limit order books. Additionally, recent industry-wide developments suggest that ECNs can even be consolidated together. The merger between Archipelago and REDIBOOK, and between Instinet and Island allow for such consolidation (Aggarwal, 2002, p.10-11). Other alternative trading systems are emerging around the world, often with links to existing trading systems. Instinet started as a local inter dealer broker and dealer but now has automatic routings to several stock exchanges. There is speculation that a few trading systems will soon allow investors to trade 24 hours a day (Ibid. p.14)

The New electronic systems have lead to lower transactions costs of trading, allowed for better price determination, and lowered the chance for market manipulation. The new advances in technology has also facilitated cross-border trading and over time for development of inter-market trading systems (ITS) (Ibid. p.12).

1.4.2 The Impact of Competition

The past two decades have witnessed a remarkable change in the competitive environment facing exchanges. As mentioned above, technology has both lead to the rise of new competitors such as ECNs and compelled stock exchanges to set new trading platforms. Traditional functions of the stock exchange became available from other sources and made investors seek the means that can provide liquidity more efficiently. As barriers to entry fell, off-floor trading systems started to compete with the traditional stock

exchanges and threaten their revenue base. An example of that is London’s Stock Exchange Automated Quotation System (SEAQ-I), the screen-based system trading international stocks which competed with European stock exchanges such as Stockholm, Amsterdam and Milan. Regulatory barriers were also decreased. For example, in 1993, the Swedish Government enacted a legislation to end the monopoly of the Stockholm stock exchange. In the US the Securities and Exchange Commission (SEC) implemented the Order Handling Rules to allow for greater competition between the Electronic

Communication Networks and National Association or Securities Dealers Automated Quotation System (NASDAQ) (Hazarika, 2005, p.3).

With these changes in the competitive environment, the mutual cooperative structure of the stock exchange corporate governance becomes less appealing. The customer – stock exchange relationship has changed to seek better liquidity and services. Members’ interests become increasingly divergent and the benefits of the cooperative structure were greatly reduced. Another issue is the ability of the cooperative structure to raise new capital. Considering the transaction cost point of view, the cost of organizing the cooperative is greater than the benefits (Mendiola and O’Hara, 2004, p.7).

It was initially hard for the traditional mutual stock exchanges to respond to competition. The mutual governance structure and the heterogeneity nature of members of the stock exchanges (local market makers, broker dealers, international banks, etc.) made it difficult for them to ignore their private cost-benefit evaluations and vote for policy change. It was noted that there was an initial resistance – by members of traditional mutual stock exchanges – to the introduction of automated trading as it would match the buy and sell orders and reduce their intermediary role. For example, NASDAQ market makers blocked

the incorporation of mandatory price-time priority in the Super Montage trading system so that they continue matching trades internally (Hazarika, 2005, p.3).

But, with these competitive pressures, some members of the stock exchanges realized the need for the cessation of floor trading and the introduction of electronic auction trading (e.g. Amsterdam in mid 1990s). Moreover, they started to realize that without a change in the governance structure, the exchange’s revenues could be eroded. Therefore, they put pressure on local stock exchange members and forced them to accept demutualization (Hazarika, 2005, p.10).

In addition, competition among stock exchanges has also attracted investors. Investors started to seek the payment of lower commissions, and look for means to handle trades more quickly with anonymity on placed orders. Thus, the rise of competition between stock exchanges and other trading systems necessitated that stock exchanges become more efficient in all activities, including their decision making processes.

Demutualization provides an opportunity for stock exchanges to be more efficient and have broader access to capital. The new organizational structure of stock exchanges allows maximizing the residual value of the enterprise, thus benefiting shareholders. Though members may dominate for sometime, demutualization is likely to end up transferring considerable ownership and decision making power to outside investors. This means that the decisions that used to be undertaken by stock exchange members will be replaced by a professional management team motivated by significant share ownership to increase efficiency and profits (Aggarwal, 2002, p. 8-9).

1.4.3 Need for Improved Governance

The decision to demutualize is expected to bring a corporation that is more capable to act decisively and rapidly to changes – such as competitive challenges - in the business environment. A demutualized stock exchange facilitates the ownership and trading privileges of the members of the exchange, thus permits the stock exchange to achieve greater independence. It brings a management that takes actions that are in the best interests of the stock exchange and ultimately its shareholders. Therefore, the interests of the owners of the stock exchange will be linked to those of the stock exchange as both parties will aim at profit maximization. Further, the demutualized organizational structure will allow for greater transparency because stock exchanges will be obliged to report to their shareholders not only regarding the bottom-line but also on issues regarding corporate governance (Hughes and Zargar, 2006, p. 10-11).

