EXCHANGE DEMUTUALIZATION

Pamela S. Hughes Partner

&

Ehsan Zargar Student-at-Law

Blake, Cassels & Graydon LLP

May 1, 2006

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List of Abbreviations ...................................................................................................................... 3 Introduction..................................................................................................................................... 4 PART I. EXCHANGE DEMUTUALIZATION....................................................................... 5 1. What Demutualization Means................................................................................................. 5 2. Historical Evolution of Exchanges ......................................................................................... 7 3. The Reasons to Demutualize ................................................................................................ 10 PART II. REGULATION OF A DEMUTUALIZED EXCHANGE ....................................... 15 A. Introduction........................................................................................................................... 15 1. The Need for Regulation....................................................................................................... 15 B. The Regulatory Challenges Surrounding Deregulated Exchanges ....................................... 17 1. Division of Regulatory Labour ............................................................................................. 17 2. Demutualization, Self-regulation and Conflicts of Interest .................................................. 19 3. DE Governance Issues .......................................................................................................... 24 PART III. THE DEMUTUALIZATION OF THE TSX AND ASX..................................... 29 1. Background to the TSX’s Demutualization.......................................................................... 29 2. Rationale for the Demutualization of TSE............................................................................ 30 3. The Demutualization Process of the TSE ............................................................................. 31 4. Background to the ASX’s Demutualization ......................................................................... 34 5. Rationale for the Demutualization of ASX.......................................................................... 35 6. The Demutualization Process of ASX .................................................................................. 36 7. Post Demutualization: Changes in TSX’s and ASX’s Focus and Activities ........................ 39 PART IV. DEMUTUALIZATION OF EMERGING MARKETS ....................................... 42 1. The Extent of Demutualization............................................................................................. 42 2. What Drives Demutualization in Emerging Markets............................................................ 43 3. Who Drives Demutualization?.............................................................................................. 44 4. Demutualization and Stakeholder Issues .............................................................................. 45 5. Regulatory Obligations of a Demutualized Exchange.......................................................... 47 6. Conclusion ............................................................................................................................ 48 APPENDIX................................................................................................................................... 50

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List of Abbreviations

Abbreviation Term

• Archipelago • Archipelago Holdings Inc. • ASIC • Australian Securities and Investment Commissions • ASX • Australian Stock Exchange • ATS • Alternative Trading Systems • Blueprint • A Blueprint for Success • CBOE • Chicago Board of Options Exchange • CLA Act • The Corporations Act 2001 • CME • Chicago Mercantile Exchange • DE • Demutualized Exchange Operated on a for-Profit Basis • Deutsche Borse • Deutsche Borse AG • DTB • Deutsche Terminbourse • Euronext NV • Euronext • Exchange Act • U.S. Securities Exchange Act of 1934 • Expert Committee • Expert Committee on Demutualization and Integration/Transformation

of Stock Exchanges • FSR Act • Financial Services Reform Act 2001 • GEM • Growth Enterprise Market • HKEx • Hong Kong Exchanges and Clearing Limited • HKFE • Hong Kong Futures Exchange Limited • HKSCC • Honk Kong Securities Clearing Company Limited • IOSCO • International Organization of Securities Commissions • IPO • Initial Public Offering • LSE • London Stock Exchange • MoU • Memoranda of Understanding • NASDAQ • NASDAQ Stock Market, Inc. • NSE • Non-for profit Stock Exchange Owned its Members • NYSE • New York Stock Exchange • OSC • Ontario Securities Commission • QTRSs • Exchanges and Quotation and Trade Reporting Systems • RS • Market Regulation Services Inc. • SEC • U.S. Securities and Exchange Commission • SEHK • Stock Exchange of Hong Kong Limited • SES • Stock Exchange of Singapore • SFC • Securities and Futures Commission • SFCO • Securities and Futures Commission Ordinance • SFE • Sydney Futures Exchanges • SFO • Securities and Futures Ordinance • SGX • Singapore Exchange Limited • SIMEX • Singapore International Monetary Exchange • SRO • Self-Regulating Organization • TSX • Toronto Stock Exchange

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- 4 - Introduction

Capital markets play a vital role in fostering sustainable capital formation by channelling the

savings of an economy into investments. This facilitates the financing of various activities and

helps to increase national output and economic expansion. In this process, stock exchanges play

a significant role by creating an organized market where issuers and investors are brought

together. In the last twenty years stock exchanges have undergone several radical

transformations. One such transformation is the demutualization of stock exchanges.

Demutualization has generally involved conversion of an exchange from a not-for-profit member

owned organization to a for-profit shareholder owned corporation.

Before we discuss the differences between the organizational structure of demutualized and non-

demutualized stock exchanges, it is important to note that within each organizational structure

there have been, and continue to be, significant variation in organization, operation, and

regulation. Some of these differences relate to the role and powers of the exchange’s Board of

Directors, the Chair of the Board of Directors, the officers, the powers of the chief executive

officer, and the various committees and subcommittees. Further differences relate to the manner

in which external bodies and public interest representatives have been able to influence the

policies of the exchange. Also, the legal and regulatory frameworks vary considerably, as does

the degree of oversight of each exchange by government or their designated regulatory

authorities. As result, the specific circumstances of demutualization, the potential issues and

regulatory responses to such issues will require a careful context specific analysis. However, an

examination of the demutualization process highlights a number of common themes which we

will explore in this paper.

In this paper we will provide a broad overview of four issues central to understanding of stock

exchange demutualization. In Part I, we will discuss what demutualization means, the historical

evolution of exchanges, and the advantages of demutualization. In Part II, we will discuss several

issues relating to the regulation of a demutualized exchange. In Part III, we will discuss the

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- 5 - demutualization experiences of the Toronto Stock Exchange (“TSX”)1 and the Australian Stock

Exchange (“ASX”) as practical examples of the demutualization process. Finally in Part IV, we

will discuss the extent of demutualization in emerging markets and some issues that are

particularly important to such markets.

PART I. EXCHANGE DEMUTUALIZATION

1. What Demutualization Means

Traditionally, stock exchanges have been organized as mutual associations owned by their

members (traditionally a national stock exchange, or “NSE”). The most distinguishing feature of

NSEs is their co-operative governance model; that is, the close identity between owners of the

organization and the direct users of its trading services. Generally, the owners of NSEs are also

its customers and share in the net gains of the enterprise in proportion to their ownership interest.

Usually, decisions are made democratically, on a one-member, one-vote basis and often by

committees of representatives of the firm’s members. As a result, the ability of members to

influence the decisions of the exchange is not related to the members’ level of economic interest

in the exchange.2 Also, the ownership rights in most NSEs are not freely tradeable or

exchangeable, and are often required to be forfeited on the cessation of membership.3

Although this has not always been the case,4 most NSEs have operated on a not-for-profit basis

such that any earned profits are returned to members in the form of lower trading costs or access

fees. Furthermore, because most NSEs’ constating documents expressly or impliedly adopt a

non-profit objective and prohibit the distribution of surpluses, NSEs are seldom able to raise

capital from anyone other than their members.

1 The Toronto Stock Exchange was originally branded the “TSE” this was later changed to the “TSX.” In this

paper we will use term “TSE” to refer to the Toronto Stock Exchange during the period it was branded as the “TSE”, and term “TSX” to refer to the Toronto Stock Exchange thereafter.

2 Technical Committee of the International Organization of Securities Commissions, “Issues Paper on Exchange Demutualization”, June 2001, at 3, available online: .

3 Traditional stock exchanging have typically limited ownership to brokers and have appointed a number of independent or public representatives to offset the self-interest of their member.

4 From 1802 until 1948 the London Stock Exchange was operated on a for-profit basis and paid large dividends to its members. F. Donnan, Self-regulation and the Demutualisation of the Australian Stock Exchange (1999) 10 Australian J. Corp. L. at 5.

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- 6 - In contrast, most stock exchanges that have demutualized have operated as for-profit entities,

organized as corporations with share capital which are listed publicly traded (a demutualized

exchange, or “DE”). As a result, most DEs have been comprised of three principal and generally

separate groups: owners, decision-makers, and customers. In this structure, the shareholders vest

decision-making power in a board of directors who are subject to election and removal. The

board of directors in turn appoints officers to manage the day-to-day operations of the

corporation. Most DEs are organized such that the voting rights of shareholders are

proportionate to their economic interest in the corporation: that is, one share, one vote.

Therefore, owners with greater economic interests are more capable of influencing decision-

making. Also most DEs separate ownership rights from trading privileges. As a result, DEs, like

other for-profit corporations are able to raise new capital from a variety of sources.5

It should be noted that DEs have taken many forms post demutualization: some have remained

private corporations; some have demutualized and become public corporations by listing their

stock on their own exchange; some have become subsidiaries of publicly traded holding

companies; some have limited the tradeablity of their shares post-public listing while others have

permitted the immediate free exchange of their shares; and most have imposed share ownership

restrictions. While the appropriateness each of the various post-demutualization structures will

be dependent on the circumstances, it should be noted that most of the benefits associated with

demutualization are generally thought to be associated with the publicly listed demutualized

exchange with freely tradable shares.

In summary, demutualization is 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 tradeable shares. In this manner, a quasi-governmental institution is transformed

into a profit-oriented publicly traded company. The emerging exchange’s governance structure

5 Technical Committee of the International Organization of Securities Commissions, “Issues Paper on Exchange

Demutualization”, at 3, June 2001, available online at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD119.pdf.

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- 7 - rests the ultimate control of the exchange in the hands of its shareholders. This effectively

separates ownership from trading privileges as stockbrokers become the exchange’s customers

and are no longer required to be owners.

2. Historical Evolution of Exchanges

The Stockholm Stock Exchange, which was acquired by the OM Group in 1998, was the first

major exchange to demutualize in 1993. Several other exchanges followed Stockholm’s lead:

the ASX, the TSX, the Singapore Stock Exchange and the Hong Kong Exchanges and Clearing

Limited (“HKEx”) among them. The ASX was one of the first stock exchanges to do a public

offering and listing its shares on its own marketplace. The TSX, which is owned by the TSX

Group, demutualized in 2000 and in 2002 became a public company by listing its shares on its

own marketplace. These two processes are discussed in detail in Part II of this paper. Singapore

Exchange Limited (“SGX”) was Asia-Pacific's first demutualized and integrated securities and

derivatives exchange. SGX was created on December 1, 1999, following the merger of the Stock

Exchange of Singapore (“SES”) and the Singapore International Monetary Exchange

(“SIMEX”). On November 23, 2000 SGX’s shares became listed on its own marketplace. The

HKEx was created in 2000 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”). HKEx shares were listed on

its own marketplace on June 27, 2000 a short three months after the merger. However, the Tokyo

Stock Exchange, which completed its demutualization in 2001 and is one of the largest

exchanges in the world, has to this date not become a listed company; although this is expected

to occur by the end of 2006.

Similarly, the major European exchanges including London Stock Exchange, Deutsche Borse

and Euronext are all public companies. The London Stock Exchange’s (“LSE”) path to

becoming a DE began in 1986 with a series of market deregulation initiatives called the “Big

Bang”, which among other things, transformed the exchange into a private limited company. In

2000, LSE’s shareholders voted to become a public limited company called the London Stock

Exchange plc and in July 2001 the LSE became listed on its own marketplace. The Deutsche

Borse AG (“Deutsche Borse”) traces its roots to the Deutsche Terminbourse (“DTB”), an

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- 8 - electronic futures and options trading system established in 1988. The DTB was structured as a

corporation with five German financial institutions as its controlling owners. The Deutsche

Borse was established in 1991 to operate the Frankfurt Stock Exchange, which then merged with

the DTB. The Deutsche Borse completed its public offering in February 2001.6 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 Exchange and the Portuguese stock exchange.

