The Nigerian Securities and Exchange Commission (SEC) has decided to develop a derivatives trading market in Nigeria. To this end, the SEC issued an amendment to its Rules and Regulations in December 2019, providing for new rules on the regulation of derivatives trading and on central counter party (CCP). In February 2020, the Central Bank of Nigeria (CBN) in collaboration with FMDQ Holdings Plc offered its first long-term Naira settled OTC FX Futures Contracts to hedge against foreign exchange (FX) risk, with a maximum tenor of 5 years and to be traded on the FMDQ OTC Securities Exchange. This combination of new rules and products is opening up derivatives trading in Nigeria to new investors and participants as both regulators seek to bolster the market and offer new risk management products.
This article will consider derivative contracts and its different forms as well as the provisions of the newly issued SEC Rules on derivatives trading in Nigeria.
2. Derivative Contracts
A derivative is a bilateral contract whose value is derived at a future date from an underlying asset, such as a commodity, currency, interest rate, property value, company share, etc. Derivatives are financial instruments used for hedging and risk management. Through a derivative contract, the value of an underlying asset is locked for a future date (settlement date) to protect the risk of price fluctuation and speculate the future value of the asset. This locked price, known as the strike price, is the value reference or consideration upon which the contract will be settled and the underlying asset will be transferred to the buyer on the settlement date. A derivative contract may be cash settled or physically settled. Under a cash settled derivative contract, settlement of the derivative is completed through a cash payment, usually the difference between the strike price and the market value at the settlement date. In the case of a physically settled derivatives contract, the underlying asset is physically transferred to the buyer on the settlement date in consideration for the strike price.
Derivatives may be used by trading companies to protect them from risks that are peculiar to their business interests (e.g. currency risk, interest rate risk, commodity risk), by lenders to redistribute their risk exposure on a transaction or by institutional investors to manage their investment portfolios.
3. Forms of Derivatives
Vanilla Derivatives vs. Exotic Derivatives
Derivative products may be vanilla or exotic. A vanilla derivative is a standard derivative product whose features are well defined and traded actively. They are commonly encountered derivatives with basic features such as strike price and settlement date, and having no special features. An exotic derivative is an unusual derivative, structured and developed to meet the specific requirements of the parties to the contract. They contain more complicated features as they are usually structured to meet a particular transaction’s requirements.