Structural reforms to expand Nigeria's capital markets

Given the difficulties experienced by Nigeria’s economy in 2016, every sector grappled with challenges, and capital markets were no exception. From external pressures such as low oil prices and US interest rate shifts, to internal factors such as depreciation and slowing oil production, investors in Nigeria had to account for a range of risks. These factors had a clear impact on inflows. In 2016 foreign investment in emerging markets fell to its lowest level since the 2008 financial crisis, with capital flight accelerating in early 2017.

However, the slowing of the economy has had some positive consequences. For example, the Nigerian Stock Exchange (NSE) – the second-largest bourse on the continent by market capitalisation – has a number of firms at attractive valuations, while the government’s plans to partially divest itself of listed companies should help stoke trading activity and retail participation. “Non-productive government assets should be sold,” Wale Agbeyani, managing director of Cordros Capital, told OBG. “It would be a win-win for public and private sectors, and generated capital could be re-invested.”

Perhaps equally important, Nigeria’s capital markets are in the midst of a robust reform programme, which should significantly improve the market’s growth and sustainability over the long term.

Exchanges

The country’s capital markets are already among the largest and most sophisticated in Africa, with two primary exchanges: the NSE, which has a main equity board, a small and medium-sized enterprise (SME) board – known as the Alternative Securities Market (ASeM) – a fixed-income market and an exchange-traded fund (ETF) market; as well as the FMDQ OTC Securities Exchange, which focuses mainly on fixed incomes and funds.

There are also a number of new efforts aimed at furthering the development of Nigeria’s exchanges. The current priorities include an ongoing demutualisation initiative, closer regional integration and the launch of new derivative tools, such as foreign exchange (forex) futures. The NSE’s efforts should come to fruition in the near term, as the economy continues its recovery.

Performance

The NSE’s bullish outlook may contrast somewhat with the evolution of key indicators over 2016. The value of the NSE All Share Index reached year-high levels in June 2016, up roughly 8.5% over year-end 2015, before falling by 6.2% by the end of 2016, with most other market and industry-specific indices following suit. In fact, between June and July 2016 foreign inflows alone dropped by 45%, although foreign investor participation in the NSE hovered just below 50%, only slightly down on year-end 2015 levels. The NSE 30 Index, which tracks the 30 largest listed companies, fell by 7% over the course of 2016. The NSE Industrial Index and the NSE Oil & Gas Index were the hardest hit, however, falling by 26% and 12%, respectively – a result of the broader economic contraction, and the drop in oil prices and production.

“Market liquidity is dependent on how the macro story pans out,” Tunde Abidoye, equity research analyst at FBNQ uest, told OBG. “For Nigeria, the key thing is oil. When investors have a positive view about oil, the macro story and the fiscal position of the government, they tend to be more active in Nigeria, and this swells liquidity. But if the macro story doesn’t improve, liquidity will not be as robust as it was several years ago.”

However, there have been some encouraging performances. The NSE Premium Index, which tracks a subset of large companies that meet strict corporate governance criteria, rose by 7% in 2016, for example. This result significantly outpaced the only other index that ended the year in positive territory, the NSE Banking Index, which gained 2.2%.

Capitalisation

In naira terms, total market capitalisation fell by a modest 4.8% in 2016. In dollar terms, however, due to the currency’s devaluation (see Economy chapter), total market capitalisation fell by 37.8%, from $85.3bn to $53bn. The corresponding figures for equities were -6.1% and -38.6%, respectively, exacerbated by the low level of new issuances in 2016; there were no new issuances on the main equity board, with 170 listed firms at the end of the year, compared to 184 in 2015. Although the NSE’s SME-focused board, the ASeM, has seen only a modest amount of activity so far, it has performed better than many of its peers elsewhere on the continent, which struggle to attract more than a handful of listings.

By August 2017 there were 10 firms on the ASeM, including a new listing in 2016 from Initiates, a local waste management and industrial cleaning firm. While the board was similarly affected by broader economic turbulence, the ASeM Index experienced a far smaller decline, down 1.6% over 2016.

