Causes and Effects of Demutualization of Financial Exchanges

Chinmay Jain1 and Pankaj Jain2

October 2010

Doctoral 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: 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 3810; Email: pjain@memphis.edu

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.

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 demutualization1 and 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
1

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

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.

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

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.

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
A high profile regulatory case alleging that 14 elite New York Stock Exchange traders cheated investor was filed in March, 2008. The lawyers for the traders, who worked at the floor- trading firms known as specialist firms told a Securities and Exchange Commission administrative law judge that the exchange's trading data were too flawed to show improper activity. In 2003, the NYSE fined a trader of Fleet Specialist Inc $25,000 for front running. The trader sold GM stock from the 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 for indulging in front-running and other unethical practices.
2

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 underpricing 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 8

standards, and the optimal regulation of the exchanges. Mendiola and OHara (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

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

10

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. 11

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

12

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

13

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

14

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,

15

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 if I > S. Members resort to equity only if I - S > Dmax, where Dmax is 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 K is 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

16

I*(

> U(m,E)

(2)

The exchange can also alternatively use this investment I to 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. Investment I 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 17

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 18

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. On March 7, 2006, the NYSE Group, Inc., a for-profit, publicly-owned company, 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 19

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

20

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, publiclyowned 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

21

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 timeinvariant covariates. The results of Cox proportional Hazard model estimation are reported in Panel B of Table IV. 22

[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
3

Heritage foundation website provides economic freedom component cores from 1995 to 2010. For the years before 1995, we use the score of 1995.

23

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 24

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: 25

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 postdemutualization 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 i in month t in local currency and the return from the world-market index in that month. 26

Excess-over-world returnit = Gross returnit World $ 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 [Insert Table VII] Two measures of equity premium are DYCG and ERW and measure of liquidity is 27 (8)

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. Conclusions Technology, 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 28

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.

29

Appendix Table A1 Time-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 the country.
Panel A: Countries where leading exchange has demutualized Country 1975 1985 1995 2000 2005 Armenia 0 0 1 1 1 3 Australia 6 6 1 2 Austria 1 1 1 1 1 Bahamas 0 0 0 1 1 Belarus 0 0 1 1 1 1 Belgium 2 2 2 1 Bermuda 1 1 1 1 1 Brazil 10 9 9 1 1 Bulgaria 0 0 2 1 1 Canada 5 5 5 3 2 Colombia 2 3 3 3 1 Costa Rica 0 1 1 1 1 Denmark 1 1 1 1 1 Dom. Rep. 0 0 1 1 1 Finland 1 1 1 1 1 France 1 1 1 1 1 Germany 8 8 8 7 6 Greece 1 1 1 1 1 Hong Kong 4 4 1 1 1 Hungary 0 0 1 1 1 Iceland 0 1 1 1 1 India 9 14 19 20 19 Iran 1 1 1 1 1 Italy 1 1 1 2 2 Jamaica 1 1 1 1 1 Japan 8 8 8 6 6 Kazakhstan 0 0 0 1 1 Latvia 0 0 1 1 1 Lithuania 0 0 1 1 1 Macedonia 0 0 0 1 1 Malaysia 1 1 1 1 1 Mauritius 0 0 1 1 1 Mexico 1 1 1 1 1 Netherlands 1 1 1 1 1 New Zealand 1 1 1 1 1 2010 1 2 1 1 1 1 1 1 1 2 1 1 1 1 1 1 6 1 1 1 1 19 1 2 1 6 1 1 1 1 1 1 1 1 1 Panel B: Countries where leading exchange has not demutualized Country 1975 1985 1995 2000 2005 Albania 0 0 0 1 1 Argentina 5 5 5 5 5 Azerbaijan 0 0 1 1 1 Bahrain 0 0 1 1 1 Bangladesh 1 1 2 2 2 Barbados 0 0 1 1 1 Bhutan 0 0 1 1 1 Bosnia 0 0 0 0 1 Botswana 0 0 1 1 1 China 0 0 2 2 2 Cte d'Ivoire 1 1 1 1 1 Cyprus 0 0 0 1 1 Ecuador 2 2 2 2 2 Egypt 0 0 1 1 1 Fiji 0 1 1 1 1 Georgia 0 0 0 1 1 Ghana 0 0 1 1 1 Guyana 0 0 1 1 1 Indonesia 0 1 2 2 2 Ireland 1 1 1 1 1 Israel 1 1 1 1 1 Jordan 0 1 1 1 1 Kenya 1 1 1 1 1 Kenya 1 1 1 1 1 Kyrgyz 0 0 1 1 1 Lebanon 1 1 1 1 1 Luxembourg 1 1 1 1 1 Malta 0 0 1 1 1 Moldova 0 0 1 1 1 Mongolia 0 0 1 1 1 Morocco 1 1 1 1 1 Namibia 0 0 1 1 1 Nepal 0 1 1 1 1 Oman 0 0 1 1 1 Pakistan 2 2 3 3 3 2010 1 5 1 1 2 1 1 1 1 2 1 1 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 3

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

30

36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53

Norway Palestine Peru Philippines Portugal Qatar Singapore Slovenia South Africa South Korea Spain Sweden Switzerland UAE UK US