1.4.4 Investor Participation

A demutualized stock exchange is more capable to respond to the needs of its various stakeholders, including participating organizations, listed companies, and institutional and retail investors. In order to respond to the emerging competitive pressure, the stock exchanges need to shift power from one group of stakeholders to another. Separating the stock exchange membership from ownership, provides a political and legitimate way to effect such shift. For example, contrary to NSE structure that is mainly composed of broker-dealers as members, a demutualized structure allows both institutional investors

and retail investors to become shareholders. In addition, it can meet the needs of institutional investors who require greater liquidity to accommodate block trading and place more emphasis on negotiating the lowest price (Ibid. p.11)

1.4.5 Raising Capital

With the capital raised from IPO private investment and the increased responsibility to stakeholders, the demutualized structure is more capable to respond to the global competitive pressures as it allows for the resources and incentives needed for investment in competitive products and information systems. In order to compete, stock exchanges must have timely, cost-effective and reliable products and services. One of the clear historical examples that show the importance of demutualization in raising capital is the replacement of floor trading with screen trading. Introducing screen trading requires considerable capital investment in the information system of the exchange.

Demutualization was an efficient and rational means of raising additional capital required to finance such activity. Continued capital investments in technology can also help to respond to competition from ATS and upstairs trading (Ibid. P. 14-15).

1.4.6 Consolidation

Another factor that has affected the competitive landscape of capital markets and stock exchanges is the strategic alliances and consolidations. One example is the merger of NASDAQ and the American Stock Exchange that was completed in November 1998, which created a stock exchange with a market capitalization of US$1.9 trillion with unique varieties of products. According to Hughes, major consolidations in the financial stock exchanges industry are expected to take place in the next 5 to 10 years. These consolidations will include leading derivative and equities exchanges. In the derivative market, both the Toronto Stock Exchange (TSX) and New York Stock Exchange (NYSE) have announced plans to expand their capabilities. In equities trading, given that North America is already dominated by the NYSE and NASDAQ, the most interesting arena will continue to be Europe where one or two large stock exchanges are likely to emerge. The demutualization structure with publicly traded shares should greatly facilitate the consolidation structure. Demutualized exchanges, as shareholders entities are forced to report their performance and seek revenue and cost-saving mechanisms (Ibid. p.13-14). 1.5 The Trend to Demutualization

The trend to demutualization started in 1993 with the Stockholm Stock Exchange, which was the first stock exchange to demutualize. This was followed by several other major stock exchanges such as ASX, TSX, the Singapore Stock Exchange and the Hong Kong Exchanges and Clearing Limited (“HKEx”). ASX was one of the first exchanges to do an Initial Public Offering (IPO) and list its shares on its own market place. TSX, which demutualized in 2000, became in 2002 a public company through listing its shares on its exchange. In Asia-Pacific, Singapore Exchange Limited (“SGX”) was the first stock exchange to demutualize in December 1999. End of 2000, SGX’s shares were listed on its own market place, after the merger process of the Stock Exchange of Singapore (“SES”) and the Singapore International Monetary Exchange (“SIMEX”). In 2000, HKEx was also created as result of the merger and demutualization of Stock Exchange of Hong Kong

Limited (“SEHK”) and the Hong Kong Futures Exchange Limited (“HKFE”) and the Hong Kong Securities Clearing Company Limited (“HKSCC”). Mid 2000, HKEx shares were listed on its own marketplace, following the merger. In 2000, Tokyo Stock

Exchange; one of the largest exchanges in the world completed its demutualization (Hughes and Zargar, 2006, P.7).

In Europe, major stock exchanges such as London Stock Exchange, Deutsche Borse and Euronext become public companies. For London Stock Exchange, the process of demutualization goes earlier in 1986 with a number of market deregulation initiatives; called the “Big Bang”, which ended by transforming the stock exchange into a private limited company. In 2000, LSE became a public limited company (London Stock Exchange plc). Listing LSE took place mid 2001. The Deutsche Borse AG (“Deutsche Borse”) goes back to 1988, when the Deutsche Terminbourse (“DTB”), an electronic futures and options trading system was established. DTB was legally structured as a corporation which was owned by five German financial institutions. In 1991, the Deutsche Borse was established to operate the Frankfurt Stock Exchange, which later merged with the DTB. In February 2001, The Deutsche Borse completed its public offering. Euronext NV (“Euronext”) which is a Dutch public company with limited liability was formed in September 2000 from the merger of the Amsterdam, Brussels and Paris stock exchanges, and became listed Euronext Paris on July 2001. In 2002 Euronext acquired the London International Financial Futures and Options Stock Exchange and the Portuguese stock exchange (Ibid. P.7-8).

