Lagos Financial Futures: Rational market or New casino?

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Lagos Financial Futures: Rational market or New casino?

The reforms going on in the different sectors of the Nigerian economy must trigger comprehensive financial market reforms. By financial market, I mean the totality of stocks, foreign exchange, government debt (bonds and treasury bills), corporate securities and commodities markets.  All these markets present different risk challenges but the major risk is market risk. Market risk management will therefore become an issue from 2006, more so with Basle 2 requirements.

In all the markets identified above, save for the foreign exchange market, there are no opportunities to hedge adverse price risk. This is a major drawback in the Nigerian financial markets.  As we create a virile government securities market, grow an active stock market, encourage rated corporate debt and nurture robust commodities market, it is the UNCERTAINTY in these markets that present opportunities for gains and losses. However, let us all also be aware that risk management is lacking in all these markets.

The truth is that with the new economy from 2006, most of the sources of our certainty on which we have come to rely will be removed.  Markets will become more volatile. We have recently witnessed measured intervention in the FX market by the Central Bank of Nigeria (CBN). However, all indications are that the debt markets (government and corporate) may experience the greatest volatility.  This year, we witnessed the crash in treasury bills rates, bond coupons and short-term interest rates by 800 basis points (8%). No one knows the direction they will take next year. We therefore need urgently to create a platform for borrowers and savers to manage uncertainty and volatility in the interest rates they expect to pay or receive.

There is therefore a pressing need for the creation of a Lagos Futures Exchange.

Futures Exchange is a market where futures contracts are traded. Futures contract is an agreement (obligation) to buy or sell a given standardized quantity of an asset at a specified future date, at a pre-agreed price. The asset may be shares (stocks) cocoa, oil, bonds, treasury bills, foreign currency or an index based on such assets.  Depending on its terms, the futures contract will be settled either by delivery of the underlying asset or by “cash settlement” i.e. payment of a cash sum that represents the value of that asset or index.  Specifically, a financial futures contract is a contract that provides a standardized means of engaging in forward transactions in certain underlying assets conducted on an organized exchange.  The contracts are standardized with respect to asset type, quantity per contract, delivery period, delivery process and tick size. Tick size is the minimum permissible movement in the contract value in any trading day.

The quick reaction from the skeptics will be that futures contracts with cash settlement encourage little speculation and may affect the market if uncontrolled. The truth is it does not have a destabilizing effect on the spot market. In May 1979, the study by the Treasury and the Federal Reserve declared that empirical studies in both Agricultural & Financial markets have not been able to prove that there is greater price variability in spot markets during periods in which the good or security was traded on a futures market. The Bank of England actually established that the existence of a futures market reduced rather than increased volatility in the underlying markets. Its existence actually helps government debt markets and does not impair the attainment of monetary policy goals.  Futures and options help to minimize risks!

Money is a raw material of business. It then follows that a bank may want to trade futures contracts to protect its portfolio the same way Cadbury would want to hedge the cash price of cocoa by buying futures contracts.  If no one has analysed the impact of highly capitalized banks then we all better do. They will play big in the stock market, London international markets (FX and money market especially), mortgages and commodities.  Banks capitalized to the tune of N25bn cannot withstand wild gyrations in interest rates without a hedging platform. Imagine a scenario in which banks buy long-dated Treasury bills and bonds today at between 3 and 5% and the market yield goes up to double digits next year. Without a mechanism by which they can align with the new market levels, the financial ramifications would be far-reaching. In Nigeria, bankers, manufacturers, insurance companies, corporate treasurers, etc. have all had these exposures uncovered for years and it is high time we did something about it before the Pension Fund Administrators that are to manage our future join this club in frustration and inefficiency.

Let us examine further some practical benefits of futures contracts: Corporate Treasurers will have interest in selling interest rate futures to hedge a rise in interest rates (because as rates go up futures prices will drop and they will close the future positions to neutralize the loss in the cash market where they borrowed), Institutions that are involved in underwriting long term debts’ issues could cover themselves against a rise in yields by trading futures. The primary dealers of government bonds come to mind here. Institutional investment managers – the likes of insurance companies, pension funds – would find a futures market in long term bonds helpful to secure a current high interest rate if they anticipate a fall in yields before cash funds are available. There is an enormous commercial demand for as mechanism that would protect all kinds of market participants from swings in NIBOR. The existence of a futures market will boost the confidence in issuing longer tenors in government debt to 30 years.

Many may still not be totally convinced about this initiative. It may look as if futures contracts are not about managing risks but taking on additional risks. Buying and selling FX is easier to understand than buying and selling interest rates. An interest rate isn’t money but it is going to be traded!

I will refer Nigerians to an advert on page 50 in the September 20, 2005 edition of Guardian Newspaper. PriceWaterhouseCoopers was looking for on behalf of a client a Group Head: International Trade that understands futures contracts. This may be the first but it is certainly the direction of the market.

