Beyond the primary market: Envisioning a greater diversity of instruments

A long slump in equities has spurred authorities and market participants to try to deepen and diversify types of market instruments in a more concerted fashion. A first milestone was reached in December 2011, when West Africa’s first exchange-traded fund (ETF) was listed on the Nigerian Stock Exchange (NSE). Succeeding in the exchange’s “five products in five years” strategy will be key to attaining the stated ambition of combined capital markets capitalisation of $1trn by 2016. Strong demand for new issues reflects an investor appetite for new and different products. Meanwhile, instruments to hedge risk and profit off downturns are around the corner, with key regulatory reforms planned for 2012.

ETFS: Both the regulator and the exchange have been instrumental in launching new instruments. The Securities and Exchange Commission (SEC) passed an “ETF Rule” in 2011, while the NSE has sought to build awareness of financial stakeholders. The aim is to draw retail investors back to the exchange with the listing of a well-performing fund, as well as attract new liquidity to the NSE. In late 2011 South Africa’s Absa Capital (affiliated to the UK’s Barclay’s Capital) listed 400,000 shares in the NewGold ETF, the largest in South Africa and fourth-largest gold ETF in the world, on the NSE with Vetiva Capital, a local house, as the sponsoring broker. The best-performing ETF in South Africa over five years, the ETF produced two- and three-year returns of 28.5% and 12.73%, respectively. One of the most straightforward means for investors to invest in gold, the ETF had already broken new ground in Botswana, where it was also the first ETF to list. By February 2012 the ETF’s funds under management reached N359.77bn ($2.3bn) with the company pursuing plans to list the ETF on Ghana’s stock exchange. In the first quarter of 2012 the NewGold ETF outperformed the NSE’s all share index (ASI), growing some 8.9%. Assets under management have reached N1.09bn ($6.98m). A number of issues are expected to follow suit. Van Eck, the world’s sixth-largest ETF issuer, filed papers with the SEC in November 2011 to list its Market Vectors Nigeria ETF, just four months after it had filed for the regional Market Vectors Nigeria-Focused Western Africa ETF. Oil companies are expected to form a significant part of both funds. Brokerages like Cordros Capital are finalising plans for an ASI-based ETF to add to the foreign ETF, or on a subset of the index.

Meanwhile sharia-compliant investment house Lotus Capital, which is launching its Lotus NSE Islamic Index in July 2012, expects ETFs to be structured on its basis. While investors have welcomed the development of new exchange-traded products, foreign funds in particular have long sought a way to be able to hedge their exposure on sub-Saharan markets.

FX DERIVATIVES: Although securitisation has yet to take off, limited trading in foreign exchange (FX) options, forwards, swaps and cross-currency interest rate swaps (CCIRS) has been allowed since March 2011. The Central Bank of Nigeria (CBN) has issued guidelines for foreign exchange derivatives (for dollars to naira) in a bid to improve and deepen dollar liquidity, improve the implementation of monetary policy and redefine treasury risk management.

This allowed banks, bureaux de change and discount houses to transact European-type “call” and “put” options for minimum bids of $500,000 and extended the maximum tenor on such forwards to five years. The initial one-, two- and three-month forwards offered under the Wholesale Dutch Auction System (WDAS-FWD) have been welcomed by dealers.

LIMITED MARKET: The market remains limited given the CBN’s ban on synthetic CCIRS, which entail that the principle amount of currencies must change hands. Meanwhile hedging is only allowed for trade-related foreign exchange, which means speculation on the naira is not possible. These limits have ruled out excessive pressure on the currency, but have kept trading within a small group of qualified dealers. “Foreign exchange is a very sensitive issue within Nigeria, given that it is linked to interest rates and foreign reserves,” Rotimi Oyekanmi, the group head of Ecobank Capital, told OBG. “Allowing foreign exchange speculation would break some of the CBN’s control so we don’t expect to see deregulation of the market anytime soon.” Yet while the derivatives market remains in its nascent stages, key regulatory changes in 2012 should see the emergence of traditional derivatives products in addition to the limited foreign currency hedging permitted by the central bank.

