The Nigeria currency has been under a lot of pressure in recent times, owing to decrease in export earnings due to the instability in price of crude, increase in demand for the dollar, incursion of the corona virus which has considerably reduced business activities, high rate of import of raw material and luxury goods etc. Not surprisingly, in a Medium-Term Expenditure Framework and Fiscal Strategy (MTEF/FSP) report1 recently released by the Federal Ministry of Finance, Budget and National Planning (Ministry), the Ministry indicated that the exchange rate between the dollar and the naira may be further devalued.
The Central Bank of Nigeria (CBN) in response to this pressure and in a bid to stabilise the currency has severally adjusted the currency rates. The official exchange rate was adjusted upwards to N360/US$1 by the CBN in March 2020 and at an auction for importers on 3 July 2020, the CBN directed that bids for foreign exchange be made at N380/US$1 against the previous rate of N360. At the Importers & Exporters Foreign Exchange (IEFX) window, where the bulk of foreign exchange transactions are consummated, the exchange rate recently depreciated from about N362/US$1 in January 2020 to over N385/US$1. Despite the CBN's strenuous efforts to stabilize the exchange rate, it is generally expected that the Naira will suffer further devaluation as Nigeria is projected to lose about US$26 billion in oil revenues, its principal source of foreign currency.2
The uncertainty surrounding the value of the naira and sheer scarcity of the dollar has made it difficult for foreign investors to access the foreign exchange required to repatriate their investment despite possession of a Certificate of Capital Importation (CCI). It is thus imperative for investors to have solutions that guarantees the return on their investments, easy repatriation of capital and avoidance of capital erosion on repatriation.
In 2016, the CBN, through the Revised Guidelines for the Operation of the Nigerian Inter-Bank Foreign Exchange Market (2016 Guidelines) introduced the Naira-settled OTC FX Futures to the Nigerian derivatives market in its attempt to the address similar foreign exchange risks plaguing the country. The Naira-settled OTC FX Futures are non-deliverable Forwards (i.e. contracts where parties agree to an exchange rate for a predetermined date in the future, without the obligation to deliver the underlying US Dollar (notional amount) on the maturity/settlement date).3
This article revisits the Naira-settle OTC FX Futures and its use as a tool for investors to hedge the currency instability risk in the Nigerian market.
The Naira-Settled OTC FX Futures
The Naira Settled OTC FX Futures merges characteristics of a derivative forward and a futures contract to innovate a hedging product adapted for the Nigerian market.
A forward contract is a bilateral agreement where one party (the seller) agrees to sell an asset to another party (the buyer) at a predetermined settlement date in the future and at a strike price which is fixed at the time of entering into the contract. The contract value is the difference between the strike price and the market value at the settlement date. As a result of its bilateral nature, forward markets are done Over-the-Counter (OTC) and the market platform fixes the price of the financial asset for future delivery.
A futures contract on the other hand is a legal agreement to buy or sell a particular commodity asset (such as currencies, commodities, stock market indices, etc.) at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.4 However, the finite nature of a standardised exchange may not be appealing to investors who may want to contract on substantially different terms and product volumes from what the exchange market offers.
In order to mitigate counterparty exposure, the futures contract incorporates a margin requirement allowing a clearing house to collect an initial margin and from time to time a variation margin amount to cover the day to day gain/ loss from the fluctuations in prices of the futures asset and settles each day by marking the daily value of the asset to its market price. At closing, the intermediary and the clearing house nets out each counterparty's final day position and pays out the difference to the party in the money. Settlement is more often done in cash than actual physical delivery.
The OTC Futures contracts are cash-settled in Naira and the differential between the contract rate and the Nigerian Autonomous Foreign Exchange Fixing (NAFEX) rate on the maturity day determines the settlement amount.
