The process of corporatisation and demutualization which began immediately with the enactment of the law stands completed on the historic day of September 2, 2012. Now our stock exchanges stand converted from non-profit, mutually-owned entities to for-profit companies owned by the shareholders. This transformation will make our capital markets more accessible to the international community, support strategic alliances with foreign counterparts, influx of state-of-the-art technologies, and make the exchanges more competitive investment destinations.
This revolution promises to put Pakistan en route to introducing globally acclaimed governance standards, which in turn shall encourage investor participation and restoration of investors' confidence in stock exchanges that are better governed, more effectively supervised and inherently more efficient. Demutualization will also facilitate consolidation of brokers leading to financially strong entities which are better placed to generate market liquidity and expand market outreach through broker branch network and via internet/online/mobile technologies.
The role of an efficient capital market in the economic growth and development of a country is of paramount importance. Stock exchanges are key national institution responsible for safeguarding public interest as they channel savings to industrial and business enterprises. The mobilisation of such resources for investment is certainly a necessary condition for economic well-being. Similar to other markets, capital markets are prone to volatility as demand and supply fluctuate. But unlike other markets, turmoil in capital markets can have far wider consequences on the rest of the economy. From the Wall Street crash of 1929 to the global financial crisis of 2008, we have witnessed how dislocations in capital markets can have negative impact on financial stability, economic growth, and the interests of public.
The stock exchanges in many countries had been set up having a mutualized structure wherein the members have the ownership as well as trading rights. This structure inherently creates conflict of interest as members predominately control the affairs of the stock exchange which results in lack of transparency in the operations of the stock exchange and compromises investors' interest. Also, mutualized exchanges while focusing on short-term benefits are generally unable, or refuse, to undertake reforms which are in the long-term interest of the market. Although, there have been several reasons for demutualization in developed and developing jurisdictions, mainly in developed countries the urge was supported by global competition and technological advances in stock market operations whereas in emerging markets the drive for demutualization was a result of the perceived and actual conflict of interest.
Consequently, in developed countries the initiative for demutualization was primarily from the stock exchanges and in developing jurisdictions the policy makers were compelled to intervene to foster the transformation. In the case of Pakistan we are proud to have followed the process in a harmonious manner. The constitution of an Expert Committee on Demutualization and Integration in 2004 to develop a comprehensive plan for demutualization and later the signing of a memorandum of understanding between the stock exchanges and the SECP in 2006 were steps to ensure a smooth transition. Upon the promulgation of the Act in May 2012, the SECP became entrusted with overseeing implementation of its extremely challenging timelines. The SECP ensured that all activities required for corporatisation and demutualization were completed within the stipulated 119 days of promulgation of the Act. Hence today, the successful corporatisation and demutualization of the stock exchanges represents a phenomenal achievement of not only the apex regulator but also illustrates the commendable role played by the stock exchanges in ensuring effective implementation of the law. This seamless transition of the stock exchanges with such massive reforms at the back end highlights the capacity and positively of the Pakistani capital markets to implement and absorb market reforms.
An apprehension that remains associated with the post-demutualization scenario is that the stock exchanges as for-profit companies are free to pursue their commercial objectives and hence, their focus on regulatory activities is perceived to be diluted. However, another school of thought suggests that the demutualization of a stock exchange is not necessarily incompatible with self-regulation. An appropriate structure of self-regulation, which ensures segregation of commercial and regulatory role of the exchange is a technique to reduce the conflict of interest in its operations. The regulators across the world have adopted different models to address these conflicts.
There are mainly four models commonly implemented for ensuring segregation, ie, (i) the Government Model, (ii) Limited Exchange SRO Model, (iii) Strong Exchange SRO Model and (iv) Independent SRO Model. In the 'Government Model' the regulation is performed by a government authority and the exchange is responsible for very limited supervision of markets.
The examples include the UK, and France. Jurisdictions such as Hong Kong, Singapore and Dubai have adopted the 'Limited Exchange SRO Model' wherein a public authority is the primary regulator. However, certain regulatory functions tied to the exchange's market operation are delegated to the exchange. In other developed jurisdictions like the US Australia, Japan, Malaysia the 'Strong Exchange SRO Model' is in place where a public authority is the primary regulator, it relies on exchanges to perform extensive regulatory functions that extend beyond its market operations, including regulating member's business conduct. In the 'Independent SRO Model' although a public authority is the primary regulator it relies extensively on an independent SRO to perform widespread regulatory functions.
The specific preference by policymakers is dependent on different factors including the size of the market and the stage of preparedness and development of the market. We in Pakistan have in the first phase adopted the strong exchange SRO model. However, to ensure potential conflict of interest in the said model, the segregation plan approved by the SECP requires the stock exchanges to constitute separate regulatory committees / departments that function totally independent from any committees/departments of the exchange that are involved in performing its commercial functions. The segregation has been envisaged through setting up of a Regulatory Affairs Department (RAD) that is headed by a Chief Regulatory Officer (CRO) and overall supervision of which vests with a Regulatory Affairs Committee (RAC), which mandatorily comprises of directors who do not represent and are not in any way connected with persons having trading rights. The RAC functions as a 'Chinese wall' between the regulatory functions and commercial activities of the exchange and is responsible for developing and measuring RAD's effectiveness in implementing the overall regulatory plan, processing all regulatory amendments, recommending budget and staff allocations for the RAD, and appointment of the CRO whose removal would require consent of the RAC. In addition, the board of directors of the demutualised entities is now dominated by independent directors, restricting representation of brokers/trading right holders from holding majority on the board. These independent SECP-nominated directors shall be replaced by representatives of strategic investor(s) and the general public after divestment of shares to them. However, to ensure good governance and transparency in the affairs of the exchanges, the SECP has the authority to appoint independent professionals as directors on the board of the exchanges over and above the elected directors, as is the case in most jurisdictions.
In the demutualised set-up the shareholding rights of trading rights certificate holders are limited to 40%, whereas the remaining 60% shares that are currently lying in blocked account at the central depository will be offered for sale to the strategic international investor(s), and the general public in a 40:20 ratio. This arrangement has been put in place to eliminate the possibility of concentration of ownership in a few hands.
The demutualization is essentially yet another step by the SECP in restructuring the capital market and market infrastructure institutions that can play an enhanced role in ensuring product innovation, market integrity and protection of investor interest. It will pave the way for strengthening the strategic positioning of the capital market while enhancing the competitiveness and efficiency of the Pakistani exchanges. The SECP stands firmly committed to introducing reforms to establish a fair, transparent and efficient market that engenders investor confidence and conforms to international levels of performance in today's highly competitive global environment. The writer is the Commissioner, Securities' Market Division, at the SECP. He has over 20 years' experience in finance, business, management, corporate governance, academia and marketing.
The writer is the commissioner, Securities Market Division. He has over 20 years of experience in finance, business, management, academia and marketing.