Developing derivatives will create more products to offer investors other alternative investment platforms. Chris Ugwu writes
ince inception, the Nigerian capital market has remained predominantly equity-driven with certain sectors dominating trading and market capitalisation.
For instance, on the main board of the Nigerian Stock Exchange, the financial services sector leads the board’s total market capitalisation while consumer goods sector is second.
However, of recent, bond trading has been on the rise through issuance of bonds by the Federal Government. It is clear, especially since the slide in the values of the exchange in 2008, that efforts, including more instruments like derivatives, are required to improve the fortunes, attraction, and experience of investors.
This will also help to reduce the current problem of shallowness and lack of breadth in the market as less than 30 per cent of listed equities are currently traded actively, while the NSE offers only basic products.
Between 2008 and 2016, the stock market has seen a reduction in its value by over 50 per cent. However, significant underlining progress has been made in terms of strengthening the process. This development is essential, because it helps the foundation and the platform on which investors rely to make reliable judgment on their investments.
There have been arguments, though, to the effect that the NSE’s product offering has only reflected the domestic economy’s financing needs.
However, on account of the economy’s radically changing financing needs, including recourse to public private partnership (PPP) arrangement as a solution to the nation’s infrastructure dearth, finance experts are of the opinion that opportunities should now abound for broadening the exchange’s product offerings to include key derivatives, expansion of listed mutual funds, index funds, among others.
In an effort to strengthen the Nigerian Stock Exchange and make it compete favourably with other exchanges across the globe, some experts have in various fora called on the regulators to create more products that will deepen and inject liquidity into the market.
In pursuit of its drive to deepen the stock market, the Nigerian Stock Exchange last week said it was intensifying efforts to introduce trading in financial derivatives next year as it seeks to deepen the market and create more products to offer investors other alternative investment platforms.
What are derivatives?
A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks, according to Invetopedia.
Futures contracts, forward contracts, options, swaps and warrants are common derivatives. A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is “derived” from that of the underlying stock.
Derivatives are used for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying asset, index or security. For example, a trader may attempt to profit from an anticipated drop in an index’s price by selling (or going “short”) the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset’s price to be transferred between the parties involved in the contract.
For example, commodity derivatives are used by farmers and millers to provide a degree of insurance. The farmer enters the contract to lock in an acceptable price for the commodity; the miller enters the contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the farmer locks in a specified price for the commodity, prices could rise (due to, for instance, reduced supply because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop and the miller will have to pay more for the commodity than he otherwise would have.
The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives.
NSE plans derivatives trading next year
The Nigerian Stock Exchange plans to introduce trading in financial derivatives next year as it seeks to deepen the market.
“We will launch with equity index futures and then grow the list from there,” Chief Executive Officer, NSE, Oscar Onyema, said in an interview in Abu Dhabi.
According to Bloomberg, the exchange plans to introduce futures and options to enable investors hedge and manage risks, he said at the Africa Investment Summit organised by the Abu Dhabi Investment Authority.
Nigeria is seeking to encourage trading in the wake of a 14 per cent slide in its benchmark index this year, the fourth-worst performer among 94 global equity gauges tracked by Bloomberg. While efforts to introduce derivatives in the past were hampered by the lack of a central counter-party clearing house, one has now been set up and the Lagos bourse is seeking a license for it from regulators, Onyema said.
Onyema has long been floating plans to introduce derivatives trading since his appointment in 2011, but has continually delayed its launch.
“The Lagos stock exchange is also in talks with regulators to increase the share of pension fund investment into equities, to raise the current allocation to stocks at 4.95 per cent,” Onyema said.
There are already signs that stocks are starting to rally a little bit, thanks to an inflow of pension-fund money after the Central Bank of Nigeria tightened restrictions OMO.
The bourse is also lobbying President Muhammadu Buhari’s government to offer tax breaks to companies and exempt securities transactions from value-added tax to boost investment, according to Onyema.
Nigeria, which vies with South Africa as the continent’s biggest economy, is seeking to expand tax revenue amid a decline in income from crude oil, which contributes the bulk of the nation’s revenue. Johannesburg is home to Africa’s largest stock exchange.
The CEO is looking to complete a demutualization of the exchange early next year, a process that will convert it to a shareholder-owned public limited liability company from a member-owned mutual organisation.
SEC’s rules on derivatives
The Securities and Exchange Commission (SEC) had recently said that the rules on derivatives would be ready soon. The Acting Director General of SEC, Ms. Mary Uduk, noted that the commission had been building capacity in-house in partnership with South Korea for the development of derivatives.
“We have a knowledge sharing programme with them, they have been to the country twice now and our workers are scheduled to travel to their country for more training. Even their ambassador has been to the Commission and all of that is part of building capacity and training the staffs.
“Even in the market the NSE is doing a lot in the area as well as the FMDQ who are taking some people to India this month on capacity building. All stakeholders including the CBN have been joining hands together to ensure that we get it right,” she said.
The commission identified derivatives as one of the investable products that would enhance the liquidity of the Nigerian capital market.
Regulators and operators have been advised to go gradually in introducing derivatives in the country for better results.
A former Chairman of the United States Commodities Futures Trading Commission (US CFTC), Mr. James Stone, gave the advice last year while speaking at forum organised by NSE in partnership with Coronation Merchant Bank Group in Lagos.
Speaking on ‘Pluses and Pitfalls of Derivatives Trading,’ Stone noted that it was better to begin with the simple form of derivatives and improve on them.
According to him, since there are already Exchange Traded Funds (ETFs) in Nigeria, it is better to begin with exchange traded derivatives.
According to Onyema, the exchange has been planning to launch exchange traded derivatives in the market, saying that the experience shared by Stone will assist in that direction.
He said that having Stone, a fellow of the American Society of Arts and Sciences, who was appointed by President Jimmy Carter as Chairman of the US CFTC, was an amazing opportunity because of the quality of engagement and insight gained from the interaction.
“The exchange is committed to building capacity and enhancing the expertise of operators and other associated parties towards collective efficiency. The lecture on ‘Pluses and Pitfalls of Derivatives provided enriching perspectives and strengthen the capacity of capital market operators, who create value for investors through their operations on the floor of the NSE,” Onyema said.
Derivatives are essential in markets with significant low product to investor ratio like the Nigerian Stock Exchange. However, the regulators and fund managers have key roles to play in ensuring the right products are introduced to the market and that product proliferation does not lead to investor abuse.
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