The impression that financial derivatives are complex to understand on the same level as rocket science, is not uncommon among many capital markets practitioners. Nothing could be less accurate. While understanding them is not kindergarten stuff, it is not rocket science either. Yet this is not the only aspect on derivatives that is generating debate in Kenya. Chief among conversation triggers is the financial risk involved in trading derivatives. A majority of the people tend to concur with Warren Buffet who famously said, “Derivatives are financial weapons of mass destruction”. Some will even have as evidence of this, the role played by derivatives in the recent global financial crisis. Those who espouse this school of thought steer clear the derivatives arena and risk being labelled “unsophisticated investors”.
Whereas trading in these financial instruments without proper understanding is risky, their value in managing and hedging risks cannot be downplayed. A recent survey by the International Swaps and Derivatives Association (ISDA) of 500 largest companies by revenue found that over 94% of these companies use derivatives to manage risk. When utilised properly, derivatives facilitate the transfer of risk among economic agents by providing mechanisms to enhance liquidity and facilitate price discovery. In Kenya the hype about derivatives and the soon to be launched derivatives exchange is at its peak. It is imperative, therefore, to contribute to the public knowledge on derivatives and provide a preliminary examination of the derivatives infrastructure in Kenya.
In order to assess Kenya’s readiness for the derivatives market, four critical elements of a functional derivatives infrastructure need to be sized up. These are; public awareness, derivatives pricing capacity, product complexity and central counterparty.
One of the reasons for the delay in the establishment of a derivatives exchange in Kenya is low-level awareness among potential investors about financial derivatives. Before these instruments can commence trading, it is important that a significant proportion of the investing public is aware of the mechanics of trading derivatives. Sufficient knowledge among market participants will ensure that, from the onset, there is a generous number of investors and market makers to sustain trading momentum.
The Kenya Capital Market Authority (CMA) and the Nairobi Stock Exchange(NSE) have been the front runners in filling this gap. Other stakeholders include Africa Risk Institute (ARI) an accredited trainer and knowledge provider in the financial services industry. ARI is finalising an open course on derivatives to be held in October. The course targets practitioners and other interested parties in the financial services industry.
Derivatives Pricing Capacity.
The pricing of financial derivatives can be a complex undertaking. Kenya must have a robust capacity to handle the pricing functionalities of derivatives otherwise the use of outdated models or outsourcing from developed markets will be the rule of thumb. The need for certified financial engineers, quants and financial mathematicians will help minimize arbitrage. Developed financial markets constantly hire such talent or candidates with PhDs in mathematics, statistics and physics to develop pricing models for derivatives. Financial engineering programmes in the local universities seemingly will meet this demand. The question, however, is whether these skills have been tested in a real market with real data.
Complexity of products
It is true that imagination is the only limit to the type of derivatives that can be traded in an exchange. The temptation to create complex derivatives products that investors have no clue about is not rare. Kenya being a young market in the derivatives frontier will need to introduce simple products and increase complexity with time. Consequently, plain vanilla products will be a good place to start. This will ensure that investors trade in products they understand at first and then move to complex products having mastered the basics. Those responsible for designing these products will be careful to match the risk and reward appetites of investors with different risk profiles without adding unnecessary complexity. The NSE has already drafted some simple products for approval. Proposed derivatives will initially include stock indices and currency futures.
Counterparty risk is a major concern in derivative transactions. This is the risk of financial loss arising from one of the parties to a derivatives contract forfeiting their obligations. To eliminate or manage this risk a clearing house must be established to enforce contractual obligations between counterparties. The CMA has already signed five banks to act as clearing members for the derivatives exchange.
The quick examination of the four elements of a sound derivatives infrastructure is not by any means exhaustive. It is a platform for subjecting the preparations for a derivatives exchange to some sort of stress testing. So far there is every indication that the market has what it takes to operate a derivative exchange. The foundation seems to be set and the superstructure will develop accordingly to ensure the market functions smoothly from the onset. With this, Kenya can hit the road on its journey to become the financial hub that it is envisaged to be.