In spite of a number of sovereign and government bond issuances – of which most saw robust trading activity – the performance of the NSE’s fixed-income market also softened, down 3% and 36.6% in naira and dollar terms, respectively. There were 28 federal listings, 27 state listings and 31 corporate listings, with a total value of $22bn as of the end of 2016.

Capitalisation for the ETF market, on the other hand, rose by 19.4% in naira terms. This gain was primarily attributed to the launch of the Vetiva S&P Nigeria Sovereign Bond ETF in 2016, which marked the eighth listing on the market. Nevertheless, in dollar terms ETF market capitalisation fell by 22%, although the market did see strong performances from safe-haven funds such as the NewGold ETF, which tracks gold bullion.

Regulation

The Securities and Exchange Commission (SEC) serves as the primary regulatory body for the sector. The SEC is in the process of transitioning from a rules-based supervision model to a risk-based one, with a particular focus on institutions deemed to be systemically important, not unlike the regulatory approach taken by the Central Bank of Nigeria (CBN). This move brings the supervision of the country’s capital markets in line with rules and guidelines set forth by the International Organisation of Securities Commissions, of which Nigeria is a member.

Much like the risk-based supervisory policies adopted by the CBN for its banks, the SEC’s level and frequency of inspection will in part be based on the level of risk inherent in the firm’s portfolio, and its potential to cause a problem that spreads throughout the sector. The SEC has been practising some form of risk-based supervision since 2013, in response to the 2008 financial crisis, but 2017 marked the first year that it fully transitioned to the risk-based model.

Enforcement

In an attempt to build a stronger foundation of participation among retail investors, the SEC has endeavoured to restore confidence lost as a result of a string of market abuses in the past.

Over the past decade the SEC has been working with the Economic and Financial Crimes Commission to bring criminal charges against market abusers, and has suspended operators. Such companies include Heritage Capital Markets, which in December 2016 was charged in relation to the “unauthorised sale of shares belonging to an investor”. This development followed the ousting of three brokers by the SEC weeks before.

Development Plans

In November 2015 the SEC released the Capital Markets Master Plan, a roadmap for the future of the Nigerian capital markets industry. The plan, which spans 2015 to 2025, aims to bring greater sophistication, liquidity and innovation to the country’s capital markets. Several key features of the plan – including the demutualisation of the NSE, and the expansion of Islamic and non-interest financial products – are already under way.

Also pushing Nigerian capital markets forward is the March 2017 listing of the federal government’s $1bn eurobond – the first foreign currency bond to be listed in the country – on both the NSE and FMDQ. While trading and settlement of the bond must still take place overseas, both exchanges are actively exploring ways to allow for trade and settlement to occur in Nigeria, giving local investors greater access to the bond issue, which will open the door for government and corporate bonds denominated in global currencies to be traded directly in Nigeria. Such a development would bring the country one step closer to realising its goal of aggregating capital market activities for the West African region more generally.

Retail Investment

Increasing retail participation in the capital markets is another key aim of the NSE, and the bourse is actively seeking to adjust its cost structure to be more accommodative to market participants, but also to maintain the exchange’s profitability.

“We are making conscious efforts to bring our costs in line with global competition; however, in doing so, we need to ensure we do not cannibalise our business model,” Okon Onuntuei, head of strategy and research at the NSE, told OBG. “Accordingly, we are looking at incentivising participants market-wide, based on how much order flow is infused into the capital markets – the greater our overall trading volumes and values, the greater our market-wide incentives are. We are also looking to place realistic caps on our listing and application fees. Right now we charge 0.3% of market cap indefinitely; however, when global best practices are considered, there is clearly a significant opportunity for the NSE to further enhance its competitive positioning by capping certain fees,” he added.

