Tochukwu Chikwendu – CBN OTC Fx Futures: Understanding The Derivatives Market
By: Tochukwu Chikwendu
The Central Bank of
Nigeria (CBN) recently removed the peg on Nigerian currency (Naira) and
officially announced a floating rate. The implication therefore is that the
value of Naira will be determined by the forces of demand and supply. In its
announcement, the CBN introduced an over- the-counter (OTC) Foreign Exchange
(FX) Futures, a derivatives product which will help open up the market and
encourage foreign investments.
Nigeria (CBN) recently removed the peg on Nigerian currency (Naira) and
officially announced a floating rate. The implication therefore is that the
value of Naira will be determined by the forces of demand and supply. In its
announcement, the CBN introduced an over- the-counter (OTC) Foreign Exchange
(FX) Futures, a derivatives product which will help open up the market and
encourage foreign investments.
Meaning of Derivatives
Derivatives (Futures,
Forward, Swaps, Options and Swaptions) are bilateral contracts or payments
exchange agreement whose respective values are derived from the value of an
underlying asset or underlying reference rate. This means that the value of a
contract entered into today will be determined on a future date based on market
forces.
Forward, Swaps, Options and Swaptions) are bilateral contracts or payments
exchange agreement whose respective values are derived from the value of an
underlying asset or underlying reference rate. This means that the value of a
contract entered into today will be determined on a future date based on market
forces.
For instance, if Party A
enters into an arrangement with Party B to buy 1,000 barrels of oil at US$40
per barrel (pb) in 6 months in anticipation that price will spike to US$50
within the period; the value for such contract is determined by
market position of the commodity at the end of the 6 months. Thus,
the price at the end of the 6 months will determine the value added to the
parties.
enters into an arrangement with Party B to buy 1,000 barrels of oil at US$40
per barrel (pb) in 6 months in anticipation that price will spike to US$50
within the period; the value for such contract is determined by
market position of the commodity at the end of the 6 months. Thus,
the price at the end of the 6 months will determine the value added to the
parties.
X-ray of Futures and
Forwards Contracts
Forwards Contracts
Futures are exchange
traded forward contracts with standardized terms. Their price is determined by
market price. Futures contracts are highly regulated by an exchange, thus
counterparties’ credit risk are largely minimized as such is borne by the
exchange. To prevent credit risk, the exchange ensures that parties post
Initial Margins (IM)[1] before they are allowed to transact on the floor of the
exchange. Counterparties, in addition to IM, are also required to mark the
market daily by posting Variation Margin (VM)[2] with the exchange. An
Illustration will aid the understanding of the concept of IM and VM. Recall our
Party A and B example; Party A wants to buy oil at US$40pb in 6 months and
Party B also wants to sell at that price despite the future price of the
commodity. The buy side approaches the exchange[3] which links it with the
sell side. Assuming the contract sum is US$40,000, the exchange will mandate
the counterparties to post at least US$2,500 each as IM. At the close of each
trading day, depending on the market movement, any counterparty the market
moved against will be required to post a VM. Thus, if at the close of Day 1
(D1) trading, oil price moved down to US$35pb, a cash call will be made on
Party A to post US$5,000 to mark the market and bring the price to US$40pb
which he contracted to pay in 6 months and vice versa.
traded forward contracts with standardized terms. Their price is determined by
market price. Futures contracts are highly regulated by an exchange, thus
counterparties’ credit risk are largely minimized as such is borne by the
exchange. To prevent credit risk, the exchange ensures that parties post
Initial Margins (IM)[1] before they are allowed to transact on the floor of the
exchange. Counterparties, in addition to IM, are also required to mark the
market daily by posting Variation Margin (VM)[2] with the exchange. An
Illustration will aid the understanding of the concept of IM and VM. Recall our
Party A and B example; Party A wants to buy oil at US$40pb in 6 months and
Party B also wants to sell at that price despite the future price of the
commodity. The buy side approaches the exchange[3] which links it with the
sell side. Assuming the contract sum is US$40,000, the exchange will mandate
the counterparties to post at least US$2,500 each as IM. At the close of each
trading day, depending on the market movement, any counterparty the market
moved against will be required to post a VM. Thus, if at the close of Day 1
(D1) trading, oil price moved down to US$35pb, a cash call will be made on
Party A to post US$5,000 to mark the market and bring the price to US$40pb
which he contracted to pay in 6 months and vice versa.