In America, major American stock exchanges have or intend to demutualize in the near future. Among these exchanges; the Chicago Mercantile Stock Exchange (“CME”), the Chicago Board of Options Stock exchange (“CBOE”), NASDAQ, and the New York Stock exchange (“NYSE”). The first demutualized stock exchange in the United States is CME, which demutualized in 2000. In 2003, the CME made its IPO and listed its shares on the NYSE. The “restructuring of the Chicago Board of Trade, included

demutualization into a for-profit, stock-based holding company was approved in 2005 with an IPO conducted in October 2005 (Ibid., p.8).”

The NASDAQ Stock Market, Inc. which used to be known as the National Association of Securities Dealers was once a wholly-owned unit of NASD. In 2000 the NASD separated from and takes NASDAQ public. A restructuring process of NASDAQ started in 2000 when NASD conducted a private placement and issued warrants.‘On July 1, 2002 shares of NASDAQ started trading on the Over-the-Counter Bulletin Board and eventually migrated to the NASDAQ Stock Market in February 2005 after NASDAQ issued shares in a secondary offering. NASDAQ acquired the BRUT ECN in 2004 and on December 8, 2005 NASDAQ acquired the Instinet Group Incorporated and sold Instinet’s Institutional Broker division to Silver Lake Partners. As a result of these transactions, NASDAQ owns INET ECN. The U.S. Securities and Stock Exchange Commission (“SEC”) on January 13, 2006 approved application of the NASDAQ to become a registered securities exchange. This application was under consideration since 2001, and it is a key step in NASDAQ obtaining full independence from NASD and competing on a more even footing with other exchanges, including the NYSE (Ibid. p. 8-9)’.

The process of demutualization in the New York Stock Exchange (NYSE) started in 2005 with the announcement to acquire Archipelago Holdings Inc. (“Archipelago”). NYSE got the approval of the governing board in 2005. The merger process was completed in 2006, by creating the new entity NYSE Group Inc. (“NYSE”) after getting the consent of the merger from the SEC. On March 8, 2006 the NYSE started to trade, and with this shift, it ended the exchange’s 213-year history as a member-owned association (Ibid. p. 9). 1.6 The Debate on Demutualization

1.6.1 Arguments For

It is argued that demutualization is the first line of response in addressing the most critical issues faced today. It responds to the needs of the exchange’s users and customers, particularly investors and issuers. It shifts the interest of the stock exchange from satisfying financial intermediaries to the satisfaction of market participants. Under demutualization, the strategy of the stock exchange is more transparent. Requests for money for acquisitions should be transferred to shareholders. Investors must concur on the long-term opportunities and challenges of the exchange. Adopting a value-based approach improves the market for trading. The cost savings to investors; resulting from improved access to market, limited restrictions on markets, low level of bureaucracy and direct access to the stock exchange without intermediation is significant (International Options Markets Association / International Options Clearing Association (IOMA/IOCA) Annual Meeting, WFE, 2005, p 15-16).

Clearly, demutualization and self-listing can also greatly free up the ability of stock exchanges to engage in many commercial activities – part of their stated purpose after all. One example is the Australian Stock Exchange which was demutualized in 2005. Few months later it announced a merger proposal (unsuccessfully) with the Sydney Futures Exchange. Within a year, the exchange formed a strategic alliance with NASDAQ, created a joint venture with Perpetual Trustees in 2000, created an operational trading link with both North America and Singapore in 2001, launched a futures market in 2002, and by 2003 had entered memorandums of understanding (MOUs) with the Philippines, Thailand, Singapore, Tokyo, Hong Kong, Shanghai and Shenzhen exchanges. A similar trend can be seen in many other demutualized stock exchanges such as see Deutsche Börse, London Stock Exchange, and Singapore Stock exchange (Worthington and Higgs, 2005/06, p.4).

Other changes were also noted in the business conduct of demutualized exchanges. According to the World Federation of Stock exchanges 2003 Cost and Revenue Survey of fifty member exchanges, the demutualized stock exchanges generated about twice as much service income from less-traditional market data dissemination as did mutuals, and much less from more-traditional transaction fees. Further, though all demutualized and listed stock exchanges in this survey identified themselves as being for-profit, more than one-third of member stock exchanges and less than one-half of association stock exchanges did not identify profits as a business goal (WFE Cost and Revenue Survey, 2003).