Legal Framework for the Naira Settled OTC FX Futures
The use of the NDFs in Nigeria dates back to 2011, when the CBN introduced NDFs into the Nigerian market through the Guideline for FX Derivatives and Modalities for CBN FX Forwards 2011 (2011 Guideline), "in order to provide hedging opportunities for customers (investors) with long-term perspectives and providing customers with a choice as to where to bank and where to hedge."5
The 2011 Guideline provided that all hedge transactions with customers must be backed by trade (visible and invisible) transactions and gave the Financial Markets Dealers Association (FMDA) the responsibility of ensuring appropriate governance over the inter-bank spot market including providing benchmarks for settlement.
The 2016 Revised Guidelines expanded on the provisions of the 2011 Guidelines, by introducing the Naira settled non-deliverable OTC FX futures (OTC FX Futures). The Naira settled OTC FX Futures are traded on the FMDQ platform and are sold by Deposit Money Banks (DMBs) who are authorized to deal in foreign exchange. The FMDQ is responsible for providing the appropriate benchmarks for the valuation and settlement of the OTC FX Futures and other FX derivatives. FMDQ is also responsible for developing detailed registration and operational guidelines and driving the development of other risk management products and attendant guidelines.6
In line with its functions, the FMDQ introduced the Foreign Exchange Futures Market Standards, 2018 (Operational Standards) and the Foreign Exchange Futures Market Framework, amended in 2020 (FX Framework) (the Operational Standards and the FX Framework together the "FMDQ Regulations") which regulate OTC FX Futures contract and trading in Nigeria.
The Naira-settled non-deliverable OTC FX Futures
Under Paragraph 2.2 of the 2016 Revised Guidelines, the OTC FX Futures are non-standardised with fixed tenors and bespoke maturity dates and must be backed by trade transactions (visible and invisible) or evidenced investments.
The CBN currently offers non-standardised amounts for different tenors, from one (1) month through to sixty (60) months to DMBs, who in turn offer same to customers with trade-backed transactions or trade same with other DMBs; settling on bespoke maturity dates. Trades will be done via the FMDQ Futures Trading and Reporting Systems (FFTRS).
While the OTC Futures are to be Naira settled, settlement amounts evidenced by an FMDQ OTC FX Futures Settlement Advice may be externalized (converted into foreign exchange and repatriated offshore) for Foreign Portfolio Investors (FPIs) and Foreign Direct Investors (FDIs) with certificates of capital importation7.
The Naira-settled OTC FX Futures is a variant of NDFs where parties agree to an exchange rate for a predetermined date in the future, without the obligation to deliver the underlying US Dollar (notional amount) on the expiry date. On the expiry date, it will be assumed that both parties would have transacted at the Spot FX market rate. The party that would have suffered a loss with the Spot FX rate will be paid a settlement amount in Naira. This ensures that both parties enjoy the rate that had been guaranteed to each other through the OTC FX Futures.
It is useful to note that customers are allowed to execute their OTC FX Futures transactions with their preferred DMB (Futures DMB) while the eligible underlying transaction documents are held by another DMB (Trade DMB). Thus, an investor's supporting documents e.g. the CCI, Form A, may be obtained through Bank A, while the OTC FX Futures trade is done with Bank B.
1. Budget Office of the Federation. July 2020. 2021-2023 Medium Term Expenditure Framework and Fiscal Strategy Paper. Pg 47
2. Ibid. Pg 15
3. https://www.fmdqgroup.com/markets/products/derivatives/ Last assessed on 28 July 2020.
4. https://www.investopedia.com/terms/f/futurescontract.asp#:~:text=A%20futures%20contract%20is%20a,specified%20time%20in%20the%20 future.&text=The%20seller%20of%20the%20futures,asset%20at%20the%20expiration%20date. Assessed on 28 July 2020
5. Regulation 4.0 Guideline for FX Derivatives and Modalities for CBN FX Forwards 2011
6. Paragraph 2.2.3 and 2.2.8 of the Guidelines for Flexible Exchange Rate Market, 2016
7. This is made pursuant to CBN Circular FMD/DIR/GEN/07/001 on the Externalisation of Differentials on the OTC FX Futures Contracts for Foreign Portfolio Investors released June 24, 2016
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.