The long-awaited Nairobi Security Exchange Next Derivatives Market is set for a historical launch to all investors in a few days.
This monumental launch will make the Nairobi bourse only the second in sub-Saharan Africa, after Johannesburg, to trade in futures contracts.
A futures contract is an agreement made through an organised exchange to buy or to sell a fixed amount of a commodity or a financial asset on a future date (or within a range of dates) at an agreed price.
The uptake of exchange-traded futures has been very slow in this part of the world, as opposed to the relatively common over-the-counter (OTC) contracts, which significant financial players in the continent have privately utilised for many years.
Ordinary investors in the stock market, and especially businesses with divergent financial risks, should be excited about the prospects of this new product.
The purpose of this piece is to explore the distinctions between the novel exchange-traded derivatives and OTC derivative products and to highlight the various uses of the former.
At the onset, it is instructive to point out that certain derivatives cannot be obtained on an exchange.
Exchange-traded products must have a good degree of liquidity and price discovery. Since they are easily transferrable, they embody a high degree of standardisation, and the buyer and seller are obligated by inflexible terms and conditions set by an exchange.
The fixed terms include aspects such as settlement dates, settlement amounts, contract maturities, strike prices, physical settlement, and at times, even limited price movements on any given trading day. On the contrary, these restrictions do not control the OTC products and the contracting parties are free to deal as they please.
The foregoing constraints notwithstanding, exchange-traded products offer the following benefits:
First, even though exchange transactions are mostly physically settled, the element of uniformity allows for contracts to trade many times before expiry. A buyer can, therefore, offset its exposure or avoid taking physical delivery by simply selling the contract.
Statistically, over all the exchanges, it is estimated that fewer than four percent of futures contracts traded in exchanges ever reach delivery, in some cases fewer than one percent.
This is fortunate because physical commodities in the world are not enough to deliver against all the futures contracts that are traded.
During the initial phase, the Nairobi bourse will only authorise cash-settled contracts.
Secondly, the possibility of financial loss accruing from exchange-traded products is limited in comparison to OTC transactions, which are dogged by counterparty risk.
This is because the effect of central clearance, coupled with the requirement to provide margin, provides a very high measure of protection against default.
To begin with, traders have to deposit initial margin with the clearinghouse via their broker before they can take out a position.
In addition, all open positions are marked-to-market on a daily basis.
If at the end of a trading day the futures price has fallen from yesterday’s close, then the accounts of the buyers are debited with their losses and the accounts of the sellers are credited with their profits. If the futures price has increased, then the situation is the reverse.
If a trader receives a variation margin call and does not send the required funds in time, the position will normally be closed out by his or her broker.
Thirdly, exchange-traded products provide a matchless consistent level of credit support to traders.
The central clearance system provided by the exchange ensures that the opposing positions taken by both sellers and buyers of the futures contracts are cash-backed.
The clearinghouse relies on rules which are extra-structural to the derivatives products themselves, such as margin, to provide it with the requisite credit protection.
Participants should, therefore, be well advised to be aware of the initial and maintenance (variation) margin requirements of the trade.
Fourthly, from a transactional cost perspective, exchange-traded contracts are inexpensive and less time consuming to put in place than OTC contracts, which can take several months of negotiations by various experts to complete and document.
Let us conclude by identifying the uses savvy investors can make of exchange-traded products.
The most common use is hedging of risk, whereby investors use futures to protect or hedge against adverse movements in commodity prices, equity indices, interest rates and bond prices, among others.
Examples include farmers who are seeking protection against a fall in the market price of their crop, fund managers and banks hedging against a drop in equity or bond prices and commercial banks covering exposures to changes in short-term interest rates.
Another common use is speculation, whereby investors buy and sell futures contracts to profit from changes in commodity price and interest rates, among others.
They are prepared to accept risks that hedgers do not wish to assume, and they provide liquidity to the market, that is, they help to ensure that there is an active market in futures contracts with up-to-date prices and that at any given time buyers and sellers are both in operation.
Lastly, arbitrageurs are investors who look to exploit price anomalies by, for example, simultaneously trading in futures and the actual underlying assets.
If a futures contract is trading ‘rich’, that is, at an expensive level, an arbitrageur will sell the overvalued futures and at the same time buy the underlying asset in the spot market, reaping gains from the price difference.
The writer is Advocate of the High Court of Kenya.