By Nkem Ekwere at Banwo Ighodalo
Introduction
The massive decline in equity prices on the Nigerian Stock Exchange has compelled investors to look to alternative investment options, notably fixed income instruments. Investors in Nigeria are increasingly turning their attention to structured products (“SPs”) such as structured notes and options/certificates issued by international investment banks. Although they are relatively new in Nigeria, there is a growing demand for these products.
What are SPs?
Although there is no definition of SPs under Nigerian law, the term “structured products” refers broadly to hybrid investments that combine a traditional security with one or sometimes more asset classes into a single “structure”. This structure is often referred to in the offering memorandum or prospectus as the “basket”. The mix of securities in the basket determines the investment’s upside potential, as well as downside protection, tax implications, risks and other considerations1. SPs could be “structured” in several ways, including:
(a) Notes: The investor will pay a notional amount upfront to invest in the notes. The notes may pay a return based on the performance of an asset, for example an underlying index of securities or a commodity. The notes may pay a coupon. They may be “autocallable” i.e. notes that redeem automatically if a certain event occurs, (for example, an index rises above a certain level), in which case the investor will be paid the principal amount plus a fixed coupon.
(b) Options/Certificates: These will typically not be capital-protected. The investor will typically pay a premium upfront rather than the full notional amount. They will generally give the investor economic exposure to an underlying asset or index and may be cash or physically-settled.
Features of SPs Some features of SPs include:
1. Combination of financial instruments: SPs are created by a combination of financial instruments and have two components: a note and a derivative.While the note provides for periodic interest payments to the investor at a predetermined rate, the derivative component provides for the payment of the maturity amount. The derivative portion can include a call or put option.
2. Capital Protection: SPs may offer full or partial capital protection. Capital protection means that an investor can receive at least their original investment (i.e. 100% capital protection) or a reduced percentage of their original investment (partial capital protection). It is important to bear in mind that an investor will only enjoy this protection if the investment is held till maturity.
3. Linked Returns: The performance of an SP can be linked to a wide variety of underlying asset classes, including bonds, equities and equity market indices.
4. Fixed term: The tenor of these products could range from one to seven years.
5. Risk: Investment in SPs is highly risky and could lead to total or partial loss of principal initially invested.
6. High returns: Depending on the risk tolerance level of the investor, investing in SPs can be potentially profitable, especially if the underlying assets to which these instruments are linked perform creditably.
7. Particular Classes of Investors: Generally, SPs are not suitable for all classes of investors. Typical investors include high net worth individuals (HNIs) and Qualified Institutional Investors (QIIs). Save for Rule 78 of the Securities and Exchange Commission (SEC) Rules, which defines these terms in relation to offerings of securities launched through a Book-building process, Nigerian law does not define these terms.
Regulatory Framework for SPs in Nigeria
Although Section 315 of the Investment and Securities Act (“ISA”) defines securities to include notes issued or proposed to be issued by a body corporate, commodities, futures, options and other derivatives, the ISA and the SEC Rules do not specifically regulate trading in SPs.
We submit that the absence of specific rules and regulations creates a lack of certainty and adversely impacts on the development of a market for SPs in Nigeria, especially in relation to the issuance of SPs by Nigerian entities and the marketing of the same to retail investors.
Further, although the CBN Foreign Exchange Manual contemplates dealings in forwards and swaps, it essentially regulates the foreign exchange aspects of such transactions and is inadequate to generally regulate trading in derivative instruments. Furthermore, the development of regulations governing trading in SPs may have been hampered by the fact that the SPs currently being distributed in the Nigerian market have typically been issued by foreign entities and targeted towards identified HNIs and QIIs, thereby falling outside the regulatory ambit of the SEC.
Conclusion
Although there are no available statistics on the actual value of SPs either issued by Nigerian entities or sold to Nigerian investors by foreign issuers, it is noteworthy that the market for SPs is gradually evolving and will gain momentum as soon as regulations governing its issuance are in place. Finally, it is hoped that recent discussions between the SEC and the International Swaps and Derivatives Association (ISDA) on the regulation of derivatives will lead to the promulgation of derivative-specific legislation in Nigeria in the near future.