Some of the major American stock exchanges that have or plan to demutualize in the near future

include: the Chicago Mercantile Exchange (“CME”), the Chicago Board of Options Exchange

(“CBOE”), NASDAQ, and the New York Stock Exchange (“NYSE”). The CME, which

completed its demutualization in 2000 was the first exchange to demutalize in the U.S.7 In 2003,

the CME conducted its initial public offering 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.”8 The

CBOE has also announced plans to demutualize by the end of 2006.

The NASDAQ Stock Market, Inc. (formerly known as the National Association of Securities

Dealers) (“NASDAQ”) was once a wholly-owned unit of NASD. In early 2000 the NASD

moved to separate from and take NASDAQ public. The NASD restructured NASDAQ in 2000

by conducting a private placement and issuing 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.9

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

6 Alfredo Mendiola and Maureen O’Hara, “Taking Stock in Stock Markets: The Changing Governance of

Exchanges”, Available at: http://www.gsm.ucdavis.edu/faculty/Conferences/ohara.pdf, March 2004. 7 Reena Aggrawal and Sandeep Dahiya, “The Demutualization and Public Offering of Financial Exchanges”,

November 6, 2005, Available at: http://faculty.msb.edu/aggarwal/exchanges.pdf, pg.6. 8 Ibid, pg.4. 9 Ibid, pg.6.

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- 9 - Partners. As a result of these transactions, NASDAQ owns INET ECN. The U.S. Securities and

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.

On April 21, 2005, the New York Stock Exchange announced its plans to acquire Archipelago

Holdings Inc. (“Archipelago”), in a deal that was intended to create a new DE. The first major

step was the approval of the NYSE’s governing board to acquire Archipelago on December 6,

2005. The final step towards the merger, creating the new entity NYSE Group Inc. (“NYSE”),

was completed February 28, 2006 with the approval of the merger from the SEC. On March 8,

2006 the NYSE began trading on its own marketplace ending the exchange’s 213-year history as

a member-owned association.

At the end of 2004, “the total stock market capitalization of world’s exchanges was $37.2 trillion

of which 30 per cent was from Europe, 20 per cent was from Asia/Oceania and rest from the

Americas.”10 With the addition of the NYSE as a publicly traded company on March 8, 2006,

presently over 70 per cent of the world’s total stock market capitalization is comprised of

publicly-listed exchanges. It should be noted that a small but significant portion of exchanges

accounting for 18 per cent of world’s total stock market capitalization have demutualized but not

listed their shares.11 Not surprisingly the overwhelming majority of demutualized and listed

exchanges are concentrated across Americas and Europe; this trend is illustrated in Figure 1. As

of March 7, 2006, twenty two stock and derivative exchanges have become publicly listed

corporations with a great likelihood CBOE will be added to this list in the near future.12 Table 1

shows the largest stock and derivatives exchanges measured in terms of capitalization as of 2004

10 Ibid, pg.3. 11 Ibid, pg.7.

12 It has been widely thought that the CBOE will demutualize by the end of 2006 or early 2007. See “CBOE May

not Complete Demutualization in 2006: CEO”, January 11, 2006, Reuters, available online at: http://chicagobusiness.com/cgi-bin/news.pl?id=19099.

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- 10 - for all the major geographic locations.13 As indicated in Table 1 almost all of the largest stock

exchanges have demutualized and listed their shares in the last decade. A similar pattern is also

evident for the largest derivatives exchanges. To understand this rapid transformation of stock

exchanges, it is useful to canvass the advantages of demutualization.

3. The Reasons to Demutualize

a) Rationalized Governance

The NSE model functions well if the exchange is a provider of trading services with limited

competition and the interests of its members are homogeneous. If either of these conditions fails

to hold true, the NSE model ceases to function well. Consensus decision making becomes slow

and cumbersome and the exchange becomes unable to respond quickly and decisively to changes

in the market. The previous ownership structure of the NYSE underscores the tensions created

by the NSE model. From the NSYE’s 1,366 seats, 464 were held by the specialists and another

317 by “two-dollar” brokers while only 565 seats were held by “upstairs brokers” (i.e., big Wall

Street Firms).14 As a result, the floor community had significant power over decision making.

However, the bulk of the NYSE’s business was, and continues to be, driven by institutional

investors, who want the lowest cost and most efficient execution of their trades. This focus on

cost and efficiency threatened profits of the floor community and made it difficult for the NYSE

to implement changes that were good for the exchange but not necessarily so for its member-

owners. This conflict has also been frequently cited as reason for some of the strategic missteps

of NYSE in the past (for example, its decision not to pursue derivatives trading in 1972 and not

to allow IPO firms to be listed until 1984.)

A DE is, ideally, a corporation that operates in a more bottom-line focussed manner and is more

capable of acting decisively and rapidly to changes in the business environment facilitating a

timely response to competitive challenges. The DE structure will enable management to take

actions that are in the best interests of the exchange and ultimately its shareholders. This result is

facilitated by the separation of ownership and trading privileges of the members of the exchange.

13 Supra note 7, pg.16. 14 Ibid, pg.7.

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- 11 - This separation will permit the exchange to achieve greater independence. As a result, the

interest of the owners of the exchange will be aligned with those of the exchange as both will

seek to maximize the profits. Another advantage of the DE structure is the greater degree of

transparency. Demutualized exchanges will be forced to account to their shareholders not only

regarding the bottom-line but regarding issues arising in corporate governance.

b) Investor Participation

In today’s 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. In order to respond effectively to emerging trends, exchanges need to shift

power from one group of stakeholder to another. Separating exchange membership from

ownership may be a politically and economically feasible way to effect such a shift and resolve

conflicts both between the exchange’s members and between the exchange and its members. For

instance, unlike the NSE structure, where often only broker-dealers may be members, a DE

affords both institutional investors and retail investors the opportunity to become shareholders.

In contrast to retail investors the assets managed by institutional investors have grown

significantly in recent years and the trading needs of institutional investors differ dramatically

from those of retail investors. In particular, institutional investors require greater liquidity to

accommodate block trading and place more emphasis on negotiating the lowest price. A DE will

have greater flexibility to accommodate the needs of the now more powerful institutional

investors and as a result adapt to change.15

c) Competition from ATSs and Upstairs Trading

The threat of competition from alternative trading systems (“ATSs”) has forced exchanges to

examine their role as trading arenas and to take measures that facilitate more competitive future

strategies. ATSs are privately operated computerized systems that perform many of the functions

of an exchange by centralizing and matching buy and sell orders and providing post-trade

information. They are often operated by exchange members or member-affiliates and are similar

15 The Toronto Stock Exchange: A Blueprint for Success (8 October 1998) at pg. 5- 6.

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- 12 - to exchanges because they allow two participants to meet directly on the system and are

maintained by a third party who also serves a limited regulatory function by imposing

requirements on each subscriber.16

Although some ATSs have been in operation for many years, technological advances, trading

value increases and pressures on trading profits have enabled some of them to become serious

competitors to exchanges. The U.S. SEC became concerned that ATSs would impair the fair and

orderly functioning of markets. In December 1998, the SEC implemented Regulation ATS that

permitted ATSs to continue to be regulated as broker-dealers but required them to comply with

rules designed to improve transparency and surveillance, as well as the systems capacity,

integrity and security of ATSs. The Canadian Securities Administrators have also implemented

rules governing ATSs which permitted their introduction into the Canadian markets effective

December 1, 2001.17

Exchanges have faced additional competition from the many broker-dealers adopting internal

systems to automate the firm’s execution of customer orders, particularly firms that internalize or

purchase order flow. These systems are not generally considered ATSs as all trades are effected

on internal systems involve only the operator of the system and not external parties – this is

generally referred to as “upstairs trading”. Upstairs trading occurs when a stock exchange

member matches customer orders against other customer orders or against its own inventory

position within the firm, rather than exposing the order to auction on the exchange. The market

only learns of the trading activity after the fact. In Canada, upstairs trading has been on the rise

as a result of several factors. The most important are the regulatory changes in the 1970s and

1980s that permitted investment dealers to trade as principals and to internalize orders; and the

consolidation of investment dealers and their willingness to commit capital to facilitate trades

have improved the services offered.

16 Jeffrey W. Smith et al, The NASDAQ Stock Market: Historical Background and Current Operation, NASDAQ

Working Paper (24 August 1998) at 36; available online at www.academic.nasdaq.com/docs/wp98_01.pdf. 17 CSA News Release, August 21, 2001; available online at: http://www.csa-

acvm.ca/html_CSA/news/ats_approval.html

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- 13 - The bundled services offered by exchanges provide the advantage of scale and liquidity, the

growing success of ATSs and upstairs trading suggests that there is a growing role for speciality,

niche player exchanges. It is not entirely clear what the ultimate division of labour will be

between exchanges, ATSs, and upstairs trading. It is clear that at least with respect to certain

services there is direct competition among the three systems. It is also clear that ATSs and

upstairs trading will not be able to entirely replace the integrated services offered by exchanges.

However a DE will be more capable of remaining competitive in terms of price, variety and

quality of their services than the exchanges organized pursuant to the NSE model.

d) Globalization

Historically, brokers and exchanges were locally focussed. National exchanges developed when

the telegraph and telephone made it easier to deal on a distant exchange.18 Modern

telecommunications have enabled capital to become more mobile as issuers and investors are

more readily able to access foreign capital markets. Consequently, global centers have grown in

importance as locality and nationality has become less of a defining characteristic of capital

markets. Thus exchanges that once were isolated find themselves in intense competition with

global rivals. For instance the recent listings of the NYSE and the Tokyo Stock Exchange are

expected to have an enormous impact globally. While all exchanges, including those in Canada,

have been impacted, this challenge has been acutely felt in relatively small home markets in

emerging countries.

e) Consolidation

Strategic alliances and consolidations are also impacting capital markets and exchanges. In the

past 5 years, mergers among stock and derivative exchanges in the U.S. have altered North

America’s competitive landscape and created super-exchanges. For instance, the merger of

NASDAQ and the American Stock Exchange completed November 2, 1998 created an exchange

with a market capitalisation of US$1.9 trillion offering an unprecedented variety of products. In

18 Timothy Baikie, “Toronto Stock Exchange – From Toronto Stock Exchange to TSE Inc.: Toronto’s

Experience with Demutualization” at pg. 6 and pg. 11, available online at: http://www.adb.org/Documents/Books/Demutualization_Stock_Exchanges/chapter_16.pdf

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- 14 - the next 5 to 10 years major consolidation is expected in the financial exchanges industry.19

These changes should introduce greater geographical consolidation and mergers/acquisitions

across product lines. One area of expected consolidation is in the leading derivative and equities

exchanges. With respect to derivatives, both the TSX and 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 exchanges are likely to emerge. These exchanges will attempt to potentially be of scale

comparable to the U.S. exchanges.