3 0 1 2 0 0 1 0 1 1 3 1 3 0 1 8

3 0 1 2 0 0 1 0 1 1 4 1 3 0 1 8

1 1 1 1 1 0 1 1 1 1 4 1 1 0 1 7

1 1 1 1 1 1 1 1 1 2 4 2 1 1 1 7

1 1 1 1 1 1 1 1 1 1 1 2 1 3 4 8

1 1 1 1 1 1 1 1 1 1 1 2 1 2 4 7

Papua N.Guinea Poland Russia Serbia Sierra Leone Slovakia Sri Lanka Swaziland Taiwan Tanzania Thailand Tunisia Turkey Uganda Ukraine Venezuela Vietnam Zambia

Total

92

100

103

99

95

93

0 0 0 0 0 0 1 0 1 0 1 1 1 0 0 1 0 0 24

0 0 0 0 0 0 1 0 1 0 1 1 1 0 0 1 0 0 28

0 1 1 1 0 1 1 1 1 0 1 1 1 0 1 1 0 1 54

1 1 2 1 0 1 1 1 2 1 1 1 1 1 2 1 1 1 64

1 1 2 1 0 1 1 1 2 1 1 1 1 1 2 1 1 1 65

1 1 2 1 1 1 1 1 2 1 1 1 1 1 2 1 1 1 65

31

Table A2 Debt-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 of the 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 LSE TMX ASX NYSE Euronext Deutsche Borse OSE Bursa Malaysia SGX Nasdaq OMX Name LSE TMX ASX NYSE Euronext Deutsche Borse OSE Bursa Malaysia SGX Nasdaq OMX 1999 0.33 9.61 1999 425 25000 2000 0.75 0.33 29.66 0 5.08 2000 2034 309 90000 0 25000 2001 0 0.67 0.18 5.77 0 61.07 2001 0 1816 113 0 0 300673 2002 0 0.55 0.03 165.26 0.03 0.13 0 330.69 2002 0 1565 23 10800 7000 1318 0 437424 2003 0 0.72 0 0 188.47 0.02 0.09 0 992.73 2003 0 1277 0 0 505200 6000 1098 0 265000 2004 1.34 0.65 0 0 184.4 0.02 1 0 1002.7 2004 500 1282 0 0 505300 5000 879 0 265000 2005 1.32 0.98 0 0 237.18 0.01 0.1 1.01 754.75 2005 500 903 0 0 501600 4000 659 2778 1184928 2006 0.38 0.41 0 0 290.66 0.01 0.08 0.63 103.18 2006 500 145 0 0 499900 3000 439 1184 1492947 2007 -71.06 0.13 0 28.91 462.17 0.01 0.06 0 5.36 2007 248700 71 0 521000 1200 2000 219 0 118438 2008 58.34 53.91 0 47.85 362.82 0 0.03 0 59.38 2008 248400 428307 0 1787000 1512900 2000 0 0 2293756 2009 65.05 56.83 3.61 40.49 308.28 0 0 0 42.46 2009 622500 434528 100000 2166000 1514900 1000 0 0 1867000

Panel B: Long term debt of listed exchanges

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

32

References 2007 Cost and Revenue Survey, 2008, World Federation of Exchanges. 2008 Cost and Revenue Survey, 2008, World Federation of Exchanges. Abdel Shahid, Shahira F., Institutional Reform: Privatization of the Egyptian Exchange (August 2004). Available at SSRN: http://ssrn.com/abstract=593365 Aggarwal, Reena, 2002. Demutualization and corporate governance of stock exchanges. Journal of Applied Corporate Finance 15, 105-113. Aggarwal, Reena and Dahiya, Sandeep, 2006, Demutualization and public offerings of financial exchanges. Journal of Applied Corporate Finance 18, 96-106. Akhtar, Shamshad, 2002, Demutualization of stock exchanges. Asian Development Bank. Amihud, Y., H. Mendelson, and B. Lauterbach, 1997, Market microstructure and securities values: Evidence from the Tel Aviv stock exchange. Journal of Financial Economics 45, 365390. Arnold, T., P. Hersch, J.H. Mulherin and J. Netter, 1999, Merging markets. The Journal of Finance 54, 1083-1107. Axelson, Ulf, 2007, Security design with investor private information. The Journal of Finance 62, 2587-2362. Bharath, S., Pasquariello, P., Wu, G., 2009, Does asymmetric information drive capital structure decisions?. Review of Financial Studies 22, 32113243. Black, Bernard S., The Role of Self-Regulation in Supporting Korea's Securities Markets. Journal of Korean Law, Vol. 3, 2003. Available at SSRN: http://ssrn.com/abstract=293565 Brau, James C., Francis, Bill and Kohers Ninon, 2003, The choice of IPO versus takeover: Empirical evidence. Journal of Business 76, 586-612 Carow, Kenneth A., Cox, Steve R., Roden, Dianne M., 2009, Demutualization: Determinants and consequences of the mutual holding choice, Journal of Banking and Finance 33, 1454-1463. Chemmanur, T.J., Fulghieri, P., 2006, Competition and cooperation among exchanges: A theory of cross-listing and endogenous listing standards, Journal of Financial Economics 82, 455-489. Dittmar, Amy and Thakor, Anjan, 2007, Why do firms issue equity?, The Journal of Finance 62, 1-54. Domowitz, I., and B. Steil, 2001, Innovation in equity trading systems: The Impact on 33

