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Demutualization of Stock Exchanges in Africa: Prospects and Problems

Demutualization is the process by which stock exchanges streamline governance issues relating to ownership and management, improve and expedite decision-making, and raise new capital. Worldwide, demutualization is driven by forces of globalization, competition and advances in technology of trading securities. Converting a stock exchange from a member-owned and managed to a for-profit, shareholder-owned corporation triggers many issues relating to ownership, management and market regulation. Many articles have examined the governance of stock exchanges; however, those devoted to African stock exchanges are scanty. This article tries to evaluate the relevance of factors driving demutualization, and review the prospects for and problems of demutualization in African stock markets. To realize their full potentials as financially viable, liquid and emerging markets, African exchanges have to restructure; but there are both prospects and challenges. Market justification reflected in a critical mass of trading activity to support financial viability, further market liberalization and mechanisms for reducing conflict of interest are critical as is government support. But exchanges must desist from donor pressures to demutualize and move cautiously through preparation, process, and post-demutualization.

Introduction

Governance issues are currently high in development and business agenda. Corporate governance is a broad term encompassing rules and market practices, which determine how corporations are owned and managed, the transparency of their decision-making process, the accountability of their directors, managers and employees, the information they disclose to investors and the protection of minority shareholders. Accordingly, it involves issues of company and securities laws, listing rules of a country’s stock exchanges, accounting standards applicable to listed firms, and competition and bankruptcy laws. It also includes the government regulatory agencies with which firms and their shareholders deal, and the regulators’ actions to ensure compliance with applicable laws and regulations (Onyuma 2004). Moreover, it also involves the courts that are called upon by shareholders, directors and managers to resolve governance disputes and enforce set rules.

Globally, stock exchanges are overhauling their corporate governance structures due to a more demanding competitive environment. A combination of factors has increased pressure on the exchanges' businesses. Research on governance (ICC 2006; OECD 2003; Akhtar 2002) concentrate more on government and corporations while ignoring institutions like capital markets and their regulators. Whereas stock exchanges are the major capital markets, they in themselves are also organizations with owners, managers and clients. In analysing the nature and conduct of African stock exchanges, there has been a tendency of ignoring their inner structures by viewing them merely as a trading system guided by their owners and not as corporations. These approaches are not rich enough in detail to explain the nature and conduct of stock exchanges. Moreover, despite the analyses examining the governance of stock exchanges, those devoted to African stock markets are very few. Nonetheless, stock exchanges form the basic structure of African development financing source. However, their future role lies in their growth and development, which calls for the need to restructure their ownership and management structures. The purpose of this article is to explore the prospects and possible problems of this reorganization in African Context.

Demutualization refers to the entire process of changing the legal structure of a stock exchange from a mutual association, with one-vote per member and usually consensus based decision-making to a company limited by shares, with one-vote per share and with majority decision-making (IOSCO 2005). It involves the separation of trading rights from ownership, and in most cases the exchange becomes a for-profit firm and even, self-list (Akhtar 2002). It has more potential for profit, and also for failure, than before, and like any business, it must stand alone for financing.

The Stockholm Stock Exchange was the first to react to this changing environment by restructuring its corporate governance in 1993 by demutualizing. Initially, it was organized as a mutual, comprising a one-member one-vote control structure and a not-for-profit orientation of their value. The mutuals' objective function is to maximize their members' utility (Karmel 2000). In the process of demutualization, exchanges change their institutional setting towards a profit-oriented one-share, one-vote structure as in other corporations. Several other exchanges in Oceania (ASX), Canada (TSE), Europe (LSE), Asia Pacific (HKEx, SGX) and Africa (JSE), followed suit.

Some exchanges merely restructure their voting system and alter their objective function towards profit-orientation, but mostly retain their old shareholders. This type of reorganization does not involve a change in the type of owners, although an internal reallocation of shares and votes may have occurred in order to more closely align the customers' voting power with their respective volume of business. Such exchanges basically remain dominated by their customers. Other exchanges have decided to go one step further by selling a substantial portion of their shares to outsiders through an IPO (self-listing). Thus, outsiders, who are non-customer and have financial interest in the exchange, dominate their ownership structure. Aggarwal (2002) has described the various stages of the process, and regarded self-listing of an exchange with a widely dispersed shareholding as the final step of restructuring an exchange.

