Demutualisation: The challenges facing global exchanges

The key buzzwords in the capital markets are flexibility and innovation. Without these words in their "vocabulary", exchanges will become dinosaurs or be surpassed by new entrants such as electronic communications networks (ECNs). Two key drivers are forcing exchanges to change:

Increasing pressure from the market for low cost cross-border access; and
The advent of alternative trading platforms, such as ECN's driving market share away from the traditional exchanges.

These drivers are increasingly placing demands on traditional exchanges to become more commercial in their approach to the market. Many exchanges feel that the cosy world of the mutualised exchange does not provide the flexibility to adequately meet these new challenges. Hence demutualisation is seen as the panacea for their problems.

However, implementing a demutualisation program is not trivial. It represents a wholesale corporate cultural transformation - changing every dimension of an exchange. BTA has created a standard blueprint, which can be adopted for any demutualisation endeavour. This blueprint accommodates each exchange's own unique set of variables and challenges.

Exchanges that simply view demutualisation as a legal manoeuvre are courting suicide. Why? Because the landscape for demutualised exchanges will be saturated within two years and the aggressive commercial and innovative demutualised exchanges will succeed. Accordingly there are whole ranges of issues that need to be analysed and considered before demutualisation commences:

What does the exchange hope to achieve from demutualisation and how far is the management prepared to commit to achieving complete demutualisation?
What infrastructure needs to be in place to achieve the desired results?
What is the appropriate corporate governance structure for an exchange?
How does the demutualised entity provide for stakeholder value and profitability?
How do you unlock the hidden value within the organisation before an IPO takes place?
How do you protect your brand in a post-demutualised environment?
Can you achieve your business goals, and in particular your target earnings rates when regulators are setting moving targets?
These are just some of the many questions that need to be answered. A failure to recognise these issues risks damaging an exchange's reputation or worse still burdening it with problems for the future.

The term demutualisation hides a number of complex issues that need to be understood and addressed. The unique nature of exchanges also tends to cloud ongoing debates over the merits of demutualisation. Exchanges are seen as platforms for creating fair and efficient capital markets, with a duty to protect the public interest.

In mature markets, exchanges face competition and are typically not saddled with an exclusive public policy role. Accordingly their demutualisation program has a greater probability of success and facilitates a truly global business.

By contrast, attempts to demutualise exchanges in emerging markets are complicated by nationalistic barriers, as well as the necessity to make them commercial, sometimes without the critical mass. The lack of adequate empirical data from wide-scale case studies makes the debate on demutualisation even more difficult.

Contrary to the opinion that there is an increasing trend towards demutualisation, not all mutual exchanges have decided to demutualise. There remains a school of thought that is not convinced of the merits of demutualisation. They argue that some of the most successful exchanges in the world are still thriving while mutualised. For example, the New York Stock Exchange is surely the most successful global exchange brand in the world. Even some demutualised exchanges believe that exchanges can succeed while keeping their mutual status.

In December of 2000 BTA Consulting decided to further the demutualisation debate by pioneering a research project into demutualisation. The response from exchanges around the world was overwhelming. 24% of exchanges participated. 80% of demutualised exchanges also took part in the survey, which represents in excess of 50% of the world's trading liquidity.

We believe this has allowed us to uniquely distil the key issues that encapsulate the demutualisation debate, and draw authoritative conclusions from the data collected.

Does demutualisation guarantee future success?

Very few exchanges would disagree with the fact that the current competitive climate has never been so intense:

The barriers to entry for new entrants have been slowly eroded through market pressures and increasing dissatisfaction with the way exchanges have been managed.
Stakeholders can be easily raided.
New electronic alternative trading systems seem to be mushrooming.
Fragmentation in an un-level playing field is rife.
There will be changes in price discovery forums in response to systemic risk management via central counterparties.

But does this really mean that the days of the mutual exchanges are numbered? This depends on the market; national laws can act as barriers to competition and in effect create monopolies.

There are obvious advantages to demutualisation:

Financial agility - Demutualised entities have wider access to capital and can have wider horizons compared with mutualised exchanges. This gives the demutualised exchange a competitive edge in winning business and a better position to embrace the technology evolution (although there is no evidence of this yet).
Lack of "peer pressure" - The major weakness of a mutual exchange is its constitution. Mutual exchanges are ultimately geared to maintaining their members' interests. The interests of the members are not necessarily the same as those of the exchange; they are disparate. The separation of shareholders, management, and users in a demutualised exchange makes for better strategic decision-making, rather than protecting vested interests.

