Causes and Effects of Demutualization of Financial Exchanges

8/13/2019 Causes and Effects of Demutualization of Financial Exchanges

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Causes and Effects of Demutualization of Financial Exchanges

Chinmay Jain1

and

Pankaj Jain2

October 2010

1Doctoral candidate, Department of Finance, Insurance, and Real Estate, Fogelman College of

Business and Economics, University of Memphis, Memphis, TN 38152. Phone: 901 678 4189;Email: [email protected]

2Suzanne D. Palmer Associate Professor of Finance, Department of Finance, Insurance, and

Real Estate, Fogelman College of Business and Economics, University of Memphis, Memphis,TN 38152. Phone: 901 678 3810; Email: [email protected]


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Causes and Effects of Demutualization of Financial Exchanges

Abstract

We examine how the forces of automation, competition, and demutualization are rapidly

changing the industrial organization, ownership, and capital structure of the financial exchange

industry. We propose the conditions under which demutualization becomes optimal from the

perspective of mutually owned exchange owners. We then proceed to build an empirical dataset

characterizing the evolution of the leading stock and derivative exchanges around the World

along these dimensions. We empirically find that technology driven growth opportunities,

product driven growth opportunities and increases in market concentration are the main

stimulants for demutualization. These factors remain strongly significant in explaining

demutualization after controlling for market capitalization, trading volume and economic

freedom environment within country where the exchange is domiciled. Finally, we analyze the

impact of demutualization from the perspectives of other stakeholders in financial markets.

Turnover and liquidity improve after demutualization helping reduce the cost of capital.


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Introduction

Stock markets have served as engines of modern economic growth. With modest

beginnings as private clubs in the seventeenth century, today they are vital financial institutions,

which are essential for efficient allocation of capital through secondary market liquidity.

Whereas the stock exchanges provide the platform for the expression of demand and supply of

equity financing, the derivative exchanges complete the market as conduits for efficient

allocation of risk. Taken together, the financial exchanges are the pillars of well functioning

capital markets and in this role, they affect a variety of stakeholders such as investors,

corporations, regulators and intermediaries. Historically, financial exchange members have not

only served as intermediaries and liquidity providers, but also owned and managed the

operations of the exchanges in many countries. Since the worlds first demutualization1and IPO

in the world by Stockholm Stock exchange in 1993, 57 exchanges in 51 countries have

demutualized by 2008, representing a major transformation in the legal structure and the

industrial organization of the financial exchanges. Our paper analyzes this separation of liquidity

provision and exchange ownership that has resulted from these demutualization initiatives

throughout the world. We investigate the causes of demutualization of financial exchanges. In

particular, we explore the interactions between technology adoption, growth opportunities,

regulation, competition, globalization, and exchange ownership structure.

We provide a background on institutional features of financial exchanges in section 1. In

particular, we discuss the changes in the organizational structure of financial exchanges from

being mutual member-owned entities to demutualized for-profit entities. We contribute to the

literature by testing the role of growth opportunities and competitive environment in determining

1Demutualization is the process of issuing and distributing shares to the owners of the exchange to allow separation


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the ownership structure of exchanges. Once the exchanges demutualize, they may find it easier to

raise capital and compete with other exchanges. The doors for mergers and acquisitions with

other exchanges also open up after the adoption of demutualized form of ownership. In section 2

of the paper, we present a simple model integrating these strategic decisions made by exchange

owners keeping in mind the perspectives of other stakeholders such as investors, corporations,

regulators and intermediaries. We look at the conditions when an exchange may prefer

merger/acquisition or debt issue over equity issue. Although the concepts can be applied to many

industries but we focus our paper on the financial exchanges industry. The model provides

empirically testable predictions. Using a sample of exchanges from 104 countries, we find strong

support for some of the key features of the model. There are various determinants of exchange

demutualization; new growth opportunity arising from trade automation stands out as a major

determinant. On the one hand technology creates new future revenue opportunities through

geographic expansion of customer base. On the other hand, trading system automation by

competing exchanges also increases competitive threats among exchanges by removing

geographical boundaries, thereby reducing the valuation of exchange members existing franchise

relative to future growth opportunities. Second, we consider the emergence of derivatives trading

in a country as a stimulant to demutualize. Exchanges can increase their revenues by offering

new products such as derivative contracts to the traders to enhance their trading fee revenues.

Third, market concentration should play a role in the demutualization decision of the exchange

and subsequent IPO versus merger activity as suggested by Brau, Francis and Kohers (2003).

Exploiting growth opportunities related to automation or new products may both require

substantial capital investments. For-profit demutualized exchanges can raise capital more easily

from a variety of sources relative to mutually owned exchanges who may not be able to ask their

of trading rights and cash flow ownership rights.


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members to commit large amounts of fresh capital for new initiatives. After demutualization,

capital can be accessed through mergers or raised through equity issue, or debt issue. We

examine the conditions for which three funding outcomes become optimal.

Three studies most closely related to our paper are the theoretical work of Myers and

Majluf (1984) and empirical works of Serifsoy and Tyrell (2006), and Ramos (2006). Myers and

Majluf (1984) provide the initial framework for our analytical work and hypotheses

development. Serifsoy and Tyrell (2006) find that competitive pressure induces exchanges to

demutualize and that publicly listed exchanges are more likely to invest into related business

activities. We use longer time-period of 40 years and 104 countries compared to their 5 year

sample of 26 exchanges. Our results are that market share concentration causes demutualization

which is diagonally opposite to their finding. One of the main reasons for this difference is that

we include one exchange countries which are some of the first ones to demutualize, but which

were not explicitly analyzed in their paper. Ramos (2006) investigates the relationship between

demutualization and political freedom. As such we add more recent values of heritage foundation

economic freedom index as a control variable in our regression analysis. Ramos (2006)

concludes that larger, older and riskier stock exchanges do not go public because NYSE had not

demutualized in their sample. Since then NYSE has both demutualized and has conducted an

equity public offering. Thus, we extend their cross-sectional research design to a time-series

analysis which helps us more completely understand the motives of demutualization, especially

by the larger, older and riskier exchanges. Other single country case studies on this topic include

empirical analysis of Australian demutualization by Otchere (2007), who focus mainly on the

effects of demutualization, unlike our study here which includes both causes and effects of the

entire universe of demutualization decisions around the world. Anecdotal discussions on


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demutualization are also contained in Shahid (2004) for Egypt, Yong and Fu (2006) for China,

and Black (2003) for Korea. Our analysis is based on a comprehensive global dataset described

in section 3. We look at the evolution of organizational structure, competition, and technological

changes in financial exchanges of 104 countries. Our empirical results in section 4 contribute to

the literature in several ways. It turns out that many variables not included in previous studies

referenced above, emerge as the key determinants of demutualization. To the best of our

knowledge, our paper is the first large scale comprehensive empirical test of the determinants

and effects of demutualization. We find that technology driven growth opportunities, derivative

products driven growth, and increases in market concentration are major stimulants of

demutualization.

We also look at the effects of demutualization for the stakeholders other than the

exchange owners. In particular, exchanges directly affect listed firms and investors through

trading in stocks. We find that demutualization positively affects turnover and liquidity variables.

Thus, investors and traders gain from demutualization. Listed firms also gain from exchange

demutualization as their cost of capital goes down after the exchange demutualizes. We discuss

the implications of these conclusions in section 5 and provide some potentially fruitful directions

for further research in this area.


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1. Background on Institutional Features of Financial Exchanges

1.1. Early dominance of mutual ownership

Historically, stocks markets were organized as physical meeting places owned by

members where buyers and sellers gathered and traded on floors. A typical stock exchange

operated as club of brokers under mutual governance structure. The members of the club had the

rights of ownership, organization decision-making and trading intermediation. Mendiola and

OHara (2003) emphasize that the factors responsible for the traditional member-owned

organizational structure of exchanges include historical antecedents, monopoly power, customer

homogeneity, and relationship investments. Mutual ownership and floor trading increase the

value of franchise for the exchange members by giving them the ability to extract bigger rents

relative to exchanges with wide ownership and electronic trading. Due to the lack of order flow

transparency to remote participants and absence of competition from remote liquidity providers,

members can earn larger bid-ask spreads from their clients. Pirrong (1999) empirically

documents that mutual structure of exchanges assured the protection of monopoly power and

rents. Floor trading also makes it possible for the members to engage in front running, as it is

evident from some of the NYSEs rule enforcements against specialists for unethical practices.2

Those enforcement measures are not beneficial to the members, but they reinforce the notion that

the specialists potentially engage in and gain from front running practices. Another advantage of

2A high profile regulatory case alleging that 14 elite New York Stock Exchange traders cheated investor was filedin March, 2008. The lawyers for the traders, who worked atthe floortrading firms known as specialist firms told aSecurities and Exchange Commission administrative law judge that the exchange's trading data were too flawed toshow improperactivity.In 2003, the NYSE fined a trader of Fleet Specialist Inc $25,000 for front running. The trader sold GM stock fromthe specialists own account on rumors of accounting problems at GM ahead of a public sell order.In another incident on March of 2004, the five biggest market-makers on NYSE paid $249 million in penalty forindulging in front-running and other unethical practices.