The obvious answer to a request to establish a financial futures platform in Nigeria would be a “NOT YET” given legitimate concerns such as the wider competitiveness of Nigeria and the need to address the requirements of various stakeholders.  However, the time is ripe. Lingering concerns can be provided for in the design of the exchange. We must not allow them to serve as our excuse for not moving forward. The wisdom that reformed the banking sector cannot desert us prematurely. We must start now and grow the exchange aggressively. The truth is our market is getting dynamic. Our banks have started expanding into Africa. Even the days of exchange controls may be numbered – such controls have limited the development of international finance in Nigeria for too long. Nigeria must stand ready to serve as at least a regional hub for the international finance network. It must present a credible alternative to South Africa, a country that boasts both a Bond Exchange and a Futures Exchange.

With a Lagos Futures Exchange, banks and other financial institutions can provide financial security to their customers. There will be no need to forecast or be exposed. There will be no need to allow interest rate changes to cause unprofitable business. With Futures, interest rates can be fixed, investment programmes protected and jobs made secure.  It will bring more jobs and investments.

Individuals can fix mortgage rates when rates are low, as the existence of futures contracts allows the banks to grant this and an opportunity to lay off or offset their risks at the Futures Exchange. The Pension Fund Administrators can protect their portfolios and secure our future better whilst individuals can insure against falls in stocks. Finally farmers will mitigate the uncertainties of weather and harvest etc. by achieving certainty in prices without government control. These are some advantages of a Futures Exchange.

If then the case for the Futures Exchange is so clear, what reasons could be adduced for the non-existence of such an exchange to-date? One might speculate that bankers were too busy with entrepreneurial banking and nobody was thinking of the financial system. There was an easy, protected and profitable life such that there was no incentive to expand the frontiers of finance in the country. The frequent banking crisis and an inactive or predictable market may have also contributed to non-development of our market. The manner in which funds are released into the system causing interest rates to awkwardly crash at predictable times is also a disincentive to the development of money market hedging products.

The single most important financial development since the establishment of the Nigerian Stock Exchange may yet be the Lagos Futures Exchange but who will establish it?

The CBN or SEC wont set it up. Indeed, the role of the CBN in all this is simple: it should have no objection to the establishment of a financial futures exchange, it should make itself available for consultation and be briefed on progress made in the design of the market, how the Exchange plans to ensure financial integrity and the contracts to trade. The CBN should provide surveillance but not responsibility for ensuring integrity.  There is also the need to start educating groups through seminars and papers. Courses should also be organized in the operations of futures contracts. It is gratifying to note that trainee stockbrokers and bankers have futures in their curricula. Other organizations such as ICAN, the Pension Diploma and our Universities also have a role to play – they should include courses on futures and options in their curricula too.

On the other hand, the International Finance Corporation (IFC) supports institutions like this and will be more than willing to support this dream. However, due to the fact that corporate treasurers, stockbrokers, bankers, insurers, asset & investment managers and commodity traders would all be served by these futures contracts it is better we have the widest possible participation in the establishment of this Exchange. The bankers, stockbrokers and commodity traders motivated the London International Financial Futures and Options Exchange (LIFFE). Bankers motivated the establishment of the South African Futures Exchange (SAFEX).

I wish that the Money Market Association of Nigeria (MMAN) had the establishment of a Futures Exchange in Nigeria as one of its projects. A working group would be immediately formed comprising representatives from potential market participants. These representatives would be those passionate about this project, selected by a visionary leader with strong strategic planning skills and a willingness to devote significant time and energy towards the actualization of this project.  With such a champion, we may have the critical factors that would make this a success:

(a) Volatile financial market: stocks, interest rates, and FX and commodity prices
(b) Clearing institution that is widely owned: Nigerian Automated Clearing Limited
(c) Reforming CBN and SEC to address market distortions
(d) Improving telephone systems
(e) Big banks and insurance companies
(f) Mismatches in the maturity profiles of banks – borrowing short and lending long
(g) Developing government securities market
(h) Nigeria as a big financial market in ECOWAS region

The goal would be to provide the market with a futures exchange that can emulate the standards of LIFFE by being:

i. Transparent in terms of price formation and dealings
ii. Truly international in terms of products and members
iii. Run by a highly qualified team of executives
iv. Backed by a board and committees made up mainly of young executives running the business of member firms
v. Blessed with a robust system encompassing instruments which are highly liquid proxies for the whole markets
vi. In-expensive to deal in
vii. Marked-to-market and cleared daily by a clearing house whose integrity is beyond question
viii. Attention to details in products, procedures, surveillance, audit trails and other world-beating computer systems
ix Governance must be worked at to prevent any clique of powerful privilege members from dominating and obfuscating the inner workings in order to gain advantages over other members.
x. Right choice of contract and right specifications for the contract

Indeed, these must be viewed as the critical success factors for a futures exchange and the establishment of a Lagos Futures Exchange must surely be a challenge that our financial markets’ practitioners must accept.

Bola Onadele (Koko)
November, 2005

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