AHAM
NZENWATA
ABSTRACT
This paper is on Developing a
Derivatives Market in an Emerging Market Economy: The Nigeria Experience. For
the purpose of the paper, we investigated the prospects and challenges of
developing a derivatives market in emerging market economies with special focus
on the experience of Nigeria in this direction. It is shown in the paper that
establishing formal derivatives markets come with benefits which include more
liquid financial instruments, deepening of financial markets, broader choices
for risk management and new avenues for raising capital for productive capacity
and costs which include: increased volatility of securities prices, increased
risk taking especially by banks among others. We also explored the challenging
requirements which setting up derivative trading entail, these include:
provision of trading and communication infrastructure, effective and expedient
regulatory and judicial processes, adequate number of market participants among
other things. Finally, we conclude that in as much as there are costs and
challenges to be faced in order to establish a derivatives market, the benefits
far outweigh the costs.
1 INTRODUCTION
A
derivative security is generally referred to a financial contract whose value
is derived from the value of an underlying asset or simply underlying. There
are a wide range of financial assets that have been used as underlying assets
for derivatives, including equities or equity index, fixed-income instruments,
foreign currencies, commodities, credit events and even other derivative
securities. Depending on the types of underlying assets, the values of the
derivative contracts can be derived from the corresponding equity prices,
interest rates, exchange rates, commodity prices and the probabilities of
certain credit events (Chui, 2012).
Derivative
Securities allow users to meet the demand for cost effective protection against
risks associated with movements in the prices of the underlying. In other
words, users of derivatives can hedge against fluctuations in exchange and
interest rates, equity and commodity prices, as well as credit worthiness.
Specifically, derivative transactions involve transferring those risks from
entities less willing or able to manage them to those more willing or able to
do so. Derivatives transactions are now common among a wide range of entities,
including commercial banks, investment banks, central banks, fund managers,
insurance companies and other non-financial corporations.
Participants
in derivatives markets are often classified as either “hedgers” or
“speculators”. Hedgers enter a derivative contract to protect against adverse
changes in the values of their assets or liabilities. Specifically, hedgers
enter a derivative transaction such that a fall in the value of their assets
will be compensated by an increase in the value of the derivative contract. By
contrast, speculators attempts to profit from anticipating changes in market
prices or rates or credit events by entering a derivative contract.
Accordingly, activities of speculators are inherently more risky and should
warrant close monitoring by financial regulators.
Hedging and speculating are not the only
motivations for trading derivatives. Some firms use derivatives to obtain
better financing terms. For example, banks often offer more favorable financing
terms to those firms that have reduced their market risks through hedging
activities than to those without (Chui, 2012). The objective of this paper is to
investigate the prospects and challenges of developing derivatives markets in
emerging market economies with special emphasis on the experience of Nigeria in
this direction.
2. CONCEPTS AND THEORIES
This study on derivatives markets is
based on the theory of market micro structure which is a field in economics and
finance concerned with the details of how exchange occurs in markets, most
commonly financial markets (Mbungu P. K., 2013).
O'Hara,
(2007) state that market microstructure is the study of the processes and
outcomes of exchanging assets under a specific set of rules. In addition market
micro structure examines trading in instruments. These instruments include
common stocks, preferred stocks, bonds, convertible bonds, warrants, options,
futures contracts, foreign exchange contracts, swaps, reinsurance contracts,
commodities, pollution credits, water rights and other betting contracts.
The
market structure and design focuses on the relationship between price
determination and trading rules of the derivatives. One of the important
questions in microstructure research is how market structure affects trading
costs and whether one structure is more efficient than another. Harris (2002) described
the market structure as consisting of trading rules, the physical layout, the
information presentation systems and the information communication systems of
the market.
This
determines what traders can do and what they can know and as a result affecting
the power relationships among traders and their profitability. Market
infrastructure allows the smooth and efficient operation of the derivatives
exchange and hence it should be well structured. A well structured market will
provide efficient price discovery, low cost risk management and help capital
markets in raising capital (Dodd, 2002).
In addition to the above, other issues
including information production and dissemination, transaction costs, market
efficiencies, price discovery are other theories and concepts that have formed
the basis of studies in derivatives trading.
3 DEVELOPING
A DERIVATIVES MARKET IN EMERGING MARKETS
A
number of developing economies have recorded success in developing derivatives
markets. These include India, Brazil, China, South Africa Malaysia and
Indonesia. Egypt’s Derivatives market which was eventually scrapped, a revisit
is being muted currently. In Sub-Sahara Africa, Only South Africa and Mauritius
has recorded any success in developing a local derivatives market.
Other
developing countries (Kenya, Ghana, Uganda and Morocco) buoyed by the success
recorded in the countries listed above are seriously considering setting up
their own derivatives markets in order to reap the economic gains that are
inherent in the industry. Most are being hindered by challenges in the area of
infrastructure and regulatory frameworks.
Nigeria
is also working on developing a formal derivatives trading market through the
Nigeria Stock Exchange by end 2016. What obtains right now is essentially
OTC/private arrangements through the banks and a few funds traded on the
Nigeria Stock Exchange (NSE). The CBN recently issued guidelines for the
introduction of FX derivatives which essentially permitted certain variants of
derivatives to be employed as hedging tools in the foreign exchange market by
authorized dealers and investors alike on a strictly regulated basis (Omozuwa,
2014).
3.1
Need for a Derivatives Market
Derivatives
markets facilitate the management of financial risk exposure, since they allow
investors to unbundle and transfer financial risk. In principle, such markets
could contribute to a more efficient allocation of capital and cross-border
capital flow, create more opportunities for diversification of portfolios,
facilitate risk transfer, price discovery, and more public information. Further
derivatives exchanges contribute to the development of the financial
infrastructure of a country by providing the links among cash markets, hedgers,
and speculators.