This consolidation process will be greatly facilitated by the DE structure with publicly traded

shares. DEs, as shareholder owned entities, face more pressing demands to deliver performance

which provides greater incentive for exchanges to seek revenue and cost-saving synergies. The

publicly listed status of DEs makes for easier execution of such strategies. These changes in turn

are likely to exert greater pressure on NSEs to demutualize and adopt a share ownership

structure.

f) Resources for Capital Investment

A DE is more capable to respond quickly to global competitive forces and technological

advances. With the capital raised from an IPO or private investment and a heightened awareness

of accountability to stakeholders, a DE should have both the incentive and the resources to invest

in the competitiveness of its information systems. To be competitive, products and services must

not only be timely and cost-effective, but also reliable.

An illuminating historical example is the replacement of floor trading with screen trading. One

of the early drivers of stock exchange demutualization was replacement of floor trading with

screen trading. Once customers were able to have direct access to screens, the economic value of

exchange memberships declined and clearing firms rather than traders become a dominant force

in exchange activities. In order to introduce screen trading considerable capital investment was

required to buy-out the interests of the traders and to modernize the information systems of

19 Supra note 7.

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- 15 - exchanges. Demutualization was an efficient and rational means of infusing additional capital in

order to finance both activities. Going forward, continued investment in technology may serve as

an effective means to meet competition from ATSs and upstairs trading systems, as well as

justifying the scale of the typical integrated exchange model.

PART II. REGULATION OF A DEMUTUALIZED EXCHANGE

A. Introduction

The process of demutualization from an NSE to a DE is a complex process that raises difficult

regulatory questions. Most broadly stated, a regulator of a DE must balance the profit motives of

the stock exchange with the greater goal of investor protection. In this section of the paper, we

consider some of the debates surrounding the regulation of DEs, particularly: 1) the desirability

of dividing capital markets regulation between regulators and self regulatory organizations

(“SROs”); 2) the conflicts of interest that arise when a for-profit exchange also regulates certain

dimensions of the primary and secondary market; and 3) the issues surrounding how to

efficiently govern DEs, with particular attention to the questions of prudential regulation, share

ownership restrictions, directors and officers of DEs, and memoranda of understanding. Before

embarking on this discussion however, it will be necessary to dwell for a moment on the need for

regulation in this area.

1. The Need for Regulation

Stock exchanges are firms that market transaction services to facilitate trading and generate

revenue from listing and other transaction fees. Exchanges provide a bundle of services for listed

firms, specifically: (a) the provision of liquidity to compensate for temporary imbalances in

order flow; (b) monitoring of trading patterns, dispute resolution and corporate governance of

exchange-listed securities; (c) the development of standardized contracts to reduce transaction

costs for investors in listed stocks; and (d) the provision of reputational capital to listing firms.20

20 Jonathan Macey and Maureen O’Hara, Regulating Exchanges and Alternate Trading Systems: A Law and

Economics Perspective (January 1999) 28 J. Legal Stud. 17, pg. 22.

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- 16 - Markets do not solve all the problems generated by economic activity within the financial

system. As a consequence, regulation is necessary to address the inefficiencies generated by

economic activity. Regulation in the financial markets is necessary for three primary reasons.

First, incomplete contracts can prevent markets from proper functioning by increasing, to

prohibitive levels, the costs of certain transactions. Second, the mechanisms for the enforcement

of rules may become too costly in the absence of some centralized regulation. Third, regulation

may be required to address the certain effects of the functioning of the market on third parties or

other externalities.21

The three main objectives of securities regulation as expressed by the International Organization

of Securities Commissions (“IOSCO”) are: (a) the protection of investors, (b) the creation and

maintenance of fair, efficient and transparent markets; and (c) the reduction of systemic risk.22

In countries with multiple developed and sophisticated capital markets, another objective of

securities regulation is enhanced competition. Generally, competition between exchanges in the

delivery of their products should be fostered as competition provides exchanges with the

incentive to innovate and become more efficient in the delivery of products and services.

The above mentioned three main objectives overlap to some extent and mutually reinforce each

other. The objective of investor protection is premised on the principle that investors must be

protected from misleading, manipulative, and fraudulent practices.23 In order to promote this

objective markets must be fair, efficient and transparent. This requires regulation that ensures

that markets do not favour some users over others and there is full and timely disclosure of all

relevant information.24 The risk reduction objective can only be achieved if regulation aims to

reduce the risk of failure of market intermediaries, seeks to reduce the impact of that failure, and

isolates the risk to the failing institution.25

21 Ibid, pg. 24. 22 International Organization of Securities Commissions, “Objectives and Principles of Securities Regulation”,

September 1998 at pg. 6, available online at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD82.pdf. 23 Ibid. 24 Ibid., Pg. 7. 25 Ibid., pg. 8.

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B. The Regulatory Challenges Surrounding Deregulated Exchanges

1. Division of Regulatory Labour

The requirement to regulate markets does not necessarily mean that the responsibility for all

aspects of the regulation and enforcement of securities law must rest with a single body.26 There

are several effective models in which responsibilities may be shared among several government

or quasi-government agencies or where responsibility is shared with self-regulatory

organizations (“SRO”). An SRO is an organization that exercises some degree of regulatory

authority over market participants. The regulatory authority of SROs could be applied in

combination with some form of government regulation, or solely in the absence of government

oversight and regulation. The ability of an SRO to exercise regulatory authority does not

necessarily derive from a grant of authority from the government. For instance, in the U.S.,

stock exchanges regulated their members and listed companies before the US government

instituted regulation of the securities markets and the securities industry. As it stands presently,

the U.S. Securities and Exchange Commission (“SEC”), pursuant to the U.S. Securities

Exchange Act of 1934, has oversight authority over stock exchanges, but stock exchanges

continued to have rulemaking and regulatory authority with respect to their members, their

trading markets and their listed companies.

The principal advantages of a government regulator delegating responsibility for oversight of the

market to SROs are:

(a) the ability to utilize industry expertise;

(b) the potential for higher standards than may be imposed by law;

(c) potentially greater compliance with mutually agreed rules set by peers than with

externally imposed requirements; and

(d) greater flexibility and responsiveness.27

26 Ibid., Pg.13. 27 Simon A. Romano, “Self-Regulation in the Securities Industry-A Regulatory Perspective”, 95 OSCB.

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- 18 - However, the delegation of regulatory responsibilities to SROs also has a number of risks,

including:

(a) operational failures resulting from lack of resources or commitment, such as the

application of inconsistent standards or arbitrary penalties or the failure to

respond promptly to problems;

(b) anti-competitive behaviour, such as entry barriers and sub-optimal market

structure, which favours the interests of members over those of investors;

(c) self-serving regulation;

(d) heightened possibility of “regulatory capture” including: (i) through control of

the information necessary to regulate properly; and (ii) increased dependence of

the government regulator on the SRO for policy input and expertise; and

(e) the chilling effect on dissent that may result from a well-organized interest

group.28

In order to reap the benefits of regulation by SROs and minimize its potential risks, a careful

balance of regulatory responsibility between the government and the SRO must be crafted.

Ideally, this balance will permit the SRO to act as the regulator of market participants and

government as its supervisor; thus ensuring a sufficient level of oversight by each branch over

the other. This will require establishing increased competency in each regulator, effectively

arranging for co-ordination and the exchange of information, and creating effective oversight of

the SRO by the government regulator. The government regulator and SRO must each commit to

promote:

(a) an improved understanding of the roles, powers and responsibilities of each

regulator;

(b) the exchange of expertise;

(c) consistent implementation of regulatory standards;

28 Ibid.

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- 19 -

(d) access by each regulator to the information necessary to fulfil its responsibilities;

and

(e) communication lines that will maintain and enhance each regulator’s ability to

react to market activities in a timely manner.

The regulatory responsibilities of an SRO may include:

(a) developing trading rules and enforcing them;

(b) setting listing standards and ensuring continuous disclosure of material

information by listed companies;

(c) adopting and enforcing rules of conduct for members of the exchange;

(d) setting qualification and financial standards for industry professionals;

(e) conducting surveillance of the market and its participants; investigating violations

of exchange rules and disciplining violators; and

(f) monitoring and regulating daily trading and the operation of the market to ensure

its integrity.29

As discussed more particularly later in this section, co-operation between SROs and regulators

can be effected by executing memoranda of understanding (“MoU”) which function to define the

relationship between institutions. Such memoranda can be useful in clarifying the regulatory

roles of SROs and regulators, although they are not typically binding. For particular examples of

how MOUs have been deployed to structure these relationships, see the section entitled

“Memorada of Understanding” below. ‘

2. Demutualization, Self-regulation and Conflicts of Interest

a) General Concerns

While incidence of conflict or potential conflict is not unique to a demutualized exchange their

potential is heightened under the DE structure due to the exchange’s profit motives. First,

29 Frank Donnan, “Self-regulation and the Demutualisation of the Australian Stock Exchange”, Australian J.

Corp. L, 1999, 10, Pg. 12.

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- 20 - commentators have argued that an exchange may sacrifice effective regulation to achieve the

short-term goal of maximizing shareholder profits. In other words, it has been argued that a for–

profit exchange and its management will be too preoccupied with profits and business

development to dedicate sufficient resources to the regulation of the markets and its participants.

Second, commentators have expressed concern regarding the duplicative costs of creating

multiple SROs, particularly if several ATSs become exchanges and engage in self-regulation.

Third, conflicts of interest may arise if there are ongoing power struggles between the SROs and

between the SROs and the government regulator or where the SRO is not independent of the

exchange.30 Furthermore, as the for-profit exchange enters into new businesses, it increases its

opportunities for conflict. If a dealer that operates an ATS is also a member of the exchange,

conflicts of interest may arise in the exchange regulating the dealer and providing a competing

service. Conflicts may lead to the denial of access to particular activities or failure to make

changes to accommodate an entity providing a competing service.

A response to these arguments is that changes may be made to the organizational structure of the

exchange to address concerns. DEs have adopted four common structural changes to address

these issues. First, DE have divided their business from their regulatory branch and taken steps

to ensure a that the regulatory branch (i.e., the SRO) has a certain level of independence from the

business branch. Second, as previously discussed steps have been taken to ensure that there is an

efficient division of regulatory duties between the SRO and the government. Thus permitting for

sufficient oversight by the government in order to detect and address such problems. Third,

mechanisms have been established to ensure sufficient disclosure by the SRO of their regulatory

duties and the process adopted in carrying out such duties (e.g., annual reports and press

releases). Fourth, limits have been placed on the level of ownership of the exchange. The model

adopted in Australia provides an example of the utilization of each of these options. In Australia,

regulating duties are divided between the ASX, the Australian Securities and Investment

Commission (the “ASIC”), and the government.31 The Australian Government passed The

30 Roberta Karmel, “Turning Seats into Shares: Implications of Demutualization for the Regulation of Stock and

Futures Exchanges”, December 2000, Pg. 57, available online at: http://www.aals.org/am2001/mat_karmel.pdf.

