Institute of Chartered Secretaries Bangladesh, Issue XIII Vol.

2, April 2011

Demutualization of Stock Exchanges in Bangladesh

Shah Md. Safiul Hoque Assistant Professor, School of Business Studies Southeast Universtiy 18 Street, Banani, Dhaka-1213, Bangladesh

Md. Awal Al Kabir Lecturer Dept. of Management Studies Jahangirnagar University Savar, Dhaka-1342, Bangladesh Contact: 01914-431532, 01676-835673 Email: awalalkabir@yahoo.com

Demutualization of Stock Exchanges in Bangladesh

[Abstract: Demutualization refers to the change in legal status of the exchange from a mutual association into a company limited by shares. Demutualization as a concept is neither a very new concept nor sophisticated. This paper analyses the demutualization of stock exchange as a mechanism to enhance the corporate governance, increased flexibility in decision-making, and responses to globalization and international alliances in the context of Bangladesh. The study also identifies few challenges in the way of demutualization such as conflicts of interests, ownership structure, regulatory issues, financial stability etc. An overall structure and a corporate structure are proposed in this paper to implement demutualization in Bangladesh. To face the challenges and make the demutualization viable a regulatory framework is necessary which will ensure appropriateness of organization structure, develop risk management strategy, corporate governance model to govern and managed the stock exchange efficiently and fairly.] Key words: Demutualization, Mutual exchange, Stock exchange, corporate governance, Globalization, conflict of interests

Introduction Stock markets around the world are going through various changes to be proficient and to provide their stakeholders with better facilities. One of the major changes is demutualization. Researchers have explored this subject and its potential benefit for the stock markets around the world as most of the exchanges have gone through this process. Many emerging markets are also considering demutualization. Stock markets all over the world lend a hand the investors to analyze the condition of an economy in order to get maximum yield on their investment. Its operational efficiency is important for the betterment of the financial system. The economies of the world rely on the stock exchanges to facilitate trade in the stocks. Stock exchanges mainly perform three major functions: regulator, development of market and operational side (Ranong, 2002). It works as front line regulator for market participants because of the intimate involvement in trading activities.
Figure 01: Market Capitalization FIBV Stock Exchange Figure 02: Stock Exchange in Asia

Source: International Federation of Stock Exchange (FIBV)

As in emerging economies like Bangladesh, a mutual stock exchange is seen as an institution, serving national interest. But to avoid instability, liquidity and other financial ratios it is the demand of time to implement demutualization of stock exchanges in Bangladesh. To be more secured and risk averse, it may act as a buffer against any financial shocks. The four-member investigation committee on the recent stock market crash already submitted its report to the finance minister suggesting some recommendations to improve transparency in the operation of the nation's two stock exchanges: Dhaka Stock Exchange (DSE), and, Chittagong Stock Exchange (CSE). The investigation report revealed the alleged manipulation of the market operation through issuing of illegal placement and preference shares, loan settlement through shares, asset re-evaluation, share split, and a series of ill-motive transactions. The recommendations they put most emphasis on is the demutualization of stock exchanges. Demutualization in its many forms has become an extensive reality, one with growing demand in emerging market countries (Elliott, 2002). The concept is initially used to refer explicitly to conversion process adopted by insurance companies. Because of the positive aspects of this process demutualization is now common in savings and loan industry, stock exchanges and agricultural cooperatives around the