Between 1999 and 2003, the number of exchanges organized as mutuals fell from 40 to 25 while the sum of those demutualized and publicly listed rose from 10 to 25 in the same period (IOSCO 2005). A combination of factors led to increased pressure on the exchanges' businesses (Pirrong 2000). These include globalization and market integration; stiff competition among exchanges, and between exchanges and alternative trading systems like electronic communication networks; need for good governance practices; efforts to improve investor participation; raising needed capital investment capital, pressure to unlock stock exchange value to owners; and attempts to integrate with other exchanges having strategic shareholders with specialized know-how and to import international skills and technical efficiencies into the domestic market.

The changing investment behaviour of stock exchange clients, which became less home-biased and sought to diversify their capital globally, results in increased competition for order flow amongst exchanges. In Europe, the deregulation of the financial markets and wider market reforms opened the path for increased competitive pressure on the incumbent institutions (Steil 2002). The primary effect on stock exchange competition is due to the developments in information technology and the reduction in communication costs, which result in the emergence of new ways of trading. Remote membership, electronic order book trading, electronic communication networks, and the internalization of order flow by intermediaries are now real threats to the traditional exchange floor trading.

Research (Pirrong 2000; Serifoy 2005; Gompers et al. 2001) highlights numerous advantages of exchange demutualization. Mendiola and O'Hara (2003) analyzed the share performance and valuation of listed exchanges and found a positive link between the fraction of equity sold to outside investors and stock exchange performance. There also seems to exist positive impact of demutualization on cost efficiency of European exchanges. African stock exchanges may also stand to derive several benefits through demutualization.

Demutualization may be the key solution to many of the problems bedeviling African mutual exchanges. The demutualization process can improve the competitiveness of African exchanges. The main motives of and expected benefit from demutualization include tapping new sources of capital through initial public offering (IPO) needed to modernize exchange trading systems. Such capital cannot be obtained through mutualized status. In fact, stockbrokers and governments cannot enable a commercial entity to raise such capital from shareholders, as do corporations. Second, demutualization can enable exchanges to pursue business opportunities unconstrained by vested interest issues since it allows for diversification of the exchanges’ shareholder base, thus improving their corporate governance. This makes the separation of ownership rights from trading rights possible. In fact, boards of directors of African exchanges would be made up of shareholders and other investors without state representation. Although state appointments may be conducive to mitigate entrenched vested interests in the short-run, they can prove counter-productive, leading to unhealthy interference by the state in the long-run. This will enable African exchanges to increase investor participation better than they currently do.

Moreover, demutualization would allow African exchanges to achieve better operational cost control, and to increase flexibility, efficiency and competitiveness through reviewing their commercial strategy. Such exchanges elsewhere have achieved consolidation in their domestic markets by merging the derivatives and cash segments or by including trading, clearing and settlement services under one roof to create economies of scale and scope (Onyuma 2005). Usually, demutualization is accompanied by the development of cross border exchange linkages and international alliances among various exchanges. Several demutualized exchanges in the UK and Oceania, US and Canada, and Asia Pacific have trading links and dual listing agreements with each other. Thus, it will speed up the ongoing process of integrating African stock markets.

In addition, demutualization would allow African exchanges to sell their equity stake to a mix of shareholders; decision-making would be based on the new ownership structure, not on the rights of intermediation or state representation, which ensures an effective oversight of the board of directors. Using new capital raised, exchanges would have the incentive and the resources to invest in the competitiveness of their information systems. They would be capable of introducing new products, recruit high-calibre staff, compete on an expensive technology level, leverage the value of the exchange as a brand name, and bring African exchanges to international standards.

Furthermore, the new structure would ensure that the management of African exchanges are fully qualified and motivated to act in the best interests of the shareholders and conduct the business in a prudent manner, which enhances orderly and fair-trading in African capital markets.

