Brookings-Wharton Papers on Financial Services 2002 (2002) 61-91
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Changes in the Ownership and Governance of Securities Exchanges:
Causes and Consequences
[Comments and Discussion]
OVER THE PAST FIVE years substantial changes have occurred in the ownership and governance structures of securities exchanges, particularly in Europe. Recent surveys indicate that a large majority of the world's exchanges would like to "demutualize" in the coming years. The concept of demutualization remains a hazy one, however, along multiple dimensions: the factors that distinguish a demutualized from a mutualized exchange, the factors that motivate demutualization, and the implications of demutualization for the way in which exchanges are regulated. In clarifying the meaning of demutualization, I hope as well to clarify the sources of conflict between the role of an exchange as a commercial enterprise acting in the interests of its owners and its role as a quasi-regulatory body.
Government regulators around the world have expressed concern about the effect of exchange ownership and governance reforms on the ability of exchanges to meet the self-regulatory obligations devolved to them. Mutuality and self-regulation in the public interest are typically seen as going hand in hand. As I discuss in some detail, it is this misapprehension that lies at the heart of many concerns about demutualization. Regulatory failures are inevitable any time self-regulatory obligations imposed on an exchange conflict with the commercial interests of the exchange's owners. Such commercial interests are no less powerful for a mutualized exchange than for a demutualized one. [End Page 61]
A Technological Account
Mutuality and Floor Trading
The traditional model of an exchange as a locally organized mutual association is a remnant of the era before trading system automation. As trading required visual and verbal interaction, exchanges were necessarily designated physical locations where traders would meet at fixed times. Access to the exchange had to be rationed to prevent overcrowding and, when single-price periodic call auctions were prevalent, to ensure that simultaneous full participation was physically feasible.
As trading "systems" were simply rules governing the conduct of transactions, exchanges were naturally run by the traders themselves as cooperatives. Organizing trading floors as companies selling transaction services would have been infeasible, as there was no "system" distinct from the traders themselves—only an empty room. Rationing access to the exchange was accomplished through a combination of substantial initial and annual membership fees, in order to ensure self-selection by high-volume users. Nonmembers naturally wished to benefit from the network externalities of concentrated trading activity (commonly referred to as "liquidity") and therefore paid members to represent their buy and sell orders on the exchange floor. This is how exchange members came to be intermediaries ("brokers") for investor transactions.
Mutuality and Automated Trading
The economics of automated auction trading are radically different. The placement and matching of buy and sell orders can now be carried out on computer systems, access to which is inherently unconstrained either by the location or the numbers of desired access points. In a fully competitive "market for electronic markets," the traditional concept of membership becomes economically untenable. As the marginal cost of adding a new member to a trading network declines toward zero, it becomes infeasible for an exchange to impose a fixed access cost, or "membership fee." Rather, only transaction-based (that is, variable cost) charging is sustainable. Indeed, this trend is clearly evident among automated exchanges faced with significant competition. The transactors on electronic networks therefore look much more like "clients" or "customers" of a firm than [End Page 62] "members" of an association. And since an electronic auction system is a valuable proprietary product, not costlessly replicable by traders, it is feasible for the owner to operate it, and sell access to it, as a normal for-profit commercial enterprise. This contrasts with a traditional exchange floor, whose value derives wholly from the physical presence of traders.
The fact that an automated exchange can be operated as a commercial enterprise, in contrast to a traditional...