The Nigerian derivatives regulatory famework and the development of an efficient derivatives market in Nigeria
Over the past decade, Nigeria has steadily developed its derivatives regulatory framework. In 2011, the Central Bank of Nigeria (CBN) issued its Guidelines for FX Derivatives and Modalities for CBN FX Forwards which was shortly after replaced by the Guidelines for FX Derivatives in the Nigerian Financial Markets (CBN FX Derivatives Guidelines).
Recently, the Nigerian Securities and Exchange Commission (SEC) also issued its Rules on Regulation of Derivatives Trading and on Central Counterparties (SEC Rules on Derivatives Trading). This progressive development shows the intention on the part of the Nigerian financial and securities regulators to develop this important financial market and properly regulate the activities within it. In addition to this, the SEC noted , its intention, in January 2020, to develop ‘an efficient derivatives market’. This desire to develop an efficient derivatives market is commendable and requires the development of proactive regulation and market structures that will drive efficiency within the market.
Market efficiency is an important concept in derivatives regulation. It generally describes the relationship between information and cost when pricing products in a derivatives market. The concept of efficient markets is based on the hypothesis that prices within a market will fully incorporate all available information. This concept was initially developed for stock markets, but its application has been expanded to financial markets in general. For derivatives markets, efficiency involves the relationship between information and cost. This relationship also underscores the extent to which risk is effectively managed, priced, and distributed in derivatives contracts. Derivatives markets are specialized markets that trade on the speculation of the future value of underlying assets. An efficient derivatives market is generally marked by low trading costs and appropriate distribution of risk. The cost of acquiring, processing, and verifying information is an important value note embedded in derivatives trading costs and a relevant marker of an efficient derivatives market. To encourage competition and appropriate distribution of risk, a derivatives market must develop and implement certain regulatory standards that ensure ease of access to information across market participants and maintain a level playing field in the market.
Building an efficient derivatives market in Nigeria is an important step in the development of our derivatives market infrastructure, especially as the volume of activity within the market continues to grow. Derivatives contracts have always been a part of large project or syndicated financings in Nigeria, where they are usually used to hedge against currency and interest rate risk. Derivatives trading has been ongoing for at least 5 years, especially with the trading in OTC FX Futures on the FMDQ Exchange since the CBN introduced the products in mid-2016. Since that time, CBN has sold over $34 billion in futures contracts and over $25 billion of those contracts have been successfully cleared and settled with no defaults occurring in the market. In addition to FX Futures, swaps and forwards are regularly traded OTC by Nigerian banks. The CBN FX Derivatives Guidelines approved FX options, forwards (outright and non-deliverable), swaps and cross-currency interest rate swaps as hedging products in the market and allows dealers to offer European-style FX call and put option contracts to their customers and in the inter-bank market.
This activity makes it important to consider how efficient the Nigerian derivatives markets are and what regulatory reforms are necessary to encourage efficiency within the market. In furtherance of the SEC’s stated objective to develop an efficient derivatives trading market this year, this article will consider the mechanisms that support efficient derivatives market in Nigeria and recommend any reforms necessary to ensure the implementation of an efficient market. It will also analyze the present regulatory structure for derivatives in Nigeria and consider how they support market efficiency.
2. Regulatory Mechanisms that Support Efficient Derivatives Markets
Efficient derivatives markets are grounded by certain regulatory standards that ensure proper dissemination of information across the market, efficient risk management and proper clearing and settlement of transactions. These standards also consider some of the lessons learned from the global financial crisis and cover the regulation of certain participants in the markets. The standards which are generally considered below are: the regulation of dealers, information dissemination, centralized clearing, exchange trading of derivatives, the use of standardized contracts and the implementation of netting and collateral regimes.
Regulation of Dealers and Informational Transparency
Dealers are important participants in derivatives transactions. They are usually banks, who originate and trade these products on behalf of clients and where permitted, may also engage in proprietary trades. Dealers sit in a significant position information-wise because they usually have or can procure the counterparty and market information necessary to price risk in a derivatives contract. This may range from universally available information to information that is specially available to them as a function of their business as bankers, such as the corporate, financial and such other requirements of counterparties. This places them in a very advantageous position and may deter other participants from engaging in the market if the cost of sourcing the kind of price sensitive or price determining information that a bank would normally have or acquire in the ordinary course of their business, is deleteriously high. This in turn would restrict access to derivatives market for other participants if this information is not readily available. It may also result in dealers acting in ways that are detrimental to the rest of the market to protect their positions.
Following from the global financial crisis, a number of regulatory mechanisms were introduced in global derivatives regulation to address some of the informational and risk concerns related to dealers. These include trade reporting and disclosure requirements, price and position transparency, imposition of speculation limits and prudential requirements on dealers. The essence of these mechanisms and the forms in which they appear or are applied in the Nigerian derivatives regulatory space are discussed below.
Trade Reporting and Disclosure Requirements
Trade reporting and disclosure requirements in securities markets generally come in the form of pre- and post-trade transparency. Pre-trade transparency mechanisms connect, and match ask and bid orders/ prices from different participants in a central market place. The ready availability of prices from different buyers and sellers in a central market place generates competition in the market and drives efficiency. Post-trade transparency involves disclosures of all information regarding executed trades including information on price, volume, counterparty, collateral, maturity, and termination. This information should be publicly available to give a clear picture of any counterparty’s derivatives contract exposures and the trading volumes in the market.