Various academic analyses (Elliot 2002; Krishnamurti et al. 2002; Hart and Moore 1996) also point to the fact that, along with the above benefits, some problems may confront the demutualization process. There are many obstacles on the way of Africa's demutualizing its exchanges. These obstacles stem from its economic, political, and other non-economic factors (Mensah 2005; Mensah and Moss 2004; Moss 2003) like the nature of its rudimentary capital markets, and its ability to deal with problems inherent in demutualization.

Cost of Demutualization. The costs associated with an exchange IPO are huge. Deutsche Borse and Euronext, respectively paid 36.8 million and 46 million euros for their quotation. Although the proceeds received from an IPO naturally more than recouped these costs, the IPO-costs amounted to 3.7% of the new proceeds in Deutsche Borse's case, and 12.7% for Euronext. Besides these one-off costs, there are also additional running costs such as stricter disclosure requirements. A strategic implication is that African exchanges may become prone to be easily taken over by other giant foreign institutions with higher investment capital endowment.

Partial Market Liberalization. Capital markets in Africa are not yet sufficiently liberalized to enable a for-profit stock exchange to explore an expanded opportunity set. For example, markets such as Ghana, still have capital account restrictions that limit the ability of an exchange to implement cross-border strategies, such as cross-listing. Other markets, including Kenya, have stringent and expensive listing requirements, while others still have capital gain tax.

Exchange Financial Sustainability. Of the 20 stock exchanges in Africa, only about 7 are likely to be financially viable. These are those exchanges with a combined market capitalization of at least $2 billion and at least 40 listings (Mensah 2005). Exchanges in Egypt, Kenya, Mauritius, Morocco, Nigeria, South Africa and Zimbabwe may have such critical mass.

Conflict-of-Interests. Ownership in demutualized exchange becomes problematic, as there are the difficulties in the choice of the financial institutions to become shareholders and marrying powers wielded by former member-owners and other new shareholders. The power wrangles in most African countries may trickle into exchanges, thus increasing the possible effect of conflict-of-interests between old owners and new shareholders, and an exchange and its regulator.

Political Bottlenecks. Where they still provide financial support to exchanges, African governments may not be in a hurry to demutualize stock exchanges. As long as exchanges are in their current mutualized form and seen as national symbols, governments will continue to provide financial support, with the usual under-funding and intermittent disbursements. They may only act when put under pressure by donors. After all, some donors have preference for supporting exchanges; for instance, the IFC provided seed money for the Ghana Stock Exchange and the BRVM, while SIDA has long supported the Tanzania, Uganda and Zambia exchanges.

Thin-Illiquid Markets. For a long time, Africa had only eighteen stock exchanges. Mozambique and Cameroon have just established their exchanges, bringing the total number of stock exchanges to twenty. African exchanges are small, illiquid and poorly regulated, with most markets classified as frontier-markets, and not emerging-markets. The Economist magazine that publishes weekly economic data on emerging markets only classifies South Africa and Egypt. Exchange market capitalization to GDP is as low as 3% in Swaziland, compared to about 71% in other emerging markets like Malaysia, or 262 % in UK and 131 % US.

Low Turnover. African stock markets lag in terms of market turnover. According to the 2004 issue of Standard & Poor Global Markets Fact Book, liquidity as measured by market turnover in African stock exchanges is low. Markets such as Ghana have turnover ratios as low as 4%, Kenya (7.4%), and BRVM (1.6 %). Even South Africa and Egypt, the largest and most liquid markets in Africa, have turnover of 44.8% and 13.7% respectively, and Nigeria 11 %. Others like Namibia even show zero turnover. This contrasts with the turnover ratios in developed markets of US (123%), UK (101%) and in other emerging markets such as India (138.5%). The number of listed firms is very low for most countries. Egypt and South Africa are outliers with listings of 967 and 426 respectively. Countries like Tanzania and Uganda have as few as eight listed firms although there are countries, such as Nigeria, Zimbabwe and Kenya and Morocco, with over 50 listings. This may create supply constraints and worsen liquidity, a critical success factor for demutualized exchanges.

