I’ve been reading up about financial market architecture these days as part of preparation for some exams and began trying to connect the stuff I’m reading with one market that has been in the news recently. In ejecting Nigeria from its emerging market government bond index (EMGBI), JP Morgan cited the lack of transparency and illiquidity of the domestic FX market as the underlying driver. Following the closure of the retail Dutch auction system (RDAS) in February 2015 the Central Bank of Nigeria (CBN) introduced a new trading system called the order based 2-way quote system to replace the hitherto OTC market.
Generally, there are two broad types of market structures in across financial markets. The first type is the order driven market structure. In Nigeria, this is the structure in use at the Nigerian Stock Exchange and involves financial market participants placing their orders (decisions to buy or sell stocks displaying quantities and pricing) in a queue system under which a central body matches the orders using the prices displayed by players. The allocation mechanism is such that aggressive buy orders are matched using their prices displayed to the least aggressive sell orders. Now all trades must go through the market in a transparent manner to ensure proper price discovery. The exchange has standard rules and trading times and players pay fees on each transaction. This system is favoured for equities globally.
The other market type is the quote driven structure favoured for fixed income transactions. Under the quote driven system, there is no standard market or exchange rather transactions are done over-the-counter (OTC) with counterparties calling up other counterparties and asking for quotes about the securities traded in the exchange. To ensure the system works, there a set of rules agreed before-hand and with advancement in technology, a display terminal via which agents post two prices ( a bid and an ask) and are under obligation to entertain any inquiry by a counterparty. Agents in these markets are called dealers and they are required to post the bid (how much they would be willing to buy) and an ask (how much they would be willing to sell) the underlying securities traded in the OTC market. This method is often in use in securities where no natural liquidity exists.
The major advantage of the quote driven system is that execution is guaranteed as dealers have to transact business at their posted bid and ask prices. On the flipside, transparency is an issue. Unsurprisingly, the roles reverse in the order driven market as transparency of posted prices is clear while execution is not guaranteed.
For foreign exchange markets, the OTC quote driven market is most popular around the world and until February 19th 2015, was the system in use for FX trading in Nigeria. Under this system, the closing price of the NGN was determined daily by the price which banks trade FX in the interbank OTC market. It was a dealers market with banks trading with one another by posting two prices on a trading terminal and entertaining requests from one another daily. Twice every week the CBN held auctions for legitimate dollar demand which were purchased at the official peg rate. Those not eligible tried their luck at the interbank or other market segments.
After that date the Central Bank of Nigeria mandated the use of an order driven system for FX trading now called the order based two way quote system (OB2WQ).
So why did the CBN elect to drop the OTC as used in other markets for the OB2WQ? The answer lies in the unique scenario that is the Nigerian economy. In developed markets, the supply is FX is plural in nature: many agents: the big banks, multinational firms etc Thus under this setting many buyers and many sellers meet and do deals over phone calls or computer screen to barter currencies. However this contrasts with Nigeria where there’s really one large source of FX: the CBN which commandeers Nigeria’s export proceeds into its vaults. The scale of CBN’s dollar supply relative to other players is unmatched changing the underlying market from one where there are many sellers but only one effective agent who can fix the price. Indeed for years the CBN determined the price via an open declaration. Now under the previous setting, applying a game theory approach, the problem of moral hazard or currency speculation is rife. The FX system is underpinned by CBN dollar liquidity. As CBN dollar source is oil, when the price drops, the probability that the CBN, now in a weaker position, will be forced to devalue rises leading to currency speculation, substitution and arbitrage. Under an OTC setting with limited transparency the possibility of cheating rises stoking NGN volatility and by panic especially when the CBN is unwilling to adjust the peg higher.
Complicating the headache is the existence, as with all countries globally a parallel market, and unique to Nigeria and a few countries: a BDC rate. Selling the same product in several market at different prices only creates incentives for all manner of skulduggery.
In an environment of low oil prices and FPI reluctance to inflow into Nigeria, all focus is now on the apex bank. Having devalued 24% since November, the CBN felt no need for further pass-through. But more importantly as it determined where the market stays, better to fix the market system. Nigeria’s current dynamic of a monopoly seller and many buyers is better suited for an order driven market vs. a quote driven one. Essentially, we have an allocation problem, how does the apex bank distribute dollars. Moral hazard meant that the old system was not fit for purpose but is the new system sustainable? I will address this in another post.