By John Kavvouras, Director, GTI London Ltd.
The focus of most discussions regarding derivatives trading has revolved around standardised exchange-traded derivate instruments. However, the reality of the Global Derivatives market is that, in terms of notional amount outstanding, over the counter (OTC) derivatives dwarf that of exchange-traded instruments.
Nigeria has an opportunity to establish its position as a regional financial centre by taking the lead in regulation and promoting OTC derivative instruments tailor-made for the regional market. FMDQ’s specialization on OTC currency and debt combined with NASD Exchange’s experience in OTC equity are ideal vehicles to develop a diverse OTC derivatives market. A regulatory regime which incorporates a clearing infrastructure will make the Nigerian OTC markets liquid and internationally competitive.
In the wake of the 2008 Global Financial crisis, a revised OTC derivatives regulatory reform program was enacted at the international level with two G20 conferences agreeing to global standards for transparency and capital requirements for OTC derivative transactions. A clear outline for best practices of regulation of the OTC derivatives market has been laid out and implemented by most of the member jurisdictions of the Financial Stability Board (FSB), the Basel, Switzerland based international organisation that monitors the global financial system. By adopting the G20 over the counter (OTC) derivatives market reforms, Nigeria would establish itself as a secure, compliant trading jurisdiction for derivatives. This, in turn, will help promote Nigeria’s financial sector globally.
Exchange-traded derivative products are standardized financial instruments that are traded on organised exchanges such as Chicago Mercantile Exchange (CME) or the London International Financial Futures and Options Exchange (LIFFE). Whereas, over the counter (OTC) derivative products are traditionally traded off exchange, and are usually bi-lateral agreements without a central counterparty. In exchange-traded products, there is a Central Counterparty (CCP) which guarantees the performance of contractual obligations. As all contingent default risk is assumed by the CCP, counterparty credit risk is limited. This differs from customized OTC products where; terms are usually negotiated by two parties and there is no CCP to guarantee performance. The main advantage that OTC products have over exchange-traded instruments is standardization versus customization.
Customized OTC derivatives offer companies more flexibility as they can be tailored to fit specific needs, such as the hedging an exchange rate, or commodity price over a specific period. This is contrasted with exchange traded derivatives which are characterised by standardization that can cause hedging mismatches.
However, the advantages of the customization of OTC products come at a price, there is a lack of transparency and an increased counterparty risk.
The G20 over the counter (OTC) derivatives market reforms are intended to address the risks associated with OTC derivatives. The main reforms include trade reporting, central clearing, margin requirements for non-centrally cleared derivatives (NCCD), higher capital requirements for NCCD and transaction transparency through trade reporting. Two institutions ideally positioned to implement this regulatory reform programme are FMDQ for FX and fixed income and NASD for equity-based OTC instruments.
FMDQ specializes in the fixed income and foreign exchange markets. The first derivative instrument offered by FMDQ was a Foreign Exchange (FX) futures product. Introduced in 2016, the OTC FX Futures product is an in fact a Non-Deliverable Forward (NDF). NDF’s are OTC Foreign Exchange Futures contracts that are settled in Naira at an agreed exchange rate at a set date in the future. They differ from futures in that they do not carry the obligation to deliver the underlying US Dollar on the settlement date. NDF’s have been used for hedging currencies in countries like Nigeria which have capital controls and are whose currencies not readily convertible into one of the “hard currencies” such as US Dollar, Euro or Swiss franc. FMDQ and Frontclear, (a financial markets development company, which provides financial guarantee products) have agreed to a partnership which will establish clearing infrastructure in Nigeria. This is clearly a step in the right direction which adheres to the G20 recommended programme. This initiative will enhance investor confidence and help promote any future product launches.
NASD OTC Securities Exchange’s expertise in OTC equity products provides an outstanding platform with which to develop an equity derivatives market. Equity derivatives are not included in the G20 clearing requirement but by proactively offering listing and central clearing through NASD, the exchange could establish itself as a safe and secure specialist. As the only exchange which offers listing and central clearing of equity derivatives in West Africa, the exchange could promote its expertise to corporations and traders throughout the region, not just Nigeria. As many corporate finance professionals will attest, equity derivative instruments such as stock options, rights and warrants are useful tools in the structuring of a transaction. The establishment of a secondary market will provide liquidity for these instruments and deepen Nigerian capital markets.
Beyond that, equity derivative instruments will provide domestic Pension Funds, financial firms and institutional investors the ability to hedge positions against adverse market moves.
Nigerian capital markets should not only follow existing best practices but become a leader in OTC derivatives regulation. Whether it be NASD, which has expertise in the domestic OTC equity market or FMDQ, which has a specialisation in the FX OTC market, Nigerian financial markets have existing, regulated platforms which can be enhanced to promote Nigeria as a global financial centre. By proactively implementing OTC derivative regulations, and highlighting its capabilities throughout West Africa, Nigerian markets will be where hedgers and speculators naturally gravitate to list and execute transactions. This will not only be in the interest of the financial services sector but ultimately aid in the development of the real economy of West Africa.
• Kavvouras has extensive experience in dealing with OTC derivative instruments in both Europe and North America. He has been a financial service professional for over 20 years serving in various executive management positions in the United States, Canada and the United Kingdom. He holds a BA (Hons) from McGill University and the CISI Certificate in Derivatives from the Chartered Institute for Securities & Investment.