Of Derivatives, Forward and Futures

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By Kunle Aderinokun

According to Bank for International Settlements (BIS), the world’s oldest international financial organisation, $25.443 trillion worth of derivatives, futures and options have been traded as at March 2016. This figure showed marked improvement compared to the 2014 figures of $25.582 trillion and 2015 figures of $25,054 trillion .

This soaring success may not be unconnected with investor’s appetite for derivatives products to hedge risks and improve returns on investment. At the forefront of exchanges providing derivatives is the Chicago Mercantile Exchange Group comprising the Chicago Board of Trade, New York Mercantile Exchange. The CME Group, according to statistics, led the other exchanges in 2015 with a trade volume of $3.53billion contracts.

The impact of this global development is not lost on the key exchanges in Nigeria as they have kicked off the process of offering investors in the Nigerian capital market derviatives to deepen.

Prior to 2013, investors in the Nigerian capital and money market were used to the strait jacket investment instruments of stocks, bonds and treasury bills. Better still, these products were in most cases in their simpler form such that those having the desire to invest in more complex instruments such as derivatives could not do so.

Presently, there are three institutions in the country specialised in the mobilising of capital for the purpose of investment whether for short term or long term. They include the Nigerian Stock Exchange (NSE), the NASD OTC Securities Exchange and the FMDQ OTC Securities Exchange. While, the first two are more concerned with the long-term or capital market perspective, the latter is more focused on the short-term and long-term money market arena. Notwithstanding, they all have to use the instrumentality of various product initiatives to get patronage. Consequently, derivatives as instruments used in the financial market are fast gaining ground.

What is Derivatives?

Investopedia defined a derivative as a security with a price that is dependent upon or derived from one or more underlying assets. By implication, a derivative itself is a contract between two or more parties based upon the asset or assets. The value of the asset or assets in question is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Derivatives can either be traded over-the-counter (OTC) or on an exchange. Technically speaking, derivatives traded on OTC platform are called Forward Contract while those traded on exchange platform are called Future Contract. Fundamentally, Forward and Futures Contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price.

In simple terms, the Forward Contract is defined as a customised agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future.

On the other hand, Futures Contracts are exchange-traded and therefore, are standardised contracts. Like a forward contract, a futures contract includes an agreement upon price and time in the future to buy or sell an asset; usually stocks, bonds, or commodities such as gold or oil.

Basically, the major difference between forwards and futures is that the former are mostly bilateral and are traded over-the-counter. It thus presents various challenges as each party to a forward contract bears inherent risk of defaults of its counterparty. In addition, a forward contract is usually custom made, that is, created to hedge a specific risk which in turn presents the problem of finding a counterparty. It is also acknowledged that forward markets are not as liquid as futures market therefore making it difficult for forward contracts to change hands.

On the other hand, because of the standardised nature of a futures contract coupled with the fact that it is traded on an exchange, the futures are highly liquid-that is, they are traded quickly without stress. In addition, futures market mitigates the risk of a counterparty default because investors are required to post margins on their trade and all trades are cleared through a Clearing Counterparty (CCP). It is important to state here that the CCPs assume counterparty risk in a derivatives exchange.

Exchange traded derivatives have become increasingly popular because of the advantages they have over over-the-counter (OTC) derivatives, such as standardisation, liquidity, and elimination of default risk. Futures and options are two of the most popular exchange traded derivatives.

Recent Developments in Nigeria Derivatives Market

With recent and pending developments, the Nigerian capital market is bound to witness an escalation in the use of derivative instruments. The Nigerian Stock Exchange (NSE), has disclosed plan to commence trading in derivatives. The proposed introduction is in fulfillment of the exchange’s decision to introduce five asset classes in five years. Similarly, the Central Bank of Nigeria and the Financial Markets Dealers Quotation (FMDQ) OTC market recently launched the Naira-settled OTC FX futures market.

NSE Efforts at Launching Derivatives

To further promote and continuously drive the development of a more transparent, liquid, accessible market, with an appropriate market structure, the NSE has reached advanced stages toward the launch of derivatives. According to the CEO of the NSE, Oscar N. Onyema, the exchange is intensifying efforts to develop the necessary infrastructure and frameworks to launch derivative products in the market. “Ingrained within the establishment of the derivatives market is the need to create a Central Counterparty Clearing house (CCP), which is primarily responsible for providing efficiency and stability in the derivative clearing and settlements process, while ultimately reducing systemic risk in the market”.

“The CCP will be a market-wide initiative encompassing various stakeholders in the financial system ranging from deposit money financial institutions to other securities exchanges.

“This approach ensures critical stakeholder buy-in pertinent to the overall success of the derivatives business, as well as inherently spreading manageable risks to the relevant parties who are better positioned to mitigate appropriately,” he said.

The exchange-traded derivatives market, which goes live this year at the NSE, is in line with the exchange’s market deepening initiatives aimed at providing a range of products that will allow investors to create well-diversified portfolios of uncorrelated asset classes.

FMDQ OTC Securities Exchange Efforts at Launching Derivatives

The Naira-settled OTC FX Futures market has been kicked off by the CBN and FMDQ OTC Securities Exchange on June 27, 2016. The naira-settled OTC FX futures market started with the CBN selling the OTC FX futures contracts of non-standardised amounts for different tenors from one month through to 12 months, which will settle on bespoke maturity dates, providing liquidity in the product that will enable corporate treasurers effectively and efficiently manage their forex risk.

The Naira-settled OTC FX Futures has been defined by experts as a non-deliverable forwards i.e. contracts that obligate the counterparties to purchase or sell a specific currency (the US Dollar, which is a notional amount) on a predetermined future date (the settlement date) for a fixed rate agreed on the date the contracts were entered into (trade date).

Simply put, the Naira-settled OTC FX Futures contracts can be used to hedge a corporate’s exposure to FX (in this situation, the US Dollar) whereby the rate at which the corporate will purchase (or sell) FX at a period of time in the future is predetermined and fixed. There is no obligation for the physical delivery of the currencies (Naira or US Dollar) and at maturity, net-settlement will be made in Naira based on the US Dollar notional amount, and determined by the difference between the agreed rate (on trade date) and spot FX rate (on settlement date).

Ahead of the establishment of a Central Counterparty (CCP), the Nigeria Inter-Bank Settlement System PLC (NIBSS) will act as the clearing and settlement infrastructure for the margining and settlement of the OTC FX Futures contracts. CBN, through the FMDQ OTC FX Futures Trading & Reporting System, will offer the Naira-settled OTC FX Futures contracts to all Authorised Dealers (and may, in addition, deal directly with its FXPDs on a two-way quote basis) who will in turn offer same to customers with trade-backed transactions.

Role of Investor Education

Derivatives are a great vehicle for hedging and managing risk; they enhance liquidity and price discovery. However, they are complicated and one should understand them before taking on any trades. The Nigerian capital and investment market is advancing rapidly, only those with a good understanding of the market can take advantage of the opportunities it offers hence operators must do all they can to expand the reach of participants thereby improving the economy generally.

From all indications, derivatives will continue to be used as a tool for risk reduction and efficient portfolio management. As Nigeria positions itself to take advantage of the benefits of these dynamic financial instruments, it may be useful for regulators to provide clarity as to what can be traded in an exchange and OTC.

Currently, the CBN spot and forwards are being called futures with Nigerian Interbank Settlement System (NIBSS) used as clearing instead of a standard CCP. The regulators of the SROs should champion an investor education to avoid ambiguity that could scare investors particularly international ones, who are very keen on investing the capital market.