Capital Markets: Derivatives 2024 Comparisons

The Nigerian derivatives market can be described as nascent and not as developed as the derivatives markets of Europe and North America. However, in recent times, the Nigerian market has received attention from leading global banks and mid-sized financial institutions from Europe and Asia. This has led to the structural growth and development of the market, products, regulations, and regulatory infrastructure.

The Nigerian Securities and Exchange Commission (SEC) performs a major role in the regulation of exchange-traded derivatives transactions in the Nigerian financial market. The SEC Rules and Regulations 2013 (as amended) (the “SEC Rules”) contains provisions on derivatives transactions, including commodities and futures trading. In 2019, the SEC published the Rules on Regulation of Derivatives Trading (the “Derivatives Trading Rules”). The Derivatives Trading Rules provides for rules to regulate derivatives trading on an exchange, including registration requirements for derivatives contracts and market participants. The Derivative Trading Rules will apply to OTC derivatives trade when specifically mentioned in the relevant derivative contract.

The SEC also introduced the Rules on Regulation of Derivatives and Central Counterparties 2019 (the “CCP Rules”) in 2019, which – among other things – outlines the requirements for registration as a central counterparty (CCP).

The Central Bank of Nigeria (CBN) also plays a major role in the regulation of the Nigerian derivatives market, especially in relation to FX trades. In March 2011, the CBN, introduced the Guidelines for FX Derivatives in the Nigerian Financial Markets (the “FX Derivatives Guidelines”), which sets out the approved FX derivatives products that can be offered by authorised dealers (ie, banks authorised by the CBN to trade in FX) in the Nigerian financial markets. The CBN also released the Revised Guidelines for the Operation of the Nigerian Interbank Foreign Exchange Market 2016 (the “Interbank FX Market Guidelines”), which provides that – in addition to the approved hedging products provided under the CBN Guidelines for FX Derivatives and Modalities for CBN FX Forwards 2011 (the “FX Derivatives and Modalities for CBN FX Forwards Guidelines”) – authorised dealers are permitted to offer naira-settled non-deliverable OTC FX Futures. The approved hedging products under the FX Derivatives and Modalities for CBN FX Forwards Guidelines are FX options, forwards (outright and non-deliverable), FX swaps, and cross-currency interest rate swaps. The FX Derivatives Guidelines supersedes the FX Derivatives and Modalities for CBN FX Forwards Guidelines where there is a conflict between the former and the latter.

Self-regulatory organisations, such as securities exchanges, also play a crucial role in the regulation of the Nigerian derivatives markets. The Nigerian Exchange Limited or NGX (formerly the Nigerian Stock Exchange) and the FMDQ (Financial Market Dealers Quotation) Securities Exchange (FMDQ) both provide platforms for the trading and settlement of derivatives contracts. The NGX, in 2019, introduced its Rulebook on the Derivatives Market (the “NGX Rulebook”). The NGX Rulebook has sundry provisions for the regulation of derivatives trading and settlement on the NGX trading platform. FMDQ introduced similar rules for the trading of derivatives on its platform in 2021. Both the NGX Rulebook and FMDQ’s Derivative Market Rules were approved by the SEC. Amendments to FMDQ’s Derivates Market Rules were approved by the SEC on 7 May 2024.

Similar to securities exchanges, commodity exchanges in Nigeria (such as the Nigeria Commodity Exchange and Africa Exchange (AFEX)) also have rules that regulate the trading and settlement of commodities derivatives on their respective platforms.

Notably, legislation enacted by the National Assembly (Nigeria’s federal Parliament) contain provisions that feature frequently in derivatives transactions and directly impact the trading and settlement of derivatives. By way of example, the Companies and Allied Matters Act 2020 (as amended) (CAMA) and the Banks and Other Financial Institutions Act 2020 (BOFIA) both contain provisions on netting of payments, which directly affect how derivatives transactions involving Nigerian counterparties are settled.

Although Nigeria exports crude oil, it is a net importer of food, machinery, goods and services. Considerable FX is required to satisfy these needs. In recent times, low crude oil production output and falling FX revenues from crude oil exports created a volatile FX market. This state of affairs necessitated the development of derivatives markets and products for financial institutions and other corporates to hedge foreign exchange risks and improve access to FX. The uncertainty regarding the enforceability or otherwise in Nigeria of netting provisions in derivatives contracts led to the enactment of netting provisions in both CAMA and BOFIA in 2020. Per FMDQ’s financial markets monthly report for June 2024, the total turnover in the FX derivatives segment of FMDQ was NGN2.48 trillion (approximately USD1.68 billion), representing a 43.20% month-on-month increase from May 2024.

