Role of CCPs in Nigerian capital markets
Impact of CCPs on capital and financial market transactions
Historically, central clearing counterparties (CCPs) have played an important role in global financial markets. They have, however, become even more critical in financial markets, with clearing now globally accepted as an effective risk management mechanism.
This article provides some context as it relates to the introduction and operationalisation of CCPs in Nigeria, outlines the current regulatory framework for the operation of CCPs, and, ultimately, spotlights the role and impact that these utilities will play in the Nigerian capital and financial markets, moving forward.
What are CCPs?
A CCP is a financial risk management institution that operates by interposing itself between market participants (known as "clearing members") who have contractually entered the CCP arrangement in order to clear financial transactions that they have executed with each other. The clearing process creates rights and obligations between the clearing members and the CCP.
A CCP generally facilitates trading in the capital and financial markets and specialises in managing counterparty credit risk, which has a correlative effect when looking at systemic risk. It takes on counterparty credit risk between parties to a financial transaction by providing clearing and settlement services (sometimes referred to as post-trade services) for trades in:
- foreign exchange;
- commodities; and
- derivatives transactions.
CCPs are especially useful as they enhance liquidity and advance safe execution.
For example, the schematic below shows an arrangement involving three hypothetical financial institutions, small, medium and large, where all parties have underlying obligations to one another. These parties, in attempting to reduce the risk of non-performance, engage a market infrastructure to intermediate and/or assume any liability arising from the arrangements among them (this is typically implemented through novation). Where a liability does arise (eg, the large party is exposed to the small party by a value of 50, the medium party is exposed to the large by 25, and the small is exposed to the medium by 20), this market infrastructure takes over the respective liabilities and sets them off against each other through a multilateral netting system.
Figure 1: CCP schematic
Therefore, if the small party fails, this poses a risk that may trigger the failure of the large party. A CCP interposes itself between each entity that owe each other funds. After the CCP interposes itself between the original parties, it functions as an intermediary by guaranteeing the performance of the parties to each transaction. This substitution of the counterparties by the CCP typically occurs through novation (as shown above), which discharges the contracts between the original trading entities and creates new, legally binding contracts – one between each of the original trading parties and the CCP. Finally, it establishes and enforces a set of rules and operational arrangements aimed at allocating, managing and reducing counterparty risk connected to the transaction.
In 2021, the Securities and Exchange Commission (SEC) registered two CCPs in the Nigerian capital markets, FMDQ Clear Limited and NG Clearing Limited. Presently, FMDQ Clear Limited's focus is clearing foreign exchange and fixed income derivatives, while NG Clearing Limited's focus is clearing index and single stock futures. As both are still evolving, it is expected that these two CCPs will play a pivotal role in ensuring safety and resilience in the Nigerian financial markets.
Laws regulating CCPs
The principal law that is relevant to the operation of CCPs in Nigeria is the Investments and Securities Act 2007 (the ISA). Pursuant to the ISA, on 23 December 2019, the SEC issued the Rules on Regulation of Derivatives and Central Counterparties 2019 (CCP Rules). This regulation sets out, among other things:
- important provisions on the regulation of derivatives;
- the trading of these products;
- relevant registration requirements (for the products themselves, market participants and market infrastructures);
- risk management; and
- clearing and settlement in the Nigerian capital markets.
The CCP Rules provide an extensive legal framework for CCPs operating in Nigeria.
To render its services, a CCP must be registered with the SEC. The SEC prescribes certain information that must be provided for the purpose of such registration. These include:
- the proposed CCP's certificate of incorporation;
- memorandum and articles of association;
- copies of its rules, regulations and code of conduct;
- information relating to its clearing facilities; and
- fidelity bonds.
