Commercial Issues and Potential Benefits of Demutalisation

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Commercial Issues and Potential Benefits of
Demutalisation

• Speaker Muhammad Munir Ladha
• Director, Karachi Stock Exchange
• September 07, 2006

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What is demutualisation ?
the transition from a mutual company, in which
here are no shares and every member has one
vote, to a company limited by shares and one
vote per share.
Strict definition is..

• The process by which a company converts to a more
  usual
• economic model or
• A company where the link between the membership
  in the
• exchange company or ownership of a share in it,
  is broken

Can also imply
..the transformation of an exchange from an
entity owned by its members into a for profit,
shareholder-owned company
A comm entity
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Why demutualise ?

• Commercial

• Governance

Internationally, demutualisation has been adopted
by exchanges more for resources generation to
meet rising capital requirement and less for
better corporate governance.
Demutualisation is considered for revamping and
separating ownership control from management
control in stock exchanges
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How commercial are the exchanges ?

• Deteriorating financial statements (KSE) in a
  bull market repeated deficits (ISE), soaring
  administrative costs, inadequate revenue streams.
• Owner/users conflict Interest of the members is
  to keep user charges at a minimum. Interest of a
  commercial entity is to price at the margin.

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Financial Malaise
In FY2002, the KSE realized a deficit of PKR
60.6mn. During the same time the KSE Index soared
32.
2002 PAT(Rs.60.6mn)

• Revenue Issues
• Trading revenue (only core revenue stream)
  decreased
• Non-core revenue stream(Return on deposits)
  accounted for 22 of Operating revenues

• Cost issues
• Inadequate resources have led to investment being
  financed from the protection fund
• Salaries account for 43 of administrative
  expenses

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NCSS,a commercial decision ?

• The S.E.s instead of pooling costs have added to
  them
• No additional revenue realised to S.E.
• S.E.s prepared to pay members contribution for
  joining NCSS
• KSE considers itself a better risk but pooled
  risk without quid pro quo

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Commercial Benefits of Public S.E.

• Potential for realisation of shareholder value
  for members
• Commercial criteria for decision making
• Enhanced ability to increase revenue
• Ability to reduce combined costs
• Spreading of ownership risk
• Greater access to capital
• Market discipline on management
• POSSIBLY A PROFITABLE SE!!!!

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The Merits of a Public S.E
Public listing of shares of the exchange would
enable it to raise funds from the market
subjecting it to transparency, accountability
accountability and market discipline
Consolidation of bourses and clearing houses
within a single entity would bring economies in
terms of operational efficiencies, savings in
infrastructure investments and financial strength
A Demutualised SE
Demutualisation would ensure that exchange would
not work in the interest of members only, but
also be responsive to market participants
A public exchange would make it possible to
infuse professional mangement
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Implied Worth of Exchanges
(Pak Rupees Million)

• K.S.E. 100m x 200 20,000
• L.S.E. 25m x 140 3,500
• I.S.E. 15m x 100 1,500
• TOTAL 440 25,000

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Broking Capital

• This value represents a very large part of
  business capital and personal net worth of
  individual broker businesses
• Very important that this value is not impaired
• Enhancement of value is the only way that brokers
  will adopt demutalisation willingly

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Where is the Intrinsic Value ?

• A membership seat value is derived from its
  components
• The value of the ownership right
• Value of the trading right (the current market
  price of the set value of ownership right)

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Issues Related to Valuation

• Different exchange will have different values for
  the trading rights
• Similarly with ownership value but this is easier
  to price

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Demutualisation Tends to Lower the Value of
Trading Rights

• The potential to increase the number of trading
  rights can cause dilution in natural share
• In a demutualised exchange, the drive for profit
  increase both the scope and the intensity of
  conflicts
• Moving to a for-profit enterprise may allow the
  exchange to enter into new businesses, thereby
  increasing the opportunities for conflicts
  between its regulatory role and those as a
  competitor in the market place
• Operating costs for members will increase (annual
  fees, charges for services, etc.)
• The scope of conflict between a corporatised KSE
  and the trading interests of members could swell

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Need to compensate on the Ownership Right

• Create entity with a minimum market value of PKR
  3.0Billion
• At current market multiples this entity should
  have net profits of PKR 400 Million
• This implies that both revenue will have to go up
  substantially and costs will have to be cut
  drastically

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Cost Cutting Can Only Be Achieve Through Mergers

• Remove duplication of management, administration,
  I.T. and other costs of the exchanges
• Have a single clearing house so that NCSS makes
  commercial sense
• Better still, merge with the CDC and remove
  costs further (communication, I.T. etc.)

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Regulatory Structure
The benefits of additional resources and
independent and professional governance can be
balanced by an efficient regulatory structure

• Appointment of public representatives appointed
  nominees from other regulatory organizations in
  related professions (Accounting, Law, etc.) have
  little or no commercial stake in the business.
• Regulation profitability regulatory decisions
  should be evaluated from the dimension of its
  impact on the share value or profitability or
  turnover of the exchange.
• Maximum limit No broker to own more than 5 of
  an exchange
• Shareholding and exit price Trading rights
  should initially be tradable and an embargo on
  issuance of new trading rights. New shareholders
  should be introduced through subscription or
  merger and should replace nominees on the board

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Revenue enhancement-burden must be shared

• Charges to brokers will rise
• Annual listing fees should rise very
  substantially say PKR 1 Million
• Steep rise in data charges to external third
  parties
• New product lines leveraging the existing
  infrastructure

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Motives for Demutualization

• Global Competition
• Technology

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Regulatory Implications of Demutualization

• Trading Setting rules for trading, conducitn
  surveillance, and enforcing the rules.
• Market Manipulation Overseeing the trading
  system to prevent abuses.
• Membership establishing rules to govern the
  conduct of members and monitoring compliance with
  and enforcement of rules.

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The Performance of Public Stock Exchange

• Deutsche Borse
• London Stock Exchange
• Australian Stock Exchange

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Estimated commission revenue per broker
natural share
Note Not for Presentation.
Pak Rupees Million

• K.S.E. 1,000 / 200 5.0
• L.S.E. 400 / 140 2.9
• I.S.E. 100 / 100 1.0