One of the most significant catalysts for the development of the Nigerian derivatives market during the past 12 months is the floating of the Nigerian naira by the CBN in June 2023 and the consequent meteoric rise of the exchange rate between the Nigerian naira and other major currencies. This resulted in substantial FX losses for many companies with FX obligations. In response, these companies increasingly turned to derivatives contracts as a means of hedging against the volatility of FX rates.

There has been a marked increase in the use of FX forwards contracts and currency swaps by Nigerian companies. These instruments allow businesses to lock in exchange (and interest) rates for future transactions, thereby mitigating the risk associated with fluctuating FX rates.

The upward trend in the use of derivatives in Nigeria is expected to continue, given the current unstable state of the Nigerian currency and the need to manage FX risk more effectively in the volatile economic environment. As companies increasingly recognise the benefits of these financial instruments, the derivatives market is likely to expand both in size and sophistication.

Moreover, regulatory support and market infrastructure improvements will play a crucial role in fostering this development. The increased activity in the Nigerian derivatives market is expected to lead to a corresponding development of regulatory frameworks and structures.

As mentioned in 1.1 Overview of Derivatives Markets, the Nigerian derivatives market is still in its nascent years. This reflects in the limited derivatives products offerings available in the Nigerian market. With regard to futures, the major securities exchanges in Nigeria – the NGX and FMDQ – have different offerings. The NGX currently has two offerings of cash-settled equity index futures, which track the NGX 30 Index (a capitalisation-weighted index that tracks the performance of the 30 largest and most liquid companies listed on the NGX) and the NGX Pension Index. For its part, FMDQ offers Federal Government of Nigeria (FGN) bond futures and naira-settled exchange-traded FX Futures, which primarily track the exchange rate of the US dollar to the Nigerian naira.

The various commodity exchanges (the Nigeria Commodity Exchange, AFEX, and the Lagos Commodities and Futures Exchange (LCFE)) are also set up to offer standardised futures contracts that track the prices of particular commodities such as crude oil, paddy rice, and wheat.

There are currently no options on futures being traded on any of the exchanges.

The Nigerian derivatives market is yet to see the emergence of unconventional or innovative futures products such as cryptocurrency futures. However, given the upward trend in the use of derivatives, it is very much possible that in the medium to long term, Nigeria will see the development of a robust market infrastructure for derivatives and increased and expanded participation of stakeholders. This will create the requisite conditions for the emergence of innovative derivatives products, including diverse futures products.

In Nigeria, swaps are traded OTC – that is, directly between the contracting parties rather than on a centralised exchange such as the NGX or FMDQ. Parties will usually agree the terms of the swap and will document those terms under a standard International Swaps and Derivatives Association (ISDA) Master Agreement, making the necessary changes in the schedule to the ISDA Master Agreement and entering into confirmations for specific transaction terms, as needed.

Swap transactions in Nigeria are primarily interest rate swaps and currency swaps (including cross-currency interest rate swaps). No law that prohibits the trading of other types of swap transactions (including commodity swaps). Although there is no streamlined framework for the regulation of swaps in Nigeria, swap transactions that involve a Nigerian counterparty are governed in more than one respect by Nigerian statutes and regulations. CAMA and BOFIA, for example, have extensive provisions on netting of payments under a qualified financial contract (such as a swap) to which a Nigerian company (and, in the case of the BOFIA, bank or financial institution) is a party. CAMA also contains general provisions on the ways in which a company can validly take corporate actions, including the due execution of transaction documents.

Importantly, the Derivatives Trading Rules (paragraph 15) requires all participants (dealing members or entities performing clearing services) and other registered capital market operators to report all OTC derivatives transactions to a trade repository or an exchange (as the case may be) in accordance with guidelines to be issued by the SEC from time to time. The report must contain:

• the entry into of an agreement or contract for the sale or purchase of a derivatives contract or product, however concluded by the parties and however described;
• a change in the beneficial ownership of derivatives contracts between parties, one of whom is a participant;
• the modification, assignment or termination of an agreement or contract for the sale or purchase of a derivatives contract or product, however described; and
• the legal entity identifier code (a 20-character, alpha-numeric code issued by accredited issuing organisations that are duly endorsed by the Global Legal Entity Identifier Foundation).

Further, in the case of a currency swap involving a Nigerian counterparty, the parties must adhere to the Foreign Exchange (Monitoring and Miscellaneous Provisions) Act 1995 (FEMMPA) and the CBN Foreign Exchange Manual 2018 (the “Forex Manual”). The FEMMPA and the Forex Manual contain extensive provisions regulating dealings in FX in the Nigerian FX market. Specifically, the FEMMPA and Forex Manual provide that where a person imports foreign currency into Nigeria that is intended to be converted into naira, such person must obtain an electronic certificate of capital importation (“eCCI”). An eCCI is a dematerialised certificate issued by an authorised dealer to a person who imports foreign capital into Nigeria, where such foreign capital is converted into naira. The purpose of an eCCI is to guarantee the holder of the eCCI unrestricted transferability of funds through an authorised dealer in freely convertible currency.