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mutual membership is that capital can be raised in a frictionless environment. For e.g., Rock

(1986) shows that offering firms must issue the shares in an IPO at a discounted price to outside

investors to guarantee that the uninformed investors participate in the IPO. But such under-

pricing is neither necessary nor does it result in any wealth transfers between new and old

shareholders in a mutually owned exchange, if they can supply fresh capital as needed.

1.2. Demutualization Scenario

The stock exchanges all around the world have witnessed a major transformation in the

ownership structure since the first ever demutualization of the Stockholm stock exchange in

1993. The new economic environment with evolving technology and cross-border mergers and

acquisitions altered the competitive environment for the exchanges but also opened up new

growth opportunities through geographic expansion and product line expansion. With new

competitive threats, the cooperative structure has lost many of the benefits that it had provided

historically. Updating trading platforms to capture market share has become a top priority and

this has stimulated many exchanges to consider alternatives such as external financing for these

capital intensive investments in new platforms. Also, many smaller exchanges have merged in

order to attain economies of scale, which are now necessary to survive the competition. Fleckner

(2006) identify deregulation, technology and globalization as factors that foster competition

among marketplaces for stocks. The competition among exchanges has an effect on the listed

firms as well. Moulton and Wei (2009) study how overlapping trading hours for the European

cross-listed stocks affect the market participation of specialist in NYSE and the market quality of

those stocks. They find that the spreads for cross-listed stocks are significantly lower during

overlapping trading hours than during non-overlapping trading hours. Chemmanur and Fulghieri

(2006) study the impact of competition and co-operation among exchanges on the listing


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standards, and the optimal regulation of the exchanges.

Mendiola andOHara (2003) define demutualization as the process of distributing shares

to the owners. This step makes the ownership stakes easy to trade and transfer. After adopting

demutualized ownership structure, an exchange can more easily issue shares to investors through

a private placement or public offering. Eventually, the exchange becomes a publicly listed

company and outsiders can own its shares resulting in a separation of ownership rights from

trading rights.

We characterize the technological advancements and evolution of the competitive

environment in the financial exchanges industry. Some of the early initiatives were started in the

United States. NASDAQ started operating on February 8, 1971 as a computer board bulletin

system, where quotations from different market makers could be observed in real time on screen.

These systems helped in increasing transparency, reaction time, and efficiency of the market.

Post-trade information systems give details about executed transactions in addition to the

information given by pre-trade information systems. The NYSE accomplished electronic routing

with the introduction of Designated Order Turnaround (DOT, and later superDOT) System on

March 4, 1976. However, the actual matching of orders and trade executions required human

intervention by dealers or specialists on those two leading exchanges. We consider computerized

matching of orders and electronic trade execution as the key step in automation of trading

process and focus on its effects in our study. Automatic trade execution was done first by

Instinet, a system dedicated purely to large institutional traders, in USA in 1969. Instinet was not

a regular exchange, though. The Toronto stock exchange became the worlds first regular stock

exchange to implement computerized order processing in 1977. Jain (2005) documents that most

of the Worlds exchanges now have fully automated trade executions. Clearing and settlement


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systems are other critical components that are suitable for automation. Electronization is

particularly useful here because, if done manually, these processes are very time-consuming and

error-prone. Thus, all the major exchanges invest large amounts of capital in building

computerized infrastructure for their clearing and settlement systems.

A demutualized legal structure along with electronic trading lets exchanges expand their

geographic horizon. It lowers the operational cost for the exchange members. Other stakeholders

like traders and listed companies can also benefit immensely from demutualization and

subsequent improvements in trading technology. Numerous studies have examined the financial

effects of automation on stock market liquidity, volatility, and cost of capital. Amihud,

Mendelson, and Lauterbach (1997), Domowitz and Steil (2001), Muscarella and Piwowar

(2001), Kalay, Wei and Wohl (2002), and Jain (2005) document that stock prices increase,

liquidity improves, and cost of equity capital falls all around the world when exchanges increase

transparency through computerized trading. Demutualization can enable exchanges to invest

aggressively in such technologies and then attract more traders to capture a greater market share,

which in turn benefits the exchange owners through new growth opportunities. At the same time,

emergence of new electronic trading platforms has led to a bigger competitive threat for the

traditional exchanges by undermining the importance of geographical distances and incumbents

monopolistic powers. In the new environment, traders do not need to be on the exchange floor to

place their orders and, thus, an electronic exchange attracts more liquidity suppliers and

demanders. The Electronic Communication Networks (ECNs) facilitate trading of financial

products outside of stock exchange and thus their growth puts pressure on the traditional

financial exchanges to adopt the most efficient trading systems themselves. According to the

NYSE Euronext website, the New York Stock Exchange traces its origins to 1792, when 24 New


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York City stockbrokers and merchants signed the Buttonwood Agreement. Because of the

limitations in telecommunication, the exchanges were limited in their capability to serve a wide

geographic area. This resulted in emergence of regional exchanges. In the nineteenth century,

there were more than 100 regional exchanges in the U.S. (SEC (1963), p.298). Beginning in

1920s and 1930s, reduction in communication costs and changes in securities regulation allowed

the regional exchanges to expand their operations outside their regions. Later, innovation in

technology and new products fuelled intense competition among the exchanges. To maintain

market shares and expand their horizon, many exchanges underwent a series of mergers. Arnold

et. al.(1999) document that the number of regional exchanges registered with the SEC fell from

18 in 1940 to seven in December 1980 to five in 1999, major reason being a series of mergers

starting in 1949. The Philadelphia-Baltimore merger in March 1949, the Midwest merger in

December 1949, and the Pacific merger in January 1957 were among the first in the series of

mergers. Now, the latest trend is that of cross-border mergers and consolidations in the financial

exchange industry. A leading example includes NYSE Euronext Inc., where Euronext first

brought together several European players and then the NYSEs transatlantic involvement made

it the biggest exchange in the world.

1.3. Exchange strategies in the corporate environment

Demutualized exchanges have access to a host of alternatives for financing new

investment opportunities. Typically, exchanges first demutualize with private placement of

shares, but then eventually make a public offering contingent on market conditions. By doing so,

they are able to compete better with ECNs and exploit new growth opportunities by investing in

advanced trading systems and by launching new trading products such as derivatives. Once an

exchange is demutualized, its shares can be used as a currency to fund mergers and acquisitions.


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At the same time, demutualization limits the liabilities of the shareholders to the value of their

fully paid-up shares.

Exchanges traditionally have higher overhead costs compared to ECNs. The merged

exchanges can offer more listed securities to the traders on the same platform thereby reducing

the per unit overhead costs. Mergers and acquisitions also offer the potential to quickly increase

market share by buying out the competition. Demutualization also helps exchanges in making

stronger alliances with other exchanges instead of having pure cooperation agreement. Thus,

demutualization and subsequent mergers and alliances between exchanges help them to compete

better with the ECNs and other types of new exchanges.

We integrate the effects of technological advancements, competitive evolution, growth

opportunities on the industrial organization and capital structure of the financial exchanges in an

elementary model in the next section.

2. A simple model about stimulants of Demutualization

A variety of reasons have been alluded to in the past literature as potential causes of

demutualization. We provide a summary of those reasons and then attempt to rigorously develop

the financial conditions that would motivate the exchange owners to transform the organizational

structure of their company.

Akhtar (2002) defines demutualization as the change in legal status of an exchange from

a mutual association with one vote per member (and possibly consensus-based decision making),

into a company limited by shares, with one vote per share (with majority-based decision

making). We posit that the key distinction between mutually-owned and demutualized

exchanges is the separation of trading rights from cash flow ownership rights. Once financial


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exchanges demutualize, they can more easily raise large amounts of additional capital through

public issue of debt or equity. Carow (2009) empirically find that thrifts with more profitable

investment opportunities and less capital are more likely to choose a full demutualization.

Demutualization also facilitates mergers and acquisitions between financial exchanges.

