Monday, 6th December 2021
Breaking News:

Derivatives as viable alternative for boosting stock market’s liquidity

By Helen Oji
25 October 2021   |   3:04 am
With less than 30 per cent of listed equities being actively traded while the Nigerian Exchange Limited (NGX) offers only basic products, there are concerns about the capital market

With less than 30 per cent of listed equities being actively traded while the Nigerian Exchange Limited (NGX) offers only basic products, there are concerns about the capital market’s shallowness and lack of breadth. There have been arguments, though, to the effect that the NSE’s product offering merely reflects the domestic economy’s financing needs.

However, on account of the growing financing needs, including public-private partnership (PPP) as a solution to the nation’s infrastructure dearth, finance experts believe that there are new opportunities for broadening the exchange’s product offerings to include key derivative categories, expansion of listed mutual funds, index funds, among others.

In a bid to strengthen the NSE and make it compete favourably with other exchanges across the globe, some experts, had at various fora, called on the regulators to create more products that would broaden, deepen and inject liquidity into the market.

The emerging markets are expected to grow exponentially due to enhanced liquidity arising from the development of new and intricate financial instruments. Due to the recent catastrophic fall of the capital market, rapidly declining Foreign Direct Investment (FDI) and scarcity of investment opportunities in an equities-centric economy, investors in the nation’s capital market are advocating an innovative and versatile financial product such as derivative securities for hedging and market expansion.

This is because uncertainties in the country and other macroeconomic challenges have continued to fuel neglect of equities and subsequent diversion to other instruments despite the stock market’s attractive valuation. Investors are not patronising the market to buy stocks, despite their poor valuation. Analysts had blamed the development on the dearth of liquidity and low confidence that have shrouded the Nigerian market in the past few years.

For instance, the Nigerian stock market closed negative for the first half of 2021, leading to N1.29 trillion losses to investors during the period.

The negative development followed the uptick in yields in the Fixed Income (FI) market, which resulted in the reallocation of assets from equities to FI during the period.

As a result, the benchmark All-Share Index (ASI) dropped by 5.87 percent to 37,907.28 points from 40,270.72 points, the opening position on the first trading day of January 2021.

Similarly, the market capitalisation of all listed equities fell by 6.16 per cent to close at N19.760 trillion from N21.057 trillion at the beginning of the year.

Recall that the positive sentiment that pervaded the market in H2 ’20 extended into the early part of the year, but was short-lived due to the reversal in the yields on fixed income instruments, which dampened appetite for stocks.

Hence, it was cheery news recently when the Nigerian Exchange Limited (NGX) announced that it had received approval for seven derivatives contracts from the Securities and Exchange Commission (SEC).

According to a statement by the exchange, the approved contracts are Access Bank Plc Stock Futures, Dangote Cement Plc Stock Futures, Guaranty Trust Bank Plc Stock Futures. Others are MTN Nigeria Communications Plc Stock Futures, Zenith Bank Plc Stock Futures, NGX 30 Index Futures and NGX Pension Index Futures.

A derivative is a contract between two or more parties whose value is based on an agreed underlying financial asset or group of assets.

An Exchange Traded Derivative (ETD) is merely a derivative contract that derives its value from an underlying asset that is listed on a trading exchange and guaranteed against default through a clearinghouse. It is a contract between two or more parties whose value is based on an agreed underlying financial asset or group of assets.

Common underlying instruments include bonds, commodities, currencies, interest rates, market indices and stocks.
The principle behind a derivative contract is to earn profits by speculating on the value of the underlying asset at a future date.

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.

The exchange explained that the announcement followed a successful registration of NG Clearing by SEC, as a premier central counterparty, effective June 7, 2021.

It stated that the NGX was inching closer to launch West Africa’s first Exchange Traded Derivatives (ETD) supported by NG Clearing in the risk management process with these approvals.

Ahead of the launch, the Chief Executive Officer, NGX, Temi Popoola, said the launch of the derivatives market aligns with the exchange’s commitment to building a market that thrives on innovation and responds to the needs of stakeholders in accessing capital.

He said NGX has continued to ensure widespread understanding of derivatives, their applicability and how investors can reap maximum value from the asset class.

According to him, the NGX has collaborated with both local and international organisations such as SEC, JPMorgan Chase, CBOE Options Institute, and NG Clearing to facilitate an in-depth capacity-building programme on the derivatives market.

He added that the exchange, through its learning and development arm, X-Academy has hosted training to prepare capital market players who wish to undertake the Chartered Institute for Securities & Investment UK Global Derivatives qualification exam, and is on track to host further training for other stakeholders in the near term.

To ensure an effective rollout of the initiative in the Nigerian capital market, the NGX and NG Clearing (NGCL), recently engaged the Trading License Holders (TLHs) on how to create a standardised ETDs market.

At the session, the Divisional Head, Trading Business, NGX, Jude Chiemeka said in its quest to be Africa’s preferred Exchange hub, the NGX recognises the importance of a well-developed derivatives market and has worked assiduously to build the regulatory, technology framework, and competence required to support the launch of a world-class ETDs market.