The NSE is also formulating a forecast disclosure regime that it intends to launch by the end of 2017. The system will allow listed companies to disclose their revenue and other financial forecasts at the beginning of their respective fiscal years, further enhancing transparency. This would expand the NSE’s current minimum level of disclosure, which is primarily limited to quarterly financial statements. As is the case in many emerging and frontier markets, any further disclosure tends to be limited, with listed companies citing competitive considerations and investor relations as reasons behind not providing more detailed information. Uwadiae Osadiaye, equity research analyst at FBNQ uest, told OBG, “One of the ways to improve local market efficiency, and the integrity of the market and participation generally, is to encourage listed companies to communicate more frequently in the market.”

Regional Integration

Another priority in terms of capital market development is tightening the integration of the NSE with other exchanges, both in the region and further afield, which would improve liquidity and access to capital. The NSE is working to implement the West African Capital Markets Integration (WACMI) programme, which would more closely integrate the stock exchanges of Côte d’Ivoire, Ghana, Nigeria and Sierra Leone, eventually allowing brokers from each country to trade directly on any of the four exchanges.

Following the first activity under the WACMI programme – between Nigeria and Ghana in 2015 – several additional trades have taken place between the two exchanges. However, progress towards further integration has stalled due to a number of factors, including the economic downturn in 2016. “We are still at phase one – the sponsored access stage. As the economy turns around we expect more activity in the programme. Given that we are a mutual organisation, we are limited in certain ways, such as bringing new trading members into the NSE, and phase two essentially entails bringing on new members,” Onuntuei, who is managing the WACMI effort on behalf of the NSE, told OBG. “However, we are reconsidering our efforts geared towards electronic open access, which would allow non-members to connect to our market for order flow purposes. If successful, this would be a fantastic interim step that would facilitate phase two of the WACMI programme, especially as we continue with our demutualisation efforts.”

Furthermore, the NSE is working with the African Development Bank and the African Securities Exchanges Association – as well as with the stock exchanges of Casablanca, Nairobi and Johannesburg – on the African Exchanges Linkage Project, which aims to allow cross-border trading among members. “The NSE is doing a lot to integrate African capital markets, which should result in more trade and capital flows across borders,” Emeka Okolo, head of asset management at Coronation Merchant Bank, told OBG. “Once more traction is gained on this initiative, it will contribute to solving issues of domestic liquidity.”

Demutualisation

After years of debate and planning the demutualisation of the NSE is closer to being realised. In March 2017 members of the NSE approved the process of converting the exchange from a member-owned entity into a publicly owned one. The move would allow the bourse to list on the NSE as its primary exchange, and retain the right to a secondary listing abroad. Crucially, the initiative would bring the NSE in line with major bourses around the world, with many having undergone their own demutualisation processes in recent years. As a key component of the SEC’s Capital Markets Master Plan, established in 2015, once completed, demutualisation will provide the exchange with the flexibility to introduce the products, capital and expertise to prepare the NSE for the future.

To formalise the demutualisation requires legislative approval by the National Assembly. Once the legislative authority for the change has been granted, the exchange estimates that it will need between six months and one year to fully implement. NSE officials told OBG that they hope to finish the process and list by 2020, with South African bank FirstRand and local investment firm Chapel Hill Denham advising the NSE on the process of becoming a listed company.

Derivatives

One of the most notable aspects of the country’s efforts to deepen and develop its capital markets is the rollout of new derivatives, which took a significant step forward in June 2016 with the introduction of forex futures by the FMDQ. As a tool to limit forex risk in light of naira exchange rate uncertainty, the CBN approved guidelines for the establishment of an interbank forex market.

“The CBN is currently the single seller of naira-settled over-the-counter (OTC) forex futures contracts of non-standardised amounts, but the FMDQ exchange will be the OTC forex futures exchange,” Kaodi Ugoji, vice-president of strategy and corporate services at FMDQ, told OBG. “The product will enable corporate treasurers to effectively and efficiently manage their forex risk, and minimise the disequilibrium in the forex spot market. It should in turn help attract significant capital flows to the Nigerian fixed-income and equity markets, helping to achieve exchange rate stability.”

