From Mutualized Exchange to Investor-Owned Demutualized Entity: The Case of Pakistan Stock Exchange

This case study provides an overview of the Pakistan’s stock exchange (PSX) journey from not-for-profit mutual company to for-profit demutualized self-listed entity. The wave of demutualization and public listing of stock markets around the globe is being witnessed for the last two decades. This study focus on three main areas. First, in 2012, the stock market stood corporatized and demutualized as a public company limited by shares. Prior to 2012, the PSX (formerly called Karachi stock exchange) was a member-owned company limited by Guarantee. The three national stock exchanges of Pakistan, i.e., Karachi, Lahore and Islamabad stock exchange merged together to form PSX in January 2016. Moreover, under enhanced cooperation between China and Pakistan in the form of CPEC, the 40% strategic ownership of PSX is transferred to the consortium of Chinese financial institutions following the competitive bidding process. However, the question arises: does this marriage between China and Pakistan makes the financial exchange of Pakistan as one of Asia’s most modern capital markets? After the acquisition of PSX by China, the Pakistan stock market is listed on its own exchange from June 29, 2017 (self-listing) following the book-building and public subscription process. Besides, the Chinese representatives have been inducted on the board of directors and a separate small &amp; medium enterprises counter is established to facilitate SMEs raising funds from capital markets. Second, this study links the conceptual framework with real life event by discussing the reasons for demutualization, such as investment in technological advancement, global competition, changes in corporate governance structure, regulatory challenges, and efficiency of demutualized stock market. Lastly, selected market efficiency indicators are compared before and after integration to assess the benefit of demutualization. On a positive note, so far, the market witnessed higher liquidity, less excessive volatility, and better returns for investors in the post-merger period compared to pre-merger period.

On June 30, 2017 a get-together was arranged by the management of Pakistan Stock Exchange (PSX) in the trading hall of PSX at Karachi. The Chairman, Securities and Exchange Commission of Pakistan (SECP) consented to be the guest of honour. The holding of gettogether by the management, where all licensed brokers-dealers were invited to celebrate the succesful completion of the process of "Offer for Sale of PSX Shares and its Self-Listing". The PSX listed with effect from June 29, 2017. The ceremony ended with the discussion on "Future Challenges and Opportunities" in the wake of self-listing of PSX. This historical milestone coincide with the the reclassification of Pakistan's equity market from Frontier market index to Emerging market index by Morgan Stanley Capital Index (Hussain, 2017).

About PSX
The Exchange was incorporated in 1949 as a company Limited by Guarantee. As a result of demutualization, the Exchange stood corporatized and demutualized as a public company limited by shares under the name of 'Karachi Stock Exchange Limited', with effect from August 27, 2012. Subsequently, the two stock exchanges namely Lahore Stock Exchange and Islamabad Stock Exchange merged into Karachi Stock Exchange to form Pakistan Stock Exchange Limited (PSX) on January 11, 2016.
PSX provides a reliable, orderly, liquid and efficient digitized market place where investors can buy and sell listed companies' common stocks and other securities. For over 60 years, the Exchange has facilitated capital formation, serving a wide spectrum of participants, including individual and institutional investors, the trading community and listed companies. After demutualization and change in ownership, the PSX plans to focus more on bonds and derivatives. Information about PSX past, present and future; see Exhibit 1.

The Corporatization, Demutualization and Integration Process of PSX
The apex regulator of Pakistan Stock Exchange, i.e., Securities & Exchange Commission of Pakistan (SECP), while approving the scheme of integration of three exchanges into one, mentioned in her order that: "The integration process would increase the liquidity of the Successor Exchange and, therefore, reduce the implicit costs of trading for investors by centralizing the trading activities. It will reduce bid-ask spreads insofar as it helps intermediaries to defray fixed order processing costs, namely, the costs of access to the trading platform and of maintaining a continuous market presence; reduce adverse-selection costs, due to the presence of informed traders; reduce the inventory-holding costs of market makers. The proposed integration is likely to have a positive impact on volume through increased trading. The liquid market, thus leads to lower volatility" (Securities Market Division, 2016, p. 4).
The Stock Exchanges (Corporatization, Demutualization and Integration) Act, 2012 envisages the process of capital market reforms in three phases. In the first phase, on August 27, 2012, in compliance with the Act, the three stock exchanges were corporatized and demutualized as companies limited by shares. Thus the major stock exchange of Pakistan, the Karachi Stock Exchange (Guarantee) Limited became Karachi Stock Exchange Limited. In the second phase, on January 11, 2016, the dawn of a new era started, when all three local bourses merged into a single bourse, called Pakistan Stock Exchange.