transactions costs and cost of capital in Richard Nelson, David Victor, and Benn Steil, ed.: Technological Innovation and Economic Performance, (Princeton University Press). Fama, E., French, K., 2005, Financing decisions: Who issues stock?. Journal of Financial Economics 76, 549582. Fleckner, Andreas M., 2006, Stock exchanges at the crossroads. Fordham Law Review 74, 25412619. Harris, L. (2007), Trading & Exchanges Market Microstructure for Practitioners, Oxford University Press Jain, Pankaj K., 2005, Financial market design and the equity premium: Electronic vs. floor trading, Journal of Finance 60, 6, 2955-2985. Jung, K., Kim, Y., Stulz, R., 1996, Timing, investment opportunities, managerial discretion and the security issue decision. Journal of Financial Economics 42, 159185. Kalay, A., L. Wei, and A. Wohl, 2002, Continuous trading or call auctions: Revealed preferences of investors at Tel Aviv Stock Exchange, Journal of Finance 57, 523-542. Mendiola, A., and OHara, M., 2003, Taking stock in stock markets: The changing governance of exchanges, Working Paper, Cornell University, Available at http://ssrn.com/abstract=431580. Moulton, Pamela C., and Wei, Li, 2009, A tale of two time-zones: The impact of substitutes on cross-listed stock liquidity, Journal of Financial Markets 12, 570-591. Muscarella, C., and M.S. Piwowar, 2001, Market microstructure and security values: Evidence from the Paris Bourse, Journal of Financial Markets 4, 209-229. Myers, S., 1984. The capital structure puzzle. Journal of Finance 39, 575592. Myers, Stewart and Nicholal S. Majluf, 1984, "Corporate Financing and Investment Decisions when Firms have Information that Investors Do Not Have", Journal of Financial Economics 13, 187-221. Oldford, Erin and Otchere, Isaac K., Can Commercialization Improve the Performance of Stock Exchanges Even Without Corporatization? (January 28, 2010). The Financial Review, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1544029 Otchere, Isaac K., and Abou-Zied Khaled, 2007, Stock Exchange Demutualization, Self-Listing and Performance: The Case of the Australian Stock Exchange, Journal of Banking and Finance 32, 512-525. Pagano, Marco, Panetta, Fabio and Zingales Luigi, 1998, Why do companies go public? An empirical analysis, The Journal of Finance 53, 27-64. 34

Pirrong, C.,1999, The organization of financial exchange markets: Theory and evidence. Journal of Financial Markets 2, 329357. Rajan, Raghuram G., 1992, Insiders and outsiders: The choice between informed and arms length debt, Journal of Finance 47, 1367-1400. Ramos, Sofia Brito, "Why Do Stock Exchanges Demutualize and Go Public?" (March 13, 2006). Swiss Finance Institute Research Paper No. 06-10 Available at SSRN: http://ssrn.com/abstract=890268 Rhodes-Kropf, Matthew, Robinson, David T., 2008, The Market for Mergers and the Boundaries of the firm, Journal of Finance 63, 1169-1211. Rock, Kevin, 1986, Why new Issue are underpriced. Journal of Financial Economics 15, 187212. Serifsoy, Baris and Tyrell, Marcel, Investment Behavior of Stock Exchanges and the Rationale for Demutualization - Theory and Empirical Evidence, (August 2006). Wharton Financial Institutions Center Working Paper No. 06-17 Available at SSRN: http://ssrn.com/abstract=928610 Shyam-Sunder, L., Myers, S., 1999, Testing static tradeoff against pecking order models of capital structure. Journal of Financial Economics 51, 219244. Yong, Kwek Ping and Fu, Kelvin, Introducing Demutualization and Listing as a Mean to Improve the Management of Chinese Stock Exchanges (October 2006). Available at SSRN: http://ssrn.com/abstract=940330

35

Status Quo (Do not demutualize)

n a tio n tr e c con

pr No

wth gro e l ab ofit

tun por op

ity

d g., , e. ) g (

t ue

wi o lo

us nd

tr y

Use slack (Do not demutualize)

ort pp ho ity un

Nature determines Growth opportunity (g)

Pr of ita bl e

S ck( Sla
g ex ist

nve >I

t(I) en stm

u req

or df ire

gro

wt

Issue Debt
>I

D
s

x ma

+S

<

r so rgie dom e n sy ree ive mic f o gat Ne econ low

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

Demutualize

Synergies with a Target exchange (T) are identified

(g) )/K

Issue Debt followed by Equity IPO

-1 )

Po s

>0

itiv es yn

er gie s

an dh igh

Do nothing
ec on

om ic f

re ed om

Merger and acquisition

Figure 1. Optimal ownership structure and financing strategy of an exchange. This decision tree shows various economic scenarios, industry concentration, and stock market conditions that can potentially occur in the strategic plane for an exchange. g represents technologydriven or product-driven growth opportunities. I is the required investment in technology infrastructure, 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 K is 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 retaining part of those profits every year. U is defined as the underpricing of the equity issue. Synergies (si) arise because exchanges are able to exploit growth opportunities by using the trading platform or derivatives product platform of the target exchange and economies of scale help reduce the cost as well. The decision nodes on the right show the optimal ownership structure and financing strategy from the perpective of exchange owners under each scenario.