Demutualization can have far reaching impact on an exchanges revenues and profitability. For

example, Arnold et al. (1999) find that the merged stock exchanges attract market share from

other exchanges. We conjecture that in the pre-demutualization era of floor trading systems,

mutual members of the exchange extracted monopolistic rents from their franchise. They were

not willing to share those rents with new shareholders and as a result would be even willing to

forgo relatively small growth opportunities that needed external capital. With the advent of

electronic trading, two things have changed. First, the value of their existing franchise has

declined due to new and intense competition from ECNs and other geographically distant

exchanges. Second, the size of growth opportunities have multiplied as exchanges can now tap

opportunities such as trading in foreign markets, launching new trading products like derivatives

and, adopting more efficient trading systems to manage growing volumes and compete

effectively with the ECNs.

There is a rich but controversial literature on how a growth project should be financed

when information is distributed asymmetrically and insider managers (an exchanges mutual

members in our study) know more than outside investors. Myers (1984) advocates a pecking

order model, where firms prefer internal finance over external finance due to information

asymmetries. An example of internal funding is financial slack. If external finance is required,

firms always prefer the safest security first. They start with debt, then hybrid securities and then

equity as the last resort. Cost of debt is always lower than equity and debt can help the firms by


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giving them an interest tax shield. However, excessive debt escalates the cost of bankruptcy and

financial distress. Thus, the mutual ownership structure of exchanges may not be very amenable

to large amounts of debt as debt can be considered too risky by members with unlimited liability.

Demutualization and limited liability corporate structure can help mitigate some of these risks.

Nevertheless, pecking order debt levels can be insufficient to invest in large scale investment

opportunities or to acquire other financial exchanges. If the return from the growth opportunities

is high enough, it might be optimal to issue fresh equity even if it is underpriced.

Demutualization is the essential first step for issuing equity in an IPO or SEO.

Shyam-Sunder and Myers (1999) conclude that pecking order model is a good descriptor

of corporate finance behavior. However, Fama and French (2005) find empirical evidence

contradicting the pecking order model of Myers (1984). They conclude that there are ways to

issue equity with low transactions costs. This may be especially true in industries with modest

information asymmetry problems. For the financial exchange industry, the information

asymmetry could be minimal for the traditional floor trading business with existing listings.

However, information asymmetries about the existence and scope of growth opportunities and

competitive pressures can be very severe. Exchange of stocks in mergers often has tax benefits,

which can outweigh transaction cost and information asymmetry problems. Bharath,

Pasquaritello, and Wu (2009) find that pecking order is only partially successful in explaining all

of firms capital structure decisions. Firms facing low information asymmetry account for the

bulk of the pecking orders failings; Jung, Kim, and Stulz (1996) find that some firms with poor

investment opportunities issue equity even though the pecking-order model suggests that they

should issue debt to raise funds. Myers and Majluf (1984) also predict that if there is


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information asymmetry about the variance rate of the return, then firms will issue equity if the

investors overestimate the variance rate.

Pagano, Panetta and Zingales (1998) list the benefits of going public and empirically test

each of them. Gaining access to a variety of finance alternatives is the biggest benefit of going

public. Rajan (1992) highlights that by going public, the firms can lower their cost of credit

and/or can get a larger supply of external finance. Public listing of the shares improves the

liquidity of the shares and initial holders of the company can diversify their portfolios. They

conclude that the probability of going public is affected by the stock market valuation of firms in

the same industry. Dittmar and Thakor (2007) predict that managers use equity to finance

projects when they believe that investors views about project payoffs are aligned with theirs.

They predict that by issuing debt, managers lose autonomy to invest in a project with a

potentially high shareholder value.

The current exchange members have existing assets (a)and an opportunity to exploit new

future growth opportunities (g). We posit that the exchange requires fresh capital investment (I)

in order to exploit these growth opportunities such as new product launch, derivatives trading,

acquisition of an existing player, or adoption of efficient trading systems. We assume that the

mutual members of the exchange have a financial slack (S)that results from a history of

profitability and a policy of retaining part of those profits every year. The funding for the new

investment can be generated in four different ways. First, is to use the financial slack (S); second,

merger (M)with another exchange; third raising money through debt (D); and fourth raising

money from a new equity issue (E). We analyze the decision of choosing one of these

alternatives from exchanges owner-members perspective. The first alternative of using

financial slack does not call for a demutualization. But for the remaining three alternatives,


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demutualization can be essential or highly beneficial. Mergers will make most sense when two

exchanges can exploit synergies in operations or benefit by increasing the amount of combined

slack. We expect the exchanges to exploit potential synergies and undertake mergers and

acquisitions in financially free societies, where corporations have the liberty to obtain market

power and exploit economies of scale. Figure 1 describes the various scenarios which exchange

members may face.

[Insert figure 1 here]

Under pecking theory, members first use internal funds to finance the investment. If S>I,

then members dont need to issue debt or equity. Next, members issue debt to finance

investments ifI> S. Members resort to equity only ifI - S > Dmax, whereDmaxis defined as the

maximum debt that members can issue while maintaining the optimal debt ratio as defined in

static trade-off theory.

Three key players in our model are the members, informed investors and uninformed

investors. Members and informed investors are fully aware of the value of growth opportunities.

They know the exact firm value:

V= S+ a+I* ( , (1)

where Kis the cost of capital for the investment project.

Rock (1986) models the underpricing (U) of equity issues in presence of informed

investors. We let the market condition (m) be a continuous variable in the region ( -1,+1). This

underpricing will be substantial in cold markets when m= -1, and it is minimal in hot markets

when m=+1, i.e., < 0. The magnitude of U will also be directly proportional to the amount of

equity being raised, i.e., U E. The exchange will issue equity IPO if and only if


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I* ( > U(m,E) (2)

The exchange can also alternatively use this investmentIto acquire another exchange and

thus exploit the growth opportunities by using the platform of the target exchange (T). An

example being the merger of Australia stock exchange with Sydney futures exchange in 2006 to

exploit the opportunities provided by derivatives trading platform. Another example is the

bidding of Deutsche Boerse AG to acquire Warsaw Exchange. Warsaw Exchange is expected to

continue attracting a large number of initial public offerings in Poland and -- with the help of the

right investor -- could act as a gateway to the untapped potential (g) of Ukraine and the Balkans.

Additionally, mergers and acquisitions can also result in synergies as the fixed cost of trading

can be defrayed over larger trading volume. Thus, the benefits of mergers and acquisitions are

much higher in financial exchanges industry after the advancement of trading technology and

new trading product launches (rm(g)> r(g)).

Equity IPO can be a prerequisite for such an acquisition. InvestmentI required for an

acquisition can be huge and after IPO, exchange can use its shares as currency. Exchange can use

shares as a currency to purchase another exchange after going public. NYSE Group offered 8

billion euros in cash and shares for Euronext on May 22, 2006. On May 23, 2006, Deutsche

Brse unveiled a merger bid for Euronext valuing it at 8.6bn, 600 million over NYSE Group's

initial bid. A run-up of NYSE Group's stock price in late 2006 made the offering far more

attractive to Euronext's shareholders. Thus, NYSEs IPO helped them merge with Euronext by

using their shares as currency.

Another benefit of equity IPO is that it brings about proper equity valuation of the

exchanges franchise (Oldford and Otchere (2010)). Exchange members can prefer equity IPO


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over debt issue in hot markets (m> 0).

3. Data sources and sample characteristics

We gather information about the institutional evolution of financial exchanges from

multiple primary and secondary sources highlighted in Table I. We hand collected the

demutualization information of exchanges in 104 countries by perusing financial exchange

annual reports, visiting stock exchange websites, emailing exchange officials, reading stock

exchange handbooks, analyzing financial exchange association (WFE) surveys, and referencing

academic papers such as Aggarwal (2002, 2006), and Mendiola and OHara (2003). Jain (2005)

provides the starting point for data on the first main determinant of demutualization, i.e.,

exchange computerization and automation dates from 1972 to 2002. We update this information

to 2008. For the second main determinant of demutualization, i.e., derivatives trading availability

dates, we again rely on stock exchange websites and exchange handbooks. To understand the

evolution of the competitive environment in this industry, we gather information about the

establishment date of the leading exchange and the other competing exchanges from the sources

mentioned above.

Table I provides a list of the leading financial exchanges in 104 countries along with their

dates of establishment, demutualization and automation. For each country, we also report the

dates and summary of major financial exchange merger events in the respective country. For

countries where the leading exchange has not demutualized, we list the ownership type of

exchange.