Finding Strategic Investor
In the third phase, the Pakistan Stock Exchange has to search for strategic investor or financial institution for divestment of 40% of its shares within one year after integration, i.e., by the end of 2016. Subsequently, in terms of the provisions of Demutualization Act, the newly integrated exchange has to perform some more tasks, i.e., a) 20% of the shares will be sold to general public within specified timelines; b) establishment of Small and Medium Enterprise (SME) counter to facilitate the listing of SMEs; and c) more than 50% of the members on the board of PSX would be independent directors until the divestment is made to the strategic investor.
In January, 2017 a Chinese-led consortium, consisting of China Financial Futures Exchange Company Limited (the lead bidder), Shanghai Stock Exchange, Shenzhen Stock Exchange and two local financial institutions, namely Pak-China Investment Company Limited and Habib Bank Limited, bought 40 percent stake in the PSX. Besides, in March, 2017; as per the roadmap four Chinese were appointed on the board of the Pakistan Stock Exchange. Moreover, in April-2017, PSX introduced Small & Medium Enterprises Board in order to facilitate SMEs to raise funds from equity market and get listed ("SMEs Board," 2017).

Self-Listing of PSX
Following the book-building process and subscription of initial public offering of shares at the strike price of Rs 28 per share, the PSX was formally listed on its own exchange on June 29, 2017. To sum-up, the integration of domestic exchanges, finding strategic partner investor, transformation of organizational setup, public offering, and setting SMEs counter was all part of road map provided in Corporatization, Demutualization and Integration Act, 2012 from Securities Exchange & Commission of Pakistan (SECP), the apex regulator of Pakistan Stock Exchange.

Future Challenges and Opportunities
However, it is yet to be seen how the management of PSX capitalize from consolidation and overseas investment. Whether PSX will be able to attract more listings on the the exchange. Initiate much needed derivatives products such as Exchange Traded Funds (ETFs), Fixed Income Derivatives, and Single Stock / Index Options. Besides, how the exchange is going to attract foreign investors by offering higher liquidity, narrower spreads, broader price limits and efficient price discovery.

Motivation for demutualization and public-listing
Aggarwal (2002) discussed the two main reasons for demutualization of stock exchanges: 1) heightened global competition and 2) advances in technology. The potential of demutualization is that, along with additional capital required to invest in technology, the owners of the recently demutualized financial markets will offer a corporate governance structure that is far more effective in exploring other sources of revenue by introducing new products / businesses in stock exchanges that would maximize the value of the firm. Further, demutualized stock exchanges wants to preserve their existing revenue stream by encouraging more and more enterprises to list on stock market. The recent introduction of SMEs board on PSX is one of the the initiatives undertaken following the changes in the corporate governance structure of PSX.
Moreover, with the advent of electronic communications networks and data processing technologies, the competition among the financial markets has intensified not only at the domestic level but also at the regional level. Hence, many companies want to cross-list on overseas exchanges, such as Hong Kong stock Exchange, London Stock Exchange, New York Stock Exchange etc. Besides, Euronext is a good example of demutualized exchange where some of the European stock market companies are traded on a single electronic platform. Another example is the merger of NYSE-Euronext.
Lastly, Aggarwal & Dahiya (2006) discussed the global trend of public listing of stock markets. Recently, on February, 2017, Bombay stock exchange (BSE) listed on rival National stock exchange (NSE) following an overwhelming response from initial public offereing (IPO). This wave has totally transformed the corporate governance structure of stock exchanges, that is, the financial markets are being efficiently run by professionals whereby technological advancement has signifcantly bring down costs by allowing trading of derivatives, bonds, and stocks on a single trading platform. However, at the same time it has increased regulatory challenges, due to shift in regulatory landscape, such as conflict of interest. That is, how the newly transformed for-profit stock exchanges segregate the selfregulating functions and commercial objectives.

