BY Geoffrey Odundo- CEO Nairobi Securities Exchange
The Nairobi Securities Exchange (NSE) has received the green light from the Capital Markets Authority (CMA) to start issuing and trading derivative contracts on the NSE’s Derivatives Market — NEXT.
For the last four years, the NSE has worked together with key partners and stakeholders to develop the regulations and rules for NEXT. These cover the structure of the contracts that will be listed on NEXT, the licensing and supervision of futures brokers and clearing banks, and the trading rules. Exchange-traded derivatives — futures and options — are traded based on a number of asset classes; agricultural commodities, energy and metal commodities, currencies and financials (fixed-income securities, stocks and indices). The first contracts to be listed will be futures on the NSE’s stock market indices and on select foreign currencies. What it means A futures contract is a contract to exchange an asset at an agreed price on an agreed future date.
When it matures, the seller (short) and the buyer (long) of the contract must honour the commitment.With an option, the buyer has the right, but not the obligation, to exchange an asset at an agreed price on an agreed future date.
To ensure competition, transparency and access, the licensing fees have been deliberately kept low. NSE Clear, the clearing house institution that guarantees the clearing and settlement of trades on NEXT, has also been set up, with its own equity capital, bank accounts and board. Rather than have the long and the short hold the contract with each other, NSE Clear will become the buyer for every seller and the seller for every buyer. It is obligated to make correct and adequate settlement for both parties, depending on their positions. When entering a trade, the long (buyer) and short (seller) must open a margin account. The margin account is a security account consisting of cash; it acts as good faith deposit that each party to the trade is able to meet obligations. The NSE Clear, bound to perform on its side of each contract, is the only one that gets hurt by the failure of any party to observe the obligations of the contract. This is necessary because a futures contract calls for future performance, which cannot be as easily guaranteed as an immediate stock transaction. NSE Clear makes it possible for traders to easily liquidate a position. NEXT and NSE Clear will require profits and losses to be realised daily. The process by which profits or losses accrue to the investor is called marking to market
If, for example, you are the long (buyer) on a contract, and today a unit of the contract increases in price by Sh1, your margin account will receive Sh1.00 by noon the next day. On the other side, for every unit owned, the margin account of the short (seller) will be deducted by Sh1.
If the market turns against you and your losses accumulate from daily marking to market, your margin account may fall below a critical value called the maintenance margin. When this happens, you will receive a margin call, requiring you add more funds into your margin account or the size of your position will be reduced. Margin calls safeguard the position of NSE Clear, and ensure at all times you have enough funds to cover your losses. This mechanism stops investors taking risky and unsustainable positions that they cannot honour. If you are currently long in a contract and want to undo your position, you would instruct your broker to enter the short (seller) side of a contract to close out your position. This is called reversing trade. The exchange nets out your long and short positions, reducing your net position to zero. You have no outstanding obligations at contract maturity. The NSE will continue working toward increasing the understanding of derivatives for both institutional and retail market participants so they can manage their risk and diversify their portfolios.