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Time for derivative trading in Nigeria

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[FILES] Digital Stock exchange panel. Photo; IFLR

Capacity building is one of the statutory functions of the Chartered Institute of Stockbrokers (CIS), even as the high-profile Institute is on a definitive journey towards changing its name to reflect the wider duties of stockbrokers. With the Theme: “ Derivative Markets, Instruments, and Contracts”, the Institute held a two-day successful virtual training on Wednesday, February 24, and Thursday, February 25.

The accomplished facilitators, including the Registrar and Chief Executive of the Institute, Adedeji Ajadi, are all stockbrokers. The Institute operates a Continuing Professional Development (CPD) programme annually. The Nigerian Stock Exchange whose Chief Executive Officer, Oscar Onyema, is not only a stockbroker but global derivative trader does a lot of training. This implies that human capital is never a threat to trading in derivatives on The Exchange. 

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As an indicator of corporate foresight, over two decades ago, the then Management of The Nigerian Stock Exchange saw the need to commence trading in derivative instruments for enhanced global risk management. Interestingly, the lot fell on the current governor of Edo State, Godwin Obaseki, the then Chief Executive Officer of one of the foremost stockbroking firms, Securities Transactions & Trust Company (SecTrust) (Now Af
rinvest West Africa) to present a paper on derivative trading on The Exchange.

The paper was a masterpiece and instantly became a reference point. Thereafter, The Exchange organized an education visit for some stockbrokers to the University of Reading, United Kingdom, where they were exposed to trading in derivative instruments through simulation. A candidate cannot qualify as an omnibus stockbroker or specialist under the Institute’s new model of Stand-Alone Certification without passing Derivative as a course. 

Derivatives are financial instruments or contracts whose value is derived from that of underlying assets. They are complex financial contracts between two or more parties and their prices are derived from fluctuations in the prices of underlying assets. The underlying assets are equity, fixed income securities, commodities, currencies, interest rates, and market indices, among others.  

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As an asset class, derivative instruments are risk management tools. The four basic types of derivatives are forward, future, options, and swaps. But the most complex among them is an option. The major players in the derivatives market are the hedgers who use derivatives to reduce risk, the speculators or traders who are risk-takers, and arbitrageurs who take advantage of price discrepancies in different markets to make a riskless profit.

Trading in derivatives thrives in an atmosphere of functioning spot market for the underlying assets, assured liquidity, defined market structure, legal compliance, and investor acceptance. By any metric, The Nigerian Stock exchange is positioned for derivative trading. Apart from having the basic infrastructure, the spot market for underlying assets is as old as the history of Nigeria’s economy.

The Exchange, like the Institute, has regularly built capacity for trading in derivatives. As a normal market, it cannot be insulated from volatility due to many factors, especially exogenous. The time for derivative trading on The Exchange cannot be more appropriate than now. Investors across the globe need an alternative way to manage the risk of share diminution. Derivative trading will avail them opportunities to hedge their risk exposure, take a large position with fractional cost, and enjoy the benefits of price discovery.

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It will enable the participants in the market and other operators in the value chain to determine the prices of underlying assets. Derivative trading will enhance The Exchange’s efficiency, attract more participants to the market and boost its income drive. It will open doors for listed companies to access otherwise unavailable assets. For instance, they can leverage interest rate swaps to enjoy a favorable interest rate.  

At the last count, the expectation was high that The Exchange will start trading in Index Futures such as NSE 30. The Index is the underlying asset and has been in existence for years. The Exchange has the capacity to commence immediately and graduate to a single stock future such as using stocks of some blue-chip companies as the underlying assets.

The derivative market is the cynosure of the global financial market. Investors are on the queue for The Exchange to blow the trumpet. There are strong indications that the new entrant to the financial market ecosystem, Lagos Commodities and futures Exchange (LCFE), may blow such trumpet sooner than later.

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It is a win-win affair for both markets and investing public. It is not clear whether the delay in The Exchange’s commencement of trading in derivatives has to do with approval from the apex regulator, the Securities and Exchange Commission (SEC). If this is this is the basis, SEC should act fast as everyone awaits the dawn of a new era. The Exchange should exploit the waiting period for more public enlightenment on the benefits and risk- aversion measures in derivative trading. There should be increased training for the capital market correspondents, the agents of information dissemination to upscale their skills in reporting the financial instruments.

The two biggest derivatives exchanges in the world are the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) where trillion Dollar worth of contracts are written daily. The Nigerian Stock Exchange has always placed a premium on capacity building. In 2009, I was sponsored by The Nigerian Stock Exchange to Chicago Board of Trade as part of my internship with the World Bank in Chicago after a rigorous training at the United States’ Securities and Exchange Commission in Washington DC. The staff at CBOT were excited to discuss the risk and return trade-off in the derivative markets.

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Derivative instruments, like any other asset classes, are not without snags.

In February 1995, at Barings Bank’s derivative trading desk, a brilliant young man, Nick Leeson, in his mid-twenties gambled on future market fluctuations and was losing more than winning. Unfortunately, he was hiding his losses in a secret trading account and using the bank’s money to cover his losses. Leeson had defrauded the bank 827 Million Pound Sterlings which made the British’s oldest merchant banks go bankrupt before the financial scandal was uncovered.  

Derivative is hinged on the pillar of a zero-sum game: When one party loses, the other gains and vice versa. Derivative trading is a high-risk investment.

Oni, Communications Consultant, Chartered Stockbroker and Commodities Trader is the chief executive officer, Sofunix Investment and Communications.

The high volatility associated with the instruments either enhances huge gains or exposes participants to potential losses. Valuation of contracts is highly complex and vulnerable to the error of judgment. Derivatives thrive on speculation and this comes with strong possibilities of monumental losses. The contracts traded on an exchange go through due diligence and there is a central counterparty for buyers and sellers. This mitigates the risk of default or failed trade. But transactions executed over-the-counter are prone to counterparty risk and this may be very costly. Investors should talk to their stockbrokers to mitigate risks.

Oni, Communications Consultant, Chartered Stockbroker and Commodities Trader is the chief executive officer, Sofunix Investment and Communications.

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