Expand derivatives to hedge risks, cut jitters about future prices


Extreme see-saws in the shilling have cast a positive light on the need to expand our derivatives offering. PHOTO | SHUTTERSTOCK

Extreme see-saws in the shilling have cast a positive light on the need to expand our derivatives offering. The volatile nature of international capital flows exacerbated by our running budget deficit, high indebtedness, dwindling competitiveness (evidenced by the long-term fall in exports to GDP), among other reasons, remind us why the development of local derivatives markets provides a crucial alternative risk management.

In the example of South Africa, their now well-established derivatives market has not only helped them “self-insure” against volatile capital flows and manage financial risk associated with the high volatility of asset prices, but has also helped its many market participants price, unbundle and transfer risk. Here’s why we need to accelerate on this path.

First, today, businesses around the world are increasingly using derivatives to effectively hedge risks and reduce uncertainty about future prices. According to a World Federation of Exchanges report, volumes in currency derivatives’ rose by 6.7 percent to 3.2 billion in the first half of 2023 compared to a similar period in the previous year.

Likewise, commodity derivatives, equity derivatives and interest rate derivatives, all increased by 21.5 percent, 55 percent and 16.5 percent, respectively, to five billion, 41.5 billion and 2.9 billion, in the same order. A study by South Africa’s National Treasury indicates that its derivatives products are particularly popular amongst a wide range of market participants including millers, exporters, importers, speculators and banks. This kind of growth testifies to the immense value derivatives add to the risk management process.

Second, the overriding mandate of asset managers to preserve capital and ensure its growth means derivatives are part of their risk management tools. Good to note that the Insurance Regulatory Authority allows up to five percent of total insurance funds to be used for derivatives.

Similarly, pensions can go up to a maximum of five per cent of the aggregate market value of total assets of a scheme in exchange-traded derivative contracts. Additionally, the recently introduced licensing option for alternative/hedge fund managers adds to this pile.

The special needs of these players mean we need to grow beyond exchange-traded single stock futures and index futures on offer currently. And there’s an added benefit to this, studies show that derivatives increase the efficiency of markets by improving price discovery for the underlying assets.

Third, the development of derivatives markets can provide an alternative to bank credit as a source of funding. This can help to create a more stable source of local currency funding, thereby cushioning the funding gap from capital flow reversals or “sudden stops.

All things considered, hedging instruments need to be available for the proper development of our local derivatives market. We need to float currency derivatives, interest rate derivatives and commodity derivatives as a matter of course.

Whether executed as a partnership with other derivatives exchanges/clearing houses with similar contracts or not, the urgency is obvious; we are largely an agricultural economy, we are a free market exposed to “hot money” outflows and have one of the most active regional bond markets second to South Africa. Of All this should be accompanied by tight regulation and supervision.

Mwanyasi is MD, Canaan Capital

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