April 10, 2018//Quantitative Financial Analytics Ltd
To stem the continued devaluation of the Naira and to breath some air of stability into the ever-volatile Naira/Dollar relationship, the Central Bank of Nigeria, CBN, introduced some far-reaching measures at different times. One of such measures was the launching of the Naira-settled OTC FX Futures Market. That “history making” event which commenced on June 27th 2016 made the CBN “the pioneer seller of the Naira-settled OTC FX Futures contracts on the FMDQ OTC Securities Exchange (FMDQ)”.
Before the advent of the Naira-settled OTC FX Futures, various governments in Nigeria had been tinkering with the Naira exchange rate management using different policy driven methodologies at different times. In 1986, the Exchange Rate Liberalization Policy was introduced and with it, the Naira was devalued officially for the very first time, on September 26th, 1986 to be specific. From that day till today, the Naira has been heading south. Economic and financial historians have it that Nigerian governments have tried to manage the exchange rate with the Foreign Exchange (Monitoring & Miscellaneous Provisions) (FEMM) Act of 1995, the Two-way Quote System (market making) in the inter-bank FX market in 1996 and the Wholesale Dutch Auction System (WDAS) in 2006. Unfortunately, it seems that none of those worked. It is therefore not surprising that the currency futures market has been put in place as a way to “stabilize” the Naira.
It is now almost two years since the Naira-settled OTC FX Futures market was out doored and the question is how far it has gone in stabilizing the Naira/Dollar exchange rate. Though the Naira/Dollar exchange rate continues to remain high, it is a bit comforting that the new FX currency risk exposure management instrument, (the Naira-settled OTC FX Futures), has been able to curb or curtail the speed at which the Naira depreciates relative to the Dollar. At least, for over six months the rate has remained in the N360s to the $.
When used properly, Currency Futures are a veritable instrument of managing foreign currency risk exposure. This works well when there are buyers and sellers and probably not so well when there are buyers with the CBN as the only seller. By definition, a futures contract is an agreement between two parties where one (the buyer) agrees to buy and the other, (the seller) agrees to sell a given amount of the underlying asset or subject of the contract, at an agreed price on future date.
A futures contract entails a long position by one party and a corresponding short position by another. It does look like the CBN is the seller or the short position party in the Naira-settled OTC FX futures contracts although it is not apparent who the long position parties are. By their nature, futures are zero sum games. Futures do not involve an initial cash flow, meaning that money does not change hands at the initiation of the contract except where commissions are charged but subsequently, it becomes apparent how much the parties to a contract will pay/receive as the price of the underlying instruments change from day to day. The method of determining the amount payable/receivable by either party is called marking to market, (the technicalities involved in mark to market calculation will not be part of this discuss).
It is noteworthy to point out that the Currency Futures market in Nigeria has been very active and vibrant since inception although the momentum seems to be reducing as rates converge. On the date that the market went live, it recorded $26.73 million in open interest. As at April6, 2018, the open interest had increased to $ 3,278.43 million, an increase of 12176%. This underscores the extent of Nigeria’s dependence on and demand for the dollar, among other implications.
The implication of this is also that, if the CBN is the only party that holds the short positions, it means that the CBN has contracted to sell $3,278.34 million to various parties over a range of period depending on the maturity dates of the contracts.
However, the Naira-settled OTC FX Futures are non-deliverable, meaning that the CBN is not going to sell or deliver $3,278.34 million to the long position holders, rather, the CBN will pay them the difference between the contract price and the NIFEX/NAFEX rate as at the maturity date of each futures contract. It will be recalled that the first futures contract matured on July 27th 2016, and the CBN had to pay ₦962.23m to the long position holder. For the almost two years of existence of the FX Futures market in Nigeria, 21 of such contracts have matured. Looking at the contract prices of the open trades in relation with the current exchange rate, there is indication that the CBN will be at the paying end of the contracts. According to analysis by analysts at Quantitative Financial Analytics, the total notional value of all contracts from inception to date is $11.743 billion while total matured contracts stand at $8.464 billion leaving current outstanding open interest at $3.278 billion. Out of the matured contracts, the short position holders (probably the CBN) has paid an estimated $503.8 million to the long position holders, according to the analysis.
As said before, currency futures are derivatives, and derivatives are high risk instruments, if used properly, they are beneficial but when misused, they can lead to catastrophe. To a large extent and in most recent times, the FX currency futures market has helped in stabilizing the Naira Dollar exchange rate although the decreasing momentum arising from convergence of rates may diminish its role in managing the currency risk exposure of Nigerians. We are watching