Other Expected benefits from demutualization were identified by Lee in his paper; The Future of Securities Exchange. According to Lee, demutualization may allow the

exchange to ‘1) To modernize its technology, 2) to create a valuable currency for strategic alliances and acquisitions; 3) to obtain a governance and management structure that is more agile, flexible and swift in its ability to respond to industry and market conditions, and that is more subject to “cumbersome decision-making and strategic gridlock”, 4) to unlock members’ equity and buy out the vested interests of traders, 5) to avoid

concentration of ownership power in a particular group of stock exchange participants, 6) to reward key market participants in equity, thus giving them a financial incentive to business to the exchange, 7) to create catalyst for pursuing new business strategies, 8) to provide both a valuation benchmark and liquidity for investors, 9) to obtain an initial infusion of capital and to gain easier ongoing access to capital and, 10) to ensure financial decision-making by ensuring that resources are allocated to business initiatives and ventures that enhance shareholder value (Lee, 2002, p.13-15).’

1.6.2 Counter Arguments

Some authors have argued that the above mentioned anticipated benefits of demutualization may in reality not materialize or may be obtainable with a mutual governance structure for a securities exchange. Thus, any cost-saving that a demutualized stock exchange with direct investor access might result in is low in comparison to the benefits that can be obtained from the presence of brokers, with ownership interests in the exchange. From their point of view, there are several claims that support their claims. In many developing countries, the creation of any financial institution is extremely hard, and the creation of investors is often harder than the creation of the brokers (Lee, Ruben, 2002, p.15).

The change in the governance structure raises concerns regarding the ability of the demutualized stock exchange to develop and enforce appropriate listing and disclosure standards, surveillance and discipline, financial and operational compliance, and fair and equitable treatment of customers. There is a question on whether or not the demutualized stock exchange will perform better (Steil, 2002, 84-86). A related issue is whether the act of demutulaization and/or listing has allowed new risky business activities that did not take place when the stock exchange was mutual and that may be of concern to regulators (Worthington and Higgs, p.3-4)). This involves new financial risks that require regulatory intervention, such as the imposition of “…firewalls to protect the resources necessary to run the exchange’s core activities (Ibid. p.3-4)”. Lucy 2004 related this point to the Australian Stock Exchange. According to Lucy, the new functions of that the stock exchange is undertaking as a market regulator and as a commercialized entity that seeks many venues to initiate businesses has widened the scope of conflict and allowed for new risks through global links such as clearing and settlement arrangements.

The emergence of the demutualized for-profit stock exchange aggravates the conflicts of interests related to running the stock exchange as a commercialized entity and as a self-regulatory organization (SRO). Some argue that in order to meet the commercial needs of the demutualized for-profit exchange, the stock exchange should sacrifice its regulatory responsibilities. Against this point of view, some have argued that demutualization will motivate the exchange’s regulators to maintain high regulatory standards because this will

allow for more order flow and business in the stock exchange (Lee, 2002, p.15). It has also been argued that more regulations are required under the demutulalized structure in order to curb the ‘Anti-competitive behavior’. According to Lee, in spite of the existence of alternative trading systems, some few securities are expected to dominate trading in most securities. Being demutualized entities, they will seek profit maximization. They are expected to behave the same way as monopolistic enterprises; raise price and reduce output (Lee, 2002, p.15-16).

1.7 Problem Definition

Stock exchanges all over the world initiate demutualization hoping to empower the market and to increase revenues. However, the trend of stock exchange demutualization continues to generate a debate amongst academics, business people and policy makers on the impact of such conversion; from the mutual to the demutualized organizational form. There remains a school of thought that is against demutualization. Some argue that some of the most successful stock exchanges in the world – such as New York Stock exchange- have remained successful for long time while mutualized.A question is often raised of whether the demutualization has so far succeeded or not. There is no clear knowledge how the various stakeholders (government, enterprises, investors, broader business environment and consumers) have been affected. Of particular importance is the impact of

demutualization on the stock exchange itself (as an organization) as it eventually extends the impact on other stakeholders (investors, employees, government, etc.). There is little empirical literature with regard to the impact of demutualization on the performance of exchanges. This literature either depends on incomplete analyses of some case studies or provides incomprehensive quantitative empirical analyses. However, the impact of demutualization should also be assessed considering the quantitative (financial and market) and qualitative (non-financial) dimensions. Such assessment is not available so far. Therefore, there is no awareness of the real impact of the international trend of demutualization on the performance of exchanges.

1.8 Research Objective

The research aims to assess the findings of an empirical analysis on the impact of

demutualization on the performance of stock exchanges in terms of financial performance, market performance, and non-financial performance.