world. Demutualization is not a new term for stock markets, as in 1993 worlds first exchange, Stockholm Stock Exchange went through the process of demutualization very fruitfully. Until the early 1990s, most financial exchanges were non-profit, mutual organizations owned by their members. But from the figure 01 and 02 it is obvious that most of stock exchanges in Asian region have implemented demutualization. Demutualization has generally concerned conversion of an exchange from a not-forprofit member owned organization to a for-profit shareholder-owned corporation. Background of Stock Exchanges in Bangladesh Bangladesh capital market is one of the smallest in Asia but the third largest in the south Asia region. Bangladesh has two Stock Exchanges, Dhaka Stock Exchange (DSE), established in 1954 where trading is conducted by Computerized Automated Trading System and Chittagong Stock Exchange (CSE), established in 1995 which is also conducted by Computerized Automated Trading System . All exchanges are self-regulated, private sector entities which must have their operating rules approved by the SEC. It also consists of a dedicated regulator, the Securities and Exchange Commission (SEC), since, it implements rules and regulations, monitors their implications to operate and develop the capital market. It consists of Central Depository Bangladesh Limited (CDBL), the only Central Depository in Bangladesh that provides facilities for the settlement of transactions of dematerialized securities in CSE and DSE. DSE & CSE comprises of 25 members of whom 12 are elected through direct election from the 235 and 134 shareholders respectively. Another 12 members representing distinguished personalities from different key economic and social arena of the country. The CEO of the Exchange is also a Director of the Board. Currently, our stock exchanges are non-profit cooperative organizations, owned by the exchange members who are usually stockbrokers. They do not distribute earnings as dividend. Rather, any profits are returned to members in the form of lower trading costs or access fees and investment for growth. Demutualization and Challenges Demutualization is a process in which non- profit organizations turn to for profit organizations (Hughes and Zargar, 2006). The essence lies with the separation of ownership and management. Traditionally, stock exchanges operate as mutualized, non- profit organizations. According to Scullion (2001) demutualization is not merely converting into for profit organization owned by its members. An exchange is genuinely demutualized when it maximizes its potential of market capitalization to the fullest and alongside it also increases its shareholders value. The expression demutualization means the transition from a mutual company, in which there are no shares, and every member has one vote, to a company limited by shares and one vote per share. Demutualization of exchanges is a response to global competition and technological innovation that is restructuring the securities markets. The trend to demutualize is being driven largely by changes in technology and increased competition. Competition from electronic communication networks (ECNs) and other alternative trading systems offering anonymity and alternative or lower cost structures is drawing volume away from traditional exchanges. The other important forces that drive to demutualization are: Incessant trends of Integration and merger Responses to international competition Blurring of product distinctions Opening Up of Markets Pressure from Investors and Financial Services Sector for bringing efficiency Huge competition on Trading The process of demutualization starts from changing an organization from its mutual ownership structure to a share ownership structure. The process entails first converting memberships into shares, which step may or may not be followed by a public issue of those or treasury shares. In this manner, a quasigovernmental institution transforms itself into a profit-oriented, publicly traded company.

Figure 03: The process of Exchange Demutualization

Source: Reena Aggarwal, Demutualization and Corporate Governance of Stock Exchange

Ownership and trading privileges are effectively separated. Stockbrokers are no longer owners but customers of the exchange. Directors are elected by shareholders and answerable to them. Today some exchanges have been transformed into for-profit shareholder-owned companies and many more are considering such a demutualization. Some demutualized exchanges have become public companies and listed on their own or other boards. Others have remained privately held companies but intend to go public in the future. The company can take different shapes and forms, that is, it could be either a listed or unlisted company which may be closely held or publicly held. This process involves the segregation of members' right into distinct segments, viz. ownership rights and trading rights. The shareholders in a corporatized stock exchange may be a diverse group, as members may decide to retain their shares or to sell them. Table 03 shows us the differences in corporate structure between mutual and demutualized exchanges. Table 01: Corporate Structure of a Mutual and a Demutualization Exchange
AREA Ownership Aims of the Exchange MUTUAL EXCHANGE Member who trade on the exchange. Usually, to maintain: 1.An efficient, low cost, trading environment; 2.Risk-minimized settlement and 3.Quality regulatory framework 1. The board usually comprise mostly or solely member representatives 2. Decision are made on one member, one vote 3.Decision making power is vested with the board Not usually a priority. Not usually a priority .Mutual exchange may maintain high levels of capital backing on the basis of better safe to meet statutory requirements. DEMUTUALIZED EXCHANGE Public shareholders. These may include members, but trading rights and ownership are separated. 1.Maximum gains from shares 2.Improve product range and distribution and 3.Protect brand quality(including by having a quality regulatory framework 1. The board is usually more diversified 2. Decisions are usually made on a one share, one vote basis. 3. Decision making power is vested with the board, Priority , given a desire to maximize growth A key priority as management attempts to maximize share holder value.