31 Supra note 29.

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- 21 - Corporations Act 2001 (“CLA Act”) and the Financial Services Reform Act 2001 (“FSR Act”)

to designate the regulatory duties of the ASX. Theses acts clarify the statutory obligation and

responsibilities of the ASX as an SRO, and its accountability to the ASIC. The CLA Act and

FSR Act impose a duty on the ASX to do everything necessary to ensure that the market operates

in an orderly, fair, and transparent manner.”32 Further to this, the ASX and the ASIC have

attempted to clarify their respective roles by signing three MoUs, the latest of which was

executed July 1, 2004.33 The ASX has transferred its regulatory functions to ASX Supervisory

Review Pty Limited (“ASXSR”). ASX has also taken initiatives to enhance the transparency of

its supervisory policies and procedures. This has included public consultation for rule

development proposals, publication of waiver and disciplinary determinations. Also the ASX

imposed a maximum ownership limitation that capped the voting power held by any one person

in the ASX to 5 per cent; this was later raised to 10 per cent.

b) Managing Conflicts of Interest Generally

IOSCO commented that the challenge for exchanges is to create an environment in which

conflicts are recognized, minimized and managed. This environment involves:

(a) corporate governance requirements such as requirements for public directors;

(b) a clear statutory statement of the obligation to provide a fair and efficient public

trading market;

(c) rigorous regulatory oversight;

(d) enhanced transparency through requirements to publish rules and decisions;

(e) mechanisms to enhance exchange accountability to the government regulator and

the public; and

(f) separation of the commercial activities of the exchange from regulatory functions:

from dividing lines of authority and accountability within a single firm to

32 Jeffery Lucy, “Mergers, Demutualization and Governance of Securities Exchanges”, remarks to International

Organization of Securities Commission, May 20, 2004, available online: http://iosco.org/library/annual_conferences/pdf/ac18-17.pdf.

33 Full text of this MoU is produced in Exhibit B.

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- 22 -

establishing a separate legal entity or transferring some regulatory responsibilities

(such as regulation of the exchange as listed corporation) to the government

regulator.34

An example of an attempt to put these principles into practice is the model adopted by the HKEx.

In 2000, the SEHK and the HKFE demutualized and, together with the HKSCC, merged to form

the HKEx. As a result of this merger, ownership in shares of the exchanges were separated from

access to trading facilities. Shareholders of the new exchanges became holders of trading rights

and trading members before the merger were deemed exchange participants. HKEx shares were

listed on its own marketplace on June 27, 2000, a short three months after the merger. The

principal regulator of Hong Kong's securities and futures markets is the Securities and Futures

Commission (“SFC”), which is an independent statutory body established in 1989 by the

Securities and Futures Commission Ordinance (“SFCO”). The SFCO and nine other securities

and futures related ordinances were consolidated into the Securities and Futures Ordinance

(“SFO”), which came into operation on April 1, 2003.

The regulation of market participants is conducted by the SFC, the SEHK, and the HKFE.

SEHK is a wholly-owned subsidiary of HKEx. Its principal function is to operate and maintain

the securities market in Hong Kong and to act as the primary regulator of stock exchange

participants with respect to trading matters and companies listed on the Main Board35 and

Growth Enterprise Market36 (“GEM”) of the Stock Exchange. HKFE is also a wholly-owned

subsidiary of HKEx. It maintains a futures market in Hong Kong and is the primary regulator of

Futures Exchange Participants with respect to trading matters. In Hong Kong no person may

carry on a business of dealing in securities or futures contracts unless they have received a

34 Supra note 5, Pg. 9. 35 The Listing rules of the Main Board prescribe are more demanding than those of GEM. Qualifying

requirements for listing applicants include an adequate track record, profit requirements, operation under substantially the same management for three years, open market for its securities, and meet minimum size requirements.

36 GEM has been established as a market designed to accommodate companies to which a high investment risk may be attached. GEM listing applicants, unlike those of the Main Board, are not required to have a profit track record.

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- 23 - license from the SFC, fall within a relevant licensing exemption, and have satisfied the

requirements of the SEHK and HKFE.

c) Discrete Problems Respecting Conflicts of Interest

Having discussed generally the problem of conflicts of interests and how to manage them, this

section of the paper will go on to discuss more discrete instances of conflicts of interests;

specifically those that may arise when a DE regulates the listing of its competitors and itself.

i) Supervision of Listing

Some commentators have articulated the concern that the conversion of an exchange to a for-

profit corporation would precipitate a “race to the bottom” in which exchanges would lower their

listing and reporting standards to compete successfully for listings. This would permit more

companies to list, which would result in more listing fees and transaction fees for the exchanges.

It is argued that while competition among exchanges would probably result in a lowering of fees

and other costs related to listing it would also be accompanied by a loosening of listing

standards. This would in turn undermine the investing public’s confidence in the strength and

quality of the capital markets in general. It has been argued that for-profit structures increase the

scope and intensity of conflicts because revenues must meet expenses and generate a rate of

return for investors. The benefits of good regulation are hard to quantify and therefore a for-

profit exchange may be unwilling to devote sufficient resources to enforcement. Further, since a

regulatory function imposes additional costs, a regulatory arm makes the exchange a less

attractive candidate for an initial public offering (“IPO”). In preparing for an IPO an exchange

will seek to minimize costs and emphasize its potential for earnings thereby it is likely to spin off

its regulatory arm.37

However, a reply to this argument is that while some exchanges may choose to lower their listing

standards in order to be more profitable for their shareholders, other exchanges will institute

more stringent and rigorous standards in order to distinguish themselves and the service they

37 John C. Coffee, Jr., “Privatization and Corporate Governance: The Lessons from Securities Market Failure”,

25 Journal of Corporation Law 1999.

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- 24 - offer. For example, the NYSE has adopted this approach to distinguish itself from other

exchanges. As a result, companies seek to list on the NYSE partly because of the reputational

capital that comes with listing on a exchange with a reputation for being one of the world’s

premier exchanges.38

ii) Self-listing

An exchange listing on itself presents a more fundamental conflict of interest than those inherent

with the regulation of its competitors. In addition to the issue of whether an exchange can

function as its own regulator is the issue of whether self-listing increases the conflicts of

overseeing competing entities that are also listed on the exchange. The IOSCO report cites two

factors that act as controls against discriminatory treatment of competitors: (a) competition for

listings among exchanges; and (b) the risk to the exchange’s reputation.39

As previously discussed, these potential conflicts are lessened by the governmental regulator’s

oversight over the regulatory duties of the exchange. When the Stockholm and the Australian

exchanges went public, the government was assigned the task of overseeing the exchange’s

disclosure its shareholders. Also ASIC supervises ASX’s listing and undertakes the day-to-day

supervision to ensure that the ASX is subject to independent scrutiny.

3. DE Governance Issues

a) Prudential Regulation

A member-owned exchange usually has the right to assess its members and request a capital

contribution. A demutualized exchange usually loses the right to demand that shareholders

contribute additional capital, but gains the flexibility to raise capital from public or private

sources. Capital and solvency requirements serve to reduce the risk of failure of a financial firm

by requiring a capital cushion to absorb losses. Capital also provides liquidity to permit a firm to

operate during an orderly wind down. Regulators have raised the issue of whether capital

requirements should be imposed on a demutualized exchange. Other alternatives raised are to

38 Exchanges supply reputational capital to the firms that list on them. Supra note 20, at Pg. 26. 39 Supra note 5, at Pg. 8.

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- 25 - require a demutualized exchange to establish a reserve to address shortfalls in capital, or for the

regulator to monitor the financial condition of an exchange and take remedial action, if

appropriate. New business lines of exchanges may reduce financial risks by diversifying the

exchange’s sources of income. A regulator could require segregation of core and non-core

activities, firewalls to protect the resources necessary to run the exchange’s core activities or

impose a requirement for prior regulatory approval.40

b) Share Ownership Restrictions

A mutual exchange is governed by consensus; no one member exerts control over the decisions

of the exchange. With demutualization, ownership is broadened to include non-member

investors. Concerns may arise if an exchange is controlled by one or more persons. An issue

arises whether the public interest requires a limit on share ownership or prior regulatory approval

for ownership above a threshold percentage. In this section of the paper, we will briefly discuss

the share ownership restrictions of the TSX, ASX and the HKEx.

i) Toronto Stock Exchange

The corporate structure that the demutualized TSX has adopted is similar to that adopted by

several of the other demutualized stock exchanges around the world. In 1999, Canada’s four

major stock exchanges were streamlined into three specialized markets, with the TSX becoming

the sole senior equity market. Each person owning a TSE seat received 20 common shares of

TSE Inc. Each common share carries one vote. Initially, no person or combination of persons

acting jointly or in concert was permitted to beneficially own or control more than 5 per cent of

the outstanding shares without the prior approval of the Ontario Securities Commission

(“OSC”). Subsequently the permitted percentage of ownership was changed to 10 per cent.

Persons who held more than 5 per cent immediately following demutualization were

“grandfathered” from these provisions, meaning that persons who do own more than 5 per cent

of TSE Inc. may not vote in excess of 5 per cent without the prior approval of the OSC.

ii) The Australian Securities Exchange

40 Ibid., Pg. 13-14.

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- 26 - The CLA Act in Australia also limits persons to owning or controlling no more than 5 per cent of

the shares in the ASX. This 5 per cent limit applies to both Australian and foreign persons. 41

Subsequently the permitted percentage of ownership of ASX was raised to 15 per cent. A

memorandum issued to explain these restrictions in Australia justified the shareholding limits by

offering two reasons: (a) the ASX has a critical role to play in the national economy and thus it is

in the national public interest not to allow any one party to gain control of the Exchange, and (b)

such a limitation encourages diverse ownership of the ASX.42

iii) Hong Kong Exchanges and Clearing Limited

In the Merger Ordinance and in the articles of association of HKEx, there is a prohibition on

holding 5 per cent or more of the voting power of HKEx at any general meeting of the

shareholders of HKEx. However, the SFC in consultation with the Financial Secretary, may give

approval to a person to hold more than 5 per cent if it can be demonstrated to be in the interest of

the investing public. The SFC will not give such an approval unless it is satisfied that it is

appropriate to do so in the interest of the investing public or in the public interest.

The consequence of share ownership restrictions is a prohibition on hostile take-overs of stock

exchanges thereby removing disciplinary tool on management. Economists argue that a healthy

take-over market works efficiently and effectively to control costs imposed by the managers on

the owners of the firm. The threat of take-overs forces management to use capital efficiently and

focus on performance.43

c) Directors and Officers

The fair and efficient functioning of an exchange is of significant benefit to the public. An

exchange provides liquidity and price discovery that facilitates efficient raising of capital for

businesses, benefiting the wider corporate sector and the economy as a whole.

41 Supra note 29, Pg. 12. 42 Ibid. 43 Ibid.

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- 27 - In recognition of the role of an exchange and the degree of conflict of interest in a member

owned exchange, exchanges are commonly required to have public directors on the board to

represent the interests of the community. Public directors monitor conflicts of interest in a SRO

and promote integrity in decision making. IOSCO raises the issues of whether a demutualized

exchange still needs to have public directors and if so, whether they should be given specific

public interest responsibilities.44 We would argue that given that the public interest in a fair and

efficient exchange continues in a demutualized exchange, the need for public directors continues.

The directors of a for-profit exchange must take into account the interests of all of its

stakeholders if the exchange is to function effectively. These stakeholders are its customers (the

companies that list on the exchange and the securities information processors), its members that

have trading privileges (the broker-dealers), its owners (the shareholders) and the investing

public. Thus, while a corporation exists to make profits for its owners, it is imperative that the

investing public not lose confidence in the integrity of the stock exchange.