36

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

37

Table I Dates of Establishment, Introduction of Automated trading, Demutualization and IPO of leading exchanges in 104 countries of the world This table shows the information about the establishment (Estd), demutualization (Demut), IPO and date of the introduction of electronic trading (Elec) in the leading exchange of each country in Panel A. Estd and Elec are from Jain (2005). We collect other data from the Stock exchange handbook (1998, 2001, 2002 and 2006), 2007 cost and revenue survey by World Federation of Exchanges (WFE 2007), Aggarwal (2006), and exchange websites. In Panel B, we list the exchanges which operate in multiple countries. Incep in Demut, IPO and Elec date column implies that the exchange was demutualized, public or had implemented trading automation since inception. 1 2 3 4 Country Albania-TSE Argentina Armenia-ASE Australia-ASX Australia-SFE 5 Austria-Wiener Borse Estd 1996 1854 1993 1859 1960 1771 Demutualization Govt. owned Mutual - Co-op 2007 1998 2000 1999 IPO Elec Floor 1995 1996 1987 1989 1996 Merger Events Demutualization Information Source http://www.tse.com.al/english/profili.php WFE 2008 http://www.nasdaqomx.am/en/history.htm Aggarwal(2006) Aggarwal(2006) wienerborse.at/about/history/1980_2000.html

1998 2002

Jan 7, 2008: Acquired by OMX April 2005 : NSX took over the Bendigo Stock Exchange July 2006 : Australian Stock Exchange and SFE merged Dec.1997 : The Vienna Stock Exchange(VSE) and Austrian Futures & Options Exchange (OTOB) merged June 2008: VSE bought Ljubljana stock exchange

6 7 8 9 10 11 12

Azerbaijan-BSE Bahamas-BISX Bahrain-BSE Bangladesh-DSE Barbados-BSE Belarus-BCSE Belgium-BSE

1993 1999 1987 1954 1987 1993 1801

Mutual - Pvt Ltd 1999 Other Other Mutual - Co-op 1998 2000

1997 2000 1999 1998 2000 2000 1996

Jan 1998: The Antwerp and Brussels stock exchanges (BSE) merged 2000: BSE & exchanges in Paris and Amsterdam formed Euronext

http://www.bfb.az/index.php?r=26&lang=en http://www.bisxbahamas.com/about.php http://www.bahrainstock.com/ http://www.dsebd.org/ http://www.bse.com.bb/ http://www.bcse.by/eng/Stock.php Aggarwal(2006), same as Euronext

13 14 15 16 17 18

Bermuda-BSX Bhutan-RSEBL Bosnia-Banja Luka Botswana-BSE Brazil-BM&F Bovespa Bulgaria-BSE-Sofia

1971 1993 2001 1989 1890 1991

1992 Mutual - Pvt Ltd Mutual - Pvt Ltd Other 2007 1997 2007

1998 Floor 2002 Floor 1990 1997 2008 : Integration of Bovespa Holdings SA and BM&F SA to create BM&F Bovespa SA July 1997: Merger of BSE and Sofia stock exchange

Handbook 2009 http://www.rsebl.org.bt/ http://www.blberza.com bse.co.bw/abt_us/bse_committee.php http://www.bmfbovespa.com.br download.bse-sofia.bg/pdf/Ustav_en.pdf

38

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. 2001: Bolsa de Bogota, Bolsa de Occidente and Bolsa de Medellin merged to form CSE

Aggarwal(2006)

20 21 22 23 24 25

China-Shanghai Colombia-BVC Costa Rica-BNV Cte d'IvoireBRVM Cyprus-CSE Denmark-CSE

1990 1928 1976 1974 1996 1919

Mutual - Co-op 2007 1993 Mutual - Pvt Ltd Govt. owned 1996

2007

1990 1996 1991 1999 1999 1988

WFE 2008 WFE 2007 http://www.bolsacr.com/?proc=2-18 Handbook 2009 Handbook 2009 Aggarwal(2002)

February 1997: The Copenhagen Stock Exchange and the FUTOP Clearing Centre merged 2005: The exchange merged with OMX

26 27 28 29 30

Dom. Rep. Ecuador Egypt-EGX Fiji-SPSE Finland-Helsinki

1991 1969 1890 1978 1912

2001 Mutual - Co-op Other Mutual - Pvt Ltd 1995

Floor 1999 1997 Floor 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 2000: Paris Stock Exchange and Brussels' and Amsterdams exchanges formed Euronext 2000 : Marche a Terme International de France (MATIF) and ParisBourse formed Euronext Paris

www.bolsard.com/app/do/frontpage.aspx Handbook 2009 WFE 2008 Handbook 2009 Aggarwal(2002)

31

France-Euronext

1826

2000

1986

Aggarwal(2006), same as Euronext

32

Georgia-GSE

2000

Mutual - Pvt Ltd

2000

http://www.gse.ge/Rules/Charter_full.htm

39

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

Aggarwal(2006)

34 35 36 37

Ghana-GSE Greece-Hellenic Guyana-GASCI Hong Kong-HKEx

1989 1876 1992 1891

Mutual - Co-op 1999 Mutual - Co-op 2000

2000 2000

Floor 1992 2003 1986 2000: Hong Kong Stock Exchange, HKFE, and Hong Kong Securities Clearing Company Limited formed HKEx Nov 2005: Budapest Stock Exchange and the Budapest Commodity Exchange merged 2008: Merger of OMX and Iceland Stock Exchange 2007: Surabaya Stock Exchange and Jakarta Stock Exchange merged to become Indonesia Stock Exchange

http://www.gse.com.gh/index1.php?linkid=1 Aggarwal(2006) http://www.gasci.com/about_gasci.htm Aggarwal(2006)