Are exchanges at a disadvantage by remaining mutualised?

Although there is a school of thought that still believes the remaining mutualised exchanges will not undermine their competitiveness, the results of the survey show that 75% of the mutual exchanges that responded believe they are not free to pursue optimum commercial solutions for their exchange.

Furthermore, 58% said that mergers, acquisitions, or alliances were unlikely to be an opportunity that could be easily pursued. Other recently published statistics also point to the same conclusion. For example, at the October 2000 meeting of the Federation Internationale des Bourses Valeurs (FIBV), 65% of the delegates agreed, "the merger of exchanges will lead to a system of a few very dominant players, thus marginalizing smaller markets." Not surprisingly 64% of demutualised exchanges thought that future success lay with demutualisation. However, what was surprising was that 60% of mutual exchanges voiced the same opinion.

A demutualisation plan is not a trivial pursuit!

Implementing a total demutualisation programme is not trivial. It represents a wholesale corporate culture transformation, changing every dimension of an exchange. Yet the barriers to demutualisation are significant, mainly because the current modus operandi has been perpetuated for over a century. Most exchanges have yet to embrace demutualisation in its widest form - total commercialisation - and face being marginalized by more nimble new entrants and their customers. Strategically deciding to ignore demutualisation because it is too difficult is not an option, and would be a huge error of judgment - both financially and reputationally.

What's in a word? - Hidden pitfalls!

The exchanges that have demutualised have not done so without crossing numerous hurdles. Unsurprisingly, the four areas of demutualisation that proved to be most problematic were:

Corporate structures - what is the fairest, flexible, and transparent structure that needs to be in place? 75% of the respondents said this was very difficult or difficult;
Legal issues - what additional legal matters now need to be considered? 75% of the respondents said this was very difficult or difficult;
Regulatory issues - how do the exchanges ensure that they are still performing their public duties equitably? 62% of the respondents said this was very difficult or difficult;
Vested interest management - how does the exchange ensure that it continues to maintain loyalty of users? 53% of the respondents said this was either very difficult or difficult.

One of the most difficult aspects of demutualisation concerns selecting the correct corporate structure. Corporate structure is the first rung of the demutualisation ladder and will adversely affect all other stages unless the optimal solution is implemented. Because there are no blueprints, it's easy to get the wrong structure for the organisation. In considering the corporate structure, some key questions that should also be factored in are:

What type of share structure is going to be put into place i.e. will shareholding be restricted to current members?
Are there going to be controls put in place (either by regulators, or other government bodies) to limit the maximum percent of shares that any one entity or individual can own?
What is the mechanism that is going to be adopted to resolve conflicts of interest between different interest groups?
What is the composition of the operating board structure? - non-executives, market practitioners, users, shareholders?
Should the self-regulatory organisation (SRO) aspects of the exchange be spun off to a new organisation, or should they be transferred to the regulator?

Will a demutualised exchange continue to perform its public duty fairly?

In many people's minds the biggest difficulties faced when contemplating demutualisation concerns regulatory issues. This is especially true in exchanges that also act as self-regulatory organisations. Potential issues that need to be addressed include:

The implications of self-listing - what happens if an exchange finds itself in a commercial conflict with another company listed on the exchange?
How should primary and secondary market regulation be handled - would a for-profit exchange be less likely to enforce disciplinary action against listed companies if this would negatively affect the exchange's bottom line?
How should cross border relationships be supervised - regulators also want to protect themselves and their own turf. There is a danger of creating a hybrid regulator that encompasses the worst aspects of each market.
Cross-subsidisation, where funds generated from regulatory sources are used to meet commercial obligations, i.e. dividend payments, etc.

However, there are also strong commercial reasons that suggest demutualised exchanges will be just as diligent in enforcing regulatory rules as their mutual counterparts. There are a number of arguments that can be used to take this stance:

A demutualised exchange that is seen to be biased or acting unethically will place its long-term viability in doubt. Brand is king, and demutualised exchanges will need to spend more money on surveillance than before.
The uncoupling of vested interests is likely to lead to a fairer, more even-handed market place.
Although surveillance is certainly not a bottom line driven function, it could be argued that enforcement might be pursued more aggressively in a for profit exchange as a means to obtain additional revenues.

