The odds against derivatives
While nobody doubts the ambition – derivatives business is estimated at more 10 times the size of the total world gross domestic product – odds are stacked up against the local project. Conditions for success are simply non-existent. Key amongst them is the liquidity problem. One aspect is the fragmentation of liquidity. Over the past several decades, Africa has had no less than 15 commodity exchanges but only five are operational and only one is truly successful; the South Africa Futures Exchange (SAFEX).
Despite the huge potential that the derivatives market holds, there are various challenges facing it chief among them financing. FILE PHOTO | NMG
Does a national derivatives exchange make good business sense? Probably not. Many have tried and failed, but the world should get ready for yet another try; the Nairobi Derivatives Exchange (NDE). While nobody doubts the ambition – derivatives business is estimated at more 10 times the size of the total world gross domestic product – odds are stacked up against the local project. Conditions for success are simply non-existent. Key amongst them is the liquidity problem. In this article, I explain why this factor could make-or-break the proposed platform.
One aspect is the fragmentation of liquidity. Over the past several decades, Africa has had no less than 15 commodity exchanges but only five are operational and only one is truly successful; the South Africa Futures Exchange (SAFEX). Despite the clear benefits of building commodity exchanges, most have remained underdeveloped, suffering from a lack of liquidity which is the life blood of any trading avenue. In order to unify liquidity, the answer is not to stand alone. The answer is to amalgamate. Granted, there are, of course, many differences between trading environments across the continent but mostly are non-fundamental. In this regard, all these national exchanges –Uganda (ALTX Exchange Uganda), Rwanda (East Africa Exchange), Ethiopia (Ethiopia Commodity Exchange), Tanzania Mercantile Exchange (TMX) and soon-to-be launched NDE – are better-off combined. A more active regional exchange with high liquidity is much more important than national pride. Every country does not need a commodities exchange. Nor is it any good to establish one when it’s bound to fail. Two is the lack of underlying liquidity. Presently, only 10 companies control almost 80 per cent of the liquidity. Now, seeing that single-stock futures are part of deal, one wonders whether these equity derivatives will attract any capital when there’s hardly any activity on the underlying assets.It is also hard to believe that this segment can grow to be a huge market (unless it’s intended to be an exotic one limited only to a few active names) even with the help of clearing and settlement agents. This problem is further compounded by reliance on foreign-investor driven liquidity (over 65 per cent of daily market transactions). Since locals don’t trade that often, where would the speculators to boost liquidity going to come from? Unless, we’re building a market that will be foreign-investor assisted, this is an Achilles’ heel. For bonds, there is hope. Bond futures (to mitigate against adverse interest rate) will build on underlying securities that currently enjoy an annual turnover ratio of almost 25 per cent. However, this may not help the crucial (but illiquid) corporate bonds market.In summary, though on paper, the idea of a derivatives exchange holds the promise of solving many financial problems, in practice, setting the idea in motion may not be simple. This is old news though—a similar move was made in 1998. The Nairobi Coffee Exchange announced that it aspired to offer futures contracts. It’s 2018, and we’re still waiting.