[Insert Table I here]

The date of demutualization is defined as the year in which the mutually owned exchange


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separates its trading rights from cash flow ownership rights. For e.g., on December 30, 2005, in

anticipation of the NYSEs transformation into a publicly held company, member seat sales

officially ended. OnMarch 7, 2006, the NYSE Group, Inc., a for-profit, publicly-ownedcompany, was formed. On March 8, 2006, shares of the newly formed NYSE Group began

trading under Ticker Symbol NYX. Thus, NYSE categorized as a mutually owned exchange

until 2005 and a demutualized exchange from 2006 onwards. In general, not-for-profit

exchanges, mutual - private limited exchanges, mutual co-operative exchange companies mainly

owned by members are all categorized as mutually owned exchanges. Exchanges where trading

rights are separated from ownership rights, and exchanges whose stocks are publicly traded and

listed are categorized as demutualized exchanges. The first stock exchange to demutualize and

issue shares to public was Stockholm stock exchange on January 1, 1993.

We list the number of exchanges in the countries at different points of times starting from

1975 in Appendix Table A1. In Panel A, we list the countries where the leading exchange has

demutualized. In Panel B, we list the countries where the leading exchange is mutually owned.

Figure 2 depicts the evolution of Demutualization in the stock exchanges industry.We graph the

time-series patterns of the transformation of stock exchanges from mutual ownership to

demutualization and then into publicly listed companies.

[Insert Figure 2 here]

We obtain exchange debt/equity ratio and long term debt from Datastream and report the

numbers in Appendix A2. We underline the years after the public listing of the exchange.

London stock exchange and Australian stock exchange issued debt during year 2009. During

2008, Toronto stock exchange, NYSE Euronext, Deutsche Boerse and Nasdaq OMX issued debt.

There were 7 equity IPOs during the bull markets of 2006-2007. NYSE Euronext, JSE Securities


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exchange (South Africa), Korea exchange and BME Spanish exchange became publicly listed in

2006. In 2007, Dubai Financial Market, BM&F Bovespa (Brazil) and Colombia stock exchange

issued an IPO.

Variables that proxy the other potential determinants of demutualization are gathered

from the following sources. Economic freedom scores are from Heritage foundation website.

Heritage Foundation measures ten components of economic freedom, assigning a grade in each

using a scale from 0 to 100, where 100 represents maximum freedom. The ten component scores

are then averaged to give an overall economic freedom score for each country. The ten

components of economic freedom are business freedom, trade freedom, fiscal Freedom,

government spending, monetary Freedom, investment Freedom, financial Freedom, property

rights, freedom from corruption, and labor freedom. Market value as % of GDP and trading

volume as % of GDP are from the World Bank Group website.

Next, we gather information on variables that capture the effects of demutualization such

as dividend yield, volume, returns and market capitalization. We obtain these variables from

Datastream country indices.

4. Research Design and Empirical Results

We test our model by empirically investigating how technology driven growth

opportunities and product driven growth opportunities lead to demutualization. In subsection 4.1,

we test the lead-lag relationship between automation and demutualization by comparing the

automation and demutualization dates of the leading exchanges of the world. Then in section 4.2,

we proxy the growth opportunities (g) with the advent of automation and derivatives trading. In


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section 4.3, we look at the choice between IPO and merger activities for the exchange after

demutualization. In section 4.4, we analyze the trading volume to further understand this

phenomenon. In section 4.5, we look at the effect of demutualization on equity premium and

liquidity.

4.1. Technological advancements, growth opportunity and the demutualization decision

We are interested in the lead-lag relationship between automation and demutualization at

the financial exchanges. Demutualization follows automation in 50 exchanges and lags in 7. This

pattern is in line with our hypothesis that the opportunities resulting from electronic trading lead

to demutualization of exchanges. Also, the investors appear to be willing to invest in only those

exchanges which already have the most advanced trading technology, because they are able to

compete effectively in the global landscape and have a higher future profit potential.

We also grouped the exchanges we study under pure derivatives exchanges and stock

exchanges. We observed electronic trading to lead demutualization in all the 4 derivatives

exchanges that we studied. We also find that mergers and acquisitions follow exchange

demutualizations, as predicted by our model. The NYSE Group, Inc., a for-profit, publicly-

owned company, was formed out of the merger of the New York Stock Exchange and

Archipelago Holdings, Inc. The NYSE went on to merge with Euronext to form NYSE Euronext

on April 4, 2007 and NYSE Euronext acquired the American Stock Exchange later on October 1,

2008. CME Group acquired New York Mercantile Exchange on August 22, 2008.

We perform one-tailed binomial tests at 1% level of statistical significance to test the null

hypotheses that there is no lead-lag relationship for demutualization and automation in stock and

derivative exchanges. If the null hypothesis is true then the mean number of (p) demutualizations


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leading automation should be 50%, i.e. 28.5 considering our sample size of 57 exchanges from

51 countries. The variance (np(1-p)) of our sample size is 14.25. Actual number of exchanges

where demutualization leads automation in our sample is 50. According to binomial distribution

(56, ) the probability of seeing 50 or more out of 57 countries by random chance is < 0.0001,

which means we can reject the null hypotheses at 1% level of significance.

Thus, automation appears to be a pre-condition for demutualization of an exchange.

4.2. Empirical Test

The automation of stock exchanges and the beginning of derivatives trading both open

new growth opportunities (g) for the exchanges. We take automation and derivatives trading to

proxy for our model parameter g. We define dummy variables for demutualization, automation

(g1) and start of derivatives trading (g2) for all the countries. Brau, Francis and Kohers (2003)

find market concentration to be an important determinant for IPO versus takeover choice made

by the firms. We make a yearly time-series of evolution of industrial organization and

competitive environment in the financial exchanges industry from year 1970 in all countries in

our sample. We define market concentration as inverse of the lag of number of exchanges in a

country. We list the correlation coefficients between these parameters in Panel A of Table II.

Next, we use the Cox proportional hazards form of survival analysis as a diagnostic tool for

estimating the survival probabilities of mutual ownership. Our survival analysis is based on three

main categories of covariates technology driven growth opportunities (trade automation),

product driven growth opportunities (derivatives trading) and market concentration. We allow

for time-varying covariates in the Cox proportional hazards model instead of using time-

invariant covariates. The results of Cox proportional Hazard model estimation are reported in

Panel B of Table IV.


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[Insert Table II]

The automation and start of derivatives trading have a significant positive coefficient in all

specifications. The exchanges demutualize to invest in these growth opportunities. We find a

positive relation between demutualization and market concentration. Our interpretation of this

result is that exchanges can fully capture the growth opportunities only when their market share

is high. Thus, higher market concentration will cause the r(g)of our model to increase. We

control for the market size as a % of GDP, trading volume as a % of GDP and the economic

freedom component scores3

in model 2 and 3. Although we report the results for overall

economic index score, but we find qualitatively similar results when we use individual

components such as financial freedom, investment freedom and business freedom.

4.3. IPO vs. Merger choice for exchanges after demutualization

Demutualization is an essential step in the process of issuing equity through an IPO. We

provide a comprehensive list of all financial exchange IPOs in the world in Table III. As

mentioned previously, the first stock exchange to issue its own shares to public was Stockholm

stock exchange on January 1, 1993. Majority of the IPOs of financial exchange occurred in the

last decade. The most recent public issue of equity by an exchange was by the Mexican stock

exchange in June 2008. 26 exchanges from 22 countries now have their own equity publicly

listed and traded.

One of the hypothesized determinants of post-demutualization financing strategy is the

amount of under-pricing necessary to sell equity or the premium pricing that the equity issue can

command. Specifically, we expect the exchanges to sell equity stake through an IPO when the

3Heritage foundation website provides economic freedom component cores from 1995 to 2010. For the years before

1995, we use the score of 1995.


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24

existing members or seat-holders expect to obtain a price above its intrinsic value due to

overpricing in hot IPO markets or other similar reasons. We test this hypothesis by analyzing

each countrys annualized stock market returns during 2 years preceding the exchanges IPO.

The raw returns are obtained from Datastream country indices and are shown in column 3 of

Table III. We also obtain world market returns shown in column 4 for the same period and use

them as a benchmark. The annualized excess returns in the last column are computed as the

difference between raw return and the world market return. We find that the excess returns

during the two-year period preceding the IPOs are both economically and statistically significant.

The average excess return is 8.62% and is statistically significant at the 10% level. We interpret

this result as evidence supporting our hypothesis that members of the exchange conduct an IPO

when they expect to receive premium pricing for the exchanges equity.

[Insert Table III]

Demutualization also facilitates mergers and acquisitions between financial exchanges.

The exchanges can explore growth opportunities and reduce cost of operation by merging with

another exchange. We list countries with post demutualization merger activities in Panel A of

Table IV. In Panel B, we list the countries with no post demutualization merger activities. We

find that most European exchanges were involved in merger and consolidation activity. Out of

25 European countries, 19 countries had post demutualization merger activities involving the

leading financial exchange in the country. Among non-European countries, only 7 countries had

any post demutualization merger activity between financial exchanges.