ENABLING REGULATIONS: A key priority for the NSE and SEC is to deepen the capital markets through bonds and ETFs as well as options and futures. The latter develop the market’s efficiency by improving price discovery, giving investors the option to both long and short securities – stocks, bonds or indexes. While the CBN regulates the FX market and the ability of financial institutions to invest in derivatives, the SEC is the main statutory regulator.

Although lending and borrowing securities, so very crucial to secondary markets, has yet to be allowed, the SEC licensed 10 market makers in early 2012. This is a key step in developing the derivatives market, since these buy and sell securities over the counter (OTC) to create market liquidity. “Nigeria is introducing securities lending and short selling with the appropriate safeguards, naked short selling will be banned for all,” Oscar Onyema, the CEO of the NSE, told OBG. “If every shareholder lent their securities, at the very least this would double transactions, but we have far greater ambitions for the market than that.”

While issues remain regarding the taxation of derivatives, the CBN will likely have to reform its cap on banks’ margin loans (currently 10% of their total book) when it comes to market makers, to allow them to raise sufficient liquidity to fulfil their role. Meanwhile the Central Securities Clearing System has begun upgrading its post-trade settlement mechanism to match the NSE’s new NASDAQ system, introduce more transparency and cope with more transaction volumes.

THE SHORT SELL: In May 2012 the SEC announced the imminent lifting of restrictions on lending as well as the ban on short selling – a first for sub-Saharan Africa (excluding South Africa). This would allow market makers, the only institutions allowed to undertake naked short-selling, to create liquidity in tight markets. Once the ban is lifted, investors will be able to reduce the cost of holding stock, hedge position and benefit from falling markets. “I think the market is ripe for gradual introduction of less complex derivatives,” Johnson Chukwu, the managing director of Cowry Asset Management, told press in March 2012.

The move will also entice hedge funds by providing them with flexibility in a number of areas. While regulatory ambiguities have yet to be cleared up, the NSE also expects pension fund administrators (PFAs) to borrow and lend securities, adding to the supply available for short selling. “There is a school of thought that says PFAs are not allowed to lend or borrow securities, but we are seeking to clarify this issue in the coming year,” Onyema told OBG.

On the back of the extension of trading hours to maximise overlap with US trading, another reform expected in 2012, this should add liquidity to the Nigerian markets. Yet the development of vibrant OTC derivatives markets remains linked to the ability to expand the number of primary issues. “Float levels need to be decent first, say above 25%, for there to be enough shares to allow for such derivatives products,” Kyari Bukar, the CEO of Central Securities Clearing System, told OBG. “Beyond a 25% float, the price of shares starts to be determined by fundamentals and derivative products can be structured on this basis.” Moreover, OTC trading of derivatives does not come without risks. In June 2012 the International Organisation of Securities Commissions raised some concerns regarding the regulation of derivatives trading in Nigeria, including the need for to manage counterparty risk. Authorities have acknowledged the potential for risk and remain on track in their plans.

The NSE hopes to establish a secondary market for bond trading in 2012 and an options market in 2013 or 2014 as a platform for trading stock, bond and index options. The plan is then to establish a futures market for currency and interest rates in 2015. While the emergence of a futures market will benefit both issuers of securities and investors, it will also pave the way for a market for credit-default swaps at a later stage. The SEC is also planning a new law covering special-purpose vehicles, which will lift one of the key constraints on the writing of asset-backed securities.

UP AHEAD: Sluggishness in the index should not obscure the exciting structural changes taking place in Nigeria’s capital markets. Long paid lip service to, product diversification has now started with the ETF’s launch. While conscious of the need to avoid the excesses of securitisation, Nigerian authorities are moving in a concerted way to develop the market’s depth and sophistication. Should short-selling succeed in attracting significant new liquidity, others like Kenya and Ghana have expressed interest in following suit.