Forwards on the other hand
are OTC negotiated i.e. they are bilaterally negotiated between participants
upon flexible terms. They mature over time based on the need of the parties.
Counterparties to Forward contracts generally do not mark the market since
there is no exchange to regulate the conduct of counterparties. The paucity of
regulation, exposes Forward contracts counterparty’s credit risk.[4].
are OTC negotiated i.e. they are bilaterally negotiated between participants
upon flexible terms. They mature over time based on the need of the parties.
Counterparties to Forward contracts generally do not mark the market since
there is no exchange to regulate the conduct of counterparties. The paucity of
regulation, exposes Forward contracts counterparty’s credit risk.[4].
Counterparties in both
Futures and Forward contracts, settle their trade positions at the end of the
contract period. Settlement could be physically or cash settled (traditionally,
Futures are cash settled while Forwards are physically settled). Following our
illustration, for Futures contracts cash settlement, if at the end of the
6 months the price of oil had risen to US$50pb, the exchange will pay US$10pb
being the difference between the contract and spot price of the commodity to
Party A. On the other hand, if the price of oil at settlement date was US$30pb,
the exchange will give the difference to Party B. In Forwards (physical)
settlement, if the oil market price was US$45pb at the last trading day of the
6 months, Party A will hand over US$40,000 to Party B who will then make up the
difference and purchase the contracted 1000 barrels. Alternatively, if the
price was down to US$30 pb, Party A will still hand over the same US$40,000 to
Party B, the US$10 made by Party B on each barrel constitutes the risk
premium[5].
Futures and Forward contracts, settle their trade positions at the end of the
contract period. Settlement could be physically or cash settled (traditionally,
Futures are cash settled while Forwards are physically settled). Following our
illustration, for Futures contracts cash settlement, if at the end of the
6 months the price of oil had risen to US$50pb, the exchange will pay US$10pb
being the difference between the contract and spot price of the commodity to
Party A. On the other hand, if the price of oil at settlement date was US$30pb,
the exchange will give the difference to Party B. In Forwards (physical)
settlement, if the oil market price was US$45pb at the last trading day of the
6 months, Party A will hand over US$40,000 to Party B who will then make up the
difference and purchase the contracted 1000 barrels. Alternatively, if the
price was down to US$30 pb, Party A will still hand over the same US$40,000 to
Party B, the US$10 made by Party B on each barrel constitutes the risk
premium[5].
CBN OTC FX
Futures
Futures
FX Futures are derivatives
contracts traded on an exchange where the delivery of underlying currency is
the subject matter of the contract. In the United States, FX Futures are traded
on the International Money Market of the Chicago Mercantile Exchange as well as
other licensed Exchanges. To replicate this, the CBN in its Revised
Guidelines for the Operation of the Nigerian Inter-Bank Foreign Exchange Market
dated June 2016 (The Guidelines) stated that the OTC FX Futures will be traded
on the FMDQ OTC Securities Exchange. It is noteworthy to state that OTC FX
Futures as explained in Guideline 2.2.2 (non-standardised contract
with fixed tenors and bespoke maturity dates), aligns more with Forwards
contract. It is the writer’s view that the CBN probably adopted OTC FX Futures
for convenience since the contract will be cash settled and FMDQ will act as an
Exchange with IM and VM mandate.
contracts traded on an exchange where the delivery of underlying currency is
the subject matter of the contract. In the United States, FX Futures are traded
on the International Money Market of the Chicago Mercantile Exchange as well as
other licensed Exchanges. To replicate this, the CBN in its Revised
Guidelines for the Operation of the Nigerian Inter-Bank Foreign Exchange Market
dated June 2016 (The Guidelines) stated that the OTC FX Futures will be traded
on the FMDQ OTC Securities Exchange. It is noteworthy to state that OTC FX
Futures as explained in Guideline 2.2.2 (non-standardised contract
with fixed tenors and bespoke maturity dates), aligns more with Forwards
contract. It is the writer’s view that the CBN probably adopted OTC FX Futures
for convenience since the contract will be cash settled and FMDQ will act as an
Exchange with IM and VM mandate.