One of the hypothesized determinants of post-demutualization corporate strategy is the

level of economic freedom prevalent in the country. Specifically, we expect the exchanges to


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exploit potential synergies and undertake mergers and acquisitions in financially free societies,

where corporations have the liberty to obtain market power and exploit economies of scale. We

test this hypothesis by comparing the average economic freedom scores of countries with and

without post demutualization merger activities. The average overall economic freedom score for

countries with merger activities is 72.27 versus a score of 64.42 for countries without exchange

mergers. We also present the Wilcoxon rank sum test-statistics to compare these scores and find

the economic freedom scores to be economically and significantly higher for countries which

had merger activities after demutualization. We interpret this result as evidence supporting our

hypothesis that exchanges are more willing and able to exploit the synergies arising from merger

in countries with higher economic freedom scores.

[Insert Table IV]

4.4. Using volume as proxy to test the model

Demutualization opens the doors to explore new opportunities for growth. We expect to

see an increase in trading volume post demutualization. We take the monthly trading volume

starting from 1973 for all the countries in our sample from DataStream. We also define two

dummy variables; pre-demutualization and post-demutualization. Pre-demutualization dummy

takes a value 1 during 24 months prior to the demutualization, else 0. Post demutualization

dummy takes a value 1 after demutualization month, else 0. A value of post-demutualization

dummy higher than the pre-demutualization will indicate that there was a positive effect of

demutualization on trading volume. We do a regression of the country volumes for each country

on the world volume, the dummy variables and the lagged return. We estimate the following

regression:


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Country trading volume = + pre-demutualization + post-demutualization+ world volume + lagged return (3)

We list the estimated value of pre-demutualization and post-demutualization dummy

variable for each country in Table V. To measure the effect of demutualization relative to

average monthly volume of the country, we scale the dummy variable coefficients by dividing it

with the average monthly volume of each country during last 1 year. A higher value of post-

demutualization dummy variable compared to pre-demutualization dummy implies a positive

impact of demutualization. We find that the out of 30 countries that we studied, 19 showed an

increase in volume post demutualization.

[Insert Table V]

4.5. Effects of Demutualization

We look at each country individually and compare the equity premium, turnover and

liquidity before and after the demutualization of the leading exchange. This method has several

benefits as outlined in Jain (2005). We collect the dividend yield, return, volume and market

capitalization data from Datastream for the country indexes from 1973 to 2009. We define equity

premium (DYCG) as average dividend yield, A(DYt), plus average rate of capital gain, A(GPt):

A(Rt) = A(DYt) + A(GPt) (4)

We estimate this equation from stock market indexes including dividends and capital gain

in local currency as well as U.S. dollars to obtain our first and second measures of the equity

premium. Excess-over-world (ERW) return for a month is defined as the difference between the

return from stock market iin month tin local currency and the return from the world-market

index in that month.


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Excess-over-world returnit= Gross returnitWorld $ returnt (5)

We measure liquidity using relative turnover and liquidity measured developed by

Amihud (2002). Turnover is defined at monthly trading intervals as

Turnover = Dollar trading volume /Market capitalization (6)

Liquidity is defined as inverse of Amihud illiquidity. We measure volumes in 1 billion

units of local currency of each country and we observe data at monthly intervals. We report the

results of this country-by-country analysis in Table VI. We find 81% of the countries to show a

decline in equity premium post demutualization using our first measure of equity premium. 84%

countries in our sample show an increase in turnover and 71% show an improvement in liquidity.

Thus, demutualization has a positive impact in the financial market from the perspective of

investors and listed firms.

[Insert Table VI]

Finally, we conduct a regression analysis that controls for world average, time trend and

market capitalization of the country. We exclude period 10 years before and after

demutualization to avoid confounding events. We use two measures of equity premium as

dependent variables in two separate regressions and one measure of liquidity:

equity premiumit= + 0demutit+ 1worldt+ 2time trend + 3 market cap + it (7)

liquidityit= + 0demutit+ 1worldt+ 2time trend + 3 market cap + it (8)

[Insert Table VII]

Two measures of equity premium are DYCG and ERW and measure of liquidity is


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Turnover. The results of this analysis are shown in Table VII, which reports the estimates for the

pooled regression equation (7). The coefficient for demutualization is negative and significant

for first measure of equity premium (DYCG) and is negative, but not significant for second

measure of equity premium (ERW). These coefficients indicate a reduction in cost of capital

after demutualization of the stock exchange. The coefficients on control variables bear signs

consistent with those in previous literature. The coefficient for demutualization is positive for

turnover regression. This indicates that demutualization is associated with an increase in

liquidity.

5. ConclusionsTechnology, regulation, competition, and globalization have made the journey of the

worlds stock and derivative exchanges full of excitement. Initially, exchanges started as private

membership clubs. Their geographic and national location was an important determinant of

which companies and investors found them accessible. Today stock and derivative exchanges are

global for-profit corporations with ubiquitous presence.

This transformation has important implications for institutional design of exchanges and

the regulatory environment within which they operate. Adoption of the state-of-the-art

computerized trading technology has become a pre-requisite for exchanges to compete

successfully. Automation has acted as a catalyst for demutualization as evidenced by the fact that

demutualization in exchanges have followed automation significantly in our sample. We also

show that market concentration and launch of derivatives trading are also a cause for the change

in ownership structure of exchanges from mutually owned to demutualized entities.

Automation and demutualization have suddenly opened the doors for cross-border

mergers and consolidations in the stocks and derivative exchange industry. A leading example


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includes NYSE Euronext Inc, where Euronext first brought together several European players

and then the NYSEs transatlantic involvement makes it the largest player in the World. This

trend of consolidations is likely to escalate in the future.

We find that demutualization has a positive impact in the financial market from the

perspective of investors and listed firms. The cost of capital declines and liquidity variables show

an improvement after demutualization.


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Appendix

Table A1Time-series of number of stock exchanges in 104 countries

We list the number of exchanges in the countries at different points of time starting from 1975. In Panel A,

underlined numbers indicate the number of exchanges after the demutualization of leading exchange in thecountry.Panel A: Countries where leading exchange

has demutualized

Panel B: Countries where leading exchange

has not demutualized

Country 1975 1985 1995 2000 2005 2010 Country 1975 1985 1995 2000 2005 20

1 Armenia 0 0 1 1 1 1 Albania 0 0 0 1 1

2 Australia 6 6 1 3 2 2 Argentina 5 5 5 5 5

3 Austria 1 1 1 1 1 1 Azerbaijan 0 0 1 1 1

4 Bahamas 0 0 0 1 1 1 Bahrain 0 0 1 1 1

5 Belarus 0 0 1 1 1 1 Bangladesh 1 1 2 2 2

6 Belgium 2 2 2 1 1 1 Barbados 0 0 1 1 1

7 Bermuda 1 1 1 1 1 1 Bhutan 0 0 1 1 1 8 Brazil 10 9 9 1 1 1 Bosnia 0 0 0 0 1

9 Bulgaria 0 0 2 1 1 1 Botswana 0 0 1 1 1

10 Canada 5 5 5 3 2 2 China 0 0 2 2 2

11 Colombia 2 3 3 3 1 1 Cte d'Ivoire 1 1 1 1 1

12 Costa Rica 0 1 1 1 1 1 Cyprus 0 0 0 1 1

13 Denmark 1 1 1 1 1 1 Ecuador 2 2 2 2 2

14 Dom. Rep. 0 0 1 1 1 1 Egypt 0 0 1 1 1

15 Finland 1 1 1 1 1 1 Fiji 0 1 1 1 1

16 France 1 1 1 1 1 1 Georgia 0 0 0 1 1

17 Germany 8 8 8 7 6 6 Ghana 0 0 1 1 1

18 Greece 1 1 1 1 1 1 Guyana 0 0 1 1 1

19 Hong Kong 4 4 1 1 1 1 Indonesia 0 1 2 2 2

20 Hungary 0 0 1 1 1 1 Ireland 1 1 1 1 1

21 Iceland 0 1 1 1 1 1 Israel 1 1 1 1 1

22 India 9 14 19 20 19 19 Jordan 0 1 1 1 1

23 Iran 1 1 1 1 1 1 Kenya 1 1 1 1 1

24 Italy 1 1 1 2 2 2 Kenya 1 1 1 1 1

25 Jamaica 1 1 1 1 1 1 Kyrgyz 0 0 1 1 1

26 Japan 8 8 8 6 6 6 Lebanon 1 1 1 1 1

27 Kazakhstan 0 0 0 1 1 1 Luxembourg 1 1 1 1 1

28 Latvia 0 0 1 1 1 1 Malta 0 0 1 1 1

29 Lithuania 0 0 1 1 1 1 Moldova 0 0 1 1 1

30 Macedonia 0 0 0 1 1 1 Mongolia 0 0 1 1 1

31 Malaysia 1 1 1 1 1 1 Morocco 1 1 1 1 1

32 Mauritius 0 0 1 1 1 1 Namibia 0 0 1 1 1

33 Mexico 1 1 1 1 1 1 Nepal 0 1 1 1 1

34 Netherlands 1 1 1 1 1 1 Oman 0 0 1 1 1

35 New Zealand 1 1 1 1 1 1 Pakistan 2 2 3 3 3


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36 Norway 3 3 1 1 1 1 Papua N.Guinea 0 0 0 1 1

