Advocate of the High Court
Business Daily
Capital Markets (Derivatives Markets) Regulations 2015
Capital Markets Authority
Eric Otonglo
International Swaps and Derivatives Association
Kenya Airways
Nairobi Securities Exchange
South Africa

LETTERS: Understanding ISDA role in derivatives market

I would like to comment on an article by Rufus Mwanyasi that was published in the February 27 edition of the Business Daily and titled ‘NSE is getting derivatives law spot on despite the slow pace’.This was a bold and commendable attempt by the writer to explain his understanding of the practical implementation of the Capital Markets (Derivatives Markets) Regulations 2015 (gazetted in 2016), even though no specific mention of this Regulation was made. Financial derivatives are infamous worldwide for their complexity and are generally relegated to the esoteric field of quants, financial engineers and other sector experts. There is certainly a dearth of indigenous literature or professional expertise on the subject locally, and therefore the efforts of pioneer writers should not go unnoticed.I do agree with what the writer said about the timeliness of the planned launch of the derivatives exchange market in Kenya sometime later this year. It is indeed true that the country would be taking an inventive step in the African continent outside South Africa with the launch of these markets, even though we will still be playing catch-up with the developed and emerging markets of the world.This view is especially reinforced if one considers how much time has lapsed since the government conceptualised the development of policy frameworks for commodities and futures markets way back in the 2010 Budget Speech.My point of departure with the opinion piece is centred around the writer’s argument that the Nairobi Securities Exchange (NSE) should adhere to the Master Agreement published by the International Swaps and Derivatives Association (ISDA) as the foundational basis of the market.This was the crux of the writer’s opinion, and I would like to counter here that the writer’s formulation of the 2015 Regulations was a little wrong. To make my point clearer, I must first classify derivatives and then briefly explain how they work. It would be instructive to point out at this juncture that as a lawyer, I neither hold brief for the industry regulator, the Capital Markets Authority (CMA), nor the NSE.Derivatives (options, swaps, forwards/futures) can be used widely, both in an organised exchange i.e. stock market, or off an exchange, otherwise known as over-the-counter (OTC). Globally, the OTC markets have traditionally dwarfed exchange traded derivatives in terms of popularity. In Kenya, OTC derivative products have been available in the market for a good number of years, in transactions between sophisticated corporates and selected lenders.

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As a simple illustration of an OTC derivative in the form of a forward contract, we can consider an airline company such as Kenya Airways getting into an agreement with an oil supplier to deliver jet fuel to it in the next two years, at a forward price that is fixed today.Such an arrangement would be beneficial to the airline by providing cash flow certainty over the next two years, at the risk of losing out if the market price for jet fuel is lower than the contractual sum on the delivery date.Under the terms of the contract, the oil company will therefore be obligated to physically deliver to the airline an agreed number of barrels of jet fuel at a set price on 1st March 2021, in exchange for a fixed sum. Because it is a contract between two parties, there is always a risk that one counter-party will not meet its end of the bargain. The oil company could fail to deliver the jet fuel as expected, or the airline could fail to pay up upon delivery.Forward contracts are therefore non-standard, customised contracts between two parties, for delivery of an asset/commodity on a future date in exchange for payment. In order to introduce uniformity thereby providing predictability in these transactions, global players in the OTC derivatives market formed an umbrella body known as ISDA, which has over the years rolled out and revised various standard Master Agreements and associated documentation for use in such transactions.Futures contracts were introduced as an innovative way of resolving the inherent counter-party risk in forward contracts. A futures contract is an exchange traded, standardised, forward-like contract that is marked to market daily. Its key features are that it is based on an underlying asset or commodity of a defined quality and maturity date, is exchange traded (as opposed to private), and payment is guaranteed through an intermediary, the clearing house, eliminating the counter-party risk.Eric Otonglo, Advocate of the High Court of Kenya.

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