Nehizena Ibhawoh and Jerry Okoye of Austen-Peters & Co outline recent developments in foreign exchange hedging
A foreign exchange (FX) hedge is simply a means of protection against the unexpected or expected changes in currency exchange rates. It is usually employed by businesses to mitigate the risks associated with doing business internationally, where different currencies are involved. It is like an insurance policy that manages the impact of foreign exchange fluctuations.
Nigeria's economy is dominated both by the production of oil, which is sold internationally in US dollars, and the importation of many products, which are also paid for in US dollars or other foreign currencies. Even after emerging as the biggest economy in Africa following the recent rebasing of its GDP, Nigeria remains essentially a non-manufacturing country and as such the economy will continue to require foreign currency to thrive. With Nigeria's return to democracy, its aggressive drive for foreign investments, and the globalisation of securities, there has been a massive influx of foreign exchange into the Nigerian economy.
The fluctuation in the value of the naira, coupled with the instability in the price of oil, on which the Nigerian economy is principally based, exposes the players in the Nigerian economy to great exchange rate risk. Therefore, to reduce the unpredictability and the risks associated with dealing in different currencies, foreign exchange hedging becomes imperative. A recent study by the International Securities Consultancy in June 2014 showed that a majority of Nigerian market players, associations and regulators welcomed the idea of a more widespread and developed use of derivatives as a risk-limiting tool. It was also discovered that the majority would even support the idea of developing standardised exchange traded derivatives, as these are perceived to possess the ability to improve price discovery and transparency of the markets. The growing desire for an increase in the use of derivatives is instructive even as over the counter (OTC) derivatives are available (as will be further discussed below).
It should be noted that FX hedging is principally used in Nigeria for international trade and not for domestic transactions, as it is illegal to denominate a domestic transaction or the price of goods or services for domestic consumption in foreign currency. Therefore, FX hedging in the Nigerian context is only applicable to international trade, or businesses involving a foreign entity.
The Central Bank of Nigeria (CBN) is the apex regulator of the Nigerian financial sector and is charged with the supervision and management of the naira and the persons that deal in foreign exchange. Further to these responsibilities, the CBN, on February 1 2011, announced the approval of hedging products for the foreign exchange market by releasing its 'guidelines for FX Derivatives and Modalities for CBN FX Forwards' (guidelines) to enable operators and users to avoid losses arising from exchange rate fluctuations. The Guidelines specifically approved FX options, forwards (outright and non-deliverables), FX swaps and cross-currency interest rates swaps.
Under the Guidelines, only authorised dealers (ie, all commercial banks in Nigeria) in the FX markets can offer European-styled call and put options to their customers and in the inter-bank market. The CBN tasked its financial policy and regulation, and banking supervision departments with the responsibility of developing further guidelines for FX options. With the FX options, parties can contract to buy (call) or sell (put) a particular currency at a specific exchange rate, and at a specific time. This is still one of the better ways to hedge against adverse movements in currency exchange rates. For example in a N to $ (Nigerian naira to US dollar) transaction, party A could have the right to sell N1,000,000.00 to party B and buy $10,000.00 on a specific date in the future. In this case, the pre-agreed exchange rate or strike price is N100 per dollar and the notional amounts are N1,000,000.00 and $10,000.00. This type of transaction is actually a put on naira and a call on dollars.
Outright forwards transactions are used by market participants to lock in an exchange rate on a specific date. It is a binding obligation for an actual exchange of funds at a future date and at an agreed rate. There is no advance payment. This FX option has always been approved and was practised in Nigeria before the Guidelines were released. However, since there are restrictions under the CBN's circulars on foreign access to local currencies, and to provide investors with an option on which authorised dealers to use and where to hedge, the CBN, via the Guidelines, approved the non-deliverable forwards (NDF). NDFs are cash-settled, short-term forward contracts on rarely traded or non-convertible foreign currencies, where the profit or loss at the settlement date is calculated by taking the difference between the agreed upon exchange rate and the spot rate at the time of settlement. In Nigeria, all hedge transactions using NDFs must be supported by trade, and they require benchmarks for settlement. This option is usually used by companies that make large purchases from foreign businesses. For example, a Nigerian company that purchases goods from Dubai may be required to provide part payment for the total value of the goods immediately and the balance upon supply in three months. The first payment can be made using the exchange rate, but in order to reduce its exchange rate risk exposure, the Nigerian company locks in the exchange rate with an outright forward. Thus, the company can purchase the foreign exchange from the authorised dealer (ie, the bank) at the agreed rate (presumably the exchange rate at the time of the first payment) when making the balance payment.
