Demutualization & Corporatization of Stock Exchanges

SEMINAR ON

By: PURUSHOTTAM.N.VAIDYA R.No.49 M.com I semester Karnataka University Dharwad.

CONTENTS :

1.Structure of Stock Exchanges in India2.Mutual Structure of Indian Stock

Exchanges3.Drawbacks prior to Demutualization4. Demutualization5.Corporatization6.PROCESS OF DEMUTUALISATION7.ADVANTAGES OF DEMUTUALISATION.8.SEBI’s GUIDELINES9.LIMITATIONS BY SEBI10.THEORITICAL FRAMEWORK

Structure of Stock Exchanges in India BSE the oldest exchange in Asia was established in 1875 as

Voluntary ‘not for profit’ un-incorporated association of persons.

Ahmadabad and Indore stock exchanges were other exchanges having similar structure.

The membership of these exchanges entitled the person to be the part owner of the exchange as well as a broker on the exchange.

All other regional stock exchanges were formed as companies under section 12 of the Companies Act, 1956 as company limited by shares/guarantee, but had a “not for profit” motive.

These exchanges worked like a co-operative society where the share of the company entitled the owner to be the shareholder of the exchange and also gave him a right to act as broker on the exchange.

Mutual Structure of Indian Stock Exchanges

Indian stock exchanges(except NSE and OTCEI) therefore followed a mutual structure where the ownership and management rights of the exchange are bundled with trading rights as a broker and all three are represented by ownership of share of the exchange.

Drawbacks prior to Demutualisation

• The conflict of interests between the owners, the members and the management - since all the brokers are managing the exchange together then such conflict is advent to happen

• Brokers were manipulating the market for their advantage-That is investor’s interest was ignored.

• Scams took place in pre-demutualization phase-1992-Harshad Mehta scam & 2001-Ketan Parekh Scam

• Lack of strict vigilance on the market-No one person or management was there to look after the affair of the exchange.

Demutualization

The process of converting exchanges from nonprofit, member-owned organizations to for-profit, investor-owned corporations.

“Demutualization is referred to the transforming the legal structure of an exchange from a mutual form to a business Corporation form”

In simpler terms it is a process by which a mutually owned stock exchange is converted into a company owned by shareholders through transforming its existing legal structure into a business entity.

Corporatization

In order to demutualise a corporate structure of the exchange is a necessity.

The process of converting the organsisational structure of the stock exchange from a non-corporate structure to a corporate structure is called Corporatization of stock exchanges

The Stockholm Stock Exchange was the first stock exchange to be demutualised. It is a Swedish based stock exchange.

How does Demutualisation and Corporatization will overcome the drawbacks of Mutual Structure

• The ownership, management and trading is separated and are in different hands.

• They are clearly separated like a commercial entity.

• The management of the exchange is

separated from the shareholders and the brokers.

PROCESS OF DEMUTUALISATION

All the assets are valued by the exchange, which includes the value of seats. A total value is founded and divided into shares, which are offered to the public. Then the stock exchange lists the shares. The members of the exchange will get the payment for their seats from the funds available through the sale of shares. The goal of demutualization is corporate structure which offers the management greater flexibility. Demutualization helps to respond to changes in a better way and it also provides the company to spin-off its subsidiaries, get into mergers and acquisitions, raise funds,etc. Membership cardholders of the exchange will be the shareholders of the exchange initially.

There would be only a single class of trading members having the same rights and privileges. If any person is admitted as a trading member then uniform standards will be followed in terms of capital adequacy, deposits, fees, etc. In the governing board of any demutualized exchange, the representatives will not exceed one-fourth of the total strength of board. The public, apart from the shareholders who have the trading rights, will hold at least 51% of its equity shares. The trades are being cleared and settled by the trading members until the clearing and settlement functions can passed on to a recognized clearing corporation which might take place within two years. The corporatized and demutualized exchange will initially use the existing assets and reserves transferred from the previous exchange. The government transfers the surplus funds built in the process of demutualization to the consolidated fund of India. It also has the option of using such funds to acquire capital assets or to develop the market.

ADVANTAGES OF DEMUTUALISATION.

1.  Rationalized Governance:- The corporate model will enable management to take actions that are in the best interest of customers and the exchange itself. There would be transparency.

2. Investors Participations:- A demutualised exchange affords both institutional investors and retail investors the opportunity to  become shareholders. Institutional investors require much greater liquidity for block trading.

3. Competition from Alternate Trading System’s (ATS) and Electronic Communication Networks:- ATS and Electronic Communication Networks provide cheap and efficient access to quoted stocks unlike traditional stocks exchanges. To cope with competition, exchange required funds. While members have limitations in raising funds.

4.Globalization: - Historically brokers and exchanges were locally focused. Exchanges did not face meaningful competition from exchanges in distance places. Through alliances, exchanges seek to attract more investors by harmonizing distinct trading environment and by offering greater product variety.

5.Resources for capital investment: - One of the drivers of stock exchange demutualization is screen trading, which has replaced floor trading on most exchanges. Once customers have direct access to screens, exchanges memberships no longer have as much economic value and clearing firms rather than traders become a dominant force in exchange activities.

SEBI’s GUIDELINES

SEBI issued its guideline on 31- 11- 2006 for investment in stock exchanges in India. Under this guidelines, shareholdings of trading Members have to be brought down to 49% which can be either by divestment or additional equity capital to be issued to make the shareholding of existing trading members to 49%.Therefore, it can be way of 1) Offer for sale by prospector by existing trading members2) Placement of shares of shareholders having trading

rights to such persons or institutions may be short listed by the exchange with the approval of SEBI.