In a demutualized exchange, the senior management of the exchange are likely to be the decision

makers on a day to day basis. Market demands will push the exchange to hire as competent

people as possible. IOSCO 45 raises the issue of whether there is a need for direct involvement

of the government regulator in hiring decisions.

d) Memoranda of Understanding

MoU are used to define the regulatory relationship between institutions. These are non-binding

agreements that are used to delineate the regulatory responsibilities of the regulator and the

exchange. MoU is useful as a means of clarifying in an explicit manner the regulatory duties of

the parties, which helps avoid duplication and promotes cooperation and efficiency.

i) MoU between ASIC and ASX

For example ASIC and the ASX put in place a number of MoU which consider46

44 Supra note 22, Pg. 11. 45 Ibid. 46 Full text of the MoU between ASX and ASIC is produced in Exhibit B

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- 28 -

(A) the referral of cases of suspected significant contraventions of ASX’s operating rules and of the Act, including misconduct by listed reporting entities and participants;

(B) consultation between ASIC and ASX as to:

(i) the appropriate response to such cases and to other issues of mutual

concern;

(ii) the most appropriate party to conduct the response; and

(iii) the assistance (if any) to be provided by the other party.

(C) ASIC and ASX keeping each other appropriately informed as to action being

conducted (subject to legal constraints on information sharing);

(D) notification by each party of various matters in accordance with the statutory

obligations of the parties;

(E) the facilitation of information sharing between ASIC and ASX for the purpose of

each fulfilling its obligations and;

(F) agreement on joint strategic objectives and the identification of any areas of

regulatory priority.

ii) MoU between the SFC, HJKEx and SEHK

Another example is the MoU between the SFC, HKEx and the SEHK. HKEx, as a listed

company on its own stock market, is regulated by the SFC to avoid conflict of interest and to

ensure a level playing field between HKEx and other listed companies which are subject to the

Listing Rules of both the Main Board and GEM. Regulation by the SFC is imposed through two

sets of provisions. Firstly, Chapter 38 of the Main Board Listing Rules and Chapter 36 of the

GEM Listing Rules contain certain provisions relating specifically to the listing of HKEx and set

out the requirements that must be satisfied for the securities of HKEx to be listed as well as the

powers and functions of the SFC in the event of a conflict of interest. Second, a MoU dated

August 22, 2001 between the SFC, HKEx and the SEHK sets out the way the parties will carry

out their respective duties:

(a) HKEx’s and other applicants and issuers’ compliance with the Listing Rules;

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- 29 -

(b) the Stock Exchange’s enforcement of its rules in relation to HKEx’s securities and

those of other applicants and issuers;

(c) the SFC’s supervision and regulation of HKEx as a listed issuer and, where a

conflict of interest arises, other applicants and issuers;

(d) conflicts of interest which may arise between the interests of HKEx as a listed

company and companies of which it is the controller, and the interests of the

proper performance of regulatory functions by such companies; and

(e) market integrity.

PART III. THE DEMUTUALIZATION OF THE TSX AND ASX

Having discussed the regulatory challenges inherent in the demutualization process generally, we

now move on in this part of the paper to discuss the two distinct experiences of the TSX and the

ASX. The ASX did not delay in going public while the TSX remained private for two years

before it went public. It should be noted that this discussion of the TSX and ASX are intended as

practical examples of the demutualization process that illustrate some of the issues previously

canvassed in this paper.

1. Background to the TSX’s Demutualization

The Toronto Stock Exchange was formed in 1852 as a mutual member-owned, not-for-

profit corporation. Members of the exchange were brokerage firms whose membership interests

(or seats) in the exchange gave them access rights to trade in listed securities, either as principal

or on behalf of clients. Trading originally occurred on the floor of the exchange with traders

executing and completing trades using manual paper-based systems. In 1997, The Toronto Stock

Exchange closed the trading floor and became a fully electronic major exchange.

Like many of the stock exchanges in the developed markets, TSE’s process of

demutualization was self initiated. In 1998, the TSE’s Board of Governors undertook a strategy

development process that involved an assessment of the TSE’s capabilities and competitive

position, a review of the experiences of other exchanges, a survey of the TSE’s constituents’

needs and attitudes, and a consideration of governance alternatives. This process was motivated

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- 30 - by the recognition that the TSE’s future was threatened and that a strategic direction was

required to enable the TSE to succeed in the future. The result of this process was a strategy

blueprint, entitled A Blueprint for Success (“Blueprint”).

The cornerstone to executing the strategic directions articulated in the Blueprint was a

new ownership and governance structure for the TSE. In order to implement these initiatives,

the Blueprint recognized the need for a different governance model than the one that was in place

and recommended a new ownership and governance model for the TSE with the following

elements:

(a) for-profit instead of not-for-profit;

(b) shareholder structure instead of member-seatholder structure;

(c) separation of access from ownership; and

(d) initially designating at least half of the seats on the Board of Directors from

outside the brokerage community.‘

2. Rationale for the Demutualization of TSE

At the time the Blueprint was published, the TSE’s not-for-profit, cooperative governance

structure, which at one point had served it well, had become more of a hindrance than a benefit.

The TSE’s Board of Governors recommended that the TSE become a for-profit, demutualized

company for several reasons, not the least of which was the fact that the TSE was facing real and

growing competition for the products and services it offered both nationally and internationally.

It was thought that a for-profit entity with a business minded governance structure would allow

the TSE to keep its mandate clear and accountability focused, which would assist the TSE in

meeting its competitive challenges.

A sense of anachronism also motivated the TSE’s move from being an NSE to a DE. A

governance structure that made sense years ago was no longer appropriate as members

themselves no longer belong to a homogenous group. Indeed, both the size of members and the

markets in which they compete were becoming more diverse. Since the TSE had historically

attempted to resolve issues by consensus, the existing governance model was becoming an

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- 31 - increasingly slow and cumbersome method of making decisions. Action was delayed by lengthy

consultation, making it difficult for the TSE to respond quickly and decisively to changes in the

market. Further, by limiting ownership to members, the TSE had not been as flexible and

proactive in responding to all of its customers’ needs. A business model of ownership would

provide the TSE with the platform from which to meet these needs more effectively and would

allow the TSE more opportunities to raise capital for itself, aside from its power to impose levies

on its seatholders.

Lastly, the notion of using “seats” as the basic governance structure of the TSE appeared

outmoded and outdated. Originally, a “seat” on the TSE was just that: a seat on the trading floor.

At the time, physical presence on the floor was the only means to trade on the TSE. Later, a seat

became an entitlement to have a certain number of traders on the floor, and restrictions on the

number of seats reflected the limited real estate available for trading. In an electronic exchange,

these concerns were no longer relevant. Any member could have as many traders accessing the

trading system as it has trading stations, and does not have to acquire more seats to increase its

complement of trading personnel.

3. The Demutualization Process of the TSE

The next section of this paper constitutes an overview of the different dimensions of the TSE

demutualization process, with an eye to highlighting the specific regulatory challenges discussed

in Part II of this paper. To that end, what follows is: a) a brief chronology of the demutualization

process; b) a short discussion of how the TSE, the Ontario government and various SROs dealt

with the relevant regulatory challenges; and c) a short overview of the ramifications of the TSE’s

demutualization on Canada’s capital markets more generally.

a) The History of the TSE Demutualization

Demutualization required member approval that was easily obtained. As of April 1, 2000 TSE

became The Toronto Stock Exchange Inc., a for-profit corporation. Members became

shareholders and the Board of Governors was renamed the Board of Directors. The TSE no

longer was a seat-based, member-owned company. Seats were exchanged for shares on the basis

of 20 shares per seat.

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- 32 - Once demutualization was approved by the TSE’s shareholders approval was sought and granted

by the regulator, the OSC, and the Government of Ontario, the Minister of Finance. As part of

the demutualization process, the TSE had to submit a new recognition order to the OSC which

set out the terms and conditions under which TSE was permitted to continue to operate as an

exchange. As a result, the Ontario Legislative Assembly passed legislation providing for the

continuance of the Toronto Stock Exchange Inc. under the Ontario Business Corporations Act on

April 3, 2000. On April 2002, the TSX group of companies introduced the “TSX” brand, name

and logo. The Toronto Stock Exchange Inc. was renamed as TSX Inc. on July 10, 2002, and

Canadian Venture Exchange Inc. (incorporated under the Business Corporations Act (Alberta)),

a wholly-owned subsidiary of TSX Inc., was renamed as TSX Venture Exchange Inc. on July 26,

2002.

Immediately before closing its initial public offering of common shares, TSX Inc. and its

affiliates completed a corporate reorganization under a court approved plan of arrangement. As

part of the reorganization, TSX Group Inc., newly incorporated under the Business Corporations

Act (Ontario) on August 23, 2002 (referred to, with its consolidated subsidiaries as the “TSX

Group”), acquired all of the outstanding shares of TSX Inc. and became the holding company

for the TSX group of companies. The shareholders of TSX Inc. were issued shares of TSX

Group in exchange for their shares of TSX Inc. The demutualization process was effectively

completed

b) Responses to Regulatory Challenges

In the Part II of this paper, we discussed concerns and criticisms that might arise if the ownership

of any particular exchange became concentrated in the hands of a few shareholders. In order to

address this issue, the TSE imposed a seat restriction on itself following its demutualization. The

original restriction stated that no person or persons acting jointly or in concert may beneficially

own or control more than 5 per cent of the outstanding shares unless the prior consent of the

regulator, the OSC, is obtained. A member that received more than 5 per cent of the outstanding

shares pursuant to the seat exchange was “grandfathered,” but is not able to exercise more than 5

per cent of the votes outstanding. This restriction on the number of outstanding shares permitted

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- 33 - to be held was later changed to 10 per cent. In addition to seat restrictions, the TSE imposed

transfer restrictions such that for two years, shares of TSE could not be transferred unless the

consent of the Board of Directors or of a majority of shareholders was obtained. As will be

discussed, these restrictions were lifted once the TSE became a publicly listed company.

As could be expected from our discussion of conflicts of interest previously in this paper,

concerns arose over the perception of conflict of interest between the TSE’s role as a provider of

trading services and a regulator following its demutualization. Some firms believed that TSE

would use its regulatory powers to hinder business activities by firms it believed to be its

competitors. Although those concerns also existed in the not-for-profit environment, these firms

believed that they would be exacerbated once TSE operated on a for profit basis. TSE’s initial

response was to restructure its operations and create a separate and distinct division to carry out

its regulatory functions. This branch of the TSE was to remain independent of its equities

trading business.

To more completely address concerns surrounding potential conflicts of interest, TSX’s market

regulation functions were transferred to Market Regulation Services Inc. (“RS”) in 2002. RS’s

mandate is to foster investor confidence and market integrity through the administration,

interpretation and enforcement of a common set of market integrity principles applied to all

regulated persons, including dealers, in the Canadian marketplace. RS provides independent

regulatory services to Canada’s equity markets, including the TSX, TSX Venture Exchange,

Canadian Trading and Quotation System, Bloomberg Tradebook Canada Company, Liquidnet

Canada and Markets Securities Inc. RS is a not-for-profit, self-regulatory organization funded

through a transparent, user-pay fee structure. While RS is jointly owned by the TSX Group and

the Investment Dealers Association of Canada, its structure ensures that the decision making

power on its Board of Directors resides with its Independent Directors. The Board of Directors

is responsible for the overall governance and strategic direction of RS. Fifty percent of RS’s

Board is made up of Independent Directors which includes representation from its marketplaces,

buy-side institutions and the regions where RS regulates. RS is one of several regulators in

Canada’s securities industry. RS’s focus is on the regulation of equities trading; that is the actual

buying and selling of securities on the marketplaces.