OTC FX Futures is a
welcome development in the Nigerian financial sector. The instrument is a sui
generis financial product that will help participants engage in FX ventures
without being inundated by currency fluctuations. The major drawback in the
Futures contract market is the activities of speculators,[6] but the Guidelines
seems to have plugged that hole as Guideline 2.2.3 provides that “OTC
FX Futures sold by Authorised Dealers to end-users must be backed by trade
transactions (visible and invisible) or evidenced investment.” The import
is that there must be evidence of a transaction that the end-user intends to
hedge before the authorized dealers will be allowed to take a trade position.
welcome development in the Nigerian financial sector. The instrument is a sui
generis financial product that will help participants engage in FX ventures
without being inundated by currency fluctuations. The major drawback in the
Futures contract market is the activities of speculators,[6] but the Guidelines
seems to have plugged that hole as Guideline 2.2.3 provides that “OTC
FX Futures sold by Authorised Dealers to end-users must be backed by trade
transactions (visible and invisible) or evidenced investment.” The import
is that there must be evidence of a transaction that the end-user intends to
hedge before the authorized dealers will be allowed to take a trade position.
The CBN also, in Guideline
2.2.1, indirectly maintained that Naira will be the only legal tender
acceptable in Nigeria as Authorised Dealers are only permitted to offer
Naira-settled non-deliverable OTC FX Futures. The implication is that at the
end of the contract tenor, settlement will be (Naira) cash settled. The Naira
equivalent of the difference in the current and contract spot prices will be
paid to the counterparty who is in positive region of the trade. The
exception to Naira settlement is for a foreign investment after a Certificate
of Capital Importation (CCI) together with FMDQ OTC FX Futures Settlement
Advice is presented, Guideline 2.2.7.
2.2.1, indirectly maintained that Naira will be the only legal tender
acceptable in Nigeria as Authorised Dealers are only permitted to offer
Naira-settled non-deliverable OTC FX Futures. The implication is that at the
end of the contract tenor, settlement will be (Naira) cash settled. The Naira
equivalent of the difference in the current and contract spot prices will be
paid to the counterparty who is in positive region of the trade. The
exception to Naira settlement is for a foreign investment after a Certificate
of Capital Importation (CCI) together with FMDQ OTC FX Futures Settlement
Advice is presented, Guideline 2.2.7.
Negotiating OTC FX Futures
Counterparties willing to
trade in OTC FX Futures will approach the FMDQ Exchange, an interface between
the buy and sell side, and decide on the positions and tenor of their trade.
The Exchange will provide the spot price at which the trade will be carried out
after the necessary KYC has been carried out to ensure that the
counterparties/dealers will comply with FMDQ’s trade regulations. If satisfied
with the KYC, the FMDQ Exchange, as part of its regulatory oversight, will
demand that counterparties post an IM (constituting at least 5% of the entire
contract sum) to hedge against counterparties’ default.
trade in OTC FX Futures will approach the FMDQ Exchange, an interface between
the buy and sell side, and decide on the positions and tenor of their trade.
The Exchange will provide the spot price at which the trade will be carried out
after the necessary KYC has been carried out to ensure that the
counterparties/dealers will comply with FMDQ’s trade regulations. If satisfied
with the KYC, the FMDQ Exchange, as part of its regulatory oversight, will
demand that counterparties post an IM (constituting at least 5% of the entire
contract sum) to hedge against counterparties’ default.
FMDQ Exchange as part of protective
mechanism, makes cash calls on the trade counterparties depending on the market
movements. The mark-to-market rate will be determined by the Inter Bank Foreign
Exchange Fixing (NIFEX). The FMDQ’s appointed agent, Nigeria Inter-Bank
Settlement System PLC (NIBSS) in charge of clearing the inter-bank OTC FX
Futures, is empowered to collect the IM and VM, and settle the party on the
maturity date. NIBSS is also empowered to settle the trade if one of the
counterparties decide to close out its position before maturity date.
mechanism, makes cash calls on the trade counterparties depending on the market
movements. The mark-to-market rate will be determined by the Inter Bank Foreign
Exchange Fixing (NIFEX). The FMDQ’s appointed agent, Nigeria Inter-Bank
Settlement System PLC (NIBSS) in charge of clearing the inter-bank OTC FX
Futures, is empowered to collect the IM and VM, and settle the party on the
maturity date. NIBSS is also empowered to settle the trade if one of the
counterparties decide to close out its position before maturity date.
