Introduction
Increased length of OTC FX futures contracts
SEC's issuance of exchange traded derivatives and CCP rules
Issuance of derivatives rulebook by NGX
Developments within FMDQ Group
Netting under CAMA 2020
Netting under BOFIA
Developments in commodities derivatives markets
Comment
Since January 2011, when the Central Bank of Nigeria (CBN) released the Guidelines for Foreign Exchange Derivatives and Modalities for CBN Foreign Exchange (FX) Forwards,(1) the Nigerian derivatives market has grown steadily. In November 2014, FMDQ Group Plc – previously known as FMDQ OTC Plc – began publishing data on turnover of products traded on its platform. Based on the data published by FMDQ Group Plc, the market turnover for foreign exchange derivatives on the FMDQ platform grew from 6.5 trillion Nigerian naira in 2014 to 28.7 trillion naira in 2021, an increase of 342%.
Nigeria's derivatives regulatory framework has evolved alongside the growth of the market. A sound and efficient derivatives market requires the presence of appropriate comprehensive and flexible laws,(2) and financial market regulators have recently ramped up regulatory activity aimed at achieving this. This article highlights some recent regulatory developments in the Nigerian derivatives space.
Increased length of OTC FX futures contracts
In 2016, following the CBN's revised Guidelines for the Operation of the Nigerian Inter-Bank Foreign Exchange Market, Naira-settled OTC FX Futures (NSOFF) were introduced as hedging products to encourage foreign investments. The NSOFF established by the CBN and the FMDQ Group are essentially non-deliverable forwards – namely, contracts where parties agree to an exchange rate for a predetermined date in the future, without the obligation to deliver the underlying US dollar (notional amount) on the maturity or settlement date and set up to be sufficient for one-year hedges.
In February 2020, the CBN, in collaboration with FMDQ Securities Exchange Limited (FMDQ Exchange), began offering monthly over-the-counter (OTC) FX futures contracts for up to five years to assist investors looking to hedge against longer-term FX risk.
SEC's issuance of exchange traded derivatives and CCP rules
In 2019, the Securities and Exchange Commission (SEC) released rules governing exchange-traded and OTC derivatives trading in Nigeria. The first set of rules highlight requirements for derivatives trading in Nigeria,(3) including a framework to guide risk management procedures and back-office operations of derivatives exchanges (derivatives trading rules). The second set of rules highlight requirements for the establishment and operation of central clearing counterparties in Nigeria (CCP rules).(4) Prior to the issuance of these rules, there was no framework for exchange-traded derivatives in Nigeria.
Pursuant to the derivatives trading rules, all derivatives contracts must be registered and approved by the SEC before being introduced on any exchange.(5) Notably, only entities registered with a recognised exchange and/or a central clearing counterparty can trade exchange traded derivatives for proprietary or client accounts, while only CBN-licenced commercial and merchant banks are eligible to register as derivatives clearing members.
The CCP rules create a framework as it pertains to the operation of central clearing counterparties. Under the CCP rules, all central clearing counterparties are obligated to register with the SEC,(6) in addition to possessing effective and reliable infrastructure for discharging their clearing functions.(7) The CCP rules also stipulate the functions to be performed by registered central clearing counterparties(8) and require registered central clearing counterparties to create regulations in order to effectively manage their operations and their clearing members.(9)
The issuance of the derivatives trading rules and the CCP rules precipitated the establishment of central counterparties in Nigeria, a critical function within a derivatives trading framework. Consequently, there are now two licenced central counterparties in Nigeria: FMDQ Clear Limited and NG Clearing Limited.
Issuance of derivatives rulebook by NGX
In August 2019, the SEC approved the Nigerian Exchange Limited (NGX) Rulebook on Derivatives Market (the rulebook). The rulebook became effective on 14 April 2022 and applies to all the members of the NGX and users of the NGX derivatives platform. It sets out membership requirements (clearing and non-clearing membership requirements),(10) details the modes for conducting transactions and trades on the NGX platform,(11) and outlines general guidelines for the listing of derivatives products on the NGX platform.(12)
Pursuant to SEC's issuance of the derivatives trading rules and the CCP rules, evidence of the resultant tailwinds, as it concerns the continued growth and development of the Nigerian derivatives market, includes the successful registration of NG Clearing Limited as a central clearing counterparty. In the same vein, the NGX received approval for seven exchange traded derivatives contracts from the SEC. The approved contracts were:
- Access Bank Plc stock futures;
- Dangote Cement Plc stock futures;
- Guaranty Trust Holding Company Plc stock futures;
- MTN Nigeria Communications Plc stock futures;
- Zenith Bank Plc stock futures;
- NGX 30 Index Futures; and
- NGX Pension Index Futures.
Developments within FMDQ Group
FMDQ Exchange is implementing a derivatives market development project focusing, among other things, on the training of market participants ahead of the official launch of the FMDQ's exchange-traded derivatives (FMDQ ETD) market. Once launched, the FMDQ ETD market is expected to provide fixed income ETDs, currencies ETDs, equity ETDs and commodities ETDs with the relevant underlying asset per product.
A recent noteworthy development is the revision of the reference rate for the valuation of NSOFF product traded on FMDQ Exchange. Under the NSOFF market rules, NSOFFs are valued using only the Nigerian autonomous foreign exchange fixing (NAFEX) rate. However, via a market notice which became effective on 1 December 2021, the reference rate for all open NSOFF contracts was revised such that NSOFF contracts with terms to maturity greater than eight days would be valued using rates to be quoted by the CBN. As a result, only NSOFF contracts with terms to maturity of eight days or less are valued using the NAFEX rate, while NSOFF contracts with a lifespan longer than eight days are valued at rates quoted by the CBN.
