Understanding Recent Changes in Nigeria’s Forex Regime by Daniel Unoke

Since the beginning of the year 2023, Nigeria has experienced several significant events, particularly in the financial sector. Among these are the cash crunch, the decision of the Central Bank of Nigeria (CBN) to ban over 100 Microfinance Banks, and the establishment of a Regulatory Sandbox. Additionally, both presidential and gubernatorial elections took place, marking crucial moments in the country’s political landscape.

Amidst these developments, the most noteworthy and captivating change is the recent modification to the Foreign Exchange regime introduced by the CBN through The Operational Changes to the Foreign Exchange Market circular^[1] (the Circular) issued on the 14^th of June 2023. This alteration has sparked considerable interest throughout Nigeria as it represents the latest effort by the CBN to strengthen the value of the Naira.

This article aims to provide a comprehensive understanding of the concept of FX, its functioning, and the specific changes that were implemented in the FX market.

Introduction

To gain a comprehensive understanding of the recent changes to the FX regime, it is essential to recognize that while money is universally acknowledged, each country primarily employs its own currency as legal tender, except in rare instances. According to Section 22 of the Foreign Exchange (Monitoring and Miscellaneous Provisions) Act^[2] (Forex Act) and the Circular on Currency Substitution and Dollarization of the Nigerian Economy^[3], the Naira is the sole legal tender in Nigeria. Therefore, any business or individual conducting transactions in Nigeria must strictly use the Naira, except in limited exceptional circumstances.

Furthermore, Section 20(1) & (5) of the Central Bank of Nigeria Act (CBN Act)^[4] provides that it is an offense for any person to refuse to accept the Naira as payment. Hence, it is imperative for parties involved to utilize the Naira for all financial activities within Nigeria. However, the situation differs when Nigerian citizens travel abroad or receive money, possibly as payment from foreign sources. This introduces the concept of Foreign Exchange and Foreign Exchange Reserves.

Foreign exchange, commonly known as forex or FX. is the conversion of one currency into another. The primary reasons for currency exchange include Business Travel Allowance and Personal Travel Allowance, payment of School Fees (education), Profit Repatriation, engaging in International Trade, and servicing foreign debt.

Foreign Exchange Reserves, often referred to as FX reserves or foreign reserves, represent assets held by a country’s central bank or monetary authority. In Nigeria’s case, these reserves primarily consist of foreign currencies, such as the US Dollar, Euro, Japanese Yen, and other internationally accepted assets like gold and are held by the CBN.

Foreign exchange reserves serve as a crucial financial buffer for a country to meet its international payment obligations, stabilize its currency value, and intervene in foreign exchange markets to manage exchange rate fluctuations. The presence of Forex Reserves enables governments to facilitate transactions requiring foreign exchange with their citizens. Therefore, the CBN strives to maintain an optimal level of foreign currencies in the reserve.

Maintaining a sufficiently filled foreign exchange reserve holds utmost significance in the economic policy of any country. The scarcity of foreign currency in the FX reserve can potentially result in the devaluation of the country’s legal tender. If the Forex reserves are diminished and there is no corresponding inflow of foreign currency into the country, it could lead to an inability to meet the demand for foreign currency, subsequently causing an escalation in the foreign currency prices. This aligns with the principle of scarcity, emphasizing the critical importance of robust Forex reserves to ensure stability in the value of the country’s currency.

The CBN is also tasked with fixing the country’s exchange rate^[5]. The CBN does not make this decision arbitrarily but considers numerous factors that influence the value of the Naira compared to other currencies. These factors include Trade Imbalance^[6], Falling Oil Prices^[7], Foreign Investment Outflows^[8], and High Inflation.^[9] Nigeria is plagued with these factors, making it challenging for the CBN to maintain a sufficient foreign exchange reserve for the country.

 

Stakeholders and Dealers

In addition to the CBN, the Forex Act delineates categories of individuals within the Nigerian forex space. These entities include:

• Authorized dealers (ADs): These entities typically consist of financial institutions such as commercial banks, merchant banks, International money transfer operators (IMTOs), and other approved financial institutions designated by the CBN. These institutions are authorized to function as intermediaries, facilitating the acquisition and receipt of foreign currency from both the public and their clientele.
• Authorized Buyers (ABs): these are entities (natural or artificial) authorized by the CBN to buy foreign exchange from the ADs. ABs include Bureau de Change Operators, licensed importers who need foreign currency to pay for goods, Investment Banks, Oil Companies etc.
• End-Users: while not expressly authorized by the CBN, the end-users are entities that are the ultimate recipient of foreign currencies. They include persons who exchange currency for tourism, medical or educational reasons etc.

Having gained background understanding of FX, the subsequent sections will be dedicated to dissecting the major changes in the circular and exploring the changes implemented.