Dominance by Foreign Firms. African stock exchanges are dominated by foreign firm listings of local subsidiaries of multinationals like StanChart Bank, Barclays Bank, Unilever and Guinness. While the parent company may be cross-listed in a number of developed markets, the subsidiary listing is domesticated, with no incentive for the listed local subsidiaries to migrate.

Poor Macroeconomic and Regulation. Some factors impeding performance of African states may also influence their exchange demutualization. According to Mensah and Moss (2004), many African states still have high budget deficits, high and volatile inflation, volatile and fast depreciating exchange and interest rates. Policy inconsistency and macroeconomic instability undermine investor and issuer confidence, thus dampening business flow to stock exchanges. Most African capital markets lack robust regulatory frameworks since fifteen out of nineteen markets have a formal oversight agency. There are rules for members and listings for every stock exchange, shortage of experienced supervisors and the absence of a strong culture of compliance with rules (Vittas 2003). Such poor regulatory enforcement may increase the problem of conflict-of-interest common with demutualization.

A demutualized exchange focuses on profit and wealth maximization of its shareholders. It has less incentive to take enforcement actions against its customers or users, who are a source of income. Given their rudimentary nature, most African exchanges would have the problem of balancing regulation by themselves and by their regulators. Self-regulatory functions of a demutualized exchange pose a challenge both for the exchanges themselves and the capital markets regulators.

Market Infrastructure. Given their sizes, African capital markets lack the resources needed to acquire key infrastructure for market operations. Ten African exchanges do not have central depository systems. Although this is a positive drive force for demutualization, it is constrained by the limited profitability prospects of most African exchanges.

Poorly Trained Finance Staff. In more developed countries, a large part of the training in capital markets is done on-the-job. Working in modern capital markets requires fundamentally different skills than working in rudimentary markets. Training in management of financial institutions is still inadequate in many African countries. With demutualization, exchange management staffs, who previously operated in a cooperative mode, might find it difficult to assimilate commercial mindset or develop the necessary capacity to execute sound business strategies.

Thin Stocks Investor Base. African markets are characterized by a small investor-base as most people have low incomes with little to save and invest. There is also a small institutional investor-base with most markets having as few as five securities markets firms. This limited investor-base may influence the financial viability of demutualized exchanges.

Wrong Reasons for Setting up Exchanges. With the exception of older exchanges like South Africa, Kenya, Egypt, Zimbabwe and Nigeria, most African exchanges have been set up as state initiatives, and benefit from state subsidies to cover operating costs. According to Moss (2003), the reasons why African states promote exchanges are both technocratic and political. The technocratic reasons are the standard economic reasons normally advanced by technocrats to justify formal capital markets like a source of long-term finance, improved capital allocation and savings mobilization. Other complex, non-economic factors which underpin government objectives for promoting exchanges are inconsistent with the market reasons for demutualization. Most exchanges emerged as symbols of international legitimacy of a country. Others came into being due to geographical advantage; for example, BRVM is a regional exchange for the eight west African countries belonging to WAEMU. Prior to BRVM, there was only one exchange within the zone, in Cote d’Ivoire. Exchanges are sometimes seen as symbols of democratising state corporations and tools for indigenisation of economy. The implication is that demutualization in Africa may not be driven by market-based reasons.

Experience from countries where demutualization has taken place show that many issues arise during and after demutualization. Evidence from Europe, Oceania, America, and Asia Pacific reveal certain preconditions important for successful demutualization.

Self-Listing. In order to achieve the full benefits of restructuring, demutualization should not simply be a matter of turning into a for-profit entity owned by members. A truly demutualised exchange would be better placed if it were able to unlock its hidden value for all stakeholders in order to maximize its potential market capitalization and shareholder value (Scullion 2001). OECD (2003) concurs that being listed is likely to improve the value of the exchange to operate more efficiently. Therefore, African exchanges should include self-listing in their demutualization plans.

Improving Profitability. The justification of demutualizing African exchanges in terms of the mobilization of resources for investment and the unlocking of stock exchange value depends on the assumption that these exchanges will be profitable in future. Excluding Egypt, Nigeria, Kenya, and Mauritius, African stock markets operate below break-even paid due to their small sizes. Since most of them rely on states and donors to support their functions, demutualization is unlikely to result in more resources.

