Commercial Issues and Potential Benefits of Demutalisation Speaker: Muhammad Munir Ladha Director, Karachi Stock Exchange September 07, 2006
“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.. What is ‘demutualisation’ ? • 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
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
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.
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;
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
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!!!!
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
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
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
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)
Issues Related to Valuation • Different exchange will have different values for the trading rights • Similarly with ownership value but this is easier to price
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
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
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.)
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
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
Motives for Demutualization • Global Competition • Technology
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.
The Performance of Public Stock Exchange • Deutsche Borse • London Stock Exchange • Australian Stock Exchange
Note: Not for Presentation. Estimated commission revenue per broker – ‘natural share’ 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