A structural review of capital market operators

Let me first start by commending the Securities & Exchange Commission and the Central Bank of Nigeria under the vision 2020 work done in time passed under the Money & Capital Markets Com

A STRUCTURAL REVIEW OF

CAPITAL MARKET

OPERATORS

Let me first start by commending the Securities & Exchange Commission and the Central Bank of Nigeria under the vision 2020 work done in time passed under the Money & Capital Markets Committee in its bold accomplishment of ending the concept of universal banking and hence, the final separation of commercial and merchant/investment banking.

However, this major accomplishment has led to a major financial

exclusion of the key players in this very important intermediation sector

of the economy

1 There are two types of intermediation;

• In Nigeria, only bank based intermediation works - Our inability to

provide a full platter of services to our clients and fulfill our role as intermediaries is a testimony…

2 Why? capital market based intermediation is cut out of the wholesale

funding markets hence, no ability to fund any part of the capital market

business, it has no repo markets for liquidity, and therefore (except for

commercial bank treasuries) generally has inefficient sales & trading

operations or maturity transformation activities

3 There is therefore no real added value from a liquidity stand point, as the

equity trading business is generally also mainly brokerage hence, market

making which is meant to significantly increase liquidity is highly

inefficient

We are not investment banks – we call ourselves that

but, we are not.

Even from the corporate finance origination stand point;

• Underwriting financing (if you can get it) is

extremely high,

• No ability to execute bought deals for sell down,

• No real leverage at the client’s table - lack of

balance sheet generally (application to stand-alone institutions)

We are not investment banks – we call ourselves

that but, we are not….cont’d

The question is:

•How long can these businesses continue to mal-function

due to their inability to operate as intermediaries across the

•As is, capital market operators currently operate in “silos”

with no access to the money markets and therefore totally cut off from the life blood or base liquidity of all financial markets.

We are not investment banks – we call ourselves

that but, we are not… cont’d

NIGERIA AND MALAYSIA COMPARISON

Malaysia and Nigeria – A factual Comparison of capital requirements - 1

Malaysian Bank Capital Requirements RM Current GDP/Capital 2012 RM NGN

Investment Bank 500,000,000.00 USD 10,432.06 0.31 $155,000,000.00 74,529,862.75 3,741,458,973.39

Universal Broker 100,000,000.00 USD 10,432.06 0.31 $31,000,000.00 14,905,972.55 748,291,794.68

Stockbroker (Broker/Market Maker ) 20,000,000.00 USD 10,432.06 0.31 $6,200,000.00 2,981,194.51 149,658,358.94

Issuing House 2,000,000.00 USD 10,432.06 0.31 $620,000.00 298,119.45 14,965,835.89

NGN Current GDP/Capital 2012 NGN

Investment Bank 15,000,000,000.00 $1,555.00 3,741,458,973.39 4.01x

Universal Broker 1,300,000,000.00 $1,555.00 748,291,794.68 1.74x

Malaysia and Nigeria – A factual Comparison of capital requirements - 2

Malaysian Bank Capital Requirements RM Current GDP/Capital 2012

Nigerian Banks Capital Requirments NGN Current GDP/Capital 2012 GDP/ Capital required for current capital Capital required at current GDP levels In Local currency

Domestic Bank National 25,000,000,000.00 165 $151,515,151.52 $1,555.36 $2,549.38 $92,438,425.39 15,252,340,189.76 1.64x

Investment Bank 15,000,000,000.00 165 $90,909,090.91 $1,555.36 $6,118.51 $23,109,606.35 3,813,085,047.44 3.93x

Malaysia and Nigeria – A factual Comparison of capital requirements - 3

Malaysian Bank Capital Requirements RM Current GDP/Capital 2005 RM NGN

Investment Bank 15,000,000,000.00 $1,555.00 7,027,646,049.11 2.13x

Market Maker (Fixed Income & Equities)+Broker Dealer 1,300,000,000.00 $1,555.00 1,405,529,209.82 0.92x

Malaysia and Nigeria – A Comparison –Key Takeaways

• The new SEC capital requirements are adequate

for the current size of the economy

economy

Malaysia and Nigeria – A Comparison – Key take aways cont’d

• This has not been possible As to date (26 th of March, 2014) there remains only one fully owned Nigerian merchant bank after c4years!!