Composition of board and decision making

Acquisitions and alliances Capital management

Source: Own analysis

The literature in demutualization shows the numbers of benefits we can yield. These are: a) b) c) d) e) f) g) h) Improvements in Corporate Governance Increased Customer Focus Increased Flexibility in Decision-Making Restructuring and Alliances of Exchanges Expansion of Activities Raise capital for strategic affiliations, technological improvements or new systems Access to human capital International alliances etc

Demutualization is a multifaceted process and to implement and retain this process efficient, several challenges have to face. Conflict of interest is the biggest challenge as management takes decisions which are not in conflict with their position in the organization whereas directors do not want any compromise

on compromise on maximum revenue. Ownership structure is another challenge since it is hard to find the actual value of ownership right. Financial stability is a big challenge which needs to be covered. Regulatory framework is another challenge for the demutualized stock exchange because exchanges incur costs to develop and apply regulatory framework. As after the demutualization, stock exchange will become a for-profit organization; so there remains a possibility that regulatory functions may be compromised with the goal of maximizing profit. Demutualization: Context Bangladesh Bangladesh has started its way to demutualize the stock markets. The present government is determined to complete the demutualization process within its tenure. Recent delegates from IMF also stated demutualization as a pre-condition for its sanction of $1 billion loan. On February 02, 2011, the DSE formed a 10-member committee in this regard conferring the Term of Reference of reviewing the process maintained for demutualization of Asian stock exchanges. Based on their opinion the demutualization process for both stock exchanges of Bangladesh will be initiated. Demutualization requires doing the valuations, structures, laws and governance which is very time-consuming. We may wait for next couple of years to complete the process. The demutualization implementation committee has prepared an action plan to demutualize the stock exchange. The 11-memebr committee, headed by managing director of Investment Corporation of Bangladesh Mr. Md Fayekuzzaman, has been formed in February in suggestion of the government that had declared to demutualize the stock exchange within its tenure. Under the action plan, the committee will prepare a plan to build up a consensus on exchange demutualization and its broader modalities among members of the exchange, which will require holding

road-show.
A demutualised exchange is way different from a mutual exchange; the three functions of ownership, management and trading are intervened into a single Group in a mutual exchange. The broker members of the exchange over here are both the owners and the traders on the exchange and they further manage the exchange as well. To implement demutualization in Bangladesh all these three functions must be precisely segregated. A comprehensive structure of demutualized exchange is proposed (figure: 04) to operate the demutualized exchange in Bangladesh. Members of FIBV all over the world have established this organogram to make the demutualization effective and efficient. Figure 04: Overall structure of Demutualized Stock Exchange

Source: Demutualization of Philippine Stock Exchange, Maria Larrie Alinsunurin

In a demutualized exchange owner and management are different. There will have several management groups who will perform different activities for the betterment of the shareholders and other stakeholders of the exchange. Table 02: Role of Stock Exchange Committee
GROUP Office of the President COMMITTEE (FUTURE ROLE) Management Audit & Finance Social Committees ( social Club) Corporate Services Business Development ( Strategic Advisory ) Financial Exchange (Strategic Advisory ) Integrity Group Business Conduct & Ethics ( Broker Disciplinary ) Floor Trading & Arbitration ( Broker Appeals ) Policy Committees ( Business rules) Capital Market Group Membership Committee ( Broker Advisory ) Listing Committee ( listing Appeals) Clearing & Settlement Group Securities Clearing ( Strategic Advisory ) Technology Services Technology ( Strategic Advisory ) Source: Demutualization of Philippine Stock Exchange, Maria Larrie Alinsunurin

