Nigeria’s OTC Market to make Foray into Interest Rate Derivatives

Within the next five years, dealers in Nigeria’s Over-The-Counter (OTC) fixed income market will make their first inroads into interest rate derivatives deals, BusinessDay can disclose.

This finding follows recent moves by Nigeria’s OTC securities exchange (FMDQ) to commence on its platform, the trading on interest rate derivatives. The Self Regulatory Organisation (SRO) had already commissioned a feasibility study towards the introduction of interest rates and currencies derivatives products within the five-year period (2015-2019).

Currently, interest rate risk is one of the most crucial forms of risk that banks and other financial institutions face in their role as financial intermediaries, but analysts say interest rate derivatives will provide investors the risk protection with minimal upfront investment and capital consumption.

An interest rate derivative is popular for investors with customised cashflow needs or specific views on the interest rate movements (such as volatility movements or simple directional movements) and are usually traded OTC.

Currently, OTC dealers are trading derivatives on the FMDQ OTC platform, but not on a large scale –an indication that there is room for growth.

Between January and March, the  turnover on this platform shows: Foreign Exchange Derivatives (N2.199trn); and Money Market Derivatives (N32.485bn) among other products like FX, T-Bills, Bonds (FGN Bonds, Eurobonds and Other Bonds), Money Market (Repurchase Agreements, Buy-Backs and Unsecured Placements/Takings), and Repurchase Agreements/Buy-Backs that contributed to the recorded N32.76trn in first-quarter (Q1) 2015 OTC market turnover. 

“The Nigerian OTC derivatives market is relatively underdeveloped, as the few existing products have remained in their formative stages. In support of the various initiatives led by Authorised Dealers (ADs) of the Central Bank of Nigeria (CBN) to deepen the foreign exchange (FX) market, the CBN released various guidelines to allow ADs offer derivative products to their customers”, said Jumoke Olaniyan, group head, product and market development at FMDQ OTC plc.

“Such hedging products approved by the CBN for banks to employ include FX Forwards (Outright and Contract for Differences (CFDs)), FX Options, FX Swaps and Cross-Currency Interest Rate Swaps (CCIRS). Yet the market remains very shallow with derivatives accounting for about 23 percent of the total OTC market turnover in 2014 (FMDQ Turnover Report 2014),” Olaniyan said.

“Interest rate risk can be controlled optimally by using derivatives along with traditional methods, in order for banks to experience less interest rate uncertainty, and to increase their lending activities, which can result in greater returns and higher overall profitability,” said Soretha Beets, a South African-based research psychologist, in her report ‘the use of derivatives to manage interest rate risk in commercial banks’.

According to Beets, “the innovation in financial theory, increased computerisation, and changes in foreign exchange markets, credit markets and capital markets have contributed to the need to supplement traditional methods to measure and manage interest rate risk with more recent methods.”

There is a strong indication that a more sophisticated derivative like currencies derivatives will be introduced into the OTC market. The findings from the feasibility study of derivative products will support the OTC securities exchange product roll-out plan for the introduction of interest rate and currency derivatives into the Nigerian marketplace.

To ensure smooth sail of OTC derivatives in Nigeria’s debt capital market, FMDQ may be reviewing and promoting enabling OTC derivatives laws, rules, guidelines, policies and documentation standards. This will include adapting the Global Master Repurchase Agreement (GMRA) and the International Swaps and Derivatives Association (ISDA) Master Agreement.

This initiative aligns with one of FMDQ’s strategic objectives, which is to introduce the full complement of fixed income and currency OTC derivative products to manage risk by 2019, BusinessDay learnt.

“Outright forwards transactions are conducted with end-users and other ADs on negotiated basis as this product is not liquid. ADs also engage in FX Swaps although not on two-way quote basis. ADs are allowed to offer the European-styled FX call and put option contracts to their customers and in the inter-bank market. “However,  the prudential guidelines on FX options covering the qualifying criteria, limits, capital adequacy charge, spot-hedge position limits, market risk management standards, internal controls standards and personnel competency requirements etc. are yet to be developed. The interest rate derivatives markets present no better performance, as there are barely any transactions consummated locally in this space,” Olaniyan summed.