1. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago 1 Financial Derivatives and Intrinsic Separation of Ownership and Control by Eugenio Simone De Nardis Discussion: Carlo Drago I-Com Istituto per la Competitività, Seminar in Finance and Corporate Governance, Rome 20 February 2009

2. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Topic Relevance: the current financial crisis and corporate governance… “In a regulatory perspective, the current financial crisis indicates the need to rethink corporate governance from its most fundamental principles” “The origins of the recent financial crisis have signaled that the starting point of this new analysis should be the financial derivatives’ industry…” “…The increased sophistication of financial derivatives, coupled with stock market and trading platform developments, have made derivatives available - to sophisticated and retail investors alike - at lower transaction costs…” “What is new is the ease and large scale in which they can be used to decouple voting rights and economic ownership, achieving an intrinsic separation of ownership and control…”

3. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago The core of the paper: the intrinsic separation of ownership and control… …”We examine the intrinsic separation of ownership and control achieved through financial derivatives when used to decouple voting rights and economic ownership. We begin from traditional theory regarding the functional separation of ownership and control in the Berle and Means public corporation, upon which most modern corporate governance analysis is explicitly and/or implicitly based”... …”We then distinguish this traditional functional separation from the developing intrinsic separation of ownership and control, as achieved at the individual level of each shareholder through decoupling transactions with financial derivatives”

4. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago The study conclusions (1) “Traditional theory asserts that an opaque system of corporate governance facilitates the extraction of private benefits of control. Accordingly, investor protection through disclosure obligations pursues the general aim of stimulating capital market development and thus, in turn, economic growth. The law and finance literature has indeed shown a correlation between investor protection and capital market development.” “The regulatory focus on disclosure - and generally on financial market information - facilitates the operation of financial market mechanisms. Moreover, an effective disclosure regime stimulates greater competition between the banking system and the stock market” “Greater transparency would allow market mechanisms and monitoring to operate effectively, reducing the risk of fraudulent activity through derivatives.” “Indeed share prices would discount any abnormal or fraudulent manifestations of the intrinsic separation of ownership and control”

5. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago The study conclusion (2) “In light of these considerations, a targeted corporate governance disclosure regime may well be the best regulatory response to intrinsic separation in the short term. However, in a medium term perspective, it will also be necessary to re-think corporate governance from some of its fundamental principles” “New corporate governance analysis will have to consider explicitly the intrinsic separation of ownership and control”

6. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Some questions… An open fundamental question, based on the paper, is, in what way can we measure this “intrinsic” separation of ownership and control A second fundamental point is defining precisely the relationship between investor protection and capital market development over time and space A third conclusive question could be: why and to what extent corporate governance is relevant?

7. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Back to square one: measuring corporate governance effectively. Latent variables in Finance and Corporate Governance Network structures and its evolution using social network analysis Corporate governance clusters and their dynamics over the time (evolving models of corporate governance)… Monitoring corporate governance over the time: control charts System dynamics modeling

8. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Measuring corporate governance: some proposals Disclosure and Transparency indicators (Patel Dallas 2002) Investor protection mechanisms …Analysing these indicators over the time and across different countries… Leximetrical approaches (Lele Siems 2006)

9. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Building latent variables in Finance and in Corporate Governance At the same time it is also possible to build new indicators through specific existing financial or corporate governance datasets…. …In this case we measure statistically unobserved latent variable can be used to monitoring a specific phenomenon

10. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Analysing possible sources of conflicts of interest Social Network analysis Network structural indicators Network dynamics over the time Network link persistancy over the time Patterns over the time…

11. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Control Charts in Finance and Corporate Governance By using control charts we can monitor some interesting corporate governance indicators over the time Sometimes there can be some “structural changes” in the system inducted by regulation

12. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Modelling corporate governance using system dynamics The corporate governance can be considered a complex system, so we can model the relationships using system dynamics tecniques. At the same time we can simulate the impact of different latent variables (or different regulation of course) in the system… At the same time we can monitor some corporate governance key variables over the time (for example investor protection)

13. Financial Derivatives and Intrinsic Separation of Ownership and Control C.Drago Bibliography De Nardis (2009) “Financial Derivatives and the Intrinsic Separation of Ownership and Control” Working Paper, Studi e Note di Economia, forthcoming Lele Siems (2006) “Shareholder protection: a leximetric approach, Working paper Patel, Dallas (2002) “Transparency and Disclosure: Overview of Methodology and Study” Working paper available on SSRN Santella Drago Polo (2008) “The Italian Chamber of Lords Sits on Listed Company Boards: An Empirical Analysis of Italian Listed Company Boards from 1998 to 2006” Working paper Sterman (2000) “Business Dynamics” MIT Press