Financial Sustainability. Successful demutualization implies that there must exist a market justification based on a critical mass of trading activity that supports financial viability. Demutualization calls for an exchange’s ability to raise more capital and make investment that bring home more revenues, other than from traditional sources like membership subscription fees, listing fees, trading charges, clearing and settlement fees, and fees from sale of listed company news and quote data. African exchanges operate at a deficit and have enjoyed financial support from government and donors. As stand-alone entities, some may become insolvent. African exchanges must develop profitable operation driven by well-developed economies, market size and business strategies. They must also possess the ability to introduce new financial products to increase liquidity and turnover since a for-profit demutualized structure does not guarantee profitable existence. Market regulators must be able to closely monitor the financial condition of demutualized exchanges. In Australia (ASX) a reserve fund was created to provide a capital cushion, and Canada (TSE) provides an early warning system whereby the exchange is required to maintain certain financial rations and to notify regulators when not in compliance.

Mechanism for Dealing with Conflicts-of-Interests. Demutualization raises many questions about the regulation of stock exchanges. Traditionally, exchanges are self-regulating, in which they set trading rules, conduct surveillance and enforce the rules on market manipulation; oversee the trading system to avoid abuses; establish rules governing the conduct of their members, and monitor compliance with the rules. Attempts to maximize profits could undermine self-regulation.

Demutualized African exchanges can establish a separate entity to conduct regulatory functions, thereby avoiding conflict-of-interest issues. Nasdaq has created two subsidiaries: Nasd Regulation Inc (regulatory arm), and the Nasdaq Stock Market (commercial trading arm). They can also outsource their regulation to a third party. This approach may help avoid the perception of conflict of interest. However, the third party regulator must be accountable and perform its functions effectively. Most conflicts in demutualization already exist with the mutual exchanges as the temptation to hurry through a lot of listings is high even for mutual exchanges.

Demutualization may exacerbate this due to stronger profit motive, unless the listing approval is taken away from the exchange. In Africa, where regulatory systems are fragile, an effective relationship between the for-profit stock exchange and the regulator must be forged, and investor confidence maintained. African regulators must be a significant player in the demutualization process. There is also a need to establish a dispute resolution system to resolve conflicts of interest among exchange members, and between the exchanges and securities markets regulator.

Risk Management and Investor Protection. Development of sophisticated risk management tools for the capital market is critical. The more the exchange improves its risk management techniques, the more investors are protected and transparency increased. Areas worth considering may include capital adequacy ratios, margin trading rules, short-selling regulations, and et cetera. African exchanges must have the capability to provide investor protection by improving corporate governance and disclosure of listed firms.

Further Market Liberalization. Capital gain taxes also discourage stock investments. Capital accounts are also not conducive for the creation of a for-profit exchange as they could inhibit its ability to implement business strategies like cross-border dealings. Africa must sufficiently liberalize its capital market where for-profit exchanges can survive with new business strategies.

Commitment from all Stakeholders. The most important task to demutualized exchanges is remaining financially viable. The road to demutualization is a complex one that requires total commitment from former owners, managers and the state. IOSCO (2005) has found that the process of demutualization has been uneven between developed and emerging markets. In emerging markets, the decision-making process is largely policy-led while in developed markets it is market-led. Because the impact of market forces may not be at the same level as that of a developed market, exchange-restructuring issues are considered from the perspective of national policy.

Strong support by the state is needed to resolve thorny issues, like how to allocate ownership of an exchange that was limited by guarantee prior to demutualization, and the relationship between the regulator and a demutualized exchange. The post-demutualization also calls for continued state support and the support from other stakeholders. Valuation of shares of an exchange is complex and challenging, and a critical issue in demutualization since, before demutualization, owners may have owned seats, which will have to be converted into moneterized shares. Accommodating all stakeholders will be crucial, otherwise, demutualization efforts would collapse.