Thus the research seeks to answer the following research questions: 1.8.1 Major Research Question

What is the impact of demutualization on the performance of demutualized exchanges? 1.8.2 Minor Research Questions

1. What is the impact of demutualization of on the financial performance of demutualized stock exchanges?

2. What is the impact of demutualization on the market performance of demutualized stock exchanges?

3. What is the impact of demutualization on the non-financial performance of the demutualized stock exchanges?

The above mentioned research questions are to provide better awareness and understanding of the real impact of demutualization on the performance of stock

exchanges and thus, to enable researchers link this impact to the impact of other on-going economic policies. The assessment also gives insights on the level of importance of demutualization to the performance of stock exchanges through analyzing the changes that this program has resulted in. The researcher plans to adopt the perspective of an advisor to policy makers who are wrestling with the practical problem of whether or not to apply demutualization to stock exchanges.

1.9 Significance of the Research

Stock exchanges play an important role in the financial sector and the functioning of any economy. The possibility that the stock exchange may go out of business can create serious problems for listed companies that may find themselves unable to raise the necessary capital and for investors who will encounter reduced liquidity for their holdings. Large successful stock exchanges might be willing to purchase the bankrupt / financially-troubled ones. However, it is still necessary for regulators and policymakers to monitor and evaluate the operational (financial and market) performance as well as non-financial dimensions of demutualized stock exchanges in order to take necessary actions; either to resolve problems or to re-mutualise the stock exchange in worse case scenario. The research performs this monitoring and evaluation exercise, and also provides the tool and criteria needed to repeat this exercise for future updates on the impact of demutualization on the performance of exchanges, or any other organization. Unlike prior empirical literature on the impact of demutualization on the performance of exchanges, the research uses a comprehensive set of criteria to evaluate the post-demutualization impact on exchanges, and is applied to stock exchanges worldwide.

1.10 Organization of the Study Chapter 1: Introduction

This Chapter provides an introduction to the study, the problem definition, the purpose of the study, the research questions and hypotheses, and the significance of the study. Chapter 2: Literature Review

This chapter is divided into six sections:

Section 1: Presents a literature review on the theory of the firm and the emergence of financial firm.

Section 2: Literature on Governance Structure

Section 3: Literature on the Organizational and Ownership Structure of Stock Exchanges Section 4: Literature on the Regulatory issues related to Demutualization of Exchanges Section 5: Literature review on empirical studies prepared on the impact of

demutualization on the performance of stock exchanges,

Chapter 3: The Conceptual Background

This chapter explains how the literature relates to the research hypotheses, and what are the main dimensions and measures used to test the major and minor research hypotheses. All measures of the study will be clearly identified and labelled.

Chapter 4: Research Design and Methodology

This chapter provides the scientific research design and methodology of the research. It will also show how the data collected fit in the study design and methodology. Chapter 5: Data Analysis and Results

A detailed analysis and interpretation of data and results will be presented in this chapter. The chapter will also introduce limitations to the study. In addition, it will show how the results fit in comparison to previous studies and its contribution to literature.

Chapter 6: Conclusions and Recommendations

The chapter will present the main conclusions of the study along with recommendations for future studies.

Appendices

Includes all data used in the study, figures and tables referred to in the literature

CHAPTER 2: REVIEW OF LITERATURE

2.1 The Theory of the Firm and the Emergence of the Financial Firm

Firms are important catalysts for economic development. There is a wide literature that review the theory of the firm, stemming from the work of Coase (1937), Alchian and Demstz (1972) and Williamson (1975). Williamson also provides insights on large corporations, particularly in relation to how firms organize themselves in order to overcome the problems of bounded rationality and opportunistic behavior. Williamson argues that failure in “free market” transactions leads to the need of establishing markets and hierarchies in order to economize the cost of transactions. Internal organizations are needed when the bounded rationality of individuals faces an uncertain environment. If everything is known, then contingent claims “contracts” could be used to regulate transactions. In an uncertain environment, alternative market forms act as intermediaries to reduce the transactional costs between individuals (Williamson, 1975, p.20-30). However, little literature has been found that reviews the implications of the theory of the firm on the emergence of financial firm. Literature that analyzes the efficacy of financial firms (e.g. Klein, 1971; Leland and Pyle, 1977) makes little use of the theory of the firm. Only one literature (Ames, 2002) has been found that reviews the implications of the theory of the firm on the financial firm. Ames uses literature on transaction cost economics and property rights to explain the purpose of the firm. Ames 2002, has extended this literature to explain the emergence of financial firms and large financial organizations (Ames, 2002, pp.129-148).