38 39 40 41

Hungary-BSE Iceland India-NSE Indonesia-IDX

1864 1985 1993 1912

2002 1999 1993 Mutual - Pvt Ltd

1998 1989 1995 1995

Handbook 2006, Handbook 2009 Aggarwal(2002) Handbook 1998 WFE 2008

42 43 44 45

Iran-TSE Ireland-ISE Israel-TASE Italy-Borsa Italiana

1966 1793 1953 1808

2006 Mutual - Pvt Ltd Mutual - Pvt Ltd 1997

1994 2000 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 March 1, 2000: Tokyo Stock Exchange absorbed the Hiroshima and Niigata stock exchanges

www.iranbourse.com/Default.aspx?tabid=56 WFE 2008 WFE 2008 Aggarwal(2006)

46 47

Jamaica-JSE Japan-TSE Japan-OSE

1968 1878 1878 1978 1997 1954 1984

2008 2001 2001 Non-profit Pvt 2007 Mutual - Pvt Ltd Other 2004

2000 1982 1988 2000 1997 Floor 1995 2001: KASE became a stockholder of Kyrgyz stock exchange

Handbook 2009 Aggarwal(2006) Aggarwal(2006) WFE 2008 http://www.kase.kz/en/page/general_info http://www.nse.co.ke/ http://www.kuwaitse.com

48 49 50 51

Jordan-ASE Kazakhstan-KASE Kenya-NSE Kuwait-KSE

40

52

Kyrgyz

1995

Mutual - Pvt Ltd

1999

Handbook 2009

53 54 55 56 57 58

Latvia Lebanon-BSE Lithuania-VSE Luxembourg-LSE Macedonia-MSE Malaysia-BM

1993 1920 1926 1929 1996 1973

2002 Other 1998 Mutual - Pvt Ltd 2001 2004 2005

1997 2000 1993 1991 2001 1992

Aug 2002: Acquired by HEX

Handbook 2006 http://www.bse.com.lb/

2004: OMX purchased 44.3% of the shares of VSE

Handbook 2006 WFE 2008 Handbook 2006 Aggarwal(2006)

2001: KLOFFE and COMMEX.MDEX merged to form Malaysia Derivatives exchange 2002: KLSE and MESDAQ merged

59 60 61 62 63 64 65 66 67

Malta-MSE Mauritius-SEM Mexico-BMV Moldova-MSE Mongolia-MSE Morocco-CSE Namibia-NSX Nepal-NEPSE Netherlands

1992 1988 1894 1994 1991 1929 1992 1983 1600

Other 2000 2008 Mutual - Pvt Ltd Govt. owned Mutual - Pvt Ltd Mutual - Co-op Mutual - Pvt Ltd 1997 2008

1996 2001 1996 1998 1999 1997 1998 Floor 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

WFE 2008 Handbook 2006 Handbook 2009 http://www.moldse.md/ http://www.mse.mn/ www.casablanca-bourse.com/homeen.html http://www.nsx.com.na/about.php http://www.nepalstock.com/about/index.php Aggarwal(2002)

68 69 70 71 72 73

New Zealand-NZX Norway-Oslo bors Oman-MSM Pakistan Palestine-PSE Papua N. G.POMSoX

1915 1819 1988 1947 1995 1998

2003 2001 Govt. owned Other 1995 Mutual - Pvt Ltd

2003 2001

1991 1988 1998 1997 1997 1999

Aggarwal(2006) Aggarwal(2006) Handbook 2009 Handbook 2006 http://www.p-s-e.com/ http://www.pomsox.com.pg/profile.php

41

74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91

Peru-BVL Philippines-PSE Poland-WSE Portugal-BVLP Qatar-QE Russia-MICEX Serbia-Belgrade Sierra Leone-SETC Singapore-SGX Slovakia-BSSE Slovenia-LJSE South Africa-JSE South Korea-KRX Spain-BME Sri Lanka-CSE Swaziland-SSX Sweden-Stockholm Switzerland-SIX

1951 1927 1817 1825 1997 1992 1989 2007 1930 1991 1989 1887 1956 1831 1896 1990 1863 1938

2003 2001 Govt. owned 2000 2005 Mutual - Pvt Ltd Mutual - Pvt Ltd Other 1999 Mutual - Pvt Ltd 2006 2005 2005 2001 Other Mutual - Co-op 1993 2002 1993 2006 2006 2000 2003

1995 1993 1996 1991 1998 1994 2004 Floor 1989 1994 1993 1996 1988 1989 1997 Floor 1989 1996

March 1996: LSE took over the Bolsa de Valores de Arequipa 1992: Manila Stock Exchange and Makati Stock Exchange formed Philippine Stock Exchange 2002: BVLP and Euronext formed Euronext Lisbon

Handbook 2009 Aggarwal(2006) http://www.gpw.pl/ Handbook 2001 http://www2.dsm.com.qa/ http://www.micex.com/group/profile/structure www.belex.rs/eng/o_berzi/o_berzi_pregled www.bankofsierraleone-centralbank.org/

Dec 1999: SES and SIMEX formed SGX

Aggarwal(2006) http://www.bsse.sk/index2.aspx?LANG=EN www.ljse.si/cgi-bin/jve.cgi?doc=2325&sid= Handbook 2006

Jan 27, 2005: KSE, KOSDAQ Stock Market and KOFEX merged to establish Korea exchange. 2001: Madrid, Barcelona, Bilboa and Valencia Stock Exchange formed BME Group