The Guidelines also authorise FX swaps where parties simultaneously borrow one currency and lend another currency to one another. Here, parties simply exchange different currencies at agreed periods. For example, if a Nigerian company knows that it would need dollars in the future, and an American company knows that it would need naira at the same period, both companies may agree to supply each other with the relevant currencies at an agreed exchange rate during that period. This removes the risk of the exchange rate being disadvantageous to any party at the time of need. FX swaps can be considered a riskless collateralised borrowing/lending.
In anticipation of foreign interests providing finance for the infrastructural development of Nigeria, the CBN approved the cross-currency interest rate swap (CCIRS). A CCIRS is based on an agreement between two parties to exchange interest payments and principals denominated in two different currencies. It is an FX product that provides the borrower with the ability to switch its interest repayments from one currency to another on a fixed or floating rate basis.
For CCIRS, the CBN is willing to provide assurances to support infrastructural projects with long-term FX exposures. It therefore implies that every CCIRS transaction must be backed by an infrastructural project. At present, the CBN does not support synthetic (multiple-currencies) CCIRS. It only supports CCIRS denominated in naira and US dollars.
The Guidelines seem to betray the CBN's preference for FX forwards, as they contain extensive provisions for the modalities for FX forwards operations. This may however be justified by the popularity and the easily controlled or regulated nature of FX forwards, unlike the other products which are, at present, rarely in use.
A Nigerian master FX agreement executed by the authorised dealers and their customers will back all FX hedging operations. This agreement must be supported by evidence of a trade/transaction for which the said FX is required. The essence of these supporting requirements from CBN is to provide risk management support to the usual exchange risk exposures encountered by customers. The documentation also prevents authorised dealers from transferring FX bought from the CBN for another purpose. Authorised dealers must make transfers of FX only for the benefit of the customers/transactions which supported the documentation for which the FX was granted. It is also expected that the impact of the exchange rates will not affect the dealers. To strengthen this protection, dealers are expected to maintain separate records for their FX trading and the normal interbank/autonomous trading transactions. For the purposes of CBN supervision of financial institutions, exposures arising from forward contracts are recognised as off-balance sheet exposures, so as to insulate any negative effect occasioned by the FX exposures.
Further, CBN reserves the absolute right on the amount of FX to be granted and the means of that grant to the dealers; but the FX granted can only be sold as FX forwards to the customers. However, where the customer for whom the dealer applied indicates that the amount granted does not meet its need, or where the amount falls short of the agreement between the dealer and its customer, or in the event of default by a customer against a dealer, the dealer has the right to manage its exposures as it deems fit, whether by the customer's spot market or the forward market.
Apart from the CBN, the Securities and Exchange Commission of Nigeria (SEC) also regulates derivatives in Nigeria by virtue of sections 13(a) and (b) of the Investments and Securities Act (ISA) 2007.
Although trading in foreign exchange derivatives is fairly new to Nigeria, the newly-established Financial Market Dealers Quotation OTC (FMDQ) provides a platform for the trading of foreign exchange derivatives through the FMDQ e-markets. The trading of derivatives, including foreign exchange derivatives, takes place via the e-markets avenue. Even though this method is still at a nascent stage, the FMDQ posted a turnover in January to Februaryn2015 of over one billion Naira.
The FMDQ is a SEC-registered OTC securities exchange and self-regulatory organisation owned and governed by the bankers committee, which consists of the CBN, the Nigeria Deposit Insurance Corporation (NDIC), the Financial Markets Dealers Association, the Nigerian stock exchange and all the banks and discount houses operating in Nigeria.
It is a platform where all the over-the-counter inter-bank market activities in fixed income and currencies can be traded and was formally launched on November 7 2013.
The FMDQ strives to maintain its attractiveness, sustain market confidence and establish its credibility and integrity by providing a well-regulated marketplace through robust documentation, enforcement of market rules, guidance and the monitoring of trading and market activities.
FMDQ works closely with the relevant regulatory authorities, including SEC, CBN, and the Debt Management Office (DMO) to develop and enforce rules and regulations with a view to building an enduring marketplace. SEC maintains regulatory oversight functions over FMDQ's activities.