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- 34 - c) Ramifications of the TSE Demutualization

Parallel with the demutualization process Canada’s securities markets have undergone significant

market realignment in order to reduce the fragmentation of the markets’ liquidity and reduce

costs for participants. Until 1999, five equity securities exchanges operated in Canada.47 As part

of this realignment and consolidation, TSX, the company that is now TSX Venture Exchange,

and the Bourse de Montréal entered into a memorandum of agreement. Under this agreement:

◦ TSX became the senior equity exchange by combining the senior equity securities

businesses of the Toronto and Montreal exchanges;

◦ The exchange that is now TSX Venture Exchange (which the TSX acquired in 2001)

became the junior equity exchange by combining operations of the Vancouver,

Alberta and Winnipeg stock exchanges, the junior listings from the Bourse de

Montréal and the over-the-counter Canadian Dealing Network; and

◦ The memorandum of agreement prevents the TSX from providing trading facilities

and services for exchange-traded derivative products, comprising (without limitation)

options and futures contracts, other than natural gas and electricity products, until

March 2009.

4. Background to the ASX’s Demutualization

ASX operates Australia’s primary national stock exchange for equities, options and fixed interest

securities. ASX was created in 1987 by the Australian Stock Exchange and National Guarantee

Fund Act 1987, which deemed the Exchange to be incorporated under Australian companies law

and to be a company limited by guarantee. ASX was formed by the amalgamation of six

state-based exchanges located in Sydney, Melbourne, Brisbane, Perth, Adelaide and Hobart.

The Sydney Futures Exchange (“SFE”) is Australia’s other major exchange. SFE provides

futures and options on the four most actively traded markets – interest rates, equities, currencies

47 See: Figure 3 for a diagram of TSX’s inter-corporate structure.

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- 35 - and commodities – and is the 10th largest financial futures and options exchange in the world by

volume turnover.

Similar to the TSX and other stock exchanges in the developed markets, ASX’s process of

demutualization was self initiated. ASX’s demutualization and listing process began in 1995

when the ASX Board formed a task force, comprised of ASX Board and Management

representatives. It was recognized that the future success of ASX required a new ownership and

governance model with the following elements:

(a) Conversion of the corporate status of ASX from a limited company by guarantee

to a company limited by shares;

(b) Vesting of the shares in ASX, in its members; and

(c) Breaking the nexus in the Corporations Law, which governed ASX, between

membership of ASX (as a corporation) and access to its trading facilities by, and

regulation of, market participants. The structure of the Corporation Law reflected

a general assumption that membership of an exchange were limited to brokers or

those with access to the securities-related services provided by the exchange.

5. Rationale for the Demutualization of ASX

On September 24, 1996, ASX distributed a Notice of Special General Meeting to its members,

together with an explanatory memorandum. The Note included a recommendation by the ASX

Board for a demutualization proposal. The reasons given by the ASX Board and Management

for the recommendation were very similar to those given by the TSE in its demutualization

process, including the recognition that a non-mutual structure would equip ASX better than a

mutual structure to meet competition and that ASX needed to become more flexible, responsible

and commercially focussed, and capable of quickly taking up emerging commercial

opportunities.

In the context of the ASX demutualization process, it was also acknowledged that members’

interests were diverging (and were unlikely to reconverge) and the same benefits were not

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- 36 - derived by all members from the services provided by ASX. The mutual structure of ASX,

including at least 500 individual members as well as large global participants, was inhibiting its

ability to make rapid commercial decisions, and to meet emerging business opportunities and

threats.

6. The Demutualization Process of ASX

As with our analysis of the TSX demutualization process, the next section of this paper

constitutes an overview of the different dimensions of the ASX demutualization process, with an

eye to highlighting the specific regulatory challenges discussed in Part II of this paper. To that

end, what follows is: a) a brief chronology of the demutualization process; and b) a short

discussion of how the ASX and the Australian government dealt with the relevant regulatory

challenges.

a) The History of ASX Demutualization

On October 18, 1996, the members voted overwhelmingly to endorse alterations48 to the

constitution of ASX, requiring the Board to seek the enactment of Australian Commonwealth

legislation that would allow demutualization. Demutualization of ASX occurred two years later

on October 13, 1998, and as part of the demutualization process former eligible members were

issued shares in ASX. The issue of shares occurred on the following basis:

◦ Each of the 606 eligible former Corporate and Natural Person Members received

166,000 shares resulting in a total issued capital of 100,596,000 shares.49

◦ There was no “cash out” offer for members, and there were no additional shares

offered or funds raised by ASX.

◦ There were no special restrictions placed on members concerning the sale of ASX

shares.50

48 Over 96% of members supported the recommendation. Members were entitled to one vote each. 49 While ASX had both corporate and natural person members, all members were treated equally for share

distribution purposes.

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- 37 -

◦ There were no minimum shareholding requirements placed on members.

Following demutualization, ASX made an application to ASIC for admission to ASX’s own

official list and for quotation of its shares. Listing of ASX and quotation of its shares occurred on

October 14, 1998.

b) Responses to Regulatory Challenges

In anticipation of the demutualization of the ASX, Australia introduced two sets of legislation to

address some of the more important regulatory challenges highlighted in Part II of this paper.

Specifically, the initial wave of legislation introduced the following changes:

◦ Detail on the ASX’s obligation for market supervision including an express power to

require it to do specified things to ensure it complies with supervisory obligations;

◦ Requirements that the ASX at least annually prepare and give to the regulator, the

ASIC reports about compliance with their supervisory obligations;

◦ Processes to require ASIC to act as the listing authority for ASX – i.e., the role that

ASX plays in relation to all other listed entities, to ensure that the ASX as a listed

company complies with its disclosure obligations; and

◦ Share ownership of ASX for any single member was restricted to 5 per cent.

Importantly however, at this time there was no legislative basis for regulating conflicts between

ASX’s commercial interests and its obligations as market supervisor were introduced.51 The

only conflict issue this wave of legislative reform law dealt with related to the ASX itself as a

listed entity and not as a commercial rival of another listed entity. In December 1998, ASX

announced a takeover bid for the SFE. In May 1999, Computershare, a public company listed on

the ASX, announced a rival bid for the SFE. Computershare has a major business in supplying

market technologies, and a substantial part of the share registry business in Australia and

50 There was however a 5% individual ownership cap imposed by the Government and contained in the

Corporations Law; this limit was ultimately raised to 15%. 51 Supra note 32.

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- 38 - elsewhere.52 A major conflict of interest had arisen, as ASX was both an interested party in the

commercial transaction and also the supervisor of Computershare, its competitor. As we stated

previously, the legislation had not dealt with this potential situation and a regulatory response

was required. Accordingly, both parties entered into an agreement with ASIC which provided

that, until the issue of the rival bids was resolved, ASX would not make any substantive decision

about Computershare without first consulting ASIC and acting in accordance with the advice

provided by ASIC. This purely contractual arrangement was made public and details released to

the market. Incidentally, neither ASX nor Computershare succeeded in their bids and SFE

remains independent today.

Subsequently, ASX recognized the importance of maintaining integrity in its own market,

structure and supervisory obligations, and in November 2000 created ASX Supervisory Review

Pty Ltd. ASXSR is an ASX subsidiary that essentially operates as an arms length “process

monitor” and “internal regulatory auditor”. Its role is to ensure the integrity, efficiency and

transparency of ASX’s supervision of its markets. ASXSR distinguishes itself as a supervisory

body that is separate from ASX, by having independent directors, a mandate approved by the

regulator (ASIC), and provides its supervisory reporting of ASX to the ASIC. However, until

recently there was no systemic structural separation of commercial and regulatory functions of

the ASX.53

On 11 March 2002, a clearer regulatory environment emerged with the introduction of the

Financial Services Reform Act 2001, the Corporations Act 2001, and the Corporations

Regulation 2001. The Financial Services Reform Act is still based on a model where the market

operator has “front line” regulatory responsibility. However, it also prescribes that:

◦ ASIC will undertake an annual assessment of ASX supervision, including by way of

public reports;

52 Supra note 32, Pg. 5. 53 Ibid, Pg. 6.

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- 39 -

◦ Market operators must have in place adequate conflict management arrangements to

deal with conflicts between commercial interests and ensuring the market operates

fairly and transparently; and

◦ The restriction on Share ownership of ASX for any single member is increased to 15

per cent.54

Additionally, Australia’s new Regulation 7.2.16 is important as it allows ASIC to intervene, at

the request of a commercial competitor of ASX, and to take a supervisory role where there is a

specific and significant conflict, or potential conflict, between the commercial interests of ASX

(or a subsidiary of ASX) and its market supervision obligations in dealing with a listed entity that

is a competitor.55

7. Post Demutualization: Changes in TSX’s and ASX’s Focus and Activities

Since demutualization of the TSX and the ASX, both exchanges have experienced a number of

significant changes in their focus and activities. These include:

(a) Increased flexibility in decision-making;

(b) Increased customer focus; and

(c) Expansion of activities.56

(d) Increased Flexibility in Decision-Making

One of the most important changes that has accompanied demutualization is that both exchanges

now have much greater flexibility in their decision-making. These exchanges are therefore better

equipped to make timely decisions for market users, and to respond to changing circumstances.

Prior to demutualization, access to both exchanges’ market facilities were largely controlled by

its existing market customers and the key criteria for admission to market participation was

“membership”. Also, much of their decision-making prior to demutualization was by brokers on

committees. Following demutualization most of the decision-making responsibility has been

transferred to each exchanges’ management. Committees continue to exist, but their

54 Ibid. 55 Full text of Part 7.2.16 has been reproduced in Exhibit A 56 Supra note 32, Pg. 5.

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- 40 - composition reflects competencies and experience required for the particular function and they

are typically used for consultation.57

a) Increased Customer Focus

Another important change that has occurred is an increased customer focus. Prior to

demutualization, as brokers were the owners of the TSX and ASX and a disproportionate amount

of time was spent serving their needs. Since demutualization, while brokers remain an important

and valued customer, each exchange has spent a great deal of time focusing on the needs of other

customer groups such as listed companies and investors. This has resulted in changes in

organizational lines to provide a better fit with customer groups, the appointment of various

account managers for key customers, and more attention being devoted to marketing, education

and information dissemination.

b) Expansion of Activities

Since demutualization, both the TSX and ASX have examined ways of enhancing profitability,

diversifying their revenue base, and providing value-adding services to customers. This has

resulted in ASX expanding into new but related businesses, including:

(A) A joint venture arrangement involving a share registry business;58

(B) The acquisition of a 15 per cent stake in a company that provides trading and

order management services to professional financial market participants59; and

(C) The acquisition of a 50 per cent stake in a company that provides an investor

consultancy service.60

57 As an example, decisions made in relation to admissions to ASX’s official list of companies used to be made

by a Listing Committee comprised of some eight members, the majority of whom were brokers. As part of the demutualization process, decision-making authority was transferred to ASX Management. Management now has decision-making authority to admit new companies to the official list, whereas there is a Listing Appeals Committee to hear appeals on Listing Rule decisions.

58 On 20 March 2000 ASX and Perpetual Trustees Australia Limited (Perpetual) announced that they had formed a joint venture, incorporating the operations of Perpetual’s share registry division, Perpetual Registrars Perpetual is listed on ASX.

59 On 19 September 2000 ASX announced that it had agreed to take a 15% stake in Bridge DFS Ltd. Bridge DFS subsequently listed on ASX.

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- 41 - ASX has also announced a number of initiatives aimed at facilitating cross-border trading by

investors. These have included:

(A) A two-way trading link with Singapore Exchange Limited, which is expected to

be operational later this year; and

(B) A one-way trading link into the United States market, utilizing Bloomberg’s

TradeBook system.

