BY EMEKA EJERE

Investors who have long anticipated the launch of derivatives trading in the Nigerian capital market may soon have their expectation met. Recent developments have shown that the Nigerian Stock Exchange (NSE) is laying the foundation to build a standardized derivatives market.

Last week, the Exchange held a derivative market capacity-building workshop, which featured a special presentation by Charlie Rubin, Derivatives Consultant at C-Rubin Futures, and former senior manager of the New York Stock Exchange, and New York Futures Exchange. Propel

Financial markets, including capital and derivatives markets, are worldwide exchanges for small and large businesses to raise capital and hedge against different types of risks. While capital markets include stock and bond markets, derivatives markets include futures and options markets. Investors may invest in these markets directly through banks and online stockbrokers and indirectly through mutual funds and pension funds.

Experience has shown that derivatives have become increasingly important in today’s financial and trade markets, offering risk protection as well as innovative investment strategies. The International Swap and Derivatives Association (ISDA) in its recent report revealed that over 90% of the world´s 500 largest companies across 26 countries are using derivatives to manage their risks. About 92% of the companies covered use derivatives to manage and hedge their risks more effectively.

According to the Bank for International Settlement (BIS), the market for this asset class “was relatively nascent three decades back but has grown impressively by about 24% growth per year in the last decade, to reach a sizeable and truly global market with about $640.44 trillion of notional amount outstanding as at June 2019.”

This growth, the institution further revealed, was fuelled by product and technology innovation driven by exchanges and intermediary firms as well as related service providers across the world. Whilst only 6 percent of the reported notional amount outstanding is traded on exchanges, users of derivatives find on-exchange trading to be approximately eight times less expensive than over-the-counter (OTC) trading.

Furthermore, risks are particularly well controlled in the exchange segment, where central counterparties (CCPs) operate very efficiently and mitigate the risks for all market participants.

Ultimately, derivatives exchanges serve three important economic purposes: risk shifting, price discovery, and enhancing efficiency by providing a focal point where buyers and sellers can easily meet.

“In this era of increased volatility and risk in financial market, the need for an effective regulatory regime in exchange-traded derivatives market is pertinent”, NSE noted in one of its documents.

The document further revealed that the Security and Exchange Commission (SEC), in fulfilling its mandate to promote fair and well-regulated capital market in Nigeria, “has adopted best practice regulatory approach with the publication of its Derivatives Trading and Central Counter Party (CCP) Rules to facilitate market integrity, efficiency and investor protection for users of derivatives in the Nigerian market.”

“The introduction of exchange-trade derivatives on our bourse is aimed at broadening the options available to support efficient implementation of risk management and investment strategies across diverse asset classes and financial instruments.

“We are working tirelessly to ensure that our derivatives market remains aligned with International Organization 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.

The chief executive officer of NSE, Mr. Oscar Onyema, had in February disclosed that as part of its commitment to building the required infrastructure for derivatives market in Nigeria, “the Exchange is partnering with Central Securities Clearing System Plc (CSCS) to launch NG Clear, a world-class central clearing counterparty (CCP) entity,

The establishment of a CCP entity which meets the European Market Infrastructure Regulation (EMIR) standards in Nigeria, he said, is in line with G20 programme to reform global financial regulation.

Speaking at the recent workshop webinar, Mr. Onyema, said: “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.”

Also, derivatives consultant, Charles Rubin, highlighted the unique benefits of derivatives trading. He noted: “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.”

The capital markets consist of regulated stock exchanges, such as the New York Stock Exchange and the NASDAQ; over-the-counter markets for stocks that do not qualify for listing on the major exchanges; and bond markets for trading corporate and government bonds.

Businesses use the capital markets to raise funds for various operational and strategic reasons. Governments also use the capital markets to issue short-term and long-term bonds to pay for services and operations. The United States Securities and Exchange Commission is in charge of enforcing governance and disclosure requirements for companies listed on U.S. exchanges.

Investment banks facilitate the listing process for stocks and bonds, which typically includes regulatory filings and marketing efforts to generate investor demand. Research Analysts use   published financial reports and industry data to provide recommendations on which stocks to buy or sell and at what price.

On the other hand, derivatives trade on regulated exchanges, such as the Chicago Mercantile Exchange and the Chicago Board Options Exchange, and on over-the-counter markets. Over-the-counter derivatives include standardized contracts, which have features similar to the standard contracts trading on the regulated exchanges, and customized contracts between two parties.

Businesses and financial institutions are the main users of the derivatives markets, which provide risk protection at minimal upfront cost. People can use derivatives to hedge their investments or to speculate on the future direction of asset prices. These risk factors include commodity price fluctuations and interest rate fluctuations.

It is critical to note that when one buys shares in the cash market and takes delivery, he is the owner of these shares or a shareholder, until he sells the shares. But he can never be a shareholder when he trades in the derivatives segment of capital market. This is because he just holds positional stocks, which he has to square-off at the end of the settlement.