FMDQ provides a platform for trade in foreign exchange derivatives between its members and also between a member and a client of another member. In this situation, the client would have to register with the FMDQ as an associate member, and must be an institutional investor. The FMDQ's clients include institutional investors (asset/fund managers, pension fund administrators, and so on) and corporate treasurers.
It is also possible to deal in foreign exchange derivatives on the FMDQ platform through a SEC-registered investment adviser or broker dealer who is also a member of the FMDQ. Investment advisers and broker dealers are authorised to purchase and dispose of securities (which are defined by the ISA to include derivatives) both on behalf of clients and for themselves, in addition to trading on registered securities exchanges and OTC markets.
The CBN and SEC, by the laws establishing them, have the power to enforce their respective regulations in respect of foreign exchange derivatives on the respective financial institutions and companies under their supervision. They do this by imposing monetary penalties, removing or punishing specific officers of defaulting companies, and by suspending or revoking the licences of the relevant institutions. These punishments are usually meted on the financial institutions that run foul of the regulations and guidelines.
The CBN stated clearly in the Guidelines that it will not tolerate infractions by authorised dealers, or unprofessional conduct by their staff. The ability of the CBN to punish authorised dealers is already an established feature of the Nigerian financial system. The FMDQ has also spelt out a dispute resolution mechanism under its codified rulebook. The FMDQ rulebook contains sample documentation with which the parties to FX hedges must comply. The sample documentation expressly incorporates the rules and regulations and jurisdiction of the relevant regulatory authorities to settle any disputes arising.
SEC authorises inter-dealer brokers to operate in the OTC derivatives market. It has already been established above that SEC-registered inter-dealer brokers are members of the FMDQ. SEC possesses a robust mechanism for dealing with infractions of the operators that it regulates. SEC first investigates complaints or infractions before referring cases with an established claim to the Administrative Proceedings Committee (APC). The decisions of the APC must be confirmed by SEC before being communicated to the parties who would have been previously invited to appear before the APC. Dissatisfied parties may appeal to the Investments and Securities Tribunal (IST) whose judgements are recognised by the courts in Nigeria as being equal to those of the Federal High Court.
In some circumstances, the entities involved in the hedging transactions are not (directly) under the supervision of either CBN or SEC, thereby ostensibly outside their enforcement reach. For example, where a dispute arises from the interpretation of the calculation of the future exchange rates in a hedging contract between the parties in an FX option or an NDF, will the consumer surrender to the authority of the CBN or SEC? Likewise, in a dispute between two different companies in different countries in an FX swap, would the Nigerian company surrender to the foreign dispute resolution platform, and vice versa? In these circumstances, the regulators and dispute resolution frameworks would arguably be irrelevant. Such transactions, however, remain enforceable in Nigeria by virtue of the fact that FX hedging contracts are essentially contracts governed by the Nigerian laws of contract. This is a body of laws not too dissimilar to its UK equivalent. The issue of the law governing the contract and dispute resolution platforms is usually taken care of by the contract between the parties, failing which, the rules on the conflict of laws would apply.
In the unlikely event that the contract is silent on these matters, an aggrieved party may rely on Section 251 1(c) of the Constitution of the Federal Republic of Nigeria, which directs that all matters pertaining to banking, foreign exchange, legal tender, bills of exchange, letters of credit, promissory notes or other fiscal measures should be interpreted by the Federal High Court. Upon a successful prosecution of such a dispute, the Nigerian counterpart can apply for the judgment to be registered in the jurisdiction of the other counterpart, and enforce the transaction or judgment in that jurisdiction.
First published by our sister publication IFLR magazine. Take your free trial today.
Austen-Peters & Co
About the author
Nehizena Ibhawoh works with Austen-Peters & Co. Over a 14-year career, she has advised extensively on capital market issues and has also provided advice on banking transactions.
Nehizena is registered with the Securities and Exchange Commission (SEC) as a capital market consultant and was financial secretary of the Capital Markets Solicitors Association of Nigeria.
Austen-Peters & Co
About the author
Jerry Okoye has been working with Austen-Peters & Co for over five years. He has been involved in various international financial transactions involving companies and core financial institutions, spanning multiple jurisdictions. He works closely with regulatory bodies on behalf of companies on various platforms. He studied law at the University of Nigeria, Nsukka, and was subsequently called to the Nigerian Bar.