Abolishment of Segmentation

Before the circular, Nigeria operated four major market segments, to wit:

• Interbank Foreign Exchange Market (IFEM): This was the main market for FX trading in Nigeria. It was open to all ADs in foreign exchange. These dealers sell and buy foreign currencies between themselves and at an (official) rate set by the CBN.
• Investors and Exporters (I&E) Window: This was a market for foreign exchange trading that was open to all investors and exporters. It was designed to provide a more transparent and efficient way for these market participants to trade foreign exchange.
• Small and Medium-sized Enterprises (SMEs) Window: This was a market for foreign exchange trading that was open to small and medium-sized enterprises (SMEs). It was designed to provide these businesses with access to foreign exchange at a more competitive rate.
• Bureau de Change (BDC) Window: This was a market for foreign exchange trading that was open to Bureau de Change operators (BDCs). BDCs are licensed by the CBN to exchange foreign currency for Naira.

The different segments in the FX market are combined into one called the Investors and Exporters (I&E) window, now termed the Nigerian Foreign Exchange Market (NFEM)^[10]. The “desegmentization” was implemented by the CBN due to the belief that some stakeholders most notably the BDCs and other parallel market (black market) dealers hoard foreign currencies thereby creating artificial scarcity for their profit.

Introduction of the Willing Buyer, Willing Seller Model:

Before the issuance of the circular, CBN held the responsibility of determining the actual value of the Naira. This meant that ADs were obligated to sell or exchange the Naira for other currencies at the rate set by the CBN. However, with the (re)introduction of the “Willing Buyer Willing Seller Model”, the exchange rate is now determined by the interaction between buyers (demand) and sellers (supply) of a specific currency.

Let’s consider a scenario, where a foreign airline operates and sells tickets to passengers in Naira. The airline subsequently needs to repatriate its profits and revenue back to its home country in a foreign currency. On the other hand, Shell Petroleum Company, a major oil company operating in Nigeria, requires Naira to pay its local staff, cover operational expenses, and meet other financial obligations within the country. Before this introduction, the parties’ best bet at securing FX at an optimal rate was through the ADs but with the changes, the Airline and Shell can meet each other to negotiate a price to trade currencies depending on their bargaining and negotiating prowess.

With this model, if there is high demand for a currency from willing buyers compared to the available supply from willing sellers, the value of that currency will increase. Conversely, if there is more supply from sellers than there is demand from buyers, the value of the currency will decrease.

This new approach aligns with the concept of floating a currency, where the value of currency is influenced by the foreign exchange market through the dynamics of supply and demand. In other words, the CBN no longer fixes the exchange rate; instead, it fluctuates based on prevailing market conditions.

 

Operational Rate for Government Transactions

Nigeria operates a managed float^[11] system and not a free float system. The managed float rate is the method employed in government-related transactions, and the CBN determines the exchange rate for government-related transactions on a particular date by calculating the weighted average rate of the previous day’s executed transactions, rounded to two decimal places.

To illustrate, let’s consider an example with three transactions that occurred on July 31:

• Transaction 1: USD 10,000 at an exchange rate of NGN 400 per USD
• Transaction 2: USD 15,000 at an exchange rate of NGN 395 per USD
• Transaction 3: USD 8,000 at an exchange rate of NGN 405 per USD.

The weighted average rate is calculated by considering the volume of each transaction and its corresponding exchange rate:

Weighted Average Rate =

[(Volume of Transaction 1 x Exchange Rate of Transaction 1) + (Volume of Transaction 2 x Exchange Rate of Transaction 2) + (Volume of Transaction 3 x Exchange Rate of Transaction 3)]   (Total Volume of Transactions)

Using the given data:

Weighted Average Rate = [(USD 10,000 x 400) + (USD 15,000 x 395) + (USD 8,000 x 405)] ÷ (USD 10,000 + USD 15,000 + USD 8,000)

= (USD 4,000,000 + USD 5,925,000 + USD 3,240,000) ÷ USD 33,000

= USD 13,165,000 ÷ USD 33,000

= NGN 398.03 (rounded to 2 decimal places)

Therefore, the CBN adopts the calculated weighted average rate of NGN 398.03 per USD as the operational rate for all government-related foreign exchange transactions on August 1, 2023.

 

Introduction of the Order-Based Two-Way Quotes

In financial markets, specifically in trading assets such as stocks, currencies, or bonds, a two-way quote is utilized as a pricing system. This system presents two distinct prices for a particular asset:

• Bid Price: This represents the highest price that a buyer is willing to pay for the asset, reflecting the demand from potential buyers.
• Ask Price: This signifies the lowest price at which a seller is willing to sell the asset, indicating the supply from potential sellers^[12].

The two-way quote system enables traders to observe both sides of the market, providing transparency regarding the prices at which buyers and sellers are willing to transact. The difference between the bid price and ask price is referred to as the “bid-ask spread.“^[13] This information is vital for traders as it helps them decide whether to buy or sell an asset and at what price.

To maintain fair trading conditions, a bid-ask spread of N1 will be enforced for all transactions. In essence, ADs are allowed to sell and buy Foreign Currency on the condition that the profit between the selling price and the asking price does not exceed NGN 1. Basically, ADs are allowed only to make a profit of NGN 1.

To ensure secure transactions, all transactions will be cleared by a Central Counter Party (CCP). The CCP functions as an intermediary, overseeing the fulfillment of obligations by both buyers and sellers, thus reducing the risk of trade defaults.