The need to adequately address SRO implications is imperative from both the regulator and exchange perspective. Exchanges cannot be expected to meet their stakeholder responsibilities when their target is constantly moving. New regulatory measures need to be designed that address the complexities of demutualisation. Considering the number of exchanges planning a demutualisation within the next 2 years, IOSCO would be well advised to issue a blueprint for regulatory management of demutualised exchanges. The scope of this blueprint would include:

SRO and investor protection requirements.
Service tariffs. There is a danger of demutualised exchanges using cross subsidises thereby stunting competition, and in turn keeping the prices of some types of transactions artificially high. Some type of pricing structure will need to be installed to avoid this risk. Many lessons may be learned from public utility regulation.

The overwhelming response from demutualised exchanges (70%) was that SRO aspects of an exchange should stay with the exchange. Considering that most exchanges also act as SRO it is unsurprising that such a clear majority want to keep the SRO functions within the exchange. More importantly, most exchanges view SRO functions as an integral part of their business and a tool for managing its users.

Retention, retention, retention

As surprising as it may sound, the percentage of exchanges with strategies for retaining and expanding clients post-demutualisation is remarkably small. Customer Resource Management (CRM) is critical. 59% of demutualised exchanges have strategies for retaining and expanding members; 53% said the same for listed companies, and only 35% could say the same for E-clients. We are so surprised about these results - particularly the results on listed companies. This reflects the scale of paradigm shift required. Mutualised exchanges see hosted companies as only regulated contracts in the domain of the listing dept. Mutualised and indeed some demutualised exchanges do not see listed companies as customers. In such exchanges the wider value proposition for the hosted company and CRM program is in fact invisible. Exchanges are also invisible to investors, and this needs to change in the demutualised world, for example through investor relationship progress. Strategies for retaining and expanding clients varied widely.

Don't forget about brand identity

The lack of strategy for retaining and improving brand identity post demutualisation was very surprising. A clear lack of understanding concerning the importance of brand identity was obviously absent in 48% of demutualised exchanges. Considering the huge premiums that are often bestowed (OM for example) on corporations with instant brand recognition, the absence of strategies for retaining or improving brand identity was very worrying. It would appear that although some exchanges have changed from mutual to demutual, their mindsets have not. Exchanges that fail to capitalise on their brand risk watching it slowly evaporate into oblivion.

Competition - what's that?

Demutualisation increases the number of potential competitors and can greatly increase the complexities of operating the exchange. However, simply ignoring demutualisation and hoping that it passes you by is not an option. 88% of demutualised exchanges think that other exchanges will be the biggest threat. Surprisingly the Internet was only cited by 65% of respondents, which might indicate a lack of foresight concerning the opportunities raised by this new medium. Again, the challenges posed by ATS/ECN has probably not been fully appreciated, especially where cross border transactions occur. ATS/ECN offer potentially huge savings by minimising inefficiencies in cross border clearance and settling the processes for international transactions.

Is demutualisation all you expected?

Having been through the process of change within the organisation, it is important to understand if the results of this complex multi-dimensional process, which involves huge costs in terms of both management resources and financial costs, was as expected. We asked participants in the survey to list some the key benefits they expected to achieve by demutualising. The table below lists the main ones:

Expected financial benefits

Access to greater variety of capital sources

Wider customer base

Improve shareholder value - payment of dividends, better relationships

More profits driven

Better cost control

Share price improvement

Increased market capitalisation

Expected non-financial benefits

More focused management

Quicker decision making

Freedom to pursue business opportunities unconstrained by vested interest issues

Flexibility, efficiency and competitiveness

Ensuring own destiny and not reliant on members

Accurate means of measuring value creation by management

Greater respect for company

Better public relations - positive press coverage

Were these expected benefits realised? Does achieving some of these benefits mean that it was a successful demutualisation?

In our opinion, if demutualisation does not involve a wholesale change in the organisation through a planned process, it is not likely to be classified as a success story. There is a need to plan the appropriate ownership structure, governance model, relationship management, and operational management. The end result of demutualisation should be an exchange that is both modelled on and performing like a Fortune 500 company.

Are you happy being demutualised?

Following on from this line of questioning, the results of our survey surprised us. Only 46% of demutualised exchanges were happy with the results of the process to achieve demutualisation. What went wrong? After all, demutualisation is supposed to be the Holy Grail of the exchange world. How could these exchanges be so disillusioned with the outcome? How can the 79% of mutual exchanges surveyed that plan to demutualise within the next two years not repeat the same mistakes?

So what has been the historic recipe for a successful demutualisation?

