Abstract: The prevailing view among many economists is that derivatives
markets simply enable financial markets to incorporate
information better and faster. Under this view, increasing the size
of derivatives markets only increases the efficiency of financial
markets.
We present formal economic analysis that contradicts this view.
Derivatives allow investors to hold economic interests in a
corporation without owning voting rights, or vice versa. This
leads to both empty voters – investors whose voting rights in a
corporation exceed their economic interests – and hidden owners – investors whose economic interests exceed their voting rights. We
show how, when financial markets are opaque, empty voting and
hidden ownership can render financial markets unpredictable,
unstable, and inefficient. By contrast, we show that when financial
markets are transparent, empty voting and hidden ownership have
dramatically different effects. They cause financial markets to
follow predictable patterns, encourage stable outcomes, and can
improve efficiency. Our analysis lends insight into the operation
of securities markets in general and derivatives markets in
particular. It provides a new justification for a robust mandatory
disclosure regime and facilitates analysis of proposed substantive
securities regulations.