3) Issue of equity shares on private placement basis by the stock exchange to any person or group of persons not having trading rights subject to approval of SEBI

LIMITATIONS BY SEBI.  No person shall directly or indirectly acquire or hold

more than5% in the paid up capital.

 No person shall either individually or together with persons in concert with him acquire and or hold more than 1% of the paid-up capital.

Foreign investment up to 49% will be allowed in stock exchanges with a separate FDI cap of 26% and FII cap of 23%.

THEORITICAL FRAMEWORK

Lets see some models of demutualization from the Indian stock market. The models are of Bombay Stock Exchange, National Stock Exchange and National Commodity and Derivative Exchanges Limited.

DEMUTUALISATION OF BSE.The Bombay stock exchange. Asia’s oldest stock exchange with 131 year old history. It was handled by 790 brokers.BSE submitted its duly approved scheme to SEBI in June 2003. Amendments to Rules and MOA and AOA also submitted in July 2003(based on Kania committee report) to SEBI for approval.It was corporatized on 19 May 2005Around51% stakes of 790 brokers were offloaded to 21 investors. Like SBI, LIC, Aditya Birla Group, beside Deutsche Brose and Singapore Exchange’s.

19 investors (like SBI, LIC, Aditya Birla and so on) have picked up41% stake.

10% by Deutsche Borse and Singapore Exchange. Each group has picked up 5 % stake for Rs. 189 crore each

Members of BSE:-1) 18 Board members2) 1 Chairman3) 1 Managing Director4) 8 Independent director5) 7 Broker director

DEMUTUALISATION OF NSEThe National Stock Exchange was formed in November 1992 as a tax paying company. Unlike other stock exchanges in the country. From day one, NSE has adopted the form of a demutualized exchange’s. It is owned by a set of leading financial institutions like banks, insurance companies and other financial intermediaries and is managed by professionals, who do not directly or indirectly trade on the exchange. The promoters of the NSE are like: – • Industrial Development Bank of India Limited. • Industrial Finance Corporation of India Limited. • National Insurance Company Limited.• Infrastructure Development Finance Company

Limited. And so on.

Members of BSE:-

1) 1 Managing director2) 2 SEBI nominees3) 4 Public representatives4) 4 Independent director5) 8 Share holder’s

representative

DEMUTUALISATION OF NCDEX.

National Commodity & Derivatives Exchange Limited, is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of Business on May 9, 2003. It commenced its operations on December 15,2003. NCDEX currently facilitates trading of 57 commodities  NCDEX is a national-level, technology driven de-

mutualised on-line commodity exchange with an independent Board of Directors and professional management - both not having any vested interest in commodity markets. It is committed to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

DEMUTUALIZATION OF REGIONAL STOCK EXCHANGES.

Government asks for demutualisation of regional stock exchanges in two ways:-1) Either by becoming trading arms of BSE & NSE,

or 2) no. of regional stock exchange joins hands to make a separate platform.

Nine exchanges recently signed an MOU with the National Stock Exchange (NSE) to extend its trading platform on the regional stock exchanges.

Demutualized Regional Stock Exchanges

1. Vadodara Stock Exchange 2. Magadh Stock Exchange3. Jaipur Stock Exchange 4. Ludhiana Stock Exchange5. Saurashtra Kutch Stock Exchange 6. Delhi Stock Exchange7. Bhubaneshwar Stock Exchange 8. Cochin Stock Exchange9. Pune Stock Exchange10. Bangalore Stock Exchange 11. Ahmedabad Stock Exchange12. Calcutta Stock Exchange 13. Madras Stock Exchange14.Guwahati Stock Exchange

The stock exchanges not demutualised are :-

1)Coimbatore Stock Exchange.2)Mangalore Stock Exchange.3)Meerut Stock Exchange.4)Uttar Pradesh Stock Exchange.

COMMITTEE FORMED FORSUGGESTION.

Under the chairmanship of Justice M.H.Kanai a group was constituted by SEBI to advice on the matter of corporatization and demutualisation of exchanges.Some suggestions are :-

1. Stock exchanges be converted into companies limited

2. Amendment is made to the Income Tax Act 1961, so that past accumulated profits of the stock exchanges are not subject to tax.

3. Amendment would also be required in the Indian Stamp Act 1899 and Sales Tax law to allow a tax- free transfer of assets from the old entity to the demutualized new entity.

4. The system of permission to trade on the basis of ownership of a trading card is replaced by a system where money is deposited to obtain trading rights.

 5.Shareholders, brokers and investing publics are equally represented on the governing board of the demutualized exchanges.

6. A uniform model for corporatization and demutualization would have to be adopted by all stock exchanges.

7. The merger of stock exchanges is a commercial decision that would be left to stock exchanges.

Challenges Of Demutualisation

• Here will be no changes in the conflict of interest if an exchange is converted from an association of persons into a limited liability company

• The same board and the same organizational structure will continue to exist and nothing much will be achieved

• The government can not solve the exchange’s management problem by steering the Demutualisation process

• There have been arguments that Demutualisation by itself may not achieve improved governance

CONCLUSION If the stock exchange are the self regulatory in

nature they find ways to profit making.

The exchange have option of setting up separate entity within stock exchange defining the regulatory power.

Though Demutualisation is beneficial, many stock exchanges are hesitating to adopt it because they are afraid of loosing their identity

They also have the fear of paying huge tax conversions

This issue has already gained importance at the international level but it needs to be considered more intensely at domestic level