It seems therefore that
the CBN has put a very strong mechanism in place to ensure that the OTC FX
Futures market minimise the disequilibrium in the FX market and cause the FX
rate to moderate and attract significant capital flows into the Nigerian
economy. It is hoped that all the holes are properly plugged to prevent
speculators from entering into this market as that will likely derive up the
dollar rate, defeating the CBN’s purpose of developing this market.
the CBN has put a very strong mechanism in place to ensure that the OTC FX
Futures market minimise the disequilibrium in the FX market and cause the FX
rate to moderate and attract significant capital flows into the Nigerian
economy. It is hoped that all the holes are properly plugged to prevent
speculators from entering into this market as that will likely derive up the
dollar rate, defeating the CBN’s purpose of developing this market.
Conclusion
The Naira- settled OTC FX
Futures product is a welcome development which will be of tremendous benefit to
individuals and corporate entities that engage in FX businesses. It will also
present an opportunity to hedge against future market movements. Whilst
applauding the CBN for its policy, it is hoped that this will be sustained and
CBN will put good surveillance in place to ensure that market participants will
not engage in activities that could undermine the effectiveness of the
innovation.
Futures product is a welcome development which will be of tremendous benefit to
individuals and corporate entities that engage in FX businesses. It will also
present an opportunity to hedge against future market movements. Whilst
applauding the CBN for its policy, it is hoped that this will be sustained and
CBN will put good surveillance in place to ensure that market participants will
not engage in activities that could undermine the effectiveness of the
innovation.
[1] IM is the percentage
(5% and above) of the contract sum deposited (at the contract start date) with
the exchange to hedge market movement from the day a party defaults in payment
of its VM to the day the counterparty’s position is eventually closed out. IM
cushions the exchange in the event a counterparty defaults in its obligation.
It prevents the exchange from using its funds to offset counterparties’ trade
positions. The amount of IM posted by counterparties may increase during high
market volatility.
(5% and above) of the contract sum deposited (at the contract start date) with
the exchange to hedge market movement from the day a party defaults in payment
of its VM to the day the counterparty’s position is eventually closed out. IM
cushions the exchange in the event a counterparty defaults in its obligation.
It prevents the exchange from using its funds to offset counterparties’ trade
positions. The amount of IM posted by counterparties may increase during high
market volatility.
[2] VM which is difference
between the contract and current market price at the close of any day’s
trading. A party whom the market moved against is required to post the amount
before the Day 2 trading.
between the contract and current market price at the close of any day’s
trading. A party whom the market moved against is required to post the amount
before the Day 2 trading.
[3] Because Futures are
exchange-traded, the parties are unaware of the counterparty taking the other
position of the trade.
exchange-traded, the parties are unaware of the counterparty taking the other
position of the trade.
[4] Since Forward contract
are largely unregulated, they are not the most reliable and efficient financial
instrument for hedging risks
are largely unregulated, they are not the most reliable and efficient financial
instrument for hedging risks
[5] Settlement of both
Futures and Forward contracts are now mostly done in cash.
Futures and Forward contracts are now mostly done in cash.
[6] Speculative trading
occurs when a market participant approaches the exchange to hedge a speculated
risk without possessing real risks i.e. hedging that the price of a commodity
will spike without actually having any intention of buying any commodity in the
future.
occurs when a market participant approaches the exchange to hedge a speculated
risk without possessing real risks i.e. hedging that the price of a commodity
will spike without actually having any intention of buying any commodity in the
future.
Tochukwu is admitted to the Nigerian Bar, and holds an LLM in Corporate,
Finance and Securities laws from the New York University School of Law. Tochukwu has a strong interest for capital markets, securities
transaction and finance, with an ardour for dispute resolution, both in
the international and local sphere. Tochukwu is goal-driven, resourceful
and a natural team player. Whilst Tochukwu’s career interest is in international business law and
transactions, he is also committed to worthy charitable courses, and has
offered his assistance on a pro bono basis in certain cases.
Finance and Securities laws from the New York University School of Law. Tochukwu has a strong interest for capital markets, securities
transaction and finance, with an ardour for dispute resolution, both in
the international and local sphere. Tochukwu is goal-driven, resourceful
and a natural team player. Whilst Tochukwu’s career interest is in international business law and
transactions, he is also committed to worthy charitable courses, and has
offered his assistance on a pro bono basis in certain cases.
Ed’s Note- This article was originally posted here.