2.1.1 Transaction Costs

Transaction costs economics provides an explanation of why firms exist. The roots of transaction costs economics goes back to the work of Coase (1937). According to Coase, the economic system is coordinated by the price mechanism (Coase, 1937, p. 387). Hence, the emergence of firms can be explained. Firms exist where it is profitable to establish them as there are costs to conducting transactions in the market. The most obvious cost is discovering what the relevant prices are. In addition, there are costs related to negotiating and concluding transactions for each transaction. For Coase, the firm is a ‘series of contracts’ that reduces and economizes on transaction costs. Further, the firm can 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 (Coase, 1937, p. 390-398). Considering the Coarsian perspective, the financial firm acts as a broker between lenders and borrowers in order to economize on search costs. Additionally, the financial firm offers lenders and borrowers standardized and homogeneous contracts (products). In addition to Coase’s argument, Williamson (1975) investigates the nature of transaction costs. For Williamson, the firm is an institutional response to transaction-specific investment and opportunistic behavior. The importance of transaction costs increases when transaction specific investments are involved. Such transaction costs come from asymmetric information, uncertainty and opportunistic behavior. Without financial firms, individuals have to bear the cost of finding another individual to contract with, the search for prices, investment in legal skills in order to be able to draw up a mutually agreed contract (or hire an agent to do this). Such high costs indicate that only large sums of

transactions are made because these are the only transactions that are economically viable. The development of financial institutions means that smaller lending and borrowing transactions can be profitably conducted (Williamson, 1975, p.20-30).

2.1.2 Property Rights

Literature on property rights explains why a particular form of ownership takes place. Highly complementary assets should be owned together. Independent or

non-complementary assets should be owned separately. Where assets are independent, there are no economies of scope (synergies) between them and thus joint ownership has no economic benefit (Ames, 2002, p.133).

Literature on property rights also tackles the ownership of assets and the right to residual income. The individual with better management skills should own the assets required for production. Individual who owns information and skills can act as brokers on behalf of other individuals who wish to conduct borrowing and lending transactions. Such individuals may form partnerships if their assets are complementary. When

complementary assets are merged, productivity of the firm increases. Financial firms are formed when individuals employ agents with specific financial and legal skills (Ames, 2002, 133). Wernerfelt 1984 argues that such skills are part of the firm’s asset and they form a firm because they complement one another (p.173-175). Assets of a firm also include brand names, in-house knowledge of technology, personnel, trade contracts, machinery and capital (Wernerfelt, 1984, p. 172).

Because complementarities between assets are limited, there are limits to the size and scope of the firm. Thus, there is a wide variety of firms that operate within the financial sector because different bundles of assets are owned separately. Management is viewed as an asset to the firm. This management asset 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 (Ames, 2002, p. 135).

The above explanation reveals that the prevailing stockholder model of corporate governance is based on the economic approach that perceives the firm as a nexus of contracts between a legal entity called a firm and its different constituencies; such as employees, customers, suppliers, investors, etc (Coase, 1937, p. 390-398, Alchian and Demsetz, 1972, p. 377-390; Jensen and Meckling, 1976, p. 9-10). All individuals with different economic assets will trade with each other in order to obtain a greater return. The maximum economic return will be achieved through merging individual assets in joint production not by participating in market alone (Boatright, 2006, p. 110).

2.2 Governance Structure

The existence of the firm requires many inputs. These are land, labor, capital and the managerial expertise needed to coordinate these inputs. Each input brings a return. These returns can be in the form of employees’ wages, suppliers’ payments and investors’ interests and dividends. It is crucial for each input provider to secure their return. This

security can be attained by contracts or legal rules that compel a firm to provide the return due to each corporate constituency.

Governance allows for contractual agreements and legal rules that secure each input provider’s claim for the return according to the contribution to the productive activity of the firm. Each asset has a different governance structure than the other, depending on the features of the assets provided. A governance structure needed to secure employees is different from that is needed to secure investors. The market also provides some protection. The customers are secured by the opportunity to shift from one seller to another (Boatright, 2006, p.112).

Shareholders have a certain bundle of rights that include the right to control the corporation. Unlike common perception, shareholders do not own. Shareholders by definition are whatever group that has the right to control and to receive profits. In most corporations, shareholders are usually equity capital providers and not employees or other stakeholders. A question is often raised, why it is usually equity capital providers that enjoy the right to control and receive profits. According to Boatright, part of the answer is a matter of definition. Equity capital is money provided to a firm in return for a claim on profits. The remaining part of the answer is very straightforward. Control is the most suitable protection for their firm-specific assets. ‘If their return on the asset they provide, namely capital is the residual earnings or profit of a firm, then this return is very insecure unless they can ensure that the firm is operated for maximum profit. By contrast the right to control is of no value to other input providers or stakeholder groups because their return is secure as long as the firm is solvent, not maximally profitable. In addition, the return on the firm-specific contribution of other, non-shareholder groups is better protected by other means (Ibid. p.113).’