The revision of the NSOFF valuation reference rates is predicated on maintaining global best practices for the valuation of derivatives contracts and is expected to encourage market confidence for existing and potential participants.
In August 2020, the Companies and Allied Matters Act 1990 was repealed, and a new Companies and Allied Matters Act 2020 (CAMA 2020) was enacted. The CAMA 2020 introduces several material concepts and changes into the body of Nigerian corporate law.
In relation to Nigerian derivatives regulation specifically, a significant introduction is the statutory codification of netting within the law. Netting generally refers to a risk management method under financial contracts by which mutual obligations of participants are aggregated and offset to a net amount. In the CAMA 2020, netting agreements are defined as:
- any agreement between two parties that provides for the netting of present or future payment or delivery obligations or entitlements arising under or in connection with one or more qualified financial contracts entered into under the agreement by the parties to the agreement;
- master agreement between two parties that provides for netting of the amounts due under two or more master netting agreements (a "master-master netting agreement"); and
- collateral arrangement related to or forming part of one or more of the foregoing.(13)
Broadly, the netting provisions under the CAMA 2020 seek to mitigate insolvency principles that could typically operate as a limitation to the application of netting arrangements. The CAMA 2020 also stipulates that such arrangements are enforceable in accordance with their terms, including in instances of insolvency. Hence, unless there is "clear and convincing evidence" of fraud, payment or delivery obligations arising from netting arrangements would not be set aside by a liquidator of a non-insolvent party to a netting agreement.(14)
In November 2020, the Banks and Other Financial Institutions Act (BOFIA) 2020 was enacted, repealing the BOFIA 1991. In addition to amendments to the regulatory regime applicable to banks and other financial institutions, the BOFIA introduced provisions on netting agreements. Further to these provisions, terms of netting arrangements involving a bank or relevant financial institution will be binding on a liquidator in respect of certain payment or settlement instructions. The netting provisions under the BOFIA would apply notwithstanding any provision to the contrary in the CAMA 2020 or any other law.(15) Hence, the BOFIA supersedes the CAMA 2020 as it concerns the interpretation and scope of netting arrangements involving banks or other CBN-licenced financial institutions.
With these provisions, there is now greater certainty regarding finality of payments and settlements in the event of licence revocation or insolvency of a bank or other financial institution.
Developments in commodities derivatives markets
There has recently been renewed interest in the establishment of a functioning commodities derivatives market, as various stakeholders within the agricultural and broader commodities value chain seek hedges for volatile economic conditions. Recently, Lagos Commodities and Futures Exchange Limited listed several tradeable instruments and registered dealing member firms and certified commodities brokers, with a view to commencing operations. Other commodities exchanges in the country include the Nigeria Commodity Exchange Plc, which is currently undergoing a government-led repositioning, and the AFEX Commodities Exchange Limited, which operates an agricultural commodities exchange platform that connects producers and buyers of commodities in Nigeria and Kenya.(16)
On the regulatory side, the SEC issued the Rules on Warehousing and Collateral Management (warehouse rules) in March 2021 to set out registration and operational requirements of warehouses and collateral managers, which are integral functions for the establishment of commodities derivatives contracts. Commodities derivatives may be physically settled, and registered warehouses serve as independent storage points for such commodities, while electronic receipts are issued to serve as confirmation of storage.
Under the warehouse rules, a warehouse that stores commodities to be traded on a registered exchange must be registered with the SEC. Collateral management companies must also be registered with the SEC to provide warehousing services involving storage and preservation of commodities. Subsequent to the issuance of the warehouse rules, activities within the commodities market have been invigorated as existing and potential stakeholders have greater clarity on the regulatory operational requirements for trading of commodities derivatives.
A sophisticated derivatives market is crucial to the advancement of the Nigerian financial markets. The efforts of the SEC and self-regulatory organisations to bolster the market and offer new risk management products are opening derivatives trading in Nigeria to new investors and participants.
Regulatory proactiveness has signalled a willingness to provide adequate guidance to existing and would-be stakeholders and has played a key role in setting the stage for further growth. One item to look out for is the Investments and Securities Bill that remains within the legislative chambers. The bill includes provisions that amplify the SEC's mandate to regulate various segments of the Nigerian derivatives ecosystem.
There is also the likelihood of increased retail participation in the derivatives market, as more familiar and vanilla-derivatives products are introduced by exchanges and dealing members. Once this occurs, the establishment of a long-term strategy incorporating investor education series and broad market surveillance framework may be required to mitigate the risk of extreme losses that has come to be associated with unchecked derivatives trading.
For further information on this topic please contact Ajibola Asolo, Bukola Akinsulere, Kareemat Ijaiya or Ofure Odia at Aluko & Oyebode by telephone (+234 1 462 8360 71) or email ([email protected], [email protected], [email protected] or [email protected]). The Aluko & Oyebode website can be accessed at www.aluko-oyebode.com.
Endnotes
(1) These guidelines were subsequently superseded by the CBN guidelines for FX derivatives in the Nigerian financial markets issued in March 2011.
(2) 2018/2019 KSP policy consultation report on the establishment and operation of derivatives market in Nigeria.
(3) SEC rules on regulation of derivatives trading.
(5) Rule 3(1) and (2) of the derivatives trading rules.
(10) Rules 3.1 to 3.3 of the rulebook.
(11) Rules 4.1 and 5.1 of the rulebook.
(12) Rule 7.1 of the rulebook.
(13) Section 718 of the Companies and Allied Matters Act 2020.
(14) Section 721(6) of the Companies and Allied Matters Act 2020.
(15) Section 54(1) of the Banks and Other Financial Institutions Act 2020.
(16) According to its half-year report, 324,108,050 contracts were fulfilled from January 2022 to June 2022 on the exchange, representing an increase of 454% when compared to the quantity of contracts executed in the previous half-year period.