The Effect of Stock Exchange Demutualization on Liquidity and Transparency of Listed Firms

Our recent working paper titled ‘The Effect of Stock Exchange Demutualization on Liquidity and Transparency of Listed Firms’, addresses concerns raised by law and finance researchers, investors, and regulators that stock exchange demutualization could have negative consequences for the regulatory role of exchanges. We examine changes in liquidity and financial reporting quality of listed firms around their exchanges’ demutualization. Stock exchange demutualization is a process by which a stock exchange changes from being owned by its members (brokers-dealers) to being owned by shareholders (with a strong for-profit focus). Starting with the Stockholm Stock Exchange in 1993, most major stock exchanges in the world have demutualized over the past three decades. The change in operating structure forces exchanges to focus on maximizing their revenues and minimizing their costs. Some of the costs come from overseeing compliance with listing requirements, related, among other things, to timely and transparent reporting by listed firms.

To examine the association between exchange demutualization and the liquidity and financial reporting quality of listed firms, we start by identifying which exchanges demutualize de facto, ie, go public and become owned by many shareholders following demutualization (not only by brokers-dealers). Next, we match these stock exchanges with a control group of stock exchanges (non-demutualized or demutualized, but not de facto) based on a number of exchange and market characteristics (economic development, regulatory environment, stock market size, and stock market trading activity level). Finally, we match firms listed on the matched exchanges in the year before demutualization based on characteristics that could be related to reporting quality outcomes (industry, year, and market value).

Using the matched samples, we confirm the findings of prior research that listed shares’ liquidity (measured by bid-ask spread, trading volume, and the number of zero-trading days) improves after de facto exchange demutualization.

Our paper then explores whether the change in liquidity is related to improvements in the quality of listed firms’ financial reporting or other factors, such as an increase in technology spending.

To examine the change in financial reporting quality around exchange demutualization, we look at a number of metrics, frequently used in accounting research, and document a decrease in financial reporting quality of listed firms after their stock exchanges demutualize. Specifically, firms listed on demutualized exchanges after demutualization exhibit more earnings smoothing (managing earnings in order to lower the variability of net income), higher total accruals, higher incidence of reporting small positive earnings (just above zero), and some evidence of more big bath accounting (reporting large losses to create reserves for the future) compared to the control sample.

In supplemental analyses, the paper shows that these results are not driven by newly listed firms and instead relate to firms already present on these exchanges. Moreover, we find that the incidence of trading suspensions decreases for de facto demutualized exchanges. As an important caveat, the results vary when certain exchanges are excluded from the analyses, which means that demutualization effects differ by exchange. Consequently, while, on average, firms listed on stock exchanges undergoing demutualization show a decline in reporting quality, some stock exchanges may be able to maintain the reporting quality of their listed firms.

Overall, the study supports the finding of previous literature that liquidity improves at demutualizing exchanges. While this outcome is beneficial, it seems to be related to changes in technology or other aspects of exchanges’ operations, rather than to improvement in reporting quality of listings. The findings of a decline in reporting quality of listed firms after demutualization support the concern of market participants, academics, and regulators that the demutualization of stock exchanges may lead to a decline in regulatory oversight of listed firms.

Shawn Huang is an associate professor of accountancy at the W. P. Carey School of Business at Arizona State University

Min Kim is a PhD candidate at the W. P. Carey School of Business at Arizona State University

Maria Rykaczewski is an assistant professor at the School of Accountancy at W. P. Carey School of Business at Arizona State University

Maria Vulcheva is an associate professor at the School of Accounting at Florida International University