NSE TAPS SIX BANKS TO CLEAR ITS DERIVATIVES TRADES

The Nairobi Securities Exchange will not clear and settle trades itself but will use six local banks to function as the Central Counterparties to trades to ensure clearance and settlement without default by the traders.

The six are Barclays Bank of Kenya, Cooperative Bank, CFC Stanbic, Chase Bank, NIC and CBA Bank.

Derivatives are contracts who take their value from the value of an underlying asset such as a commodity or financial instrument.

For example when an insurance company insures my car against an accident, the value of the premium (derivative) will be based first and foremost on the value of my car hence a higher premium for a new car. That is a rudimentary derivative credit default type contract although finance experts deny this to avoid bringing derivatives under insurance regulations.

The NSE will kick off its derivatives market with what are called futures before introducing options.

Futures also known as forward contracts are simply agreements to purchase an underlying commodity at a set price at a set time in the future.

Unga Flour Mills can for example visit farmers in the North Rift and secure contracts to purchase in six months time, when the harvest comes in, maize at Sh3000 per 90Kg bag.

That is a forward contract.

If drought hits and the price of a 90Kg bag shoots to Sh4000, the farmer may want to opt out of the contract and avoid losing so much money.That is not Unga's problem, there is a contract in place.

But to keep things orderly, Unga can then do another contract saying they agree to sell in six months a 90kg bag of maize to the farmer at Sh4000.

This would free up the farmer to go and explore the market prices and just pay Unga Sh1000 without delivering the maize.

Alternatively, if the two were trading on the NSE, the farmer could have shopped around his contract to a third party and exit the deal leaving that third party to figure out where to get and deliver the said maize at the given price from,

In reality, the NSE derivatives market is expected to feature hundreds if not thousands of such trades where traders take positions based on what they think the future price of a commodity or stock or currency will be.

If the price of a stock a trader has taken a position on goes up, he can choose to take the gains and exit by selling to another trader his contract.

To avoid players defaulting if they lose too much money on a bet gone bad, the six banks appointed to act as clearing houses will come in between the trades and act as the counter parties.

They will most likely demand a collateral deposit from the traders known as a margin to cover their risk or at least partially cover their risk of defaulting.

Once the market has matured, the NSE has said it will look to introduce an options market which is another kind of derivative.

These can be either Call or Put options.

The last major Put option seen in this market was one which was issued by TransCentury to its then partner in Rift Valley Railways, Citadel Capital. Essentially, it asked Citadel Capital to either buy TC's stake in RVR or exit the utility.

Unfortunately for TransCentury, Citadel called its bluff and came up with the money to buy out the local firm.

The NSE is expected to give more details as to commencement of trading of derivatives on its platform.