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Demutualisation and the evolution of stock exchanges

Tsheole recently guided the BSE to its demutualisation
Stock Exchanges are vital enablers of economies in that they facilitate the transfer of capital from economic agents with surplus capital to those with a deficit in order to create economic activity.

In other words, stock exchanges provide a platform on which Governments and Corporates can issue securities in exchange for capital (from investors seeking returns) as well as serve as a market on which these issued securities can be traded. 


Evolution of Stock Exchanges

Typically, stock exchanges evolved through three distinct stages. The initial stage was characterised by an informal network of brokers who would meet at a physical place and match orders from the public (buyers and sellers). This meeting of the brokers to match the order constituted a market.

The second stage of the evolution came when these networks of brokers gradually formalised into not-for-profit mutual or member-owned organisations that employed governance structures akin to those of associations or cooperatives.

This stage brought about the earliest version of the modern-day stock exchange. Then, the Exchanges were established using the capital of the members (stock brokers) and in some instances with assistance of Government. During this stage the stock brokers owned the exclusive rights to trade on the stock exchange as well as the ownership rights. They even had the right to admit or reject any new entrants to the market.

As the stock exchanges grew in relative importance to their host economies, capital markets regulation evolved and strengthened, primarily to protect the interests of the investing public. Consequently, it was recognised that the brokers’ exclusive rights to trade on the market ought to be separated from their ownership rights.  This ushered in the third and the current stage of the evolution of stock exchanges: the age of demutualised stock exchanges. Most stock exchanges have transformed from mutual or member-owned organisation to companies limited by shares. 


What is Demutualisation

Demutualisation is the process of transforming from a member owned, not-for-profit, entity to a for-profit, investor-owned corporation which involves the changing of legal status, structure and governance of an entity. In the case of a stock exchange, the Proprietary Rights of the members, as well as the cash injection by Government, are converted to shares and the Exchange can subsequently be listed on its own platform.


History of Stock Exchange Demutualisation

Demutualisation can be traced to a number of events paramount of which was the liberation of the European Union (EU) capital markets’ regulation as prescribed in the EU Council Directive 93/22/CEE of May 10, 1993 on investment services in the securities field. The directive opened up access to stock exchange membership and financial markets in the EU to authorised firms other than stock brokers. That is, stock exchanges

could also be owned by regulated market participants. As a result, this led to the demutualisation of the Stockholm Stock Exchange (SSE) in 1993, the first Exchange to do so. From the 1990s, demutualisation gained prominence as a way of enhancing the fortunes of stock exchanges. Following the demutualisation of the SSE in 1993, more stock exchanges have followed suit especially in developed markets.


Reasons for Demutualisation

Broadly speaking stock exchanges demutualise because mainly for the following reasons:

Improvement of governance structures – demutualisation helps in streamlining decision making by separating trading and ownership rights as well adopting international best practise with regards to the constitution of the board of directors. Access to capital– broadening access to capital needed for investment in ever improving technology (electronic trading and clearing and settlement systems), seek innovation in technology and services as well as acquire other markets, products and services.

The turn of the 20th century brought with it rapid progress in the development of technology. Consequently, stock exchanges looked towards electronic trading and settlement platforms.

It was then that the open outcry trading method began to be replaced by the automatic trading system (ATS). This, coupled with the strides in the telecommunications, meant that stock exchanges could serve customers from outside their countries. Stock exchanges could list companies (primary or secondarily) from anywhere in the world and investors from anywhere in the world could trade on any exchange without having to be at the market physically. Therefore, the open-outcry floor based method of trading shares gradually became a thing of the past. Competition amongst stock exchanges increased and they had to evolve and adapt in order to survive. This meant that Exchanges had to adopt corporate governance structures that rendered them agile enough to manoeuvre the competitive environment.

Moreover, stock exchanges also needed to broaden their access to capital needed for investment. Before demutualisation, stock exchanges depended on the capital of their limited members, and that of Government. It is through demutualisation, and sometimes self-listing, that the stock exchanges ensured access to greater capital necessary for their growth and commercial survival.

This is particularly important given the faster pace of globalisation and the rapid emergence of alternative trading platforms which threaten to lure trading activity away from regulated exchange.

*Thapelo Tsheole is the Chief Executive Officer of the Botswana Stock Exchange which recently finalised its demutualisation. This is the first in a four part series. The second article will cover the demutualisation of the Botswana Stock Exchange




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