Additional requirements may apply where an exchange such as FMDQ Clear is engaged as a CCP for the forward transaction or where the forward contract is standardised and traded on the exchange. The Derivatives Trading Rules provides that all standardised OTC derivatives contracts shall be traded on an exchange and further states that the SEC must issue guidelines on standardised OTC derivatives contracts from time to time (paragraph 6(2)(3)). By way of example, FMDQ has a set of rules that apply to cleared naira-settled non-deliverable forwards, including the requirement of adequate eCCIs for the transaction and contingent eCCIs to deal with any contingent FX risks.

Also, as noted in 1.1 Overview of Derivatives Markets, the Interbank FX Market Guidelines permits authorised dealers to offer naira-settled non-deliverable OTC FX futures. This is also provided for under the FX Derivatives and Modalities for CBN FX Forwards Guidelines and the FX Derivatives Guidelines, which both provide that the maximum tenor allowed for FX forwards (and by implication FX swaps and cross-currency interest rate swaps) is five years but authorised dealers may seek specific approval for longer tenors. Naira settled non-deliverable forwards (OTC FX futures) are traded on FMDQ. Naira-settled non-deliverable FX forwards have been used as tools to hedge against the volatility in the exchange rate of the naira with other major currencies.

In Nigeria, there are different requirements for exchange-traded derivatives and OTC derivatives. The requirements for exchange-traded derivatives are primarily set out in the Derivatives Trading Rules and the respective derivatives rules introduced by various exchanges such as the NGX and FMDQ. The Derivatives Trading Rules (paragraph 3(1)) provides that the approval of the SEC must be sought and obtained prior to the introduction of any exchange-traded derivatives contract. All exchange-traded derivatives contracts are required to be registered with the SEC. An application for registration of a contract must be filed with the SEC by or on behalf of an exchange, along with the relevant SEC form and an information memorandum detailing the specifications of the contract.

The Derivatives Trading Rules provides that exchange-traded derivatives can only be traded on exchanges registered or recognised by the SEC. These exchanges are required to develop rules for the derivatives market such as the NGX’s Rulebook and FMDQ’s Derivatives Market Rules. Furthermore, the Derivatives Trading Rules requires that all exchange-traded derivatives contracts must be cleared by a CCP registered or recognised by the SEC. The rules also contain requirements for market participants and provisions on position limits to prevent participants and clients from holding positions large enough to control and/or manipulate the underlying asset.

In Nigeria, there is no robust legal framework regulating OTC derivatives contracts. The OTC derivatives contracts are usually governed by the terms of the contracts themselves. However, as earlier stated, the Derivatives Trading Rules require standardised OTC derivatives contracts to be traded on an exchange.

As mentioned in 2.2 Swaps and Security-Based Swaps, the Derivatives Trading Rules (paragraph 15) also requires all participants (dealing members or entities performing clearing services) and other registered capital market operators to report all OTC derivatives transactions to a trade repository or an exchange (as the case may be) in accordance with guidelines to be issued by the SEC from time to time.

Additional requirements may apply where an exchange such as FMDQ is engaged as a CCP for the OTC derivatives contract or where the OTC contract is standardised and traded on the exchange.

The most common assets that underlie derivatives products in Nigeria are securities (primarily stocks, government bonds, treasury bills and open market operation (OMO) bills), currency exchange rate, interest rates, and commodities (such as paddy rice, crude oil, wheat, cotton and maize). Notably, the FX Derivatives Guidelines recognises FX options, forwards (outright and non-deliverable), FX swaps and cross-currency interest rate swaps as approved hedging products for authorised dealers.

There are no outright restrictions on asset classes on which derivatives products can be based. In principle, parties to an OTC derivatives contract can base the derivatives product on any asset class and the contract will be valid. This is because Nigerian law and courts will enforce an agreement voluntarily entered into by parties, subject to unlawfulness, public policy considerations or other vitiating concerns. As regards exchange-traded derivatives, however, even though there is no outright prohibition or restriction on any asset class, the SEC reserves the right to approve every exchange-traded derivatives contract before that contract is introduced on an exchange. As such, the SEC can exercise this discretion in favour of or against the approval of a derivatives product based on a particular asset class.

As mentioned in 1.1 Overview of Derivatives Markets, the Nigerian derivatives market is still nascent. Unconventional or innovative futures products such as cryptocurrency futures have not been introduced into the market. The asset classes underlying derivatives products in the Nigerian market are fairly conventional.