Before implementing demutualization we should revisit the commercial strategy to improve viability and enhance business prospects. If the demutualization does not become financially viable it will become the burden in the long run and will lose the attention of all concerns. Over the last five years, given the exchanges move towards for-profit structures there has been a steady rise in revenues of FIBV member exchanges (growing at a rate of 12.3% per annum) that outpaced their costs (growing at a rate of 10% per annum-Figure: 05). Figure 05: Revenue Breakdown by legal Status (2006) The Cost and Revenue Survey 2000, undertaken by the FIBV confirmed that the mutual exchanges and associations were relatively less cost competitive and profitable. Demutualized exchanges, with a new strategic mandate, were the most profitable bourses and earned an average return of 41%. So from the experiences of other countries it is apparent that demutualization will be financially viable in the context of Bangladesh. Because trade volume and investors are sharply increasing day by day in bourses of Source: World Federation of Exchanges, 2007.WFE Bangladesh. Last 2-3 years, investors in the stock Annual Report & Statistics ,2007 exchanges of Bangladesh increased by more than 50 times. Table 03: FIBV Member Stock Exchanges Analysis of Costs and Revenues, 2000

Source: International Federation of Stock Exchange (FIBV)

So demutualization may open the new era of excellences of stock exchanges because a for-profit

exchange strives to keep its cost within manageable level, charges fees to recover its operational costs, and earn a profit margin on top of the costs to replenish reserves, pay for new investments to improve services, and provide dividends to investors. However, these exchanges need to continue to strive to ensure the financial viability is sustainable. Implementation of demutualization of exchanges may establish a new milestone in the history of financial restructuring. Exchanges of our country will enjoy the following benefits by implementing the demutualization. These are: Demutualization will help the stock exchanges in Bangladesh to improve corporate governance. Demutualization would restructure governance at the stock exchanges on a sustainable manner. Another advantage of demutualization is access to economic capital. After demutualization stock exchanges of Bangladesh can raise capital from many sources as normal for profit organization. A demutualized exchange can borrow from conventional lenders such as banks. Whereas mutualized stock exchanges have to look up to their guarantor for finances. Better management would also increase the efficacy of the exchange by introducing better practices and policies. It will help to broaden Exchange ownership and allowing Members the ability to realize the value of their assets Spreading ownership risk and making the Exchange less susceptible to Members vested interests Demutualization would also enhance the profit motive for growth and development of exchanges in Bangladesh. After demutualization exchanges have to earn their own bread and butter. This will have a constant pressure on the exchanges to grow and develop their businesses which will increase profitability. Demutualization would also help an exchange to attract listings. Better and efficient system of a demutualized exchange would increase the confidence of other companies and this would result in greater listings. Then Bangladesh can go for international alliances and such alliances provide openings for investments and cross border listings. One of the most important changes that will accompany demutualization is much greater flexibility in its decision-making. The Exchange is therefore better equipped to make timely decisions for market users, and to respond to changing circumstances. Responses to Globalization and Consolidation. Through alliances, exchanges seek to attract more investors by harmonizing distinct trading environments and by offering greater product variety. Enhance their global specialization strategy through strong brand management and by becoming a more entrepreneurial organization. Actively pursue strategies that contribute to the growth of the capital market; provide facilities to trade equities, debt, derivatives and commodities futures and options; promote a corporate culture that encourages commitment, creativity and teamwork; Maintain a balanced and responsive regulatory framework that will enhance market integrity and investor confidence; and focus on customer orientation, strive for organizational excellence and promote professionalism within the industry. It will broaden investor base concentrating on building the local institutional investor base, improving the dissemination of information and investor confidence; Demutualization enhances the efficiency and effectiveness of the stock exchange and the Central Depositary System by restructuring CSE to a more commercially focused organization; It will develop the stock broking industry by promoting the emergence of full service brokers and enhancing professionalism within the industry; Demutualization will harmonize strategy with statutory and other government institutions of Bangladesh through better interaction and coordination with related capital market institutions; and pursue international initiatives through alliances and other strategic linkages. Although demutualization has many benefits, it is not without risk specially a developing country like Bangladesh where there is absence of financial stability. To implement and run demutualized exchange, Bangladesh will have to face many challenges. One is that once ownership and use are decoupled, brokers may not feel any loyalty in the market and may easily turn to alternatives. They may develop alternative

