Introduction
The Ethiopian Commodity Exchange (ECX) has been a cornerstone in the trading of various commodities like coffee, sesame, and maize. However, the ECX largely operates on spot contracts, where commodities are sold or bought for immediate delivery and payment. As Ethiopia aims to become a middle-income country, there’s a growing need to introduce financial derivatives, including forward contracts, futures, and options, to enhance market efficiency and global competitiveness.
Key Financial Derivatives: Definitions and Examples
Forward Contracts
A forward contract is a non-standardized agreement between two parties to buy or sell an asset at a specified future date at a predetermined price.
Example: Imagine a coffee farmer in Ethiopia who expects his coffee beans to be ready for sale in six months. He could enter into a forward contract with a coffee exporter to sell a specified amount of coffee at a predetermined price six months from now.
A forward contract is a type of derivative product that allows two parties to agree on the price and delivery date of an asset in advance. A forward contract is customized to the needs and preferences of the parties involved, and it does not trade on an exchange.They are not traded on a centralized market, but rather between two parties who agree on the terms of the contract. They are considered over-the-counter (OTC) instruments, meaning that they are customized and not standardized, there is no secondary market for forward contracts, meaning that they are not easily bought or sold by other investors
A secondary market is a place where investors can buy and sell existing securities, such as stocks, bonds, or futures contracts.
Futures Contracts
Futures are standardized contracts to buy or sell an asset at a predetermined price at a specified time in the future. Unlike forward contracts, futures are traded on exchanges and are standardized in terms of quantity, quality, and settlement dates.
Example: An Ethiopian sesame seed producer can lock in a future price by buying a futures contract, thereby protecting herself against the volatile price changes in the sesame market.
Future contracts are traded in the market. Futures contracts are standardized legal agreements to buy or sell an asset at a predetermined price and date in the future. They are traded on futures exchanges, which act as a marketplace between buyers and sellers. Futures exchanges provide liquidity, price discovery, and risk management for the futures contracts
Options Contracts
An options contract gives the buyer the right, but not the obligation, to buy (call) or sell (put) an asset at an agreed-upon price during a certain period or on a specific date.
Example: An Ethiopian maize distributor could buy a call option to purchase maize at a set price three months from now. If the price of maize increases, the distributor can exercise the option and buy at the lower, agreed-upon price, thereby making a profit.
Some key challenges in establishing forward contracts in Ethiopia include:
- An ambiguous legal environment: Ethiopia lacks a well-defined legal framework for governing forward contracts, creating uncertainty about the arbitrability of disputes related to these contracts. There’s no administrative legislation specifically addressing this issue, causing confusion for parties looking to hedge or speculate on future prices.
- Inadequate market infrastructure: A centralized exchange or clearing house that could standardize and enforce forward contracts is missing. Although the Ethiopian Commodity Exchange (ECX) does offer some advanced pricing options for future delivery, it remains limited in its functionality and accessibility.
- Limited awareness and trust: Many potential users, particularly small-scale producers and traders, are unfamiliar with the benefits of forward contracts. These parties often lack financial literacy and may struggle to find reliable counterparties, making them hesitant to engage in such agreements.
- Regulatory Constraints: Ethiopia’s financial regulatory framework may not be mature enough to handle the complexities of forward contracts.
- Market Maturity: The Ethiopian financial market’s state of development may not be advanced enough to manage the risk levels associated with forward contracts.
- Lack of Expertise: The skill set needed to manage and regulate forward contracts effectively may not yet be widespread in Ethiopia.
- Operational Complexity: Introducing forward contracts would require advanced risk management systems and data capabilities, which might not yet be available.
Advantages of Introducing Financial Derivatives in ECX
- Risk Management: Derivatives allow for better risk management by enabling market participants to hedge against price volatility.
- Price Discovery: Forward and futures contracts can help in more efficient price discovery, reflecting the market’s future expectations.
- Financial Innovation: The introduction of derivatives could lead to more advanced financial products, further enhancing market efficiency.
- Global Competitiveness: Offering such instruments would make ECX more globally competitive, attracting both local and foreign investment.
- Derivatives can help market participants to manage various financial risks, such as price, foreign exchange, interest rate, and credit risks. By allowing investors to unbundle and transfer these risks, derivatives can contribute to a more efficient allocation of capital, facilitate cross-border capital flows, and create more opportunities for portfolio diversification
- Derivatives can also enhance the operational and market efficiency of the ECX, by reducing transaction costs, increasing liquidity, and improving price discovery. Derivatives can also allow users to create exposures that are unavailable in the cash market, such as synthetic positions or leveraged bets
- Derivatives can also foster the development and innovation of the Ethiopian capital market, by attracting more domestic and foreign investors, diversifying the range of financial products and services, and increasing the competitiveness and integration of the market
Disadvantages for the Ethiopian Market
- Market Complexity: Derivatives are complex instruments that require a sophisticated understanding of financial markets, which might be lacking in the Ethiopian context.
- Risk of Speculation: The use of derivatives could encourage speculative behavior, leading to market instability.
- Regulatory Challenges: Regulating these new financial instruments would require new skills and technologies, adding an extra burden on Ethiopian regulatory authorities.
The Ethiopian Capital Market Authority (ECMA) is the regulatory body that oversees and supervises the development and operation of the capital market in Ethiopia, including the derivative market. The derivative market is a segment of the capital market where financial instruments, such as futures, options, swaps, or contracts for difference, are traded.
The role of the ECMA in the derivative market is to:
- Grant licenses and permits to any person or entity that wants to operate as a derivative exchange, a derivative clearing house, a derivative depository, or a derivative service provider
- Establish rules and standards for the admission, listing, trading, clearing, settlement, and disclosure of derivatives and other financial instruments in the derivative market
- Monitor and enforce compliance with the laws and regulations governing the derivative market, and to impose sanctions or take corrective measures for any violations or misconducts
- Protect the rights and interests of investors and the public, and to promote fair, efficient, transparent, and competitive derivative market practices2.
Conclusion
Introducing financial derivatives like forward contracts, futures, and options into the Ethiopian Commodity Exchange could offer manifold benefits including better risk management, price discovery, and global competitiveness. However, the introduction of such financial instruments must be carefully planned and executed, keeping in mind the readiness of the Ethiopian financial market and its regulatory frameworks.
The potential rewards are enormous, but the challenges are not insignificant. It’s an endeavor that requires the concerted effort of regulatory bodies, market participants, and financial experts. Therefore, the ECX and the Ethiopian government should consider a phased approach to introducing these complex yet rewarding financial instruments.
By:
Samson Tsedeke, Managing Director-Multilink Consulting+251911207364