In terms of liquidity, the limited offerings in the Nigerian derivatives markets make it difficult to properly estimate liquidity across all asset classes. However, most liquidity can be seen in the currency asset class, with the recent rise in the use of currency swaps and FX forwards by Nigerian companies to hedge against the falling value of the naira.

There are no derivatives products that are exempted from regulation in Nigeria. As mentioned in 2.2 Swaps and Security-Based Swaps, while the regulatory framework for OTC derivatives products is not as robust as that for exchange-traded derivatives, the Derivatives Trading Rules still requires that standardised OTC derivatives contracts be traded on an exchange and requires market participants to report all OTC derivatives transactions to a trade repository or an exchange (as the case may be) in accordance with guidelines to be issued by the SEC from time to time. There are more extensive regulations applicable to exchange-traded derivatives contracts, including a requirement that every such contract must be approved by the SEC.

Spot commodities transactions are regulated in accordance with the regulations put in place by the relevant exchange or self-regulatory organisation that acts as a CCP in such transactions – for example, the Nigeria Commodity Exchange, AFEX, or LCFE. Such regulations are made in accordance with applicable laws regulating commodities trading, which are generally non-discriminatory with regard to spot commodities trading.

FX trading in Nigeria is regulated by the FEMMPA and the Forex Manual. The FEMMPA establishes an autonomous FX market and provides for the appointment of authorised dealers. With the CBN’s abolition of exchange rate segmentation and the re-introduction of the “willing buyer–willing seller” model in June 2023, transactions in the FX market are completed with the rate mutually agreed between the purchaser and the authorised dealer concerned.

Except for those that may be imposed by the respective commodities exchanges, there are no unique rules applicable to leveraged retail spot commodities transactions. However, the Derivatives Trading Rules (paragraph 10) requires the exchange to liaise with the CCP to determine the applicable leverage relevant to each type of derivatives contract and the same should be disclosed to the SEC within 24 hours.

In Nigeria, derivatives are regulated only at the national level under the framework and regulators that have been highlighted in 1.1 Overview of Derivatives Markets and 3.1.1 National Regulators. There is no framework for regulating derivatives transactions at the state or local level.

Some self-regulatory organisations or entities that operate in Nigeria are:

• FMDQ;
• NGX;
• Nigeria Commodity Exchange (NCX);
• AFEX; and
• LCFE.       

These self-regulatory organisations are important stakeholders in the Nigerian financial markets and are generally licensed and regulated at the national level by the SEC.

Clearing brokers in Nigeria rely on a range of documentation to facilitate their clearing activities, which may vary depending on the type of cleared derivative and the specific requirements of counterparties and the clearing house. Common types of documentation include clearing agreements, the foundational derivatives contract (whether the ISDA Master Agreements, the Nigerian FX Master Agreement, or some other agreement), clearing house documentation outlining rules and procedures, customer account documentation for KYC compliance, and product-specific documentation tailored to the type of cleared derivative.

Issues of greatest concern to clearing brokers and their customers when negotiating clearing documentation typically revolve around margin requirements, netting, default procedures, operational efficiency, legal and regulatory compliance, and risk management. Negotiations often focus on determining acceptable margin calculation methodologies, streamlining confirmation processes, ensuring compliance with applicable laws and regulations, and addressing risk mitigation strategies.

In Nigeria, there is generally no statutory or regulatory requirement that a legal opinion be provided in respect of trading agreements. However, it is usual for parties to a trading agreement to request legal opinions on trading agreements and the transactions entered into under these agreements. As such, clients most often require opinions to be provided when they enter into swap or forward transactions documented under the ISDA Master Agreement and its relevant annexes. Clients also require opinions when entering into repurchase agreements under GMRAs or a securities lending transaction under the GMSLA, as well as other transactions documented under other trading agreements.

These legal opinions usually address a broad range of matters ranging from the validity of the agreements (which involve Nigerian counterparties) under the laws of Nigeria to the enforceability of collateral or security arrangements under these trading contracts. Opinions are also provided on specific questions asked by clients, including questions concerning recharacterisation risks and counterparties’ netting of payment obligations.

During the past year, there have been no notable enforcement activities and trends in Nigeria’s derivatives market. This might be because the market is still in the early stage of its development and there is close co-operation between the participants, the exchanges and the regulators to ensure that the market operates in a transparent, efficient and orderly manner.

That is not to say that there have been no infractions committed by participants ‒ only that such infractions are either not particularly significant or the details thereof are not publicly available. It is worth noting, however, that exchanges in Nigeria such as FMDQ closely monitor trades on their platforms to ensure compliance with their trading rules and consequently assume enforcement roles where applicable.

The SEC exercises significant discretion in determining the areas of priority for examination and surveillance in the financial market. The SEC may choose to outline its examination priorities or make its observations on surveillance and compliance issues public, but it has no obligation to do so.