What you should know about Exchange Traded Derivatives

Stories by Chinenye Anuforo

The Nigerian Stock Exchange (NSE) has concluded arrangements to introduce Exchange Traded Derivatives (ETDs) into the market to expand its various investment instruments.
Speaking at the training programme on legal and risk aspects of derivatives and central counter-party clearing in Lagos, NSE’s 1st Vice President, Mr. Abimbola Ogunbanjo, said the Exchange would launch the ETDs into the market later this year.
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to investors who are most able and willing to take it – a process that has improved national productivity growth and standards of living, according to capital market experts.
Nigeria being one of the emerging economies in the global financial markets is an exploratory gold mine for derivatives transactions. While the Nigerian derivatives market is still relatively in its infancy, with NSE’s recent plan to launch ETDs, it is important to fully understand the initiative.
What is a derivative?
A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Derivatives can either be traded over-the-counter (OTC) or on an exchange.
OTC derivatives
OTC derivatives constitute a greater proportion of derivatives in existence and are unregulated. OTC derivatives generally have greater risk for the counter-party than the standardised derivatives.
An exchange traded derivative
An exchange traded derivative is a financial instrument whose value is based on the value of another asset, and that trades on a regulated exchange. Exchange traded derivatives have become increasingly popular because of the advantages they have over OTC derivatives, such as standardisation, liquidity and elimination of default risk. Futures and options are two of the most popular exchange traded derivatives. These derivatives can be used to hedge exposure or speculate on a wide range of financial assets like commodities, equities, currencies and even interest rates.
ETDs are especially suited for the retail investor because of the following features that distinguish them from OTC derivatives:
•Standardisation: The exchange has standardised terms and specifications for each derivative contract, making it easy for the investor to determine how many contracts can be bought or sold. Each individual contract is also of a size that is not daunting for the small investor.
•Elimination of default risk: The derivatives exchange itself acts as the counter-party for each transaction involving an exchange traded derivative, effectively becoming the seller for every buyer, and the buyer for every seller. This eliminates the risk that the counter-party to the derivative transaction may default on its obligations
•Exchange traded derivatives are not favoured by large institutions because of the features that make them appealing to small investors. For instance, standardised contracts may not be useful to institutions that trade large amounts of derivatives because of the smaller notional value of exchange traded derivatives and their lack of customisation. Exchange traded derivatives are also totally transparent but this may be a hindrance to large institutions that may not want their trading intentions known to the general public.
•Another defining characteristic of exchange traded derivatives is their mark-to-market feature wherein gains and losses on every derivative contract is calculated on a daily basis. If the client has incurred losses that have eroded the margin put up, he or she will have to replenish the required capital in a timely manner or risk the derivative position being sold off by the firm.
For his part, Ogunbanjo said ETDs are variants of derivatives traded on an organised securities exchange as against other derivatives traded through informal OTC market. Derivatives derive their values from their underlying assets such as commodities, stocks, bonds, interest rates and currencies as well as other derivatives and indices.
He said the development of new and intricate financial instruments such as ETDs will lead to exponential growth in the frontiers of the financial market, noting that derivatives hold great prospects for the market.
He pointed out that with impressive yearly growth of about 24 per cent over the last decade and about €457 trillion of notional amount outstanding in 2014, no other class of financial instrument has experienced as much innovation from its embryonic development to a fully developed and respected financial market than derivatives.
“We believe that Nigeria’s ETD initiative will eventually develop into a robust market place that can support our growth ambitions as a nation, using South Africa as an example of Africa’s first derivative market,” Ogunbanjo said.
He said the Exchange has taken a bold step towards providing a strong capacity base in anticipation of the launch of ETDs and to create a viable, efficient, innovative and risk absorbent derivatives market.
According to him, given the derivatives market’s global nature, users can trade around the clock and make use of derivatives that offer exposure to almost any “underlying” asset class across various global markets.
He, however, underscored the importance of effective trading and regulatory frameworks and adequate human capacity, noting that the imperatives for a truly functional derivatives market are safety, effective risk mitigation, innovation and efficiency.
He pointed out that risks such as counter-party risks, operational risks, liquidity risks, systemic and legal risks could be implicit in even the most developed markets citing the global financial crisis between 2007 and 2010 that was mainly fuelled by delinquent underlying assets.
“Such is the attendant risk that may rear its head in a derivative market, which can have far reaching impact on various global markets and economies.
It is imperative that we learn from our past mistakes and ensure the proper construct for risk mitigation is adequately addressed via mechanisms like counter-party clearing (CCP) transactions and their associated default waterfall structure,” Ogunbanjo said.
However, FBN Capital Limited, a subsidiary of FBN Holdings, at the inaugural edition of the Nigerian Structured Product Summit by the Capital Market Solicitors Association (CMSA), aimed at addressing the fundamental issues around structured products and derivatives in Nigeria, stated that derivatives offer the potential for enhanced liquidity and increased funding solutions in the capital market.

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