Chiemeka said the derivatives market will complement existing cash markets and provide investors and other market players with the necessary tools for tactical asset allocation, risk, and cost management tools for effective portfolio management.

Head, Derivatives Markets, NGX, Mrs. Chidinma Chukwueke-Okolo spoke on the roles, as well as the minimum operating standards for participating in the derivatives market.

She listed areas TLHs must show a high level of competence to include, manpower and equipment, organisational structure and governance, effective processes, global competitiveness and technology.

The Chief Operating Officer, NGCL, Ayokunle Adaralegbe pointed out that the derivatives market remained the largest single segment of the global financial market and has been estimated to be more than five times larger than global equity and bond markets.

He said local and international players in the derivatives market space anticipate the launch of ETDs in the market and are keeping a keen eye on the activities of NGX in this regard.

Globally, the derivatives market has attained the highest growth of all financial market segments in recent years and has become the central contributor to the stability of the financial world. In recent years, derivative markets have grown by leaps and bounds in emerging economies and given the high level of economic and financial risks faced by market participants and investors in emerging countries, derivatives contribute to a country’s economic development by making these risks manageable.

For instance, in the United Kingdom, pension funds have in the past years increased their use of derivatives, an idea that could be emulated by Nigeria. The overall derivatives market is vast and 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 development, therefore, is no doubt a step in the right direction, as it would signal a new opportunity for Nigeria because derivatives are extremely flexible due to their contractual nature and they can be used to accomplish a broad array of risk management objectives if properly utilised.

But the Nigerian capital market is yet to leverage the potential inherent in the product to grow the market. The exchange has said that it is working cohesively with its ecosystem to officially launch ETDs. The president, National Council of NSE, Abimbola Ogunbanjo, stated this while speaking at the exchange’s 57th yearly general meeting.

According to him, Nigeria’s ETDs will boost the nation’s stock market, adding, “We believe that Nigeria’s ETD initiative will eventually develop into a robust marketplace that can support our growth ambitions as a nation, using South Africa as an example of Africa’s first derivative market.”

He noted that 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.

“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 bring about competition which is a basic driver towards development and growth in the market”, he highlighted.

Ogunbanjo added that the concept of derivatives remains relatively novel in the Nigerian financial market space and has only been noticeable within the Over-The-Counter (OTC) segment of the market.

Experts have argued that due to the absence of a robust regulatory and legal framework to accommodate the peculiarities of derivatives in Nigeria, a majority of the transactions may still be bilateral.

According to them, the advent and increased utilisation of structured financial products in Nigeria have encouraged the need for well-tailored legislation/legislation to further bolster the capital market.

“A well-developed derivatives market is crucial to the advancement of the Nigerian financial markets. It is impossible to harness the benefit of derivatives where there is no concrete financial regulatory framework in place and a substantial number of lawyers who are well informed on structured products to give adequate advice.

“Given the vulnerability that derivatives may pose where they are left unregulated, it is important that care is taken to ensure that adequate regulation is introduced to protect the market. It may also be instructive to ensure that the regulation so introduced is not such that it will limit the potential of derivative transactions in Nigeria,” Ogunbanjo noted.

On how trading in derivatives would accelerate market growth, the Head, Research, FSL Securities, Victor Chiazor, said the introduction of derivatives will greatly impact the market positively as it will bring significant liquidity to the market.

According to him, the kickoff of the product in the capital market would also help to attract foreign investment as foreign investors and investment fund managers seem to prefer more sophisticated and financially rewarding investment products like derivatives.

He pointed out that derivatives would also bring new investment options outside the usual ‘plain vanilla investments’ available in the market.

“More so once investors are excited about the derivative market, it positively affects the underlying asset and the entire market at large.

“We are excited about the imminent introduction of derivatives into the equities market and expect investors to benefit from these new opportunities.”

The Managing Director of United Capital Securities, Jude Chiemeka, said in terms of product development, derivatives would help enhance the array of services that the brokerage communities are currently enjoying.

“Derivatives are derived from other things that exist in the economy. First of all, in terms of product development, it would help enhance the array of services that the brokerage communities are currently enjoying.

“It would help the brokers to improve their revenue stream and improve their expertise so we are now able to meet more needs along with what is going on because the keyword now is digital technology.

“With derivatives, brokers can do structured products that they can sell in the form of derivatives. The derivatives market is huge internationally. But I think human capital development is also key because you need to train people who are going to create these products and people that will trade on this product.

Also speaking on the benefits of the product, the Head, Structured Products of FBN Capital, Michael Okon, said derivatives offer the potential for enhanced liquidity and increased funding solutions in the capital market.

In addition to its potential to generate income, the instrument, according to him, can serve as a hedge against certain exposures in the Stock Market.

“The introduction of derivatives like options and futures will create an alternative investment outlet for those who can assume risks that are greater than normal. As the market evolves and we have more market participants, we should see increased liquidity and price discovery which will help develop the exchange-traded market,” he said.

In data obtained from the World Federation of Exchanges (WFE), Exchange Traded Derivatives volumes overall in 2017 were up 0.6 per cent in 2016, driven largely by increases in volumes traded of single stock options, stock index options and interest rate futures.