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New vista in stock market liquidity with derivatives options

By Helen Oji
07 August 2018   |   4:12 am
There was no cheery news on the floor of the Nigerian Stock Exchange (NSE) last month as activities on the Nigerian stocks market took a negative turn in the month...

There was no cheery news on the floor of the Nigerian Stock Exchange (NSE) last month as activities on the Nigerian stocks market took a negative turn in the month of July following high capitalised stocks and huge price cuts. July experienced free-fall of equity prices despite the month being the peak of the half-year earnings season.

The continuous monthly decline of the stocks market was due to sustained sell-offs by foreign and some domestic investors, due to dwindling confidence in the system, as economic slowdown continue in the midst of insecurity and anxiety ahead of the 2019 general elections.

The bear dominancy during the period under review was obvious in the 22 trading sessions of the month of July at the NSE, as the market was down for 13 days and up in just nine, thereby continuing the six months of decline.

Year-to-date returns on the Nigerian stocks market remain negative at 3.20 per cent, a factor that was attributed to a combination of low liquidity, capital outflows, mixed performance of listed companies and political uncertainties.

Others include, the delay in passage, assent and possible implementation of the 2018 budget, as well as the declining buying pressure as revealed by volume traded for the period.

The positive economic data emanating from the Central Bank of Nigeria (CBN) and the National Bureau of Statistics (NBS) in the preceding months before were simply ignored by money investors that kept selling down their positions.

A crucial part of the current problem with the capital market is its shallowness and lack of breadth. Currently, less than 30 per cent of listed equities are actively traded, while the NSE offers only basic products. 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 infrastructure dearth, 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 a bid to strengthen the NSE and make it compete favourably with other Exchanges across the globe, some experts had in various fora called on the regulators to create more products that would broaden deepen and injection of 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 capital market, rapidly declining Foreign Direct Investment (FDI) and scarcity of investment opportunities in an equity centric economy, investors in the nation’s capital market are crying out for an innovative and versatile financial product such as derivative securities for hedging and market expansion.

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.

According to Investopedia, due to its presence on a trading exchange, ETDs differ from over-the-counter derivatives in terms of their standardized nature, higher liquidity, and ability to be traded on the secondary market. ETDs include futures contracts, options contracts, and futures options.

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 economics 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, something that could be emulated in 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).

Therefore the development 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 in second half of the year 2018. The president, National Council of NSE, Abimbola Ogunbanjo, stated this while speaking at the exchange’s 57 Annual General Meeting (AGM).

According to him, Nigeria’s Exchange Traded Derivatives (ETDs) will boost the nation’s stock market. “We believe that Nigeria’s ETD initiative will eventually develop into a robust market place 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 bringing about competition which is a basic driver towards development and growth in the market.”

Ogunbanjo added that the concept of derivatives remain 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 has encouraged the need for well-tailored legislation/legislations 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 pro ducts to give adequate advice.

“Given the vulnerability that derivatives may pose where it is 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 will limit the potential of derivative transactions in Nigeria,” Ogunbanjo noted.

On how trading in derivatives would accelerate market growth, the Managing Director of Capital Bancorp Plc, Aigboje Higo, in an interview with The Guardian, explained that markets with derivatives respond quickly to information as the information is more rapidly incorporated into the prices of underlying securities in the presence of derivatives because of the link between the derivatives market and the underlying market.

According to him, it is also fundamental to attracting foreign investment as foreign investors and investment fund managers seem to prefer more sophisticated and financially rewarding investment products like derivatives.

“Derivatives trading will increase turnover on the NSE and advance the market by giving it another business. Operators will make more money and it will give people the opportunity to hedge against risks and bring more certainties to the market. On the overall, it would put Nigeria on world stage.”

The keyword now is digital technology, so it is a layer of different technologies that will be required. So derivatives clearly is a welcome product

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.

According to him: “Derivatives is derived from other things that exists on 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 need along what is going on because the key word now is digital technology.

“With derivatives, brokers are able to do structured products that they can sell inform of derivatives. 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.

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

Volumes traded of single stock options, which account for 77 per cent of single stock derivatives, increased by 4.8 per cent on 2016, driven by a 3.6 per cent increase in the Americas where over 80 per cent of the trading takes place. The Asia-Pacific saw a significant 26.6 per cent increase in volumes traded, while only the EMEA region experienced a decline in volume traded (down 2.4 per cent) on 2016.
Stock index options volumes traded increased by 22.6 per cent on 2016. In the Asia-Pacific region, where over 65 per cent of the trading takes place, volumes traded were up 34.3 per cent on 2016. In the Americas volumes traded were up 12.7 per cent, while the EMEA region experienced a 3.2 per cent decline in volumes traded.