37 Palestine 0 0 1 1 1 1 Poland 0 0 1 1 1

38 Peru 1 1 1 1 1 1 Russia 0 0 1 2 2

39 Philippines 2 2 1 1 1 1 Serbia 0 0 1 1 1

40 Portugal 0 0 1 1 1 1 Sierra Leone 0 0 0 0 0

41 Qatar 0 0 0 1 1 1 Slovakia 0 0 1 1 1 42 Singapore 1 1 1 1 1 1 Sri Lanka 1 1 1 1 1

43 Slovenia 0 0 1 1 1 1 Swaziland 0 0 1 1 1

44 South Africa 1 1 1 1 1 1 Taiwan 1 1 1 2 2

45 South Korea 1 1 1 2 1 1 Tanzania 0 0 0 1 1

46 Spain 3 4 4 4 1 1 Thailand 1 1 1 1 1

47 Sweden 1 1 1 2 2 2 Tunisia 1 1 1 1 1

48 Switzerland 3 3 1 1 1 1 Turkey 1 1 1 1 1

49 UAE 0 0 0 1 3 2 Uganda 0 0 0 1 1

50 UK 1 1 1 1 4 4 Ukraine 0 0 1 2 2

51 US 8 8 7 7 8 7 Venezuela 1 1 1 1 1

52 Vietnam 0 0 0 1 1

53 Zambia 0 0 1 1 1

Total 92 100 103 99 95 93 24 28 54 64 65


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Table A2Debt-to-equity ratio and long term debt of listed exchanges

We list the debt/equity ratio of listed exchanges in Panel A. In Panel B, we report the long term debt ofhe listed exchanges. We obtain these year-end numbers from Datastream. We underline the years after IPO

of these exchanges.

Panel A: Debt/equity ratio of listed exchanges

Name 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

LSE - - 0 0 0 1.34 1.32 0.38 -71.06 58.34 65.05

TMX - 0.75 0.67 0.55 0.72 0.65 0.98 0.41 0.13 53.91 56.83

ASX 0.33 0.33 0.18 0.03 0 0 0 0 0 0 3.61

NYSE Euronext - - - - 0 0 0 0 28.91 47.85 40.49

Deutsche Borse - 29.66 5.77 165.26 188.47 184.4 237.18 290.66 462.17 362.82 308.28

OSE - - - 0.03 0.02 0.02 0.01 0.01 0.01 0 0

Bursa Malaysia - - - 0.13 0.09 1 0.1 0.08 0.06 0.03 0

SGX - 0 0 0 0 0 1.01 0.63 0 0 0

Nasdaq OMX 9.61 5.08 61.07 330.69 992.73 1002.7 754.75 103.18 5.36 59.38 42.46Panel B: Long term debt of listed exchanges

Name 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

LSE - - 0 0 0 500 500 500 248700 248400 622500

TMX - 2034 1816 1565 1277 1282 903 145 71 428307 434528

ASX 425 309 113 23 0 0 0 0 0 0 100000

NYSE Euronext - - - - 0 0 0 0 521000 1787000 2166000

Deutsche Borse - 90000 0 10800 505200 505300 501600 499900 1200 1512900 1514900

OSE - - - 7000 6000 5000 4000 3000 2000 2000 1000

Bursa Malaysia - - - 1318 1098 879 659 439 219 0 0

SGX - 0 0 0 0 0 2778 1184 0 0 0

Nasdaq OMX 25000 25000 300673 437424 265000 265000 1184928 1492947 118438 2293756 1867000

Notes. For Nasdaq OMX, we use the IPO year of Nasdaq, which is 2002.


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Nopro

fitable

growth

oppor

tunity

(g),e.

g.,duetolow

indust

ryconc

entrati

on

Profitablegexists

I*((r(g))/K-1)U>0

Synergies with a

Target exchange

(T) are identified

Nature determines

Growth opportunity

(g)

Demutualize

Status Quo

(Do not

demutualize)

Do nothing

Positivesynergiesandhigheconomicfreedom

Merger andacquisition

Negatives

ynergie

sor

lowec

onomicfre

edom

Dmax

+S>I

Slack(

S)>In

vestme

nt(I)r

equired

forgro

wthop

portun

ity

S 0

Issue Debt

Issue Debt

followed by

Equity IPO

Figure 1. Optimal ownership structure and financing strategy of an exchange.This decision tree shows various economic scenarios, industry concentration, and stock marketconditions that can potentially occur in the strategic plane for an exchange. g represents technology-driven or product-driven growth opportunities.Iis the required investment in technologyinfrastructure, product development, or acquisition of an existing player, to exploit the growth

opportunities. Intrinsic enterprise value of the exchange is V= S + a + I* ( , where Kis the

cost of capital for investment project. The current exchange members have existing assets (a).Financial slack (S) is defined as accumulated internal funds such as large holdings of cash or

marketable securities, which result from a history of profitable operations and a policy of retainingpart of those profits every year. Uis defined as the underpricing of the equity issue. Synergies (si)arise because exchanges are able to exploit growth opportunities by using the trading platform orderivatives product platform of the target exchange and economies of scale help reduce the cost aswell. The decision nodes on the right show the optimal ownership structure and financing strategyfrom the perpective of exchange owners under each scenario.


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Figure 2.The Global Shift from Mutual ownership of exchanges to Demutualization in theleading exchanges of the World.


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19 Canada-TMX 1878 2000 2002 1977 Nov 1999 : Merger of Alberta and Vancouver Stock

Exchanges to form Canadian Venture

Exchange(CDNX)

2001: TSE purchase CDNX to form TSX Group

2001: TSX Group bought TSX Venture Exchange

2004: TSX Group acquires NGX Canada Inc

2008 : TMX Group Inc. was created in May

following the combination of Montral Exchange

Inc. and TSX Group Inc.

Agg

20 China-Shanghai 1990 Mutual - Co-op 1990 WF

21 Colombia-BVC 1928 2007 2007 1996 2001: Bolsa de Bogota, Bolsa de Occidente and

Bolsa de Medellin merged to form CSE

WF

22 Costa Rica-BNV 1976 1993 1991 http

23 Cte d'Ivoire-

BRVM

1974 Mutual - Pvt Ltd 1999

Han

24 Cyprus-CSE 1996 Govt. owned 1999 Han

25 Denmark-CSE 1919 1996 1988 February 1997: The Copenhagen Stock Exchange

and the FUTOP Clearing Centre merged

2005: The exchange merged with OMX

Agg

26 Dom. Rep. 1991 2001 Floor www

27 Ecuador 1969 Mutual - Co-op 1999 Han

28 Egypt-EGX 1890 Other 1997 WF

29 Fiji-SPSE 1978 Mutual - Pvt Ltd Floor Han

30 Finland-Helsinki 1912 1995 1988 1998: Merger of SOM and HAP -> HEX Ltd

2001: The HEX Group became a majority

shareholder in the TSE Group

2002: The HEX Group acquired a majority

shareholding of the Riga Stock Exchange

2003: The HEX Group and OM Group of Sweden

merged to form OMX

Agg

31 France-Euronext 1826 2000 1986 2000: Paris Stock Exchange and Brussels' and

Amsterdams exchanges formed Euronext

2000 : Marche a Terme International de France

(MATIF) and ParisBourse formed Euronext Paris

Agg

32 Georgia-GSE 2000 Mutual - Pvt Ltd 2000 http


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33 Germany-DB 1585 2000 2001 1991 March 14, 2003: Berlin stock exchange & Bremen