Digging deeper, the survey results highlighted several important differences between exchanges that were happy with demutualisation, and the ones that were not. 100% of happy exchanges had a form of listing or readily accessible public ownership. The ingredient that drove exchanges to this success was mindset. Exchanges who experienced unhappy outcomes from demutualisation overwhelmingly behaved like a mutual exchange. Demutualisation is not simply an exercise in changing legal status, i.e. simply turning into a for profit entity owned by members. A truly demutualised exchange would be better placed if it were able to unlock its hidden value for all stakeholders in order to maximise its potential market capitalisation and shareholder value.

The overwhelming majority of exchanges who have historically been happy with demutualisation recognised the importance of the following critical success factors:

A balanced ownership structure and public listing status.
Modern corporate governance.
Stakeholder relationship management (SRM).
Customer relationship management (CRM), in particular using modern technologies.
Aggressive Service Level Agreements (SLAs).

BTA recognise that where success has been achieved it has been a result of appropriate corporate governance and management structures. Why? The right mix of entrepreneurial flare coupled with an effective management team are critical to steering the exchange towards success. Where demutualisations have neither succeeded nor created "quick wins" or positive results, these key ingredients are missing. So let us look more closely at the five critical success factors that have historically contributed to success.

Ownership structure and listing

100% of happy exchanges are either listed or publicly tradable with few restrictions on the transferability of the shares. To get to this stage requires a necessary mindset change, proving the exchange can innovate, while being flexible and transparent - so much so, that it can support the share price of the exchange by its expected future earnings. The real time price is therefore the acid test.

Modern corporate governance

The adoption of a modern corporate governance approach is essential to create the correct environment for the growth of the business, and enhancing the value of the company for following reasons:

To create fast tracked innovation rather than slow mutual consensus management. This is essential given that mutualised exchanges have proved to be unable to respond efficiently to the needs of all stakeholders (customers, employees, shareholders, suppliers, regulators). Instead mutuals concentrate on achieving a balance within their communities, which in the demutualised world is a major problem as the focus should be on shareholder value, irrespective of the community representation.
To create the right domestic and international image for all stakeholders, particularly given the current intensification of competition, the greater mobility of capital and the fragmentation of price discovery. Recent research has suggested that investors are willing to pay a premium, of up to 28% for shares in well governed companies in some developing countries.
To diversify risk and facilitate international investment, reach and branding of hitherto domestic exchanges.

SRM & CRM

One of the immediate benefits of demutualisation should be improved relationships with external parties, particularly through the introduction of SRM programmes and CRM software. The differences in relationships experienced by the happy and unhappy exchanges were massive. 61% of happy exchanges enjoyed improved relationships with third parties. This compared to 63% of unhappy exchanges that did not enjoy any improvement in third party relationships. This failure to immediately achieve improvements with stakeholders is probably a good indication of future problems for demutualised exchanges.

The exceptions to this rule are regulators. BTA Consulting believe that demutualisation will not automatically be followed by improvements in relationships with governmental entities, particularly where governments force a public policy role on the exchange. Regulators are not sufficiently attuned with their role in the post demutualisation era. As we explained earlier they are creating a moving target by continually changing the ball game, which is particularly unhealthy.

Commercial entities need SLAs (Service Level Agreements)

Quite surprisingly only 33% of demutualised exchanges have implemented more aggressive SLAs. We were surprised to see this was so high. However, the percentages of happy exchanges that have implemented more aggressive SLAs are clearly much higher than average, and considerable higher than unhappy exchanges. The competitive playing field for exchanges will be critically dependant upon SLAs - and will be a way to attract and retain clients on a long-term basis.

58% of happy exchanges have implemented more aggressive SLAs. 67% of unhappy exchanges have not implemented more aggressive SLAs, and 100% of exchanges that said that it is too early to tell have also not implemented more aggressive SLAs.

So will the past be representative of the future? Will the 79% of exchanges that are considering demutualisation in the next two years be successful if they focus on the five critical success factors discussed in this section. Sadly, the answer is No, and you need to read on, to consider the new success factors that are looming on the horizon.

Is the past representative of the future?