In order to prevent speculation the CBN requires purchasers to provide documentation of exposure to forex risk, such as a certificate of capital importation. Banks may participate in the forex futures market to hedge their own currency risk, or do so on behalf of clients, but in either instance proof of forex exposure must be provided to the CBN at the time of purchase.

Henry Okoye, a trading and fixed-income analyst at Coronation Merchant Bank, told OBG, “The fact that companies and banks are able to hedge forex exposure has meant that there has been a de-risking of the forex market. It has brought a lot of liquidity into the market and made foreign investors more comfortable.”

Going forward, it is expected that the forex futures market will eventually include contracts sold by entities other than the CBN. “When you are starting out with a product, someone will have to handle the liquidity side of things before it gets on its feet,” Olatunji Odesanya, CEO and managing director of Coronation Securities, told OBG. “The CBN has been the sole provider of that liquidity, but with time we will have others. It will be a massive market going forward.”

Clearing Agents

The NSE is on track to launch derivatives by the end of 2017. Its maiden derivatives venture will be an index futures product based on the NSE 30, with the NSE working to develop a temporary clearing agent until a formal clearing house is established, which is expected to be in 2018. As part of this, the NSE and the Central Securities Clearing System – the body currently licensed to handle the deposit, clearing, settlement and delivery of securities transactions – are working to develop a central counterparty (CCP) to handle the transactions.

“We are facing two primary hurdles,” Onuntuei told OBG. “First, we need to develop the legal framework: the rules relating to everything from the trading of derivative products, to the trade default fund of our proposed waterfall structure for the CCP, to rules around margin calls and so forth. The second hurdle is the technology required to trade derivative instruments, which we have engaged NASDAQ to implement.”

Much of the infrastructure is already in place. The NSE already possesses the ability to trade the NSE 30, along with more sophisticated products. The NSE purchased NASDAQ’s X-Gen trading system in 2013, which includes derivative trading capabilities.

Similarly, the NSE is looking to expand securities lending in line with plans to roll out derivative trading. “It has been a deliberate process in anticipation of the launch of exchange-traded derivatives in our market, as the two go hand-in-hand,” Onuntuei told OBG.

New Debt Offerings

Elsewhere, the SEC approved FMDQ’s rules for short-term bonds in October 2016, capping off a multi-year effort by the exchange. Currently, there is a gap in corporate financing options between the commercial paper – generally covering one year or less – and medium-term bonds, which generally have a minimum duration of three years. The introduction of short-term bonds is expected to fill the financing gap previously occupied by bank loans. According to the new rules, the SEC has devolved the registration authority to FMDQ.

As a result, FMDQ will undertake the necessary due diligence and registration associated with the issue of a new short-term bond before sending the application to the SEC. The SEC then has 48 hours to approve, reject or request revisions to the application. Once a completed application is submitted to FMDQ it is hoped the registration process can be finalised within as little as two weeks, allowing companies to apply for and issue bonds before interest rates change materially.

Private Equity

Faced with low rates of bank lending and difficulty in raising money on debt and equity markets, private equity holds a third option for Nigerian companies looking to raise capital and improve performance. Although private equity funds in Nigeria are usually quoted in dollars, they are invested in the country for the long term, making them potentially less sensitive to currency volatilities than others.

However, private equity also comes at a price. “Somebody can be a very successful entrepreneur but not necessarily be ready to admit institutional investors into their business, because it comes with certain obligations,” Vlassis Liakouris, managing director of ARM Capital Partners, told OBG. “For example, we tend to expect a certain corporate governance framework. It is not enough to like the business, the business also needs to like us, or recognise some value beyond money. This is always the case, but in the middle of a recession, good opportunities become even scarcer.”

Outlook

In light of all of the development and expansion efforts under way, and with a broader macroeconomic recovery ongoing, 2017 and 2018 should prove more welcoming than 2016. The government’s ambitious Economic Recovery and Growth Plan 2017-20, combined with the managed float of the naira and import substitution programmes, means that the outlook for the real economy is particularly bullish.