Stock Exchange merged

Jan, 2000: Hanburg Stock Exchange and Hannover

Stock Exchange formed BOAG Borsen AG

Agg

34 Ghana-GSE 1989 Mutual - Co-op Floor http

35 Greece-Hellenic 1876 1999 2000 1992 Agg

36 Guyana-GASCI 1992 Mutual - Co-op 2003 http

37 Hong Kong-HKEx 1891 2000 2000 1986 2000: Hong Kong Stock Exchange, HKFE, and

Hong Kong Securities Clearing Company Limited

formed HKEx

Agg

38 Hungary-BSE 1864 2002 1998 Nov 2005: Budapest Stock Exchange and the

Budapest Commodity Exchange merged

Han

39 Iceland 1985 1999 1989 2008: Merger of OMX and Iceland Stock Exchange Agg

40 India-NSE 1993 1993 1995 Han

41 Indonesia-IDX 1912 Mutual - Pvt Ltd 1995 2007: Surabaya Stock Exchange and Jakarta Stock

Exchange merged to become Indonesia Stock

Exchange

WF

42 Iran-TSE 1966 2006 1994 www43 Ireland-ISE 1793 Mutual - Pvt Ltd 2000 WF

44 Israel-TASE 1953 Mutual - Pvt Ltd 1997 WF

45 Italy-Borsa Italiana 1808 1997 1994 Dec 1999: MIF Spa was merged into Borsa Italiana

Spa

2000: Borsa Italiana acquired 60%of the Cassa di

Compensazione e Garanzia(CC&G)

December 2002: Borsa Italiana acquired Monte

Titoli

Agg

46 Jamaica-JSE 1968 2008 2000 Han

47 Japan-TSE 1878 2001 1982 March 1, 2000: Tokyo Stock Exchange absorbed the

Hiroshima and Niigata stock exchanges

Agg

Japan-OSE 1878 2001 2004 1988 Agg

48 Jordan-ASE 1978 Non-profit Pvt 2000 WF

49 Kazakhstan-KASE 1997 2007 1997 2001: KASE became a stockholder of

Kyrgyz stock exchange

http

50 Kenya-NSE 1954 Mutual - Pvt Ltd Floor http

51 Kuwait-KSE 1984 Other 1995 http


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52 Kyrgyz 1995 Mutual - Pvt Ltd 1999 Han

53 Latvia 1993 2002 1997 Aug 2002: Acquired by HEX Han

54 Lebanon-BSE 1920 Other 2000 http55 Lithuania-VSE 1926 1998 1993 2004: OMX purchased 44.3% of the shares of VSE Han

56 Luxembourg-LSE 1929 Mutual - Pvt Ltd 1991 WF

57 Macedonia-MSE 1996 2001 2001 Han

58 Malaysia-BM 1973 2004 2005 1992 2001: KLOFFE and COMMEX.MDEX merged to

form Malaysia Derivatives exchange

2002: KLSE and MESDAQ merged

Agg

59 Malta-MSE 1992 Other 1996 WF

60 Mauritius-SEM 1988 2000 2001 Han

61 Mexico-BMV 1894 2008 2008 1996 Han

62 Moldova-MSE 1994 Mutual - Pvt Ltd 1998 http

63 Mongolia-MSE 1991 Govt. owned 1999 http

64 Morocco-CSE 1929 Mutual - Pvt Ltd 1997 www

65 Namibia-NSX 1992 Mutual - Co-op 1998 http

66 Nepal-NEPSE 1983 Mutual - Pvt Ltd Floor http

67 Netherlands 1600 1997 1994 January 1997: Amsterdam Stock Exchange and

European Options Exchange formed Amsterdam

Exchanges

February 1997: AEX-Agriculture Futures Market

became a part of Amsterdam Exchanges

September 2000: Amsterdam Exchanges and the

exchanges of Brussels and Paris formed Euronext

Agg

68 New Zealand-NZX 1915 2003 2003 1991 Agg

69 Norway-Oslo bors 1819 2001 2001 1988 Agg

70 Oman-MSM 1988 Govt. owned 1998 Han

71 Pakistan 1947 Other 1997 Han

72 Palestine-PSE 1995 1995 1997 http

73 Papua N. G.-

POMSoX

1998 Mutual - Pvt Ltd 1999 http


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74 Peru-BVL 1951 2003 1995 March 1996: LSE took over the Bolsa de

Valores de ArequipaHan

75 Philippines-PSE 1927 2001 2003 1993 1992: Manila Stock Exchange and Makati Stock

Exchange formed Philippine Stock Exchange

Agg

76 Poland-WSE 1817 Govt. owned 1996 http

77 Portugal-BVLP 1825 2000 1991 2002: BVLP and Euronext formed Euronext Lisbon Han

78 Qatar-QE 1997 2005 1998 http

79 Russia-MICEX 1992 Mutual - Pvt Ltd 1994 http

80 Serbia-Belgrade 1989 Mutual - Pvt Ltd 2004 www

81 Sierra Leone-SETC 2007 Other Floor www

82 Singapore-SGX 1930 1999 2000 1989 Dec 1999: SES and SIMEX formed SGX Agg

83 Slovakia-BSSE 1991 Mutual - Pvt Ltd 1994 http

84 Slovenia-LJSE 1989 2006 1993 www

85 South Africa-JSE 1887 2005 2006 1996 Han

86 South Korea-KRX 1956 2005 1988 Jan 27, 2005: KSE, KOSDAQ Stock Market and

KOFEX merged to establish Korea exchange.

Han

87 Spain-BME 1831 2001 2006 1989 2001: Madrid, Barcelona, Bilboa and Valencia Stock

Exchange formed BME Group

Agg

88 Sri Lanka-CSE 1896 Other 1997 WF

89 Swaziland-SSX 1990 Mutual - Co-op Floor http

90 Sweden-Stockholm 1863 1993 1993 1989 1998: Merger of OM and Stockholm Stock Exchange http

91 Switzerland-SIX 1938 2002 1996 1995: Switzerland's three stock exchanges in

Geneva, Zurich and Basle formed SWX

1998: Swiss and German derivatives

markets(SOFFEX and DTB) formed Eurex

2003: SWX acquires virt-x

2005: SWX acquires Bremen stock exchange

Agg

www

grou

92 Taiwan-TWSE 1961 Mutual - Pvt Ltd 1985 serv

93 Tanzania-DSE 1998 Mutual - Co-op Floor http

94 Thailand-SET 1974 Other 1991 WF

95 Tunisia 1969 Mutual - Pvt Ltd 1996 http

96 Turkey-ISE 2000 Other 1993 WF


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97 Uganda-USE 1773 Mutual - Co-op Floor Han

98 UAE-DFM 1992 2005 2007 2000 http

99 UK-LSE 1792 2000 2001 1997 2007: LSE acquired Borsa Italiana Agg

100 Ukraine-USE 1992 Mutual - Pvt Ltd 1996 http

101 US-NYSE 1792 2006 2006 2000 Nov 1998: American stock exchange and NASD

merged

Agg

US-CBOT 1848 2005 2005 1998 2007: NYSE and Euronext merged to form NYSE-

Euronext.

Agg

US-CME 1898 2002 2002 1992 Feb 27, 2008: Nasdaq bought OMX Agg

US-ISE 2000 2002 2005 2000 October 1, 2008: NYSE Euronext acquired AMEX Agg

US-NASDAQ 1971 2001 2002 1985 Dec 19, 2007: Eurex acquired ISE Agg

102 Venezuela 1840 Mutual - Pvt Ltd 1992 Han

103 Vietnam-HOSE 2000 Govt. owned Floor http

104 Zambia-LuSE 1994 Mutual - Pvt Ltd Floor http

Panel B: Multiple country Exchanges

105 Euronext 2000 Incep 2001 Incep 2000: Amsterdam, Brussels and Paris exchanges

merge to create Euronext2002: LIFFE is acquired by Euronext

BVLP merges with Euronext to become

Euronext Lisbon

106 NYSE Euronext 2007 Incep Incep Incep 2007: NYSE Group and Euronext merge

107 OMX 2003 Incep Incep Incep 2003: Merger of OM and HEX Group ->

OMHEX(later name changed to OMX)

2004 Acquisition of Vilnius Stock Exchange

2005: Merger of OMX and Copenhagen Stock

Exchange

2006: Merger of OMX and Iceland Stock Exchange

2007: OMX acquires Armenian Stock Exchange

108 Nasdaq OMX 2007 Incep Incep Incep 2007: Nasdaq buys OMX

Notes.2007 Cost and Annual survey by World Federation of Exchanges categorizes stock exchanges as 1) Private, limited companies 2)

listed exchanges 3) Publicly listed exchanges 4) Associations, mutuals 5) Other legal group exchanges. We consider categories 2 and 3

