Business

Leveraging derivatives to raise trading activities

Developing derivatives will broaden trading options and boost market activities. Chris Ugwu writes

The Nigerian Stock Exchange remains a predominantly equity-driven market with certain sectors dominating trading and market capitalisation. On the Main Board, the Financial Services sector leads the pack of the board’s total market capitalisation while Consumer Goods sector is second. However of recent, bond trading has been on the rise through the issuance of bonds by the Federal Government.

But 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 in the Nigerian stock market.

This will also help to reduce the current problem of shallowness and lack of breadth in the capital market as, currently, less than 30 per cent of listed equities are actively traded, while the NSE offers only basic products. Between 2008 and today, the stock market has seen significant reduction in its value.

However, significant underlining progress has been made in terms of strengthening the process in the capital market. This development is essential, because it helps the foundation and the platform on which investors rely to make reliable judgments 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 the recourse to the public private partnership (PPP) arrangement as a solution to the nation’s dearth in infrastructure, finance experts are of the opinion that opportunities should now abound for a broadening of the exchange’s product offerings to include key derivative categories, 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 would broaden deepen and inject liquidity to the market.

In pursuit of its drive to deepen the stock market, the regulators have said it would intensify efforts to create more products like derivatives to offer investors other alternative investment platforms. The NSE last week said it continues to lay the ground work to build a standardised derivatives market.

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, however, 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 beinto two, that for exchange-traded derivatives and that for over-thecounter derivatives.

NSE intensifies efforts

As investors anticipate the launch of derivatives trading in the Nigerian capital market, Nigerian Stock Exchange (NSE) last week said it continued to lay the ground work to build a standardized derivatives market. Part of these efforts include capacity building sessions such as the virtual derivatives workshop which was organized by the exchange.

The training was themed, “Adopting Derivatives During Stressed Market Conditions” and it featured a special presentation from Charlie Rubin, Derivatives Consultant at C-Rubin Futures, and former Senior manager of the New York Stock Exchange, and New York Futures Exchange. Speaking at the webinar, the Chief Executive Officer, NSE, Mr. Oscar Onyema, stated: “The global financial market has seen good growth and innovation over the past 20 years, and derivatives have contributed substantially to this impressive development.

“Today, the global derivatives market is the main pillar of the international financial system and the economy as a whole. The exchange in its quest to be Africa’s preferred exchange hub, recognizes the importance of a well-developed derivatives market and has worked assiduously to build the regulatory and technology framework as well as the competence required to support the launch of a standardized Exchange Traded Derivatives (ETDs) market.” Rubin highlighted the unique benefits of derivatives trading, noting that “derivatives have been known to increase trading activity significantly across markets. “For instance, the National Stock Exchange of India is witnessing trading activity 25 times more than pre-derivative levels in its 8th year since introducing derivatives.

“This accounts for four times more than its cash business. Markets are likely to continue to enjoy such activity due to the fact that derivatives provide a hedge against risk, facilitate short selling and allow investors to undertake leveraged buying and selling.”

The exchange began its journey to launching ETDs in 2014 with a feasibility study k, which showed that the Nigerian capital market is indeed ready for the more sophisticated investment products ETDs will introduce. Speaking on the efforts the exchange had made, the Head, Trading Business, Jude Chiemeka, stated: “NSE is committed to building a derivatives market that meets global standards. “We have worked with regulators such as the Securities and Exchange Commission and the Central Bank of Nigeria to establish the right regulatory and legal framework for derivatives in our market. “We also continue to build on the trading infrastructure that will ensure domestic and foreign stakeholders are able to trade seamlessly once we launch within subsequent months.”

Derivatives to broaden options

The Nigerian Stock Exchange had said that the introduction of Exchange- trade derivatives on the local bourse was aimed at broadening the options available to support efficient implementation of risk management and investment strategies across diverse asset classes and financial instruments.

Onyema stated this at a workshop on the legal and regulatory requirements of derivatives trading for capital market operators yesterday in Lagos. ====Onyema said: “We are, therefore, delighted to host this event in recognition of the importance of capacity building and investor education to the development of this asset class. “We are working tirelessly to ensure that our Derivatives market remains aligned with International Organisation of Securities Commission (IOSCO) principles by facilitating access to recognized and licensed derivative products, world class market surveillance technology, effective trading rules as well as appropriate risk management and clearing facilities.” Speaking on the rules guiding derivatives market, a former Acting Director General, SEC, Ms Mary Uduk, represented by Head of Department, Registration, Exchanges, Market Infrastructure & Innovation, Mr. Emomotimi Agama, said: “The NSE and SEC have provided the platform and requisite rules to guide activities in the derivatives market. It is, therefore, the responsibility of capital market operators to work with us to galvanise activities within this market segment.

“Furthermore, interested dealing members or clearing houses must build strong capacity to deliver on investor education, proper legal frameworks, effective risk management procedures, and advanced reporting standards to engage in derivatives trading for the safety and security of investors.”

Last line

Derivatives are essential in markets with a 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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