Financial
derivatives are essential for the development of efficient capital markets
because of their contribution to a more efficient capital allocation,
facilitation of cross-border capital flows, and creation of opportunities for
portfolio diversification (Ilyina 2004).
Dodd
(2002) is of the opinion that the economic functions of derivatives are close
complements to international capital flows. As a result, derivatives markets
emerged along with these forms of capital flows as part of an effort to better
manage the risks of global investing. In doing so, derivatives facilitate the
flow of capital by unbundling risk and redistributing it away from investors
who did not want it and towards those more willing and able to bear it.
Further,
Dodd (2002) stated that an important incidental benefit that flows from
derivatives trading is that it acts as a catalyst for new entrepreneurial
activity. The derivatives have a history of attracting many bright, creative,
well-educated people with an entrepreneurial attitude. They often energize
others to create new businesses, new products and new employment opportunities,
the benefit of which are immense.
The
operation of futures markets and the introduction of futures contracts trading
in stock markets have lead to a decrease in the volatility of the underlying
index which results from the increase in the market liquidity. The increased
market liquidity enables investors to hedge their positions more effectively
and thus, reduce their risk (Siopis and Lyroudi, 2007). In conclusion
Derivatives are believed to bring improvements in market efficiency in the
underlying market by allowing for free trading of risk components and that
leads to improving market efficiency and liquidity.
3.2 Requirements for Establishing a Derivatives
Market
Several
factors have been fingered to hinder development of derivatives markets.
According to Hathaway (1998), the major contributory factors for success or
failure of derivatives market are market culture, the underlying market
including its depth and liquidity and financial infrastructure including the
regulatory framework.
If
not well organized, derivatives trading may have militating effect on the
development of the financial system. Derivatives trading thrives in
environments where information is readily available and the misuse of
information is not only frowned on but severe expeditious punishments are meted
out if any individual or group commits an infringe. For virile derivatives
markets to develop, investigation and punishments for infringements must be
swift and unrelenting.
Without
a proactive regulatory system, market participants are likely to take undue and
in some cases criminal advantage of the market thereby causing serious problems
for the financial system and economy at large. Putting in place the necessary
regulatory and judicial processes that will effectively check the likely
excesses of market participants is a task which at the moment is a big
challenge for emerging economies.
Another
serious challenge in setting up a derivatives market is the provision trading
infrastructure with special emphasis on information and communication technology
systems. This is an issue that continues to be a headache in the mainstream
capital and money markets and will likely be a serious challenge in developing
derivatives markets in Nigeria. But as with most things, these challenges are
not insurmountable.
Furthermore,
the success of derivatives markets in any locality depends to a large extent on
the breadth and depth of the existing financial markets (money and capital
markets). Dealing in a large number of financial securities will to a large
serve as fodder to fuel activities in the derivatives.
In
addition to the depth and breadth of the existing markets for securities, the
existence commodities market will also be necessary for a successful derivatives
trading. Where a local commodities market is non-existent or inactive as in the
case of Nigeria, developing a vibrant derivatives market will be very
challenging.
Derivatives markets require a large
number of financial/investment savvy participants with different risk profiles
(risk averse, risk neutral and risk lovers). It also requires a large number of
institutional dealers like banks and other non-bank financial institutions to
actively participate in the market.
4. SUMMARY CONCLUSIONS
This
paper is on Developing a Derivatives Market in an Emerging Market Economy: The
Nigeria Experience. For the purpose of the paper, we investigated the prospects
and challenges of developing a derivatives market in emerging market economies
with special focus on the experience of Nigeria in this direction. It is shown
in the paper that establishing formal derivatives markets come with benefits
which include more liquid financial instruments, deepening of financial
markets, broader choices for risk management and new avenues for raising
capital for productive capacity and costs which include: increased volatility
of securities prices, increased risk taking especially by banks among others.
We also explored the challenging
requirements which setting up derivative trading entail, these include:
provision of trading and communication infrastructure, effective and expedient
regulatory and judicial processes, adequate number of market participants among
other things. Finally, we conclude that in as much as there are costs and
challenges to be faced in order to establish a derivatives market, the benefits
far outweigh the costs.
REFERENCES
Chui, Michael (2012) Derivatives
Markets, Products and Participants: an Overview, Office for Paper presented at
BIS Representative Office for Asia and the Pacific, Hong Kong, IFC Bulletin No
35
Dodd, R. (2002). Consequences of
Liberalizing Derivatives Markets, Washington D.C. September, Financial Policy
Forum Derivatives Study Center
Harris, L. (2002). Trading &
Exchanges: Market Microstructure for Practitioners, Oxford Press, Oxford, 2002
Ilyina, A. (2004). „The role of
financial derivatives in emerging markets‟ in D.J. Mathieson, J.E. Roldos, R.
Ramaswamy, and A. Ilyina eds. 2004 Emerging Local Securities and Derivatives
Markets, global financial stability report, Washington, IMF.
Mbungu P. K., (2013). An Investigation
Into Factors Influencing The Development Of Derivatives Markets In Kenya, Maters
Degree Thesis, Kenyatta University, Kenya
O'Hara, M. (2007) Market Microstructure
Theory, Blackwell, Oxford, 1995Siopis, A. & Lyroudi K. (2007) The effects
of derivatives trading on stock market volatility: The case of the Athens stock
exchange.
Omozuwa, J. (2014): CBN'S Regulatory Framework Permitting
Derivatives Stimulates The Capital Market In Nigeria, Securities & Exchange
Commission, Nigeria, http://www.sec.gov.ng/paper-on-derivatives.html
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