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Causes and Effects of Demutualization of Financial Exchanges Chinmay Jain1
and
Pankaj Jain2
December 2009
1 Doctoral student, Department of Finance, Insurance, and Real Estate, Fogelman College of Business and Economics, University of Memphis, Memphis, TN 38152. Phone: 901 678 4189; Email: chinmay.jain@memphis.edu

2 Suzanne 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 3801; Email: pjain@memphis.edu

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Abstract
We model how the forces of automation, competition, and demutualization are rapidly changing the industrial organization, ownership, and capital structure of financial exchanges industry. We propose the conditions under which demutualization becomes optimal from mutually owned exchange owners’ perspective. We then proceed to build an empirical dataset characterizing the evolution of leading stock and derivative exchanges around the World along these dimensions. We empirically find that trade automation appears to be a pre-requisite for demutualization of exchanges and competition serves as stimulus for demutualization. The potential for launching new products, such as derivatives products, stimulates exchange owners to adopt demutualization.

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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. 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 have owned and managed the operations of the exchanges in many countries. Since the first demutualization1 and IPO in the world by Stockholm Stock exchange in 1993, 56 exchanges 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 demutualizations throughout the world. We investigate the causes of demutualization of financial exchanges. In particular, we explore the interactions between technology adoption, regulation, competition, exchange ownership structure, and globalization.

We provide a background on institutional features of financial exchanges in section I. We discuss the changes in the organizational structure of financial exchanges from being memberowned entities to demutualized “for-profit” entities. Automation and competition are stimulants for the changes in the ownership structure. We contribute to the literature by studying the 1 Demutualization is the process of issuing and distributing shares to the owners of the exchange to allow separation of trading rights and cash flow ownership rights.

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evolution of exchange automation, competition and the effect of these forces on the ownership structure of the exchanges. In the earlier days, member owners of the exchanges enhanced the value by restricting access to exchange membership. The viability of this strategy changed with trade automation, which made entry by new exchanges easier and less costly. Thus, we hypothesize that the evolution of exchange automation and competition between the exchanges altered relative importance of existing assets and growth opportunities and caused the financial exchanges to demutualize. Once they demutualize, they find it easier to raise capital and compete with...
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