trading systems to internalise their order flow rather than send it to the exchange. The second is the exchanges ability to transform itself. Once it demutualises, it must become a profit-oriented, competitive organization accountable to its shareholders. If the exchange also becomes a public company (as many have), it will also become subject to the disciplines of the market, having to release bad news as well as good, meet financial and periodic reporting obligations and meet market earnings expectations. Third, the exchange can become a potential take-over target, although this can be managed through ownership limits. Fourth, the conflicts of interest that exist in a self-regulatory organization may be exacerbated in a for-profit environment. The exchange may adopt anti-competitive rules (e.g. restricting the ability of trading participants to trade elsewhere). A for-profit exchange may not adequately fund its regulatory activities because there is insufficient return on investment. Other risks associated with demutualization of exchanges in Bangladesh are as follows: rules governing primary and secondary market qualification, operative and ethical practices of market Transparency of market transactions, etc Exchanges costs might rise as pressure increases to supply existing and additional services at international quality levels. Furthermore, exchanges may end up spending more on regulatory oversight, particularly if they retail these services out to independent subsidiaries Absence of Corporate culture Conclusion and Recommendations In todays competitive environment, a stock exchange must be responsive to the needs of its many stakeholders, including participating organizations, listed companies, and institutional and retail investors. Separating exchange membership from ownership may be a politically and economically feasible in the context of Bangladesh. Unlike a mutual structure where often only broker-dealers may be members, a demutualized exchange affords both institutional investors and retail investors the opportunity to become shareholders. A demutualized exchange will have greater flexibility to accommodate the needs of institutional investors as customers, and potentially, as owners. Demutualization is typically but one component of an exchange gearing itself up for survival in the face of frantically paced globalization. Exchanges in Bangladesh must get things in shape domestically as part of steeling themselves for a more global focus. Shareholder-owned market-oriented corporations are more capable of rapid change, allowing for the implementation of various steps necessary to become and stay competitive. To be competitive, exchanges must be transparent, fair and efficient. Demutualization in our country may facilitate the changes necessary to improve standards of self-regulation and increase investor confidence. However demutualization is not necessarily a panacea for poor self-regulation by existing stock exchange in our country unless the new owners of a demutualized exchange are committed to consistent and effective selfregulation, the regulatory benefits of demutualization are likely to be illusory. To enjoy the benefits of demutualization we must try to remove the challenges associated with stock exchanges. So, it is recommended that one committee should watch over the whole process both pre and post demutualization to make it a success. A regulatory framework will help to reduce conflict of interest, unethical practices, and would help to make rules for the primary and secondary market, investors protection and transparency in stock exchanges. The securities market regulations will ensure efficiency, integrity and fairness of the markets that together lend credibility to markets and safeguard investor interest and confidence. it must plan the appropriate organization structure, risk management strategy, corporate governance model, business model, and ownership structure. Effective structure of the exchanges in Bangladesh can only make a difference if the outfit is well governed and managed efficiently and fairly, while ensuring high standard market surveillance and trade practices monitoring, and effective checks and balances on market participants. However, demutualization itself cannot solve all problems. We need to educate investors, owners, management and as such all stakeholders to adjust to the changed scenario and make best out of this. We need to keep in mind specific issues pertaining to the overall economic and political environment in Bangladesh when implementing demutualization and give it time for transition and settle into the system.

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