The Feeling is Demutual

In the battles between technology and tradition that have raged for over twenty years in America and around the world, it's fair to say that technology usually carries the day. It's been true in how personal computers transformed the traditional office; true in how email and the Internet transformed communications and commerce; and now it also appears to be true in the tradition-bound world of equity, and commodities, exchanges.

Demutualization is the watchword coming from all major exchanges, from the biggest (the New York Stock Exchange has a plan in progress) to the smaller and more nimble (the New York Mercantile Exchange has received permission from the SEC to demutualize) -- and from our nearer neighbors (the Toronto Stock Exchange demutualized on April 3rd of this year) to exchanges around the world (Stockholm and the Australian exchange have been demutualized for several years). On June 6th the Chicago Mercantile Exchange voted overwhelmingly (with a whopping 98.3% of support) to demutualize -- the first in the U.S., passed with the widest margin of support in its 102-year history. The New York Mercantile Exchange is expected to do the same when its members vote in favor of demutualization later in June. And all of this sudden rush to demutualize has been driven by advances in technology.

Financial exchanges have traditionally been set up as some form of mutual association owned by members -- in the U.S., in fact, the Securities Exchange Act of 1934 mandates that all stock exchanges be structured this way. And trading was traditionally conducted in "the pit" -- as some form of open outcry where members could link buyers and sellers of stocks or other instruments -- as it still is on the NYSE and on each of the U.S. commodities exchanges. But in 1939 the NASD introduced a new wrinkle by establishing over-the-counter trading without a traditional trading floor -- and by peacefully co-existing with the traditional exchanges for half a century.

But more recently, technological innovations have begun to permanently alter the way financial instruments are bought and sold. Screen trading on some level sounded a warning if not the death knell to the old system. An article in the New York Law Journal (8/19/99) by Roberta Karmel states the point succinctly: "Once customers have direct access to screens, exchange memberships no longer have as much economic value, and clearing firms rather than traders become a dominant force in exchange activities."

However, the NYSE and each of the three major U.S. Futures Exchanges have argued convincingly that their methods of floor trading combined with some form of electronic order system are by far the most efficient in terms of liquidity and price -- and are still the methods of choice for their customers (given the option of floor or screen trading, 95% of the CBOT's customers stayed with the pit). In Europe, however, the exact opposite was seen: in 1996, the German bourse gave customers the choice of either electronic trading or the traditional method with individual specialists making markets; two years later more than 90% of their customers chose electronic trading. And when the MATIF (a Paris--based Futures Exchange) gave their customers the same option, they ended up closing their pit in a month.

But beyond how exchanges are conducting their trading comes new forms of competition for the exchanges themselves, from for-profit business corporations and their Electronic Communications Networks (ECNs) and Alternative Trading Systems (ATSs). These are proliferating at such rapid rates that many brokerage houses that do business with them and the exchanges are buying ECN companies to hedge their bets against their possible future dominance.

One thing is clear, however: most exchanges agree that their old member-owned association structure does not allow the kind of flexibility and adaptability to change that they need to survive in the new world of buying and selling financial instruments. Nor does it allow members to access the kind of capital they will need to compete. Testifying before the Senate Banking Committee last September, NYSE Chairman and CEO Richard Grasso outlined the advantages of giving up the member-owned structure: "Demutualization will better align the interests of NYSE owners with those of the Exchange itself and enable us to provide quicker and more innovative responses to competitive challenges. It will also give us access to capital for business enhancements and strategic affiliations which may be needed to compete with private trading systems who enjoy access to large pools of public capital." Efficiency, adaptability, and access to capital are clearly required for any business to be successful today and in the future -- and that is certainly true for the exchanges.

A perfect case in point is the New York Mercantile Exchange, whose Board approved a demutualization plan and simultaneously formed an e-commerce subsidiary appropriately dubbed e-NYMEX. This venture will provide the over-the-counter physical commodity market with an internet-based system for both the trading and clearing of a wide gamut of strategic products. The vision for the venture incorporates side by side over-the-counter trading and order routing to the Futures Markets. In an article in the May 18th Wall Street Journal, New York Mercantile Exchange Chairman Daniel Rappaport said "from our perspective, we think that the more the market fragments, the more it will need an entity to offer a single place where buyers and sellers know they can get the best price." He went on to say " we think we're in a good position to play that role here."

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