BTA Consulting has analysed these results and has also used its considerable experience to consider the impact on both mutualised and demutualised exchanges. Our belief is that the past will not be representative of the future. Accordingly, some key lessons need to emerge. Successful demutualisations that lead to successful IPOs and a growth of shareholder value will in the future be dependant upon other additional critical factors:

Being right first time - the novelty factor for demutualisation is wearing off and the market for exchange shares will soon be saturated. Can the markets absorb in excess of $50 billion of exchange shares in the next 2 years? In this context, the demutualisation needs to be right first time, and needs to escalate to Step 9 of the BTA Methodology very quickly. If the demutualisation programme stalls around Step 3, then it will take significant capital and time to recover the market capitalisation of the demutualised company.
Timing - there is going to be a saturation of exchanges on the global market and they will also be competing with some interesting B2B, B2C, and C2C markets. Therefore, the 79% of exchanges planning a demutualisation within the next two years need to undertake this sooner rather than later, and need to move to step 9 quickly. Demutualising around the end of 2002 may be either too late, or may reduce shareholder value.
Service offering -exchanges need to offer a compelling value proposition that will support an IPO and future price/earnings ratios. In the context of growing competition, our opinion is that exchanges will need to diversify their businesses, become niche, and/or become vertical silos that embrace settlement. The value of price discovery and market data, the traditional revenue generators of exchanges, will in the medium term be minimal as they are quickly becoming a commodity,
Where to list? The "backyard" may not be the only serious location to consider. Competition would normally dictate significantly more aggressive cross-border strategies.
Widening the scope of CRM programmes - in the future these will need to be electronic, and in this world where the Internet offers a new complementary channel to market, the CRM programmes need to embrace Internet-style technologies.

Conclusions

The cosy world of the mutualised exchange has now been superseded by the commercial realities of the 21^st century. Flexibility, innovation and mindset changes are the new winning ingredients. Exchanges that fail to adapt to this new environment risk the same fate as the dinosaurs. Demutualisation is now viewed as the panacea for all the woes afflicting mutual exchanges. Although the allure of demutualisation is not universally accepted, 79% of mutual exchanges interviewed plan to demutualise within the next two years. A survey taken at the October 2000 FIBV conference found that 78% of exchanges either had approval to demutualise or were actively considering it. Timing to list has now become critical. First mover advantage has now been lost. Exchanges only have one shot at demutualisation.

Demutualisation can, and does offer unprecedented opportunities. But only for exchanges that tackle the whole process in a systematic fashion, where the end result is a structured organisation that is:

Transparent to its shareholders, management and staff and its users.
Truly segregated - stakeholders (users and shareholders) from the management of the business.
Governed by a board with non-executive and executive directors.
Capable of delivering sustainable value without cross subsidies.

When demutualisation only takes the form of a legal manoeuvre leading to a for-profit entity, the results are overwhelmingly a failure. Exchanges that successfully manage the necessary structural changes but continue to act as a mutual are also doomed to failure. A poorly conceived demutualisation plan can be costly both in terms of brand erosion and financial leakage.

There is a clear distinction between exchanges that reported being satisfied with the outcome of demutualisation and those that where not. Exchanges that were listed and aggressively tackled all the areas encapsulated in core competencies and value added services such are SRM and CRM reported a significantly higher satisfaction rate than exchanges that did not.

With the exception of a few exchanges, demutualisation has really only been in vogue for the last few years and therefore as more exchanges move towards demutualisation it will be interesting to see how many have learned from the mistakes of others. We believe that by following the 10-step approach developed by BTA Consulting these mistakes can be avoided.

BTA's exchange commercialisation methodology

BTA Consulting's methodology sees ten steps in the commercialisation of an Exchange:

Step 0	Mutualised Exchange
Step 1	Corporate structure
Step 2	Exchange shares traded amongst mutual members
Step 3	Exchange shares traded OTC with some restrictions
Step 4	Corporate governance
Step 5	Stakeholder relationship management
Step 6	SLA-driven operational management
Step 7	Customer relationship management
Step 8	Private placement of Exchange shares to internationalise
Step 9	No restrictions on trading or ownership of Exchange shares

BTA Consulting believes that the capital markets can learn from nature. We have therefore developed a demutualisation methodology, which we have named "Metamorphosis".

BTA's metamorphosis methodology

Stage	Description	Comments
Egg Stage	Starting point (mutualised)	If starting now, start as a commercial entity, like ECNs
Caterpillar Stage	Getting fatter, earthbound and vulnerable - victim of circumstance	Demutualised - up to step 3 - a legal manoeuvre
Pupa Stage	Massive internal changes in process, still vulnerable	Demutualised - implementing steps 4-7
Butterfly Stage	Highly mobile, very attractive, able to mate - master of own destiny	Highly commercialised - steps 8 and 9