The TSX, in addition to the acquisition discussed previously, in the last three years has

undertaken several initiatives to solidify its role at the centre of the Canadian equity market. The

most recent of these initiatives include:

◦ The acquisition of approximately 40 per cent (now 45 per cent) equity interest in

CanDeal.ca Inc., which owns and operates an electronic trading system for the

institutional debt market and which is registered as an ATS. This acquisition has

diversified TSX’s business in the electronic fixed-income market.

◦ The creation of CNX Marketlink with Canada NewsWire Ltd., now CNW Group Ltd.

(“CNW Group”). CNX Marketlink provides publicly listed issuers with enhanced

investor communication tools. This furthered TSX’s strategy to leverage their

existing data capabilities and to deliver new services to their listed issuers.

Marketlink offers webcasting and conference call services, which assists issuers to

meet their corporate communication needs and to deliver time-sensitive information

to their shareholders and other stakeholders.

◦ The purchase of NGX. NGX operates a Canadian electronic commodity exchange

which trades and clears natural gas and electricity contracts. This transaction

extended and diversified TSX’s position in Canada by broadening their product and

service offering, while at the same time expanding their reach outside Canada. NGX

enables energy traders to trade and clear physical and derivative natural gas spot and

forward contracts and derivative electricity forward contracts.

60 ASX announced on 5 February 2001 that it had acquired a 50% stake in Orient Capital Pty Ltd., an unlisted

company.

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- 42 - c) Post-IPO Returns

Consistent with the well documented “IPO effect”, DEs have tended to post significant

returns on their first day of trading. The TSE and the ASX are not exceptions to this rule. On

their first day of trading the TSE and AST posted a 13% and 3% returns on investment,

respectively. What is additionally interesting is that these results have not only endured, but

increased by substantial margins. As at September 30, 2005, the TSE had reported a 302%

increase in cumulative returns since its IPO, while the ASX had reported an over 600% increase

in returns.

PART IV. DEMUTUALIZATION OF EMERGING MARKETS

In this part of the paper we will discuss some of the issues that are particularly important to

emerging markets in the process of demutualization. Although one cannot generalise the

experiences across all emerging markets given their wide spectrum and level of development

some of the experiences of emerging markets61 with demutualization will be instructive.

1. The Extent of Demutualization

The pace of exchange demutualization in developed market jurisdictions has been quite rapid. In

the time since the first exchange demutualization in 1993, 21 exchanges in developed market

jurisdictions have demutualized. This represents almost 40 per cent of the membership of the

61 The term emerging market implies a stock market that is in transition, increasing in size, activity, or level of

sophistication. Most often the term is defined by a number of parameters that attempt to assess a stock market's relative level of development and/or an economy's level of development. Typical characteristics of emerging stock markets:

o relatively small; market capitalization is only 30-40% of GNP, as compared to 70-80% of GNP in the developed markets

o small investable-market capitalization relative to gross domestic product; investable-market capitalization is a market's capitalization after removing holdings not truly "in the market" for foreign portfolio investors. Noninvestable-holdings include, but are not limited to, large block holdings and parts of companies that are inaccessible due to foreign investment limits.

o illiquid; lower turnover

o smaller market capitalization values

o lower ”float”

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- 43 - World Federation of Exchanges.62 In contrast, the pace of demutualization in emerging market

jurisdictions has been relatively slower. The IOSCO Report63 on market demutualization stated

that as of April 2005 (the date of the report) exchange demutualization had been completed in

only 5 jurisdictions out of a total of 76 emerging market jurisdictions.64

2. What Drives Demutualization in Emerging Markets

The IOSCO’s Report found that one of the main drivers of demutualization in many emerging

markets is the increasing competition for global order-flow. Although this pressure has also

been one of the drivers of demutualization in developed markets, it seems that this pressure is

particularly pronounced in the smaller markets of emerging countries. As a result of

globalization and technology, local and regional markets are forced into more direct competition

regionally and particularly internationally. Overall market size is increased and cost of capital is

lowered, as issuers have access to multiple markets. This permits order flow and liquidity to

migrate quickly to major markets with adverse consequences for many smaller markets of

emerging countries. As Figure 2 turnover velocity, an indicator of market liquidity, is extremely

low in emerging market exchanges (although some exhibit very high turnover ratio).

Emerging markets as a group make up about 12.7 per cent of the total global market

capitalisation and individually many of these markets are less then 0.1 per cent. The Asia-

Pacific emerging markets represent, around 10 per cent of the global market capitalization, the

Middle-East and African region represents 1.4 per cent, Central and South American markets

constitute 1.5 per cent and the European emerging markets less than 0.5 per cent. Despite the

numbers the individual size of these markets remain small.

62 Emerging Markets Committee of the International Organization of Securities Commission, “Exchange

Demutualization in Emerging Market”, April 2005, available online at: http://www.iosco.org/library/annual_conferences/pdf/ac19-22.pdf.

63 Supra note 7, Pg. 13. 64 Ibid.

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- 44 - Demutualization has been seen as providing the necessary catalyst to enable a transformation of

the exchange business model to facilitate a more effective response to forces reshaping the

exchange business and competition for investment capital.

Another pressure for demutualization, which has existed in developed markets but prevalent in

emerging markets, is the pressure to reform the exchange’s governance structure as part of a

broader trend reflecting increased domestic and international expectations for higher standards of

governance. It has become increasingly unacceptable that an exchange can function as a

members club and operate without appropriate governance structures.

3. Who Drives Demutualization?

One central difference of demutualization efforts in many of the emerging markets is that they

are typically pursued by either the government or the regulator. This contrasts with the position

in many of the developed markets where the process has been in most instances driven by the

exchange or industry. In the IOSCO Report, all jurisdictions that had already completed

demutualization of their exchange or were in the process of demutualization stated that the

demutualization process was initiated by the government or the statutory regulator.

For example, in the Philippines, legislation was specifically enacted mandating the exchange’s

demutualization within a specified timeframe.65 In Pakistan, the Expert Committee on

Demutualization and Integration/Transformation of Stock Exchanges66 (“Expert Committee”)

recommended that the Securities and Exchange Commission of Pakistan implement

demutualization and integration of Pakistan’s three stock exchanges given the importance of

integration and demutualization to the public interest. The Expert Committee further

recommended that if sufficient progress was not made towards the integration and

demutualization of the existing exchanges within a year, a new stock exchange would be

established to become the national exchange.

65 Section 32.2(a) of the Securities and Regulation Code (RSC) required the Philippine Stock Exchange, Inc. to

incorporate within one year from the date of coming into effect of the SRC.

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- 45 - Even in instances where exchanges chose not to demutualize, policy-makers often have a lead

role in the decision-making process. For instance, in Thailand, it was the Minister of Finance

that appointed a steering committee to consider the demutualization of the Stock Exchange of

Thailand. These trends indicate that the government and/or regulator in emerging markets will

likely play a more significant role in initiating, overseeing and ultimately enforcing reform

efforts in the demutualization of stock exchanges.67

In this regard, concerns have been expressed that this prescriptive approach could force a pre-

mature solution in an environment where the necessary preconditions for demutualized

exchanges to thrive successfully may not be present. For instance, if there is still a fairly closed

and insufficiently liberalized capital market environment, then creating a for-profit exchange,

where its ability to implement business strategies, including those across borders, are constrained

would be leading the exchange to failure. We would argue that, in all markets the political will

and support of the government is critical irrespective of who drives the efforts to demutualize.

Also the government and/or the regulator may alleviate some of the potential problems that

prescriptive solutions may impose by adopting a consensus building approach and pragmatic

solutions to instituting the appropriate framework for balancing the commercial and regulatory

considerations.

4. Demutualization and Stakeholder Issues

In developed markets, it is the existing stakeholders that, in seeking to serve their own interests,

initiate change, in a more or less consensus basis. The tensions arising from a demutualization

exercise could actually be more pronounced in emerging markets where the government and the

regulator are the prime movers in the demutualization. In order to succeed, policy-makers

should adopt a consultative and consensus-seeking process. Policy-makers must be cognizant

that the existing commercial stakeholders have substantial lobbying and other powers to delay

66 Report of the Expert Committee on Demutualization and Integration/Transformation, “Demutualization and

Integration/Transformation of Stock Exchanges, September 2, 2004, available online at: http://www.lahorestock.com/Rpt_Demutualization_Integration.pdf.

67 In some countries, exchanges are owned by the government and therefore the demutualization exercise is

really a privatization of a state-owned entity.

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- 46 - reform efforts. Sufficient “buy-in” measures should be instituted to align varied interests and

converge expectations. The process of demutualization can be implemented in a timelier manner

once support from a broad group of shareholders has been obtained.

Typically, the obvious and direct stakeholders are the brokers who are members of the exchange

in a mutual structure. Other stakeholders include the exchange management, exchange directors,

investors and listed companies.

Furthermore, it is critical to develop a robust strategic framework, outline a well-planned

transformation process and have strong support from policy-makers for its implementation.

Regardless of whether the decision-making process is driven by the public or private sector, it

should be recognized that government or regulatory involvement can help in many aspects,

including expediting the process for regulatory changes and approval. The Malaysian

demutualization experience provides a good example of how the interests and expectations of

stakeholders can be carefully managed to ensure consensus and support for the demutualization

process. This can be summarized as follows:

◦ Stockbrokers. The decoupling of broker membership from management of the

exchange was not a major issue since the implementation of oversight rules in the

mid-1980s. There was general support from the stock broking community as they

saw benefits arising from the unlocking of value in the exchange through the

demutualization process.

◦ Exchange management. Exchange management perceived demutualization as

opening up new opportunities and were major proponents of the demutualization

process. Indeed, considerable efforts were made early on, about two years prior to

the actual demutualization, to design and implement plans to restructure and

streamline the organization to capture operational efficiencies.

◦ The government and regulator. Extensive consultation was undertaken with the

major stakeholder groups prior to making a decision to demutualize the exchange.

Given the broad support from the major stakeholders, the role of the regulator and the

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- 47 -

government focused almost exclusively on public interest issues such as re-designing

the regulatory role of the exchange as well as ensuring that effective governance

mechanisms were put in place to prevent potential conflict of interest situations.

◦ Investors and issuers. While major institutional investors and issuers were not central

to the process, nonetheless their opinions were sought as part of the process to ensure

that decisions took into account a wide spectrum of views. This can prove to be a

useful process in providing a mediating influence where there are divergent views

between the different stakeholder groups.

5. Regulatory Obligations of a Demutualized Exchange

As in developed markets, a critical issue that arises in the context of demutualization in

developing markets is what the regulatory role of the exchange be after demutualization. Some

have argued that following a demutualization, exchanges should be left to concentrate on their

goal of building the business and enhancing the value of the exchange. According to this

approach the potential conflict of interest situation discussed previously in this presentation

would be minimized. It has been argued that this could be achieved either through a transfer of

many of the regulatory functions conducted by the exchange over to the regulator, or to create

semi-autonomous entities where the regulatory functions can be separated from the exchange and

bundled into a new entity, as has been the experience with the ASX and the TSX.

It could be argued however that demutualization is a massive exercise involving a substantial

amount of legislative and organizational work as seen in my discussion of the ASX and TSX.

Perhaps the optimal solution is a pragmatic one which would try to streamline, and to the extent

possible demarcate regulatory responsibilities. This approach is a more practical and gradual

approach to defining regulatory arrangements by fine-tuning “as-is” arrangements.

