The need to leverage market data in trading derivatives remains incontrovertible. CHRIS UGWU writes
Between 2008 and now, the stock market has seen significant reduction in its value. However, noticeable 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 NGX’s and FMDQ’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 infrastructure dearth, finance experts are of the opinion that opportunities should now abound for broadening the exchange’s product offerings to include key derivative categories, expansion of listed mutual funds and index funds, among others. In an effort to strengthen the Nigeria capital market 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 deepen and inject liquidity into the market. In pursuit of its drive to deepen the stock market, the regulators have said it will intensify efforts to create more products like derivatives to offer investors other alternative investment platforms. However, as the launch of derivatives in the local bourse get closer, market stakeholders have stressed the importance of leveraging market data in this regard.
What is derivative?
A derivative is a contract between two or more parties whose value is based on an agreed 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, while 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 basic principle behind a derivative contract is to earn profits by speculating on the value of the underlying asset at a future date. As such, derivatives are used as a risk management instrument, and are suited to both professional and private investors who wish to hedge an open position or gain exposure to assets and markets without necessarily holding the underlying assets. ETDs are variants of derivatives traded on an organised securities exchange as against those other derivatives traded through informal overthe- counter (OTC) market. 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 into two – that for exchange-traded derivatives and that for over-the-counter derivatives.
Importance of data in trading derivatives
Nigerian Exchange Limited (NGX) has highlighted the importance of leveraging market data in trading derivatives. The Chief Executive Officer, NGX, Mr. Temi Popoola, while speaking at the sixth edition of its Market Data Workshop recently, noted: “The innovation of financial derivatives in Nigeria and trading them through the organised Exchange will play a pivotal role in contributing to economic development by making risk manageable, enabling price discovery and reducing transaction costs for both financial and non-financial firms. “Their continued contribution to economic growth will depend on the markets becoming more transparent and liquid, enabling end users to generate competitive returns while effectively hedging risk.” He highlighted the importance of leveraging market data in this regard, stating that “through cutting-edge technology, NGX continues to promote a high level market transparency by enabling easy access to quality real time market data to all market participants including regulators. “Market data such as transaction prices, bids/offers and other trading information becomes the bedrock for price discovery and investment strategies. “Derivatives traded on exchanges disseminate price information that aids both private and public entities because exchanges make contract volume and price publicly available. Such transparency helps markets function more efficiently.” This year’s event was held virtually in collaboration with Official Partners, Zenith Bank, Reliance Infosystems Limited, Infoware and MTN Nigeria; Gold Sponsor, CSCS Plc; and Corporate Sponsors, United Capital, NG Clearing, Cordros, Neulogic, Apel Asset Management and ARM. With the theme: “How Market Data Powers Investment Strategies Using Derivatives Products,” the workshop was designed to provide capital market stakeholders – particularly institutional investors, actuaries, portfolio managers – with insights into price, valuation and investment strategies using derivatives and fixed income products, as well as technical tools that can be applied to mitigate risk.
Derivatives to deepen options
NGX 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. The NGX boss, Mr. Oscar Onyema, stated this at a workshop on the legal and regulatory requirements of derivatives trading for capital market operators yesterday in Lagos. The workshop was organised in collaboration with the Securities and Exchange Commission (SEC) to guide market participants to properly interpret the approved Exchange traded derivative rules and recently released SEC’s derivatives and clearing rules, as well as address concerns on the onboarding process. 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.”
Launch of derivatives trading gets closer
Following the approval in principle received by NG Clearing Limited from SEC to launch clearing and settlement of exchange traded derivatives products as Nigeria’s premier Central Counterparty Clearing House (CCP), NGX said recently that it has intensified engagements with stakeholders as it look forward to launching its first derivatives product in 2021. Onyema recently said: “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.” As Nigerian Exchange (NGX) Limited inches closer to the launch of Exchange Traded Derivatives (ETDs) in the Nigerian capital market, it continues to engage with the capital market ecosystem. In collaboration with NG Clearing (NGCL), NGX recently hosted an engagement session with trading license holders (TLHs). Speaking at the session, the Divisional Head, Trading Business, NGX, Mr. Jude Chiemeka, noted: “NGX in its quest to be Africa’s preferred Exchange hub, recognises the importance of a well-developed derivatives market and has worked assiduously to build the regulatory and technology framework and competence required to support the launch of a standardized ETDs market. “We are confident that the Derivatives market will complement existing cash markets and provide investors and other market players with the necessary tools for tactical asset allocation, risk management and cost management for effective portfolio management. “Our adoption of a best in class Central Counterparty (CCP) and Clearing House, NG Clearing further engenders confidence in the ETD market segment amongst market participants, as the clearing infrastructure being set-up will be of international standards capable of reducing systemic risk and enhancing market transparency.” During the session, the Head, Derivatives Markets, NGX, Mrs. Chidinma Chukwueke-Okolo, provided TLHs with information on their roles, as well as the minimum operating standards for participating in the Derivatives market. Areas where TLHs must show competence across the following areas: manpower & equipment, organisational structure & governance, effective processes, global competitiveness, and technology.
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.