The recent merger of the New York Stock Exchange with Archipelago, and its subsequent listing as a for-profit organization on the NYSE, can be viewed as the final phase of a wave of organizational transformation that has swept across most of the world's major financial exchanges in the last ten years.

Until the early 1990s, almost all stock and derivatives exchanges were organized as non-profit, mutual organizations owned by their members. But starting with the demutualization of the Stockholm Stock Exchange in 1993, the number of stock exchanges that have adopted a for-profit, publicly listed organizational form has grown steadily. At the same time, the largest derivative exchanges, such as the Chicago Mercantile Exchange and Eurex, are either already publicly listed or are part of publicly listed parent companies.

The idea that the stocks of companies accounting for almost 70% of the world's total market capitalization are now trading on publicly listed exchanges was unimaginable even just ten years ago. What are the factors that led to the mass demutualization of financial exchanges? And how is the financial exchange industry likely to evolve from this point forward? A recent Journal of Applied Corporate Finance article addresses both of these questions.

One contributor to the exchanges' demutualization are the latent conflicts of interest within the mutual form of organization, such as those between floor broker members and major investment banks. These conflicts can block changes that, while good for the exchange, will hurt some of its members. Converting to a for-profit investor-owned organization allows the exchange's managers to focus on a single mission-maximizing the profits and value of the exchange.

Perhaps even more important, however, are the deregulation of financial exchanges and new developments in information technology that have made securities trading much more competitive and led to the almost complete replacement of traditional floor-based trading by electronic trading.

The growing threat from alternative trading systems that serve as electronic marketplaces has put pressure on exchanges to commit significant capital to cutting-edge technology. The economics of exchanges-high fixed costs, but very low marginal cost per trade-favor size. A public listing facilitates the growth through M&A that enables exchanges to achieve an efficient scale.

As if to confirm the superiority of the new organizational form, the early evidence is that conversions to for-profit status and public ownership have led to significant increases in operating performance and share values. However, these results are preliminary, and the demutualization and listing of exchanges creates a new challenge for exchanges as self-regulating institutions: managing the conflicts that may arise between the owners and those who transact on the exchange.

If demutualization and the public listing of exchanges is the first wave of transformation, expect the second to be consolidation within the industry, both on a geographical basis as well as mergers across product lines. The former is already well underway, with the NYSE Group working to finalize its deal with Euronext and Nasdaq considering an acquisition of the London Stock Exchange. In equities trading, the most interesting arena will continue to be Europe, where one or two large exchanges are likely to emerge on a scale comparable to that of U.S. exchanges. However, such potential consolidation is not without its challenges. Cross-border mergers are extremely difficult in general, but financial exchanges are often viewed as national icons and political pressures to curb such mergers can be especially strong.

The merger of leading equities and derivatives exchanges is another possibility, creating “side-by-side trading” that would allow a trader to hedge their position in the underlying security on the same exchange. The NYSE has already announced plans to add derivatives trading capabilities, possibly organically or through an acquisition. In either case, the next five to ten years is likely to witness further dramatic changes in the financial exchange industry.

To learn more, and view addition articles from the current issue of the Journal of Applied Corporate Finance, click here.