Legal & risk aspects of derivatives and central counterparty clearing (CCP) transactions


By  Abimbola Ogunbanjo

TUE, JUNE 13 2017-I am extremely delighted to have been invited to give this key note address to an audience I can certainly see is made up of the some of the brightest capital market professionals locally and internationally. With Exchange Traded Derivatives (ETDs) expected to be launched by the Nigerian Stock Exchange later this year, this training could not have been better timed.

The concept of derivatives remains relatively novel in the Nigerian financial market space and has only been noticeable within the Over-The-Counter (OTC) segment of the market. The frontiers of the Nigerian financial market is expected to grow exponentially due to enhanced liquidity arising from the development of new and intricate financial instruments. Given the open and transparent financial market place the NSE offers to a wide range of domestic and international investors, it is expected that all participants must have the commensurate capacity and knowledge-base to deal with the intricacies and the sometimes esoteric features of derivatives. Accordingly, the need for this training in the face of the dearth of local capacity cannot be overemphasized.

The Global Derivatives Market

Few topics are as controversial today as derivative instruments. To some, derivatives are simple tools that allow market participants to efficiently manage their risks. To others, derivatives are weapons that allow market participants to thwart regulations, exceed risk limits, hide market exposures and threaten the very fabric of the world’s economic system. As with any tool, the answer as to whether the tool is good or bad is determined by the way it is used and who is using it. No wonder Warren Buffett described Derivatives as “financial weapons of mass destruction”.

A highly adept and skilled Suya man can wield a razor-sharp knife with blazing speed and thinly slice enough Tozo for a table of 10 in just 30 seconds. A thief can use that same knife to kill and maim innocents. The knife itself is neither good nor evil. The same is true of derivatives. If the person using them is a business owner who wants to reduce the risk in a portfolio of stocks in order to increase the odds that his employees will enjoy a comfortable retirement, that’s a good thing. A flow trader at a major bank could use that same derivative to hide risk in an offshore account in direct violation of the Bank’s Policy and Nigerian securities laws. It’s the intent of the person using it that determines whether a derivative is a tool for good or for evil.

Approximately 40 years ago, the modern derivatives market was small and domestic to mainstream Europe and America. Since then it has grown impressively – around twenty-four (24) percent per year in the last decade – into a sizeable and truly global market with about €457 trillion of notional amount outstanding in 2014. No other class of financial instruments has experienced as much innovation from its embryotic development to a fully developed and respected financial market. Product and technology innovation together with competition has fuelled this impressive growth and has created many new jobs both at exchanges and intermediaries as well as at related service providers. European derivatives players today account for more than 20 percent of the European wholesale financial services sector’s revenues and contribute 0.4 percent to total European GDP.

Given the derivatives market’s global nature, users can trade around the clock and make use of derivatives that offer exposure to almost any “underlying” asset class across various global markets. The derivatives market is predominantly a professional wholesale market with individuals, corporations, institutions and governments as its main participants. A single derivatives transaction may attract diverse levels of professional financial counterparts across the value chain. There are two competing segments in the derivatives market, being the off-exchange or over-the-counter (OTC) segment and the on-exchange segment (ETDs). From a customer perspective in Europe, exchange trading is approximately eight times less expensive than OTC trading, hence we hope the immense opportunity for improved efficiency via the launch of ETDs in Nigeria will mirror their popularity experienced globally.

Risk and Riskier: Derivatives Impact of the Global Economy and Nigeria

It is important to emphasize that the imperatives for a truly functional derivatives market are safety, effective risk mitigation, innovation and efficiency. Risks, such as counter party risks, operational risks, liquidity risks, systemic and legal risks could be implicit in even the most developed markets. The financial global market was shaken to its very foundation in the wake of the Global Financial Crisis (GFC) between 2007 and 2010 when it became apparent that the underlying assets securing collaterised mortgages had suddenly become delinquent.

Specifically, collateralized debt obligation or CDOs, which are securities whose value is collaterised (i.e. ‘backed’) by a pool of underlying fixed-income assets, gave way to complex synthetic financial structures, which essentially were understood by very few financial experts in the industry. The peak of the financial crisis in 2008 crippled some of the world’s most dynamic financial institutions, as banks found themselves with a trillion dollars tied up in now worthless assets. Of this, around half, i.e. $500 billion, was tied up in CDOs. With many banks sitting on huge losses, the interbank lending market dried up, as no bank wanted to lend to another bank that was potentially “going bust”. CitiGroup lost $34 billion on mortgage CDOs, while Merrill Lynch lost $26 billion. The insurer AIG was crippled due to selling $500 billion worth of Credit Default Swaps to in effect insure against defaults on CDOs and payments of which it could not meet. As Robert Kiyosaki, the famed author of ‘Rich Dad, Poor Dad” said, “the subprime disaster was a result of financial bombs-derivatives-exploding in financial institutions such as AIG and Lehman Brothers as well as banks and financial institutions throughout the world”.