Depending on the circumstances this may be achieved through MoUs which were discussed

earlier in this paper. These non-binding agreements between regulators and exchanges can be

used to delineate, on an interim basis, regulatory responsibilities. Those agreements are

advantages in that they extend the time to allow for the gradual minimization of the exchanges

regulatory duties.

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- 48 - One cautionary note arising from this is the risk that if these MoUs are not carefully structured,

they may end up imposing unnecessary constraints on regulatory powers – which shouldn’t be

the intention because it is likely that further refinements to regulatory arrangements may be

needed arising from the future changes in the exchange business model.

6. Conclusion

The previous discussion attempts to highlight certain issues impacting stock market

demutualization in emerging markets. Although the process of demutualization does not differ

markedly from the experience of demutualization in developed economies, certain key

challenges can be identified. These challenges include:

• Differences in market conditions and private sector infrastructure that can influence the

philosophies and strategies of market regulators, leading to conditions where it is

necessary to shift post demutualization regulatory responsibilities gradually;

• Constraints in domestic markets can narrow policy alternatives available, leading to the

regulator taking the lead in the demutualization initiative as opposed to the market itself;

• The overall strength of market reforms in some emerging economies may not be

sufficient to support successful demutualization and may not be appropriate in all

emerging markets

These challenges have thus far been met with mixed success. While certain DEs in emerging

markets, such as the Bursa Malaysia have generated long-run returns in the 26% range, others,

such as the Philippines have been less successful, reporting a first day trading return of more

than 120%, but failing to realize durable profitability, posting negative returns close to 74% as at

September 30, 2005. While the reasons for these widely differing outcomes are still subject to

debate, it is clear that there is no fixed formula for the success of demutualization in the

emerging markets context.

Unsurprisingly, the Emerging Markets Committee of the International Organization of Securities

Commissions has stated that it is too early to assess the benefits of demutualization of stock

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- 49 - markets in an emerging market context, as insufficient time has passed since the demutualization

exercise was initiated68. Since this is the case, it is likely that there will be considerable debate on

this topic as time passes and additional information is made available.

Nevertheless, it is evident that in general, emerging market regulators have made substantial

progress in strengthening practices and infrastructure in their capital markets. In this evolving

context, markets that may not yet be in a position where demutualization in a viable option as a

top-down policy initiative may find that market-led initiatives will lead to demutualization in the

near future. As a result, it is important that regulators and exchange operators continue to work

together to create policies and market conditions that are fair and efficient.

68 Emerging Markets Committee of the International Organization of Securities Commission, “Exchange Demutualization in Emerging Markets”, April 2005, available online at: http://www.iosco.org/library/annual_conferences/pdf/ac19-22.pdf.

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- 50 -

APPENDIX

Figure 1

Source: Reena Aggrawal and Sandeep Dahiya, “The Demutualization and Public Offering of Financial Exchanges”, November 6, 2005.

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- 51 -

Figure 2 Historical Evolution of Major Stock Exchanges

Source: Reena Aggrawal and Sandeep Dahiya, “The Demutualization and Public Offering of Financial Exchanges”, November 6, 2005.

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- 52 -

FIGURE 3: TSX’s INTER-CORPORATE RELATIONSHIPS

Source: TSX Annual Information Form, May 29, 2005.

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- 53 -

FIGURE 4: POST LISTING PERFORMANCE OF MAJOR EXCHANGES

Source: Reena Aggrawal and Sandeep Dahiya, “The Demutualization and Public Offering of Financial Exchanges”, November 6, 2005.

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- 54 -

FIGURE 5: AVERAGE ANNUAL TURNOVER RATIO IN EMERGING MARKETS, 1999-2003

Source: EMC of the IOSC, “Exchange Demutualization in Emerging Market”, April 2005.

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- 55 -

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FIGURE 6: EMERGING MARKETS' SHARE OF WORLD MARKET CAPITALIZATION,

1994-2003

Source: EMC of the IOSC, “Exchange Demutualization in Emerging Market”, April 2005.

12

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, and

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ity &

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rest

Rat

e D

eriv

ativ

es

BM

E Sp

anis

h Ex

chan

ges

2001

N

o Pl

ans

940,

673

Equi

ty, a

nd E

quity

& In

tere

st R

ate

Der

ivat

ives

Sw

iss E

xcha

nge

2002

N

o Pl

ans

826,

041

Equi

ty

Bor

sa It

alia

na

1997

N

o Pl

ans

789,

563

Equi

ty, a

nd E

quity

Der

ivat

ives

O

MX

Gro

up

1993

1-

Jan-

93

715,

779

Equi

ty, a

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quity

& In

tere

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ate

Der

ivat

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O

slo

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20

00

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ov-0

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518

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18

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12

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Eq

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cant

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xcha

nge

2002

6-

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omm

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& In

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ate

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ivat

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eriv

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tern

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ecur

ities

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e 20

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-05

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sian

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Exc

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es

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like

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Osa

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Exc

hang

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287,

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ty, a

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ong

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00

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tralia

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1998

14

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776,

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Equi

ty, a

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quity

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ivat

ives

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iwan

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p.

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ty

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s N

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389,

473

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Bur

sa M

alay

sia

2004

18

-Mar

-05

181,

624

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ate

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N

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- 2 -

12

34

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& In

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ate

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ivat

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So

urce

: Ree

na A

ggra

wal

and

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deep

Dah

iya,

“Th

e D

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d Pu

blic

Off

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Fin

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, 200

5.

Exhibit A Corporations Regulation 2001 (Australia)

Division 6 The Australian market licence: other matters 7.2.16 Potential conflict situations (1) For subsection 798E (1) of the Act, this regulation applies in relation to specific and

significant conflicts, or potential conflicts that would be specific and significant, between:

(a) the commercial interests of Australian Stock Exchange Limited (ASX) in dealing with a body (the competitor) that operates a business with which:

(i) ASX is in competition; or (ii) a subsidiary of ASX is in competition; or (iii) a joint venture (however described) to which ASX is a party is in competition;

or (iv) a joint venture (however described) to which a subsidiary of ASX is a party is

in competition; and (b) the need for ASX to ensure that the market operated by it operates in the way

mentioned in paragraph 792A (a) of the Act. (2) The competitor may lodge with ASIC in the prescribed form, an application for ASIC to

decide that ASIC, instead of ASX, will make decisions and take action (or require ASX to take action on ASIC’s behalf) in relation to:

(a) if the competitor is seeking to be listed — the compliance by the competitor with the applicable listing rules of the market operated by ASX; or

(b) if the competitor is listed on the market operated by ASX — the compliance by the competitor with the applicable listing rules of the market operated by ASX.

(3) As soon as practicable after receiving an application under subregulation (2), ASIC must: (a) consider whether a conflict, or potential conflict, exists as described in

subregulation (1); and (b) if it considers that a conflict, or potential conflict, exists —consider whether, having

regard to ASX’s obligations under subparagraph 792A (c) (i) of the Act, the conflict, or potential conflict, would be dealt with more appropriately and efficiently by a means other than taking the action mentioned in subregulation (2); and

(c) decide whether (and to what extent): (i) to make decisions and take action; or (ii) to require ASX to take action on ASIC’s behalf; in relation to the matters mentioned in paragraphs (2) (a) and (b). (4) If ASIC decides to make decisions and take action (or to require ASX to take action on

ASIC’s behalf) as mentioned in subregulation (2), ASIC:

1234

- 2 - (a) may consult with ASX and the competitor to identify the listing rules of the market

operated by ASX for which ASIC needs to make the decisions and take the action; and

(b) must, as soon as practicable, decide the extent of ASIC’s role, having regard to: (i) the rationale for the listing rules of the market operated by ASX; and (ii) the desirability of treating the competitor consistently with other entities

listed, or seeking to be listed, on that market; and (iii) the extent to which action taken by ASIC is severable from the wider

supervision of the competitor’s compliance with the listing rules; and (iv) its consultations (if any) with the competitor and ASX. (5) ASIC must, as soon as practicable, advise ASX and the competitor, in writing, of

decisions under paragraphs (3) (c) and (4) (b). (6) If ASIC decides to make decisions and take action (or to require ASX to take action on

ASIC’s behalf) as mentioned in subregulation (2): (a) the decisions made and actions taken have effect despite anything in the listing rules

of the market operated by ASX; and (b) decisions made and actions taken by ASIC (or action taken by ASX on ASIC’s

behalf) have effect as if they were decisions made and actions taken under the listing rules.69

(7) If ASIC believes, on reasonable grounds, that: (a) the period during which decisions will be made and action will be taken in a

particular case is likely to be more than 3 months; and (b) the decisions and actions likely to be required are not adequately reflected in the

listing rules of the market operated by ASX; ASIC must notify ASX, in writing, of its belief.

69 Note 1 It is expected that the listing rules of the market will support ASIC’s power to take a supervisory role in

relation to compliance with some or all of the listing rules.

Note 2 Under section 246 of the Australian Securities and Investments Commission Act 2001, ASIC is not liable to an action or other proceeding for damages for or in relation to an act done or omitted in good faith in performance or purported performance of any function, or in exercise or purported exercise of any power, conferred or expressed to be conferred by or under the corporations legislation.

Note 3 The powers available to ASIC include the power:

(a) to grant, or not to grant, waivers of the listing rules; and

(b) to impose conditions on which the grant of a waiver is made.

1234

- 3 - (8) ASX must, as soon as practicable after being notified under subregulation (7), amend the

listing rules of the market operated by ASX to the extent necessary to meet ASIC’s concerns.70

(9) If ASIC decides that it is no longer necessary for decisions to be made and action to be taken in relation to the particular conflict or potential conflict, ASIC must notify ASX and the competitor of its decision as soon as practicable.

(10) ASX may repeal any listing rule or amendment made for subregulation (8) only if: (a) the repeal or amendment is necessary or convenient to meet ASIC’s concerns more

effectively; or (b) ASIC has notified ASX under subregulation (9). (11) Paragraph (10) (b) does not prevent ASIC from: (a) reviewing a particular conflict or potential conflict; and (b) deciding, at any time (with or without complying with paragraph (4) (a)), that it has

again become necessary for ASIC to make decisions and take action (or for ASIC to require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict.

(12) If ASIC makes the decision mentioned in paragraph (11) (b), ASIC must notify ASX and

the competitor of its decision as soon as practicable. (13) For this regulation, ASX must: (a) give ASIC the information and documentation that ASIC reasonably needs to make

decisions and take action under this regulation; and (b) establish administrative and procedural arrangements for that purpose. (14) A competitor may notify ASIC that the competitor no longer wishes ASIC to make

decisions and take action (or for ASIC to require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict.

(15) If ASIC is notified under subregulation (14), ASIC must, as soon as practicable: (a) decide whether it will cease to make the decisions and take the action (or cease to

require ASX to take action on ASIC’s behalf); and (b) notify ASX and the competitor of its decision. (16) If ASIC decides to cease to make decisions and take action (or to cease to require ASX to

take action on ASIC’s behalf), ASIC must cease to make decisions and take action (or must cease to require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict.

70 Note Amendments of the listing rules are subject to procedural requirements, including possible disallowance,

mentioned in sections 793D and 793E of the Act.

1234

- 4 - (17) If ASIC decides not to cease to make decisions and take action (or not to cease to require

ASX to take action on ASIC’s behalf), ASIC must continue to make decisions and take action (or must require ASX to take action on ASIC’s behalf) in relation to the conflict or potential conflict.

1234

- 5 -

Exhibit B MoU Between ASX and ASIC

11966440.1.DOC

1234