• This means we require a new way or approach to our operations and

markets – not in regulatory and operational silos but across the full curve from the shortest end to the longest (permanent capital or equities)…see fig 2

• We therefore require a new paradigm shift in thinking and make some

major changes to the way we operate and regulate our markets

• The first being - like other liquid markets (Malaysia included)……

….THE CENTRAL BANK MUST JOINTLY WORK WITH THE SECURITIES EXCHANGE TO GROW AND REQULATE THE INDUSTRY - WHY?

Approach to our Operations and Regulations

• ALL IMPORTANT LIQUIDITY

• “The tri-party repo market is the most important source of funding for investment banks and securities broker-dealers as they can obtain short- term liquidity to finance their securities portfolios Liquidity providers are usually money markets, investment funds, asset managers or public authorities with surplus liquidity” - Deutsche Bundesbank Monthly Report Dec 2013

• TODAY in Nigeria 2014 – this resides ONLY at the short end of the curve (Money and Interbank Markets plus the discount window – Lender

of last resort – comfort to all investors)

• No Broker/Dealer/Market Maker has access to this and therefore the

business is severely illiquid, fragile, small, viewed as high risk and can

NEVER grow into real institutions

Addressing the NEED for a WHOLESALE FUNDING

MARKET

• We therefore suggest one or a combination of the following options

:-1 Adopt the Malaysian model of a Universal Broker

2 A Financial Market Dealer licence that will support financial market intermediation to act as a stop-gap measure to operators becoming a full fledged Merchant Bank (jointly regulated by SEC and CBN)

3 A two-tier Merchant Bank Licence

• International Merchant Bank License

• National Merchant Bank License

• Each position is discussed in-turn in exposition to follow

Possible Suggestions

BACKGROUND TO OUR MARKET

The Nigerian capital market operates in silos of its own, cut off from the rest of the financial markets We currently have a market that looks as follows:-

Money Markets DMB

D.H D.M.B D.H NBFI* brokers I.H NBFI

Broker/Dealer Issuing houses

Short Term Capital

Medium Term Capital

Permanent Capital

Fig 1

In effect, for the same credit risk, the cost of shorter term money should by all definition be cheaper than longer term capital or permanent capital “A normal yield curve”

So, whose responsibility is it to price the entire financial markets

as depicted in fig 2 appropriately?

Different parts of the market are concentrated in silos and there is

no one institution that can design/create, price and trade across instruments across the curve

Our competitive ability should be to fully serve our clients, and market across the curve and hence have a real impact on our economy

How do you promote innovation across markets where each participant is confined to only one part of the market? More importantly, how do you efficiently price across all asset classes in one continuous price curve, intermediating across all markets?

We believe we require a major shift in our thinking to allow

an institution intermediate the short, medium and long term securities across the entire financial markets.

This is the only way the deficient issues mentioned above can be addressed and the market begin to see real growth

THE IMPORTANCE OF INTERMEDIATION

 Users of financial intermediation will include

corporations, institutions, high net worth individuals; in addition to short, medium and long term investors

 Financial intermediation firms will generally advise

companies on buying and selling businesses and assist them in managing risks

 They will generally work with businesses, local, state and

national governments to finance their operations through debt and equity offerings

THE IMPORTANCE OF INTERMEDIATION

 They will buy and sell equities, bonds, currencies,

commodities primarily to facilitate transactions by their clients in all of the key sectors of the financial markets

 They will manage assets for institutions, including mutual

funds, pensions and foundations as well as for individuals

 They may also invest capital together with their clients in

growing businesses which help to create jobs

 Finally and importantly, they will create and manage

liquidity across the financial markets by acting as

OPTION 1 – UNIVERSAL SECURITIES BROKER

THE CASE FOR A UNIVERSAL SECURITIES

DEALER

This is defined herein as a firm that is SEC and NSE approved and regulated:-

Capital

N1,300m

the wholesale funding market

THE CASE FOR A ADOPTING THE MALAYSIAN UNIVERSAL BROKER MODEL

In Malaysia, the Universal Broker - means a brokerage firm that has merged or acquired at least 3 other brokerage firms (To meet Capital requirements) and has satisfied all conditions and requirements stipulated by the Securities Commission under the Policy frame work for the brokerage industry consolidation

Minimum Paid-up capital of RM100m ($31m)

Minimum shareholders funds of RM100m ($31m) to be maintained at all times

Minimum Capital Adequacy ratio of 1.2x

NOTE: these parameters operate in economies c4.5x the size of the Nigerian economy and we can be clever by scaling the requirements to suite our market size – this was previously depicted

THE CASE FOR A ADOPTING THE MALAYSIAN UNIVERSAL BROKER MODEL

The Universal Broker - Why is this important?