Understanding the global implications of financial connectedness is also essential to developing a robust derivatives financial market. Recall that at the early stages of the GFC, it was anticipated that Nigeria would not be directly impacted as there were no complex derivatives products being traded in our market at the time. However, the United States Federal Reserve (Fed) dropped its benchmark lending rate to zero and began pumping money into the global financial system via its Quantitative Easing (QE) program, which initially had a positive impact on Nigeria, as FPI investors began to increase their exposure to emerging and frontier markets in the search for higher return on investments, compared to the risk-free financial instruments or comparable products in the US yielding zero returns. However, as the Fed signaled an imminent reversal of their QE program, coupled with a commodities bubble, Nigerian banks found themselves exposed to large toxic non-performing loans to leading Nigerian corporations, combined with our local bank’s exposures to an agglomeration of margin loans as domestic investors speculated immunity to the GFC; hence the birth of AMCON, and initiatives like forbearance for margin loans for our brokerage community.

Such is the attendant risks that may rear its head in a derivatives market which can have far reaching impact on various global markets and economies. Accordingly, trainings such as this has become ever more critical to the viability and sustainability of a healthy financial market in understanding the “dos” and “donts” of financial engineering. It is imperative that we learn from our past mistakes and ensure the proper construct for risk mitigation is adequately addressed via mechanisms like CCPs and their associated default waterfall structure.

The Opportunity before Us: Training for ETDs in Nigeria

To my fellow lawyers amongst us who are seeking to specialize or consolidate their derivatives practice, I am confident that you will be very busy in the years to come as there is an array of participants and products in this market that will require our support. Potential clients include broker-dealers, banks, insurance companies, investment advisers, commodity advisers, hedge funds, private equity funds, securities and futures exchanges, clearing houses and pension fund administrators to name a few as well as any commercial enterprise that is the “end user”. Products may be used to hedge a countless array of risks, such as interest rates, equities, agricultural, energy, credit, currency etc. All of these products and these participants are potentially subject to multiple federal, state, and foreign laws based upon the nature of the enterprise (e.g., banking, insurance, etc), the nature of the product (e.g., equities, commodities, etc.) and the nature of the transaction (e.g., sales, trading, etc.). I am sure by the end of this training you will be well placed to serve the pool of potential clients professionally and diligently.

We believe that Nigeria’s ETD initiative will eventually develop into a robust market place that can support our growth ambitions as a nation, using South Africa as an example of Africa’s first derivative market. South Africa’s derivatives market has grown rapidly in recent years, which has supported capital inflows and helped market participants to price, unbundle and transfer risk. Their market comprises two broad categories of derivatives, namely options and futures. Within these two categories, a wide range of instruments may be identified: warrants, equity futures and options, the agricultural commodity futures and options, interest rate futures and options, currency futures and fixed income derivatives. The fixed income derivatives are made up of bond futures, forward rate agreements (FRAs), vanilla swaps, and standard bond options2. Notwithstanding the foregoing, South Africa has had to manage the risks associated with misuse of complex financial products via continuous improvement and enhanced enterprise risk frameworks. Accordingly, as innovation drives interest in any product, the market will require continuous advancement to risk frameworks, technology and critical thinking to bringing about competition which is a basic driver towards development and growth in the market. As such, this is the first training of many others, which we will continually promote to enhance Nigeria’s global positioning as a thought leader in the African derivatives space.

In closing, The Exchange has taken a bold step towards providing a strong capacity base in anticipation of the launch of ETDs by organizing this training and inviting some of the finest subject matter experts from Europe, South Africa and the United States where the concept of derivatives has stood the test of time. I trust that each of us as stakeholders in this market will take advantage of the opportunity afforded us by this training to transpose the experience of other jurisdictions and create a viable, efficient, innovative and risk absorbent derivatives market.

I thank you most warmly for your attention and I take this opportunity to commend the Legal Department of The Exchange for stepping forward with this training initiative.

Mr. Abimbola Ogunbanjo, First Vice President, The Nigerian Stock Exchange

DCSL 90X780