The above mentioned quote goes in line with the purpose of the firm; to enable each corporate constituency or stakeholder group to obtain the maximum benefit from their involvement. These benefits result from the wealth creating economic activity. Benefits distributed to stakeholders can not be more than what the activity creates. In other words, wealth must be created before it can be distributed. The distribution of the wealth is largely determined by the market. Governance assures that each group receives what the market allots. In the prevailing system of corporate governance, security can be provided by giving shareholders control, making them the beneficiaries of management’s fiduciary duty, and setting shareholder wealth as the objective of the firm (Ibid. p. 116).

Firms can be owned by stakeholder groups other than equity capital providers (Ibid. p.115). In his book, the ownership of enterprise’’, Hansmann looked at the relations between the firm and its “patrons” (e.g. all persons, individuals, or other firms, who transact with the firm either as purchasers of the firms products or as sellers to the firm of supplies, labor, or other factors of production”2_{. According to Hansmann, firms can be} classified according to three ownership structures:

- Producers-owned enterprises such as employee-owned firms or investor-owned enterprise; which include patrons that supply one of the factors of productions: capital.

- Customer-controlled enterprises. This means customers who have a share of the property of the firm. There are many cases where customers own the firm and there are no outside shareholders (shareholders who are not at the same time customers of the firm). This situation does is not always true3_.

- Non-profit and mutual enterprises. Examples of non-profit firms that have no owner include banks and insurance companies4 _{(Hansmann 1996).}

In case where shareholders have contrasting interests; they benefit from the increase of the firm’s profit but also if the price of the good decreases as their private consumer surplus increases. A clear example of this case is in the stock exchange industry where the stock exchange shareholders are generally broker-dealers and listed companies.

The cost of market contracting and the cost of ownership lead to the different structures of the firm. As a way to reduce and internalize the cost of transactions, firms and patrons find it efficient to have one category owning the other. In other words, different structures of firm’s ownership imply different costs of governance. These costs vary among the different classes of patrons and allow some of them to better govern the firm (Di Noia, 1998, p.6-7).

According to Di Noia, Hansmann’s ideas can be exploited to explain why member exchanges emerge and why they are changing:

‘First of all, exchanges were firms with a great degree of monopoly power in dealing with their customers and “this is a common reason for organizing the firm as a consumer cooperative”. In this way, member firms could avoid two types of costs: the first is paying a monopoly price for the trading services they purchased from the exchange; the second is the under consumption of trading services due to high prices. The cost of ownership in an exchange led naturally to a members’ ownership, as exchange members were quite homogeneous. Thus, this minimized the cost of collective decision making and gained managerial control with low costs as generally the intermediaries themselves had all the relevant information needed to organize and manage their exchange […]. Nowadays, exchanges are moving from being customer-owned to being investor-owned and Hansmann’s general explanation can be exploited, too.

Integration of the markets and evolution of technology change the monopoly position of exchanges, reducing the main advantage of members’ ownership. Exchanges must raise capital to compete efficiently and investor ownership is the obvious solution to solve, at least partially, asymmetric information problems in the capital market. The cost of ownership in the new environment is reduced by investor-owned exchanges mainly because the cost of collective decision making is increasing due to the massive heterogeneity of exchange members. There are no more simple brokers of the same size and profitability but they are more and more diverse. Banks are much different from brokers. Market makers, which may be different from banks, have different interests from brokers. In short, there are many conflicts among members that increase the cost of governance. Furthermore, risk bearing is reduced in an investor-owned exchange by definition, as investors are in a position to eliminate firm-specific risk through diversification of their investment5 _{(Di Noia, 1998,}

p.7-8)’.

Other than Hansmann’s analysis of customer-controlled firms, there is no much literature on customer-controlled firms.

3 _{According to Di Noia, not all owners are customers of the firm and not all customers are also owners. There may exist other}

customers who purchase the products of the firm and shareholders who do not purchase the products of the firm. An example of that can be seen in the exchange industry.

4 _{An owner is defined as the person who has two formal rights; the right to control the firm and the right to appropriate the firm’s}

profits or residual earnings. In non-profit enterprises, persons who have control do not have residual earnings. Thus, they can not be considered owners.

One of the key points that distinguish customer-controlled firms from normal firms is that because of this type of ownership structure, the management may not necessarily be willing to maximize profits. From an industrial organization point of view, the income effect has a greater importance than the price effect. Though the price of one of the firm’s products can influence the shareholders’ value through their consumption of goods, this exception is of minor importance. According to Tirole (1988), “The shareholders’ (at least influential ones’) consumption of their firms’ products is usually very small relative to the income effect generated by the firm’s profit level6_”.