As at April 2005, exchange demutualization had been completed in only five jurisdictions out of a total of 76 emerging market jurisdictions. The demutualization fever has not caught on in Africa as compared to other emerging markets. Discussion about prospects of demutualization in Africa cannot be complete without profiling the African exchange pace-setter, the Johannesburg Stock Exchange (JSE). In Africa, only one exchange, JSE, has fully demutualized on 1 July 2005 (JSE 2005). After 118 years as a mutual entity, JSE Limited joined the world’s most prominent international exchanges in operating as a fully-fledged publicly-listed corporate.

To give effect to the demutualization, all existing right holders received 1,000 new JSE Limited shares in exchange for each right held. As a result of a statutory requirement, no single shareholder may own more than 15 per cent of the shares in issue. In order to create a market for the shares, the JSE first created an over-the-counter (OTC) trade using its own trading system and Strate as the settlement agent. This was necessary to enable the future listing of JSE owned shares. The exchange had 8.3 million shares, each trading on the OTC market at between R220-250. To meet its own listing requirements that a listed firm needed more than 25 million shares in issue, the JSE split its shares in issue ten to one, implying a listing price in the range of R22-25. Following the amendments to the Income Tax Act that resulted in the exchange losing its tax-exempt status, the exchange decided to self-list. On 5^th June 2006, JSE Ltd was listed on its own trading board by offering for sale 84.27 million shares, which, based on their OTC trading prices, were valued at R2.1b ($310.7m).

The JSE demutualized structure envisages a board and executive management that remained same. JSE has 17 directors as before, of which, four are females and the rest, males. The board has a CEO and a Chairman. It has an executive committee made up of 15 members, six of whom are females, and the rest, males. The operations of the exchange and its contractual relations were not affected and no capital raising was undertaken. Other stock exchanges, such as Mauritius and the Bourse Régionale des Valeurs Mobilières (BRVM), are limited by shares and, in theory, demutualized. However, there is a significant overlap between licensed stockbrokers and shareholders. Other African exchanges can learn from the JSE demutualization case.

There seems to be no one-size-fits-all demutualization model. There are several exchange governance models based on local business practices and cultural patterns. Larger and financially sustainable stock exchanges in Africa should be the ones to think of demutualization. Once a demutualization decision is made, African exchanges must desist from rush. They should move cautiously through the preparation, process, and post-demutualization, while viewing it as a long-term objective for growth, development and sustainability. The factors that have fuelled demutualization in the developed and the larger emerging markets are largely absent from Africa. In addition, the key preconditions such as a sufficiently liberalized market and critical mass of exchange trading and related services do not exist in most markets. However, there are few African stock exchanges that may have the readiness for demutualization, especially the larger stock exchanges with market capitalization and listings that are adequate to sustain profitable operations upon demutualization, and whose markets are currently sufficiently liberalized.

African stock exchanges must avoid pressure from donors to demutualize. They should seize control of the demutualization agenda and only move when the objective and conditions are favourable. Demutualization does not have to be an all-or-nothing model. Stock exchanges that do not have the necessary preconditions for demutualization at this time should consider demutualization as a long-run objective. In the transition period, which may be long for many exchanges in Africa, some of the benefits of demutualization can be partially captured by re-engineering Africa’s mutual exchanges through corporate governance; increasing representation of non-members, and by continuous improvement in trading and post-trade technology to remain competitive and avoid possible migration of liquidity as companies mature on their exchanges. Continuous market liberalization will enhance the prospects of the demutualized stock exchange.

Finally, improving corporate governance is not just a box ticking exercise; thus African exchanges need a wealth of experience and practical guidance in order to conceive and implement successful demutualization. Training on capital markets development and modern day investment strategies are as critical as balancing majority and minority shareholders interests. Exit routes and dispute settlement mechanisms are needed to deal with conflicts-of-interest that may arise during demutualization. The Cairo & Alexandria Stock Exchanges’ experience shows how an emerging market can integrate successfully corporate governance principles to improve its capitalization and liquidity. The journey has been started by JSE, and other African exchanges should learn from its experiences and solder on.

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* Department of Business Management, Egerton University, Laikipia Campus, P. O. Box 1100, Nyahururu-Kenya
Email: sonyuma@yahoo.com

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