As part of measures to strengthen capacity & competitiveness of universal brokers, brokers that meet the eligibility criteria were allowed to access the interbank market to undertake borrowing or lending

•Minimum shareholders funds of RM100m

•Strong capital position as measured by capital adequacy ratio (CAR) imposed by the Malaysian bursa (stock exchange)

•Satisfactory conduct of current credit facilities obtained from banking institutions

•Compliance with prudential and financial regulators imposed by the securities exchange and stock exchange

•Limit on aggregate interbank borrowings not to exceed 2x shareholder funds

THE CASE FOR A ADOPTING THE MALAYSIAN UNIVERSAL BROKER MODEL

monitor risks and

• A sound liquidity management framework that encompass strategies to

manage funds, ability to match near and short term liquidity requirements and maintain sufficient credit lines, liquefiable assets in managing potential liquidity shortfalls

Universal brokers are allowed to borrow securities from the central bank via repo arrangements to enhance their securities broking activity and will be subject

to examination by the central bank and the securities commission where appropriate.

THE CASE FOR A UNIVERSAL SECURITIES DEALER

OPTION 2 – A FINANCIAL DEALER LICENCE

THE CASE FOR A FINANCIAL MARKET DEALER LICENCE

A Financial Market Dealer (FMD) licence will provide a very

essential intermediation function by ensuring that our financial markets across the curve (see fig 2) remain liquid.

This will be achieved where such licence and skills give the holder the ability to fund and trade securities across the financial markets from say a 7day note issued under a commercial paper program or medium term note program to

permanent capital (equities).

THE CASE FOR A FINANCIAL MARKET DEALER LICENCE

Going forward, with such a licence, we would expect financial market dealers to provide liquidity and begin to create new products for companies, institutions and governments like interest rate swaps, currency swaps etc for improved risk management for the institutions and the financial markets

THE CASE FOR A FINANCIAL MARKET DEALER LICENCE

Graphical depiction of how a combined Issuing House and Broker Dealer (regulated by SEC) and a FMD (regulated by CBN) can now perform

THE CASE FOR A FINANCIAL MARKET DEALER LICENCE

The additional licence should encourage a new paradigm shift to allow for the combined entity to have an evenly spread business model as depicted above.

The financial market dealer/Issuing house/Broker/Dealer will therefore be able to function across the entire sphere of

ADVANTAGES OF THE PROPOSED MODEL TO REGULATORS

Commodity Dealers

1 Jointly regulated by SEC/NSE with oversight from the CBN

Fig 4

ADVANTAGES OF THE PROPOSED MODEL TO REGULATORS

 Allows for each regulator to still focus on their core areas

of competence whilst being able to have an oversight on the other areas of this important financial market intermediary

 This leads to greater scrutiny and therefore less

probability of systemic risk to the system

 Allows for sharing of information, stricter regulation as

these firms will be jointly regulated with formalised shared information for all procedures

 It also allows for the regulators to grow with these

institutions learning from lessons where capital is still relatively small and risks are very manageable

ADVANTAGES TO MARKET

 Wider product coverage

 Origination, distribution and trading of securities should

become seamless

 Product development, increased knowledge on pricing

across the financial markets leading to deeper liquidity in all markets

 Deeper liquidity reduces costs to the end user

 Creation of new jobs as sales and trading operations

become much bigger, more sophisticated and less risky to manage due to significantly improved information technology infrastructure and risk management systems.

ADVANTAGES TO MARKET

 The users of financial intermediaries will strongly benefit

from lower costs across all markets, efficient pricing, and

an ability for firms to now create products for their clients across the entire sphere of the financial markets

 To build resilience in the domestic financial markets to

withstand shocks by increased participants in the financial intermediation market

WHAT SHOULD A FINANCIAL MARKET

 Call Money and short term borrowings

 A FMD that is short of funds must be able to:

• Obtain from the CBN an overnight advance against acceptable

collateral

• Sell short term AAA rated assets to the CBN for the CBN to provide

rediscounting facilities for treasury and other eligible securities

• Enter into repurchase transactions with CBN using eligible securities

 Have a CBN account

 Access to the interbank market (as discount houses have for alternative short-term funding purposes)