Handbook 2006 Aggarwal(2006) WFE 2007 http://www.ssx.org.sz/

1998: Merger of OM and Stockholm Stock Exchange 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

http://www.nasdaqomx.com/ Aggarwal(2006) www.sixgroup.com/about/ownership_en.html

92 93 94 95 96

Taiwan-TWSE Tanzania-DSE Thailand-SET Tunisia Turkey-ISE

1961 1998 1974 1969 2000

Mutual - Pvt Ltd Mutual - Co-op Other Mutual - Pvt Ltd Other

1985 Floor 1991 1996 1993

serv@twse.com.tw http://www.dse.co.tz/main/index.php?page=1 WFE 2008 http://www.bvmt.com.tn/ WFE 2008

42

97 98 99 100 101

Uganda-USE UAE-DFM UK-LSE Ukraine-USE US-NYSE US-CBOT US-CME US-ISE US-NASDAQ Venezuela Vietnam-HOSE Zambia-LuSE Euronext

1773 1992 1792 1992 1792 1848 1898 2000 1971 1840 2000 1994 2000

Mutual - Co-op 2005 2000 Mutual - Pvt Ltd 2006 2005 2002 2002 2001 Mutual - Pvt Ltd Govt. owned Mutual - Pvt Ltd Incep 2001 2006 2005 2002 2005 2002 2007 2001

Floor 2000 1997 1996 2000 1998 1992 2000 1985 1992 Floor Floor Incep 2000: Amsterdam, Brussels and Paris exchanges merge to create Euronext 2002: LIFFE is acquired by Euronext BVLP merges with Euronext to become Euronext Lisbon 2007: NYSE Group and Euronext merge 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 2007: Nasdaq buys OMX Nov 1998: American stock exchange and NASD merged 2007: NYSE and Euronext merged to form NYSEEuronext. Feb 27, 2008: Nasdaq bought OMX October 1, 2008: NYSE Euronext acquired AMEX Dec 19, 2007: Eurex acquired ISE 2007: LSE acquired Borsa Italiana

Handbook 2009 http://www.dfm.ae/pages/default.aspx?c=801 Aggarwal(2006) http://www.ukrse.kiev.ua/ Aggarwal(2006) Aggarwal(2006) Aggarwal(2006) Aggarwal(2006) Aggarwal(2006) Handbook 2009 http://www.hsx.vn/ http://www.luse.co.zm/

102 103 104 105

Panel B: Multiple country Exchanges

106 107

NYSE Euronext OMX

2007 2003

Incep Incep

Incep Incep

Incep Incep

108

Nasdaq OMX

2007

Incep

Incep

Incep

Notes. 2007 Cost and Annual survey by World Federation of Exchanges categorizes stock exchanges as 1) Private, limited companies 2) Demutualized, but not publicly listed exchanges 3) Publicly listed exchanges 4) Associations, mutuals 5) Other legal group exchanges. We consider categories 2 and 3 as demutualized exchanges. For Austria, we gather information on demutualization through the Wiener Boerse website. We categorize Switzerland as demutualized through information on their website and we also verify it from Aggarwal (2006). We gather information about stockholders of Taiwan stock exchange through email and classify it as member-owned. Website addresses eliminate the characters http:// and www as needed to save space. Some long Internet addresses are truncated to show the homepage address.

43

Table II Stimulants of Demutualization: Effect of market concentration, technology driven growth opportunities and product driven growth opportunities We 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. We define 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 growth opportunities, market concentration and demutualization parameter. In Panel B, we estimate the effect of Technology growth opportunity, new product driven growth opportunities and market concentration on the change in the ownership structure of exchanges from mutually owned to demutualized ownership. We present the parameter estimates of the Cox proportional Hazard model for survival of mutual exchanges. The proportional hazards model is represented as: hi(t) = h0(t) exp(Xi(t) ) where the Xi are the technology driven growth opportunities and new product driven growth opportunities, market concentration, which is inverse of lag of number of exchanges in a country, market value as % of GDP, trading volume as % of GDP and index of Economic freedom. Market value as % of GDP and trading volume as % of GDP are from the World Bank Group website. Economic freedom component score is from Heritage foundation website. For two observations, i and j, the ratio of two hazard function can be expressed as follows. = exp[1(Xi1-Xj1)++1(Xik-Xjk)] Variable Demutualization Technology driven growth opportunity Product driven growth opportunity Market concentration Panel A: Correlation matrix Demutualization Technology driven growth opportunity 1 0.1545*** 0.1382*** 0.021 1 0.3919*** -0.0576*** 1 -0.3128*** 1 Product driven growth opportunity Market concentration

Panel B: Cox Proportional Hazard model applied to demutualization decisions Variable Model 1 Model 2 Model 3 Technology driven growth opportunity Product driven growth opportunity Market concentration Market cap (% of GDP) Value Traded (% of GDP) 0.9689* 1.3895*** 1.2304* 1.7167* 1.3354*** 1.4116* 0.0009 0.0041 1.0829* 1.3279*** 1.1513*

Economic Freedom 0.0202 component score The symbols ***,**,* indicate significance at the 1%, 5% and 10% level respectively.