Though this deviation from the profit maximization behavior exist in abundance, it is minimized by the competitive forces, the self-interest of stock owning management, and the threat of managerial displacement by important outside stockholders and takeover traders7_{. These limiting conditions also apply to exchanges: competition is increasing,} stock-owning management already exists in some of the stock exchanges (such as London Stock Exchange (LSE)), and where takeovers started to happen (OM over Stockholm Stock Exchange), as well as outside ownership so that new owners replace the old management (Di Noia, 1998, p.8).

2.3 Organizational and Ownership Structure of Exchanges

Though there is an extensive literature on the functions that financial exchanges perform8_, there is very little literature on the ownership and governance structures of exchanges. The importance of looking at the ownership structure of stock exchanges has earlier been highlighted by King (1977)9 _{who provided a simple model of a stock market economy.} The model views a two-period, three states, and one commodity world with a certain number of securities consisting of shares in a fixed number of firms. The firm’s policies affect the level of shareholders’ consumption and there is no presumption that the policy that maximizes the share price is in the shareholders’ interest. This is because the firm can change the effective prices of products that the shareholders purchase. This can happen when the firm is a monopolist or in any case where the firm can affect the prices of commodities. This situation is often ignored when the firm is viewed as a black box and the composition of its owners is ignored.

One paper that analyzed the organizational structures of stock exchanges is that of Pirrong 2000. Pirrong presented a model that identifies the factors that determine whether

exchanges are organized as a for-profit enterprises or non-profit enterprises. Pirrong’s analysis is based on two assumptions; that members of an exchange are profit maximizers and that exchanges have some market power (their members collectively face a downward sloping demand curve for their services) (Pirrong, 2000, 443).

Pirrong argues that the rules governing the trading process can impact the organizational structure of the exchange. There are two ways by which the profit-maximizing exchange members can utilize the market power inherent in centralized trading. One way is that the exchange can charge a ‘super-marginal’ cost for its services and distribute the profits to its

8 _{Contribution to the literature on the functions of financial exchanges include Telser (1981, 1986), Telser and Higginbothan}

(1977) and Mulherin, Netter, and Overdahl (1992).

members. In this way, the exchange is operated as a for-profit enterprise; either as a corporation, partnership or a for-profit cooperative/ mutual. Another way is for the exchange to set prices for its services that are equal to marginal cost, and establish rules that enforce cartels among stock exchange members and limit the number of members. The stock exchange then is labelled as a non-profit mutual organization. Thus, a for-profit stock exchange sets prices for its services to earn a profit that is distributed to its members through a dividend or other means. On the other hand, a non-profit stock exchange do not transfer rents between different classes of members (Ibid. p.440-441).

Specialization is another factor that affects the organizational structure of stock exchange. The predominance of the non-profit form indicates that there are differences in costs between stock exchange members and member specialization in the provision of services. Heterogeneities among exchange members – arising from specialization - are important to understand the salient features of the stock exchange organization. When members are homogeneous, for profit organizational form of stock exchange dominate. But, when members are heterogeneous, a non-profit stock exchange form will prevail. In this case, stock exchange members can exploit market power. Suppliers of some specialized services (e.g. brokers) may lose from the adoption of a rule that maximizes the joint wealth of stock exchange membership. Thus, they may work to prevent the adoption of these rules. Members who earn the smallest rents favour a for-profit form of stock exchange (Ibid. p.438).

Pirrong, 2000 also argues that changes in the distribution of rents among members (that result from technological changes) lead to changes in the organizational structure of the stock exchange (non-profit or for-profit form) (Pirrong 2000, 462-463). For example, exchange members will support the transformation into a for-profit organizational form whenever they suffer from loss of rents due to competition and/or some technological changes.

Competition of stock exchanges is also central to the analysis of the organizational structure. Exchanges that face near perfect competition on the supply of financial transactions services adopt efficient rules and governance structures to ensure their survival. On the contrary, exchanges that possess market power or are protected by market barriers have their profit maximizing members have an incentive to create rules and organizational structures that allow them to exploit this power. This means that the existence of inefficient exchange practices depends to a great extent on the existence of exchange market power. Thus, any theory of exchange organization and practices should take into consideration the role of market power and entry barriers (Ibid. p.438).

Pirrong’s analysis explains why most floor-based stock exchanges are non-profit organization. Heterogeneity among stock exchange members – with regard to costs of providing brokerage services - allows low-cost members to enforce a non-profit mutual organizational structure.

One paper that relates the organizational and ownership structures and stock exchanges is that of Hart and Moore (1995)10_{. Hart and Moore noted that many stock exchanges differ}