The minimum share capital requirement for a CCP is 5 billion naira, which must be in the ratio of 90% cash, with 10% in fixed and other assets. In line with usual practice, the 90% cash shall be escrowed in an interest-yielding account domiciled with the Central Bank of Nigeria (CBN) until the registration approval is granted by the SEC. A CCP is prohibited from carrying out any business, activity or function that is not related or incidental to clearing.(1)
Key regulatory requirements
Upon registration, a CCP must have sufficient assets and resources, a comprehensive risk management process, as well as effective and reliable infrastructure to facilitate its clearing operations or services.(2) Some of the operational requirements for a CCP include:
- sufficient assets and resources that include financial, management and human resources with appropriate experience to perform its functions as delineated in the CCP Rules;
- an effective and reliable infrastructure to facilitate its clearing operations or services;
- a comprehensive risk management process;
- appropriate systems, controls and procedures that are reliable and secure and have adequate scalable capacity;
- adequate mechanisms for the purpose of reviewing, monitoring, and evaluating its internal controls;
- proper arrangements for security and back-up procedures to ensure the integrity of the records of transactions cleared through its facilities;
- arrangements for the efficient and effective supervision of clearing members to ensure compliance with its rules and directives;
- consistent communication procedures and standards relating to securities, future contracts and member identification; and
- a complaint management framework in line with the SEC's rules on complaint management.(3)
Role of CCPs in Nigerian capital markets
Mode of operation
A CCP is required to set out rules and procedures that support financial stability and the safety of its clearing activities. It must also have a charter for its board, which should be made publicly available to ensure responsibility and accountability, as well as processes to identify, assess and manage the potential conflicts of interest of its stakeholders.(4) Also, the board must be independent of the CCP's management. The appointment of the members of the board is subject to approval by the SEC. Specifically, the CCP Rules provide that the board shall comprise, at least:
- five members with a chairman;
- a chief executive officer;
- at least one independent director; and
- a clearing member.
The directors of a CCP shall hold office for four years, subject to a cumulative maximum of two terms.
CCPs are required to manage their liquidity risks by, among other things, having highly liquid resources and a committed line of credit to enable them meet their financial obligations.(5) The CCP Rules outline stringent collateral requirements a CCP must abide by; accordingly, they are to only accept highly liquid assets with low credit and market risks and avoid concentrating collateral in one class of asset (with the exception of Federal Government of Nigeria Securities).(6) CCPs also manage their risks by collecting margins from each market participant to cushion adverse market fluctuations.
In Nigeria, CCPs have reporting requirements to the SEC including:
- daily transaction reports on clearing activities;
- monthly reports;
- quarterly financial statements;
- operational reports;
- annual reports and audited financial statements;
- quarterly assessments of risks from its operations; and
- any other information that may be required by the SEC.(7)
It is worth highlighting the existence of the CBN Guidelines on Large Exposures (LEX) (LEX Guidelines), which regulate the exposure of commercial, merchant and non-interest banks to CCPs. Under the LEX Guidelines, banks are required to capture all exposures to third parties across all the entities falling within the scope of regulatory consolidation for the CBN-issued risk-based capital requirement and should compare the aggregate of these exposures with the eligible regulatory capital at the consolidated (group) level. In particular, banks are required to identify exposures to a CCP related to clearing activities and sum together these exposures. Other types of exposures that are not directly related to clearing services provided by the CCP (eg, funding facilities, credit facilities and guarantees) are to be aggregated and subjected to the large exposure limit.
Impact of CCPs on capital and financial market transactions
With the introduction of CCPs in Nigeria, once the regulatory framework is fully implemented, clearing members in relevant capital and financial market segments will no longer be exposed to each other or several counterparties with different risk profiles, but to a CCP. Market-wide management of credit risk will improve as CCPs cover exposures with high quality collateral.
Where a clearing member defaults or fails, CCPs will be able facilitate the transfer of positions and collateral of such failing clearing member to non-defaulting or solvent, surviving clearing members and coordinate the orderly replacement of defaulted trades through auctions and hedging of exposures, thereby acting as a firewall.(8)
Also, as indicated in the illustration above, CCPs enable multilateral netting among clearing participants. This way, there will be a reduction of the total credit exposure in the market, as well as the number of transactions that require settlement, thus improving operational efficiency. CCPs provide anonymous trading, resulting in benefits such as increased liquidity and reduced spreads, while protecting the data of transacting counterparties.(9) A CCP will further contribute to the transparency of a market by providing for the centralised administration of long and short positions of clearing members in relevant capital and financial market segments.
As the importance of CCPs continues to grow, CCPs in Nigeria will become increasingly sophisticated and efficient. CCPs must maintain adequate systems capacity to process anticipated volume and must be capable of protecting against threats to the integrity of their operations.
It is expected that the financial system will respond by equipping and strengthening available infrastructures accordingly.
Although CCPs in Nigeria are relatively new, it is expected that they will enhance efficiency and transparency in the Nigerian capital and financial markets.
For further information on this topic please contact Ajibola Asolo, Michael Nwanneka or Ayomide Ogunsesan at Aluko & Oyebode by telephone (+234 1 462 8360 71) or email ([email protected], [email protected] or [email protected]). The Aluko & Oyebode website can be accessed at www.aluko-oyebode.com.
(8) Central Counterparties: Addressing their Too Important to Fail Nature; by Froukelien Wendt; IMF Working Paper No. 15/21; 1 January 2015.