Austria, we gather information on demutualization through the Wiener Boerse website. We categorize Switzerland as demutualized throu

we also verify it from Aggarwal (2006). We gather information about stockholders of Taiwan stock exchange through email and classify

addresses eliminate the characters http:// and www as needed to save space. Some long Internet addresses are truncated to show the hom


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Table IIStimulants of Demutualization: Effect of market concentration, technology driven growth opportunities and

product driven growth opportunitiesWe use panel data of 104 countries starting from 1970 to 2008. Trading automation (Technology driven growth

opportunity) and derivatives trading (Product driven growth opportunity), proxies for g, take a value 0 or 1. Wedefine demutualization parameters as 1 for the years when the leading exchange in a country had demutualized,otherwise 0. In Panel A, we report Correlation of Technology driven growth opportunities, Product driven growthopportunities, market concentration and demutualization parameter. In Panel B, we estimate the effect ofTechnology growth opportunity, new product driven growth opportunities and market concentration on the changein the ownership structure of exchanges from mutually owned to demutualized ownership. We present the parameterestimates of the Cox proportional Hazard model for survival of mutual exchanges. The proportional hazards modelis represented as:

hi(t) = h0(t) exp(Xi(t))

where theXiare the technology driven growth opportunities and new product driven growth opportunities, marketconcentration, which is inverse of lag of number of exchanges in a country, market value as % of GDP, tradingvolume as % of GDP and index of Economic freedom. Market value as % of GDP and trading volume as % of GDPare from the World Bank Group website. Economic freedom component score is from Heritage foundation website.

For two observations, i andj, the ratio of two hazard function can be expressed as follows.

= exp[1(Xi1-Xj1)++1(Xik-Xjk)]

Panel A: Correlation matrix

Variable Demutualization Technology drivengrowth opportunity

Product drivengrowth opportunity

Marketconcentration

Demutualization 1

Technology driven growthopportunity

0.1545*** 1

Product driven growthopportunity

0.1382*** 0.3919*** 1

Market concentration 0.021 -0.0576*** -0.3128*** 1Panel B: Cox Proportional Hazard model applied to demutualization decisions

Variable Model 1 Model 2 Model 3

Technology driven growthopportunity

0.9689* 1.7167* 1.0829*

Product driven growthopportunity

1.3895*** 1.3354*** 1.3279***

Market concentration 1.2304* 1.4116* 1.1513*

Market cap (% of GDP) 0.0009

Value Traded (% of GDP) 0.0041

Economic Freedomcomponent score

0.0202

The symbols ***,**,* indicate significance at the 1%, 5% and 10% level respectively.


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Table IIICountry returns in two years preceding financial exchange IPO

In this table, we report the annualized country returns in two years preceding financial exchange IPO. The return onworld index during the same period is also listed. The difference between the two is presented in last column. Theaverage difference is positive and significant at 10% significance level.

Country/Exchange IPOReturn during last 2

yearsBenchmark world

returnDifference

Australia-ASX 1998 16.08% 11.10% 4.99%

Australia-SFE 2002 6.38% -16.98% 23.36%

Brazil-BOVESPA 2007 35.25% 16.12% 19.13%

Canada-TSX 2002 18.87% -16.98% 35.85%

Colombia-BVC 2007 81.38% 16.12% 65.26%

Euronext4 2001 17.64% 4.48% 28.75%

Germany-Deutsche Boerse 2001 21.56% 4.48% 17.08%

Greece-Hellenic 2000 72.08% 24.93% 47.15%

Hong Kong-HKEX 2000 -19.56% 24.93% -44.49%

Japan-OSE 2004 -20.98% 4.83% -25.81%

Malaysia-Bursa Malaysia 2005 8.25% 24.74% -16.49%

Mexico-BMV 2008 41.18% 16.95% 24.23%

New Zealand-NZX 2003 2.02% -18.03% 20.05%

Norway-Oslo Bors 2001 6.95% 4.48% 2.47%

Philippines-PSE 2003 -17.21% -18.03% 0.82%

Singapore-SGX 2000 -16.54% 24.93% -41.47%

South Africa-JSE 2006 18.93% 13.30% 5.63%

South Korea-KRX 2006 24.80% 13.30% 11.50%

Spain-BME 2006 25.58% 13.30% 12.27%

Sweden-Stockholm 1993 -11.90% 3.52% -15.42%

UAE-DFM 2007 72.93% 16.12% 56.81%

UK-LSE 2001 8.50% 4.48% 4.02%

US-CBOT 2005 1.00% 24.74% -23.74%

US-CME 2002 2.71% -16.98% 19.69%

US-ISE 2005 1.00% 24.74% -23.74%

US-NASDAQ 2002 2.71% -16.98% 19.69%

US-NYSE 2006 18.37% 13.30% 5.07%

Average 15.48% 7.44% 8.62%*

The symbol* indicates significance at the 10% level.

4For Euronext, we compute the returns by taking the mean of the country returns from Belgium, France andNetherlands.


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Table IVEconomic freedom scores in European and non-European countries where leading exchange demutualized

In this table, we report the overall score of economic freedom and important components of economic freedom in the countries wheleading exchange has demutualized. We find that the countries which had post demutualization merger activities in financialexchange industry have a higher economic freedom. The difference between average scores between Panel A and Panel Bare reported below. Z-statistics for wilcoxon rank sum test of the difference in economic freedom is also presented.

Panel A: Countries with merger activities after demutualization of

leading exchange

Panel B: Countries with no merger activities after

demutualization of leading exchange

CountryOverallScore

Types of Economic FreedomBusiness Trade Investment Financial

CountryOverallScore

Types of Economic FreedomBusiness Trade Inv. Fin.

European countries:

Armenia 69.2 83.4 80.5 75 70 Belarus 48.7 72.1 80.3 20 10Austria 71.6 73.6 87.5 75 70 Greece 62.7 77.4 82.5 60 60Belgium 70.1 92.9 87.5 80 70 Hungary 66.1 76.8 87.5 75 70Bulgaria 62.3 77.8 87.4 50 60 Kazakhstan 61 73.5 85.9 30 50Denmark 77.9 97.9 87.5 90 90 Macedonia 65.7 65.2 83.3 60 60Finland 73.8 95 87.5 75 80 Norway 69.4 88.8 89.2 65 60France 64.2 86.3 82.5 50 70Germany 71.1 89.6 87.5 85 60Iceland 73.7 93 87.9 65 60

Latvia 66.2 72.9 87.5 80 50Lithuania 70.3 82 87.5 75 80Netherlands 75 82.6 87.5 90 80Portugal 64.4 80.5 87.5 70 60Spain 69.6 75.8 87.5 80 80Sweden 72.4 95.5 87.5 85 80UK 76.5 94.9 87.5 90 80Italy 62.7 77.9 87.5 75 60Slovenia 64.7 83.3 87.5 70 50Switzerland 81.1 81.2 90 80 80Non-European countries:

Australia 82.6 90.3 85.1 80 90 Bahamas 67.3 73.4 42.2 30 70Brazil 55.6 54.5 69.2 45 50 Colombia 65.5 83.6 72.5 55 60

Canada 80.4 96.5 88.1 75 80 Costa Rica 65.9 59.3 82.5 70 50Hong Kong 89.7 98.7 90 90 90 Dom. Rep. 60.3 62.4 80 55 40Singapore 86.1 98.2 90 75 50 India 53.8 36.3 67.9 35 40South Korea 69.9 91.9 70.8 70 70 Iran 43.4 69.9 50.2 10 10US 78 91.3 86.9 75 70 Japan 72.9 84.5 82.4 60 50

Malaysia 64.8 69.9 78.7 30 50Mauritius 76.3 82.2 85.6 85 70Mexico 68.3 83 82 65 60New Zealand 82.1 99.9 86 80 80Peru 67.6 65.8 85 70 60Philippines 56.3 48.1 77.8 40 50Qatar 69 73.7 82.2 45 50South Africa 62.8 73 76 45 60

UAE 67.3 67.4 82.8 35 50Average 72.27 86.06 85.90 75.00 70.38 64.42 72.1 78.30 50.9 52.7

Difference 7.85 13.96 7.60 24.09 17.66

Wilcoxonrank sumZ-statistics

3.06*** 3.69*** 4.07*** 4.20*** 3.61***

The symbol *** indicates significance at the 1% level.


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Table VTrends in trading volumes before and after Demutualization

We estimate the following regression equation:Country trading volume = + Pre-demutualization + Post-demutualization + World volume + laggedReturn

Pre-demutualization dummy is 1for the 24 months preceding the demutualization, and 0 otherwise. Post-demutualization dummy takes value 1 for the months after demutualization, and 0 otherwise.

Causes and Effects of Demutualization of Financial Exchanges

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