Brief Analysis:
In this section, we want to see how the response of market efficiency measures following the integration of Pakistan stock exchange. The market measures are shown in Exhibit 2; before and after the merger. The first proxy depicts the volatility of PSX, which is the difference between high price and low price divided by the average of high & low price. We can see that the excessive volatility has slightly declined in the post-period (18-month period) compared to pre-period. The average daily price volatility of KSE-All Share Index decreased to 0.996% from 1.072% in the pre-period. This suggests that excessive volatility owing to speculators and sentiment driven traders has slightly declined. The other reason could be that mutual funds, not brokers, dictate the bourse now. † In the past brokers used to manipulate stock market through pump-and-dump trading strategy (Ijaz & Mian, 2005). Pakistan stock market considered to be one of the volatile markets in the region. Hence offer higher returns.
Next, we look at liquidity proxy, before and after the integration, i.e., trading volume. Again we observe that trading activity has increased to 295.125 million shares (daily average) in the post-merger period compared to 225.472 million shares changed hands in the premerger period. Hence, following the merger of three national bourses into one, the management has been able to attract more public / investors through awareness programs across the country. We also investigated the returns accrued to investors in the post-period compared to pre-period. Returns are 18-month daily average of KSE All-Share Index calculated by taking natural logarithm of today's index value divided by previous day's index value. The market participants have earned slightly higher returns of 0.098% in the postmerger period compared to 0.065% in the pre-period. Thus the market has performed well during the 18-month post-period compared to 18-month pre-period.
Finally, Exhibit 3 reports the correlation of Pakistan's All-Share Index and aggregate indices of selected countries. It appears that the correlation of Pakistan's capital market with developed and emerging markets has significantly declined in the 6-month post-merger period compared to 6-month pre-merger period. However, the result seems to be surprising, since we expected that after the consolidation of three exchanges, the correlation between Pakistan and other regional markets would have increased. The evidence suggests that PSX offers foreign investors and global fund managers huge diversification potential. Javed (2012) also find lower correlation of Pakistan's financial market with other global markets.

Conclusion
This case study has discussed the journey of PSX from member-owned, non-profit entity to investor-owned, for-profit company. After the demutualization in 2012, the three domestic stock exchanges merged together in January 2016. In the late 2016, a consortium of Chinese financial institutions acquired 40% ownership of PSX and in June 2017, the PSX listed on her own bourse through pulic offereing process. The study discussed the benefits that would accrue from the major changes in the structure and operation of PSX. We also linked the transformation and demutualiztion of Pakistan equity market with the wave of demutualization and public listing across the globe. The major reasons / motivation for transformation and regulatory implications were also discussed briefly. In the end, a brief statistical analysis is conducted to document the market efficiency of PSX in the pre-and post-merger period. Overall, we find slightly higher liquidity and better returns in the postperiod compared to pre-period. Similarly, the excess volatility following the merger has also declined to certain extent.
On the other hand, Uppal (2009) is of the view that integrating the stock exchanges is expected to increase transaction costs, lower the incentives for regulatory compliance, and diminish the motivation for promoting capital market development. Uppal's evidence suggests that the merger eliminates inter-exchange competition, as Lahore stock exchange (LSE) also contributes to informational efficiency along with country's dominant exchange, the Karachi stock exchange (KSE). However, it is yet to be seen whether the newly emerged PSX has been able to capitalize on the benefits of demutualization and foreign ownership. Since, a sample period of one-and-half year is very samll in the life of PSX to pass any verdict on its performance.