Preparing for Standardised Derivatives Market

The Nigerian Stock Exchange is preparing to launch Exchange Traded Derivatives later this year. Solomon Elusoji writes on what the financial instruments mean and how they will impact the capital market

Derivative instruments always come with controversies. Many analysts and pundits claim that derivatives increase systemic risk and blame it for the economic recession of 2007 to 2009, when credit-default swaps in the derivatives market incurred massive losses that sent the United States(U.S) and in fact the global, financial system into a meltdown. But there are also those, who see derivatives as a powerful tool to reduce risk and hedge bets against an uncertain future. The negativity attributed to derivatives, they argue, is not inherent in the tool, but in those who use it. One cannot, for example, say a knife is evil because it was used to kill a man because it is the same knife that is used in surgery to save lives.

In Nigeria, derivatives are new. The local derivatives market exists mainly within the Over-The-Counter (OTC) segment of the market. But this is in sharp contrast to the global derivative market. According to investopedia.com the derivatives market is gigantic and often estimated at more than $1.2 quadrillion. Some market analysts estimate the derivatives market at more than 10 times the size of the total world gross domestic product (GDP). The reason the market is so large is because there are numerous derivatives available on virtually every possible type of investment asset, including equities, commodities, bonds and foreign currency exchange

The Origin of Derivation
Derivatives are simply securities with a price that is dependent upon or grafted from one or more underlying assets. This means that these are securities with no inherent value save for the assets which back them. Put in more practical terms, the derivative itself is a contract between two or more parties based upon certain assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets are stocks, bonds, commodities, currencies, interest rates and market indexes. Derivatives can either be traded OTC or on an exchange. It is generally believes that OTC derivatives, which are unregulated, constitute the greater proportion of derivatives in existence, but they are less risky when traded on exchanges, which have standardised requirements and possess less risk for the counterparty.

There are different kinds of Derivatives, but futures contracts is one of the most common. A futures contract is an agreement between two parties for the sale of an asset at an agreed price. One would generally use a futures contract to hedge against risk during a particular period of time. For example, suppose that on July 1, 2016, Ajibola owned 10,000 shares of Dangote stock, which were then valued at N82 per share. Fearing that the value of his share would decline soon, Ajibola decides that he wants to arrange a futures contract to protect that value of his stock. Nneka, a speculator predicting a rise in the value of Dangote stock, agrees to a futures contract with Ajibola. The contract stipulates that in one year’s time, Nneka will buy Ajibola’s Dangote shares at their current value of N82.

It is reasonable to view the futures contract as a sort of bet between the two parties. If the value of Ajibola’s stock declines, his investment is protected because Nneka has agreed to buy them at their 2016 value, and if the value of the stock increases, Nneka will be better off as she is paying January 2016 prices for stock in January 2017.

Defining Standards for Derivatives
Now the Nigerian Stock Exchange (NSE) has taken on the challenge of launching Exchange Traded Derivatives in the country, later this year. This is expected provide some structure and transparency, compared to the OTC version, which is a lot riskier due to lack of information, the lifeblood of financial speculation. Between June 12 and 15, the NSE held training on the legal and risk aspects of derivatives and Central Counterparty Clearing (CCP) transactions in Lagos, as part of its efforts to educate market professionals.
Speaking at the training was the first Vice President of the NSE, Mr. Abimbola Ogunbanjo, who noted that while the concept of derivatives was relatively novel in the Nigerian financial market space, the frontiers of the market has the potentials to grow exponentially due to enhanced liquidity arising from the development of new and intricate financial instruments like derivatives.
“From a customer perspective in Europe,” he said, “exchange trading is approximately eight times less expensive than OTC trading, hence we hope the immense opportunity for improved efficiency via the launch of ETDs in Nigeria will mirror their popularity experienced globally.”

Ogunbanjo also pointed out that the imperatives for a truly functional derivatives markets are evident in the need to improve safety, ensure effective risk mitigation, provide innovation and encourage efficiency.
“Risks, such as counter party risks, operational risks, liquidity risks, systemic and legal risks could be implicit in even the most developed markets. The financial global market was shaken to its very foundation in the wake of the Global Financial Crisis (GFC) between 2007 and 2010 when it became apparent that the underlying assets securing collaterised mortgages had suddenly become delinquent,” he said.

Ogunbanjo noted that the NSE believes the local ETD initiative will eventually develop into a robust market place that can support Nigeria’s growth ambitions, using South Africa as an example of Africa’s first derivative market.
“South Africa’s derivatives market has grown rapidly in recent years, which has supported capital inflows and helped market participants to price, unbundle and transfer risk,” he said.

According to him, their market comprises two broad categories of derivatives, namely options and futures.
He said: “Within these two categories, a wide range of instruments may be identified: warrants, equity futures and options, the agricultural commodity futures and options, interest rate futures and options, currency futures and fixed income derivatives. The fixed income derivatives are made up of bond futures, forward rate agreements (FRAs), vanilla swaps, and standard bond options.

Notwithstanding the foregoing, South Africa has had to manage the risks associated with misuse of complex financial products via continuous improvement and enhanced enterprise risk frameworks. Accordingly, as innovation drives interest in any product, the market will require continuous advancement to risk frameworks, technology and critical thinking to bringing about competition which is a basic driver towards development and growth in the market. As such, this is the first training of many others, which we will continually promote to enhance Nigeria’s global positioning as a thought leader in the African derivatives space.”