44

Table III Country 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 on world index during the same period is also listed. The difference between the two is presented in last column. The average difference is positive and significant at 10% significance level. Return during last 2 Benchmark world Country/Exchange IPO Difference years return Australia-ASX 1998 16.08% 11.10% 4.99% Australia-SFE Brazil-BOVESPA Canada-TSX Colombia-BVC Euronext4 Germany-Deutsche Boerse Greece-Hellenic Hong Kong-HKEX Japan-OSE Malaysia-Bursa Malaysia Mexico-BMV New Zealand-NZX Norway-Oslo Bors Philippines-PSE Singapore-SGX South Africa-JSE South Korea-KRX Spain-BME Sweden-Stockholm UAE-DFM UK-LSE US-CBOT US-CME US-ISE US-NASDAQ US-NYSE 2002 2007 2002 2007 2001 2001 2000 2000 2004 2005 2008 2003 2001 2003 2000 2006 2006 2006 1993 2007 2001 2005 2002 2005 2002 2006 6.38% 35.25% 18.87% 81.38% 17.64% 21.56% 72.08% -19.56% -20.98% 8.25% 41.18% 2.02% 6.95% -17.21% -16.54% 18.93% 24.80% 25.58% -11.90% 72.93% 8.50% 1.00% 2.71% 1.00% 2.71% 18.37% -16.98% 16.12% -16.98% 16.12% 4.48% 4.48% 24.93% 24.93% 4.83% 24.74% 16.95% -18.03% 4.48% -18.03% 24.93% 13.30% 13.30% 13.30% 3.52% 16.12% 4.48% 24.74% -16.98% 24.74% -16.98% 13.30% 7.44% 23.36% 19.13% 35.85% 65.26% 28.75% 17.08% 47.15% -44.49% -25.81% -16.49% 24.23% 20.05% 2.47% 0.82% -41.47% 5.63% 11.50% 12.27% -15.42% 56.81% 4.02% -23.74% 19.69% -23.74% 19.69% 5.07% 8.62%*

Average 15.48% The symbol* indicates significance at the 10% level.

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

45

Table IV Economic 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 where leading exchange has demutualized. We find that the countries which had post demutualization merger activities in financial exchange industry have a higher economic freedom. The difference between average scores between Panel A and Panel B are 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 Panel B: Countries with no merger activities after leading exchange demutualization of leading exchange Overall Types of Economic Freedom Overall Types of Economic Freedom Country Country Score Business Trade Investment Financial Score Business Trade Inv. Fin. European countries: Armenia 69.2 83.4 80.5 75 70 Belarus 48.7 72.1 80.3 20 10 Austria 71.6 73.6 87.5 75 70 Greece 62.7 77.4 82.5 60 60 Belgium 70.1 92.9 87.5 80 70 Hungary 66.1 76.8 87.5 75 70 Bulgaria 62.3 77.8 87.4 50 60 Kazakhstan 61 73.5 85.9 30 50 Denmark 77.9 97.9 87.5 90 90 Macedonia 65.7 65.2 83.3 60 60 Finland 73.8 95 87.5 75 80 Norway 69.4 88.8 89.2 65 60 France 64.2 86.3 82.5 50 70 Germany 71.1 89.6 87.5 85 60 Iceland 73.7 93 87.9 65 60 Latvia 66.2 72.9 87.5 80 50 Lithuania 70.3 82 87.5 75 80 Netherlands 75 82.6 87.5 90 80 Portugal 64.4 80.5 87.5 70 60 Spain 69.6 75.8 87.5 80 80 Sweden 72.4 95.5 87.5 85 80 UK 76.5 94.9 87.5 90 80 Italy 62.7 77.9 87.5 75 60 Slovenia 64.7 83.3 87.5 70 50 Switzerland 81.1 81.2 90 80 80 Non-European countries: Australia 82.6 90.3 85.1 80 90 Bahamas 67.3 73.4 42.2 30 70 Brazil 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 50 Hong Kong 89.7 98.7 90 90 90 Dom. Rep. 60.3 62.4 80 55 40 Singapore 86.1 98.2 90 75 50 India 53.8 36.3 67.9 35 40 South Korea 69.9 91.9 70.8 70 70 Iran 43.4 69.9 50.2 10 10 US 78 91.3 86.9 75 70 Japan 72.9 84.5 82.4 60 50 Malaysia 64.8 69.9 78.7 30 50 Mauritius 76.3 82.2 85.6 85 70 Mexico 68.3 83 82 65 60 New Zealand 82.1 99.9 86 80 80 Peru 67.6 65.8 85 70 60 Philippines 56.3 48.1 77.8 40 50 Qatar 69 73.7 82.2 45 50 South Africa 62.8 73 76 45 60 UAE 67.3 67.4 82.8 35 50 Average 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 Wilcoxon rank sum 3.06*** 3.69*** 4.07*** 4.20*** 3.61*** Z-statistics The symbol *** indicates significance at the 1% level.

46

Table V Trends in trading volumes before and after Demutualization We estimate the following regression equation: Country trading volume = + Pre-demutualization + Post-demutualization + World volume + lagged Return Pre-demutualization dummy is 1for the 24 months preceding the demutualization, and 0 otherwise. Postdemutualization dummy takes value 1 for the months after demutualization, and 0 otherwise. We control for world volume and lagged country returns. We divide the coefficients of pre-demutualization and post-demutualization dummies by the mean monthly volume during the last 1 year before the demutualization. A higher value of postdemutualization variable than the pre-demutualization variable shows a positive effect of demutualization on the trading volume of the country. Country Pre-demutualization Post-demutualization 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Australia Austria Belgium Brazil Canada Colombia Denmark Finland France Germany Greece Hong Kong Hungary Italy Japan Malaysia Mexico Netherlands New Zealand Norway Philippines Portugal Singapore South Africa South Korea Spain Sweden Switzerland UK -0.93*** -0.56*** -1.47*** 0.18*** -0.67*** 0.93*** -0.41 -4.42** -0.23*** 0.56*** 0.07 -1.23*** -3.19** -1.07** -0.55*** -0.30** 0.32*** 0.50*** -0.09 -3.09*** -2.77*** 0.23** -1.16*** 0.33*** 0.13 -1.05*** -1.28 -0.33*** -0.03 -1.62*** -1.74*** -0.91*** 1.15*** -0.35*** 1.01*** -1.78*** -6.60*** 0.08* -0.39*** -0.36*** -1.06*** -1.44 -0.83** 0.14 0.05 0.17*** 0.94*** 0.33*** -1.02*** -2.96*** -0.30*** -1.19*** 1.10*** 0.47*** -0.20*** -1.97*** -0.06 0.32***

30 USA -0.09*** -0.07*** The symbols ***,**,* indicate significance at the 1%, 5% and 10% level respectively.

47

Table VI Country-by-country analysis of change in equity premium and liquidity after demutualization In this table, we report the changes in the equity premium for 30 countries after the demutualization of leading exchange in the country. Changes in dividend yield plus capital gains (DYCG), dividend yield plus capital gains (DYCG$), Excess return in local currency minus world return in U.S. dollars (ERW) are reported. Changes in trading turnover and LiquidityAmihud are in the last two columns. Average change and proportion of countries with decline in equity premium and increase in turnover and liquidity are reported in Panel B. We also report the results of Wilcoxon rank sum test for the change in equity premium and liquidity after the demutualization in Panel B. Country DYCG DYCG$ ERW Turnover Liquidity Panel A: Country-by-country analysis Australia -0.40% 0.20% 0.19% 3.47% 0.03 Austria -0.13% 0.16% 0.53% 0.02% 0.00 Belgium -1.00% -0.53% -0.03% 2.32% 0.01 Brazil -2.08% -1.27% -0.61% 1.99% 0.02 Canada -0.49% 0.00% 0.20% 4.30% 0.08 Colombia -0.59% 0.12% 1.08% 0.33% 4.74 Denmark -0.31% -0.29% -0.17% 3.75% 0.07 Finland 0.44% 0.61% 0.45% 7.67% 0.01 France -1.57% -0.96% -0.92% 4.44% 0.01 Germany -1.48% -0.88% -0.83% -14.64% -0.10 Greece -2.82% -1.81% -2.34% 1.30% 0.00 Hong Kong -0.93% -0.93% -0.28% 0.29% 0.15 Hungary -0.69% 0.75% -0.72% -4.34% -0.40 Italy 0.14% 0.40% 0.61% 8.76% 0.58 Japan 0.05% 0.24% 0.15% 5.40% 10.26 Malaysia -0.44% -0.12% -0.13% 0.74% -0.02 Mexico -2.57% -3.11% -0.50% -0.32% -0.05 Netherlands -0.93% -0.97% -0.30% 5.49% 0.05 New Zealand -0.06% 0.31% -0.40% 1.26% 0.00 Norway -0.38% 0.45% 0.18% 6.84% 0.12 Peru 0.91% 1.62% 0.44% -1.50% 0.00 Philippines -0.14% 0.52% 0.03% -0.21% -0.02 Portugal -1.13% -0.42% -0.41% 3.03% 0.01 Singapore -0.24% -0.16% 0.64% 3.03% 0.01 South Africa 0.00% 0.42% 0.18% 3.41% 0.06 South Korea 0.26% 0.25% 0.53% 2.67% 40.03 Spain -0.69% 0.34% -0.49% 5.08% 0.07 Sweden -0.40% -0.14% 0.27% 6.96% 0.28 Switzerland -0.78% -0.34% -0.90% 3.02% 0.06 UK -1.04% -0.95% -0.27% 6.05% 0.08 US -1.01% -1.01% -0.23% 15.34% 21.64 Panel B: Summary Statistics: Average Change and Proportion of Countries Average change -0.66% -0.24% -0.13% 2.77% 2.51 Proportion of countries 81% 52% 55% 84% 71% Wilcoxon Z-statistics -3.95*** -1.32* -0.83 3.17*** 2.32** The symbols ***,**,* indicate significance at the 1%, 5% and 10% level respectively.

48

Table VII Effects of demutualization on equity returns and liquidity We estimate regression for cost of capital and turnover variables for 31 countries on world measures and other control variables. Dividend yield plus capital gains, excess return over world and turnover are based on exchangemonths 10 years before and after the date of demutualization of leading exchange. Demutualization is an indicator that signifies demutualization of leading exchange in a country. Market capitalizations are in trillions of U.S. dollars. World market is the (1) average world dividend in month t for DYCG model (2) average world turnover for the turnover model. Time trend gives the relative position of the month starting from the beginning of the data. Statistical significance is based on White's heteroscedasticity-consistent standard error. Dividend yield plus Excess return over Dependent variable -> Turnover capital gains (DYCG) world (ERW) Intercept 0.0000 0.0000 0.0000* Demutualization Market capitalization World Time trend Number of observations Adjusted R-square -0.0259* -0.0202** 0.5882*** 0.0160 6456 34.68% 0.0219 6456 0.04% -0.0280 -0.0255** 0.0397** 0.1895*** 0.1421*** -0.0363 6456 6.12%

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

49