At a time when the country is faced with political uncertainty, serious economic challenges and a falling stock market, demutualisation of the Karachi Stock Exchange (KSE) is probably the least priority item.

However, it is at this time of turbulence that the KSE needs to focus on building confidence, enhancing transparency and planning for growth.

In January 2006, through a memorandum of understanding, the Securities and Exchange Commission of Pakistan (SECP) and the KSE agreed to a roadmap for demutualisation of the largest bourse. After two years of painstakingly slow progress, in January this year, the caretaker government approved a demutualisation ordinance which was originally to be signed by President Pervez Musharraf.

Following the February elections and formation of the new government, this draft has now been referred to the National Assembly where it needs to be tabled, debated and turned into law by an act of parliament.

The demutualisation process is expected to be initiated within 120 days of its approval from the parliament while the entire process is expected to be completed in an additional 12 to 18 months after that. The three stock exchanges are expected to be ready for implementation of the law within 119 days of its approval by the parliament.

According to the draft demutualisation law, local financial institutions will hold 40 per cent of the exchange’s equity, the general public will hold 20 per cent while 40 per cent will rest with existing brokers.

Demutualisation is the process through which the KSE, a member-owned entity will become a shareholder-owned company. As part of the demutualisation process, members will receive a “windfall” payout, in the form of shares in the successor company, a cash payment, or a mixture of both.

Globally, exchanges have either changed or are changing their traditional business models. Until a few years ago, most of them were organised as “mutuals” or cooperatives of members. Now, after a listing of 22 exchanges, with the likes of London, New York, Toronto and Singapore bourses to name a few, demutualisation has given birth to a new structure which facilitates greater business and operational efficiencies, transparency and the transition to new electronic trading platforms.

Under the new business model that has evolved through demutualisation, exchanges have gone public and have listed themselves in the stock market. In terms of capital productivity, exchanges have performed better than the rest of the financial sector and much better than traditional industries, like energy. The average return on invested capital (ROIC) for exchanges over the 2003-06 period was 24 per cent compared to 20 per cent for financials overall and 17 per cent for energy over the same period.

This model is not without its weakness. Demutualisation of exchanges has created a conflict of interest between market participants (brokers, as well as investors) and the operator of the exchange, which now attempts to maximise returns to shareholders.

The KSE is a regulated entity, overseen by the SECP. Globally, regulatory rules are far from uniform across different jurisdictions, and the involvement and goals of regulators also differ. However, in most cases, regulators have the function of market oversight, with the objective of providing a framework of rules or laws, and the power to enforce or even prosecute for the orderly functioning of financial markets (e.g., ensuring fairness among market participants).

During the past few years, the KSE has provided a convenient locus for the regulator to carry out its duties and responsibilities. At times, there has been a difference of opinion between the KSE and the SECP; the two have often taken different views about how to enforce the objectives of transparency, fairness and disclosure and to what extent these measures may have an impact on the day-to-day business of the exchange.

At a time when demutualisation is being planned, revenue diversification has become increasingly important for the KSE if it wants to be a major player in the region. It appears that the exchange is well-placed to develop an “integrated” offering for less traditional market opportunities. The KSE must target revenue diversification through aggressive product development, strategic stakes in regional exchanges with strong product portfolios and acquisition of fast growing niche exchanges or trading platforms that trade products with little or no correlation to the existing portfolio (e.g. energy, commodities, weather, etc.).

In search of new sources of growth, KSE can pursue two main avenues. First, it could utilise better technology and specialised offerings to facilitate new trading styles. The bourse needs to focus on rapid development of algorithmic-trading technology and enhancement of its current trading platform to allow efficient trading opportunities to institutions looking to transact quickly across a basket of stocks (for instance, programme traders and hedge funds).

Second, it can launch new asset class products aggressively, like ETFs and derivatives; the wave of new ETFs across Europe exemplifies such innovation.

McKinsey estimates that listing fees represent 18 per cent of revenues for the world’s largest exchanges. The KSE too must offer a comprehensive and efficient infrastructure to issuers for raising capital and to investors for transacting and clearing financial products. As Pakistan’s leading exchange, KSE has to strive to continually innovate and provide its customers (issuers, investors, broker-dealers) with convenient access to quality products and the best price discovery and liquidity at a competitive cost while seeking to create value for its shareholders.

The KSE is at a defining moment in its history. The exchange business is a profitable one if managed efficiently along the pillars of cost rationalisation, revenue growth through product development and strategic acquisitions. It is a volume-driven business where economies of scale matter and there is usually scope for further efficiency gains to support earnings growth. Across the globe, exchanges have increased their EBIT margins to 39 per cent (2006) from 18 per cent (2001).

Over the last five years, the KSE has achieved several milestones. But has its own business and profitability grown at the same level as the growth in market capitalisation? Has its image as a fair and transparent institution in the eyes of investors improved? Ad hoc measures like suspending short-selling or holding special trading sessions are hardly confidence boosters.

Now, as the bourse nears its integration and demutualisation, the opportunity is ripe for the KSE and its management to regenerate itself and take the exchange business to a new level that is not only scaleable, profitable and diversified, but also transparent and well-governed. Is demutualisation the answer? We will find out.