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February 1, 2003

A Bad Bet For Public Exchanges? Demutualization Is Not the Only Answer

By Desmond MacRae

A demutualized exchange, proponents say, is better suited to access capital for future needs and can enter alliances for expansion at home and abroad.

But the principal motivation is technology. "The idea of electronic order entry for cash markets, for instance, clarified the idea of exchange ownership because it questioned the value of trading seats once remote access became standard," Clifford said. "Some exchange members cashed out in the demutualization process."

As with so many other institutions in society, exchanges had to keep up with the pace of technological change, said one securities lawyer.

"In the end, it

was technology that changed the exchange business model," said Kevin O'Hara, general counsel for Archipelago.

For instance, Eurex embraced electronic order entry to become the world's largest futures/options exchange - eclipsing both the CBOT and the CME. On many exchanges, the advanced technology that enables officials to handle increasing volume is costly. Demutualization is one way to pay the bill.

However, some say demutualization is not the only way to survive in a dog-eat-dog trading world. "Some exchanges adapted to the drivers of this world-wide trend without demutualizing," said Clifford at the World Federation of Exchanges. "Failure to demutualize will not necessarily put an exchange behind the curve."

Over the past ten years, trading costs for many private membership exchanges have dropped in line with the dramatic growth in trading volumes. At the same time, revenues exploded.

Indeed, the NYSE, which spends heavily on technology - and toyed with demutalization - still has some 80 percent of the market in listed trading business. NYSE Chairman Richard Grasso says "public ownership for this institution at this juncture is not being considered." However, the NYSE is perhaps already de facto demutualized because half its 27-person board is made up of outside members.

Floating an IPO is problematic for the NYSE. One issue is costs: State and local taxes are rising.

"The other is that the SEC saw exchanges as a kind of utility, but sensed that privatized exchanges should perhaps spin off their regulatory arm to avoid conflicts of interest," said O'Hara, who is a former SEC official.

Nasdaq is awaiting approval on its application as a stock exchange. Nasdaq says it could abandon that application if the SEC requires it to make certain changes as a pre-condition. One controversial issue is internalization which accounts for some one third of Nasdaq's flow of business. If the application is to succeed, the SEC might force Nasdaq to curb the ability of members to internalize.

Private Placement

But Nasdaq is ready on another front. It is quasi-public - at least on the OTC Bulletin Board - following the expiration of lockup provisions in which stock that Nasdaq sold in a private placement is trading for around $10 a share. That's several dollars a share lower than the price at which the shares were sold to a group of investors. All told, 2,900 investors ponied up $516 million; another $240 million was invested by Hellman & Friedman which purchased a 9.8 percent stake.

But even if Nasdaq eventually has an IPO of its own shares, it does not mean it will take back the huge volume of trading siphoned off by competitive ECNs, according to analysts. A sudden cash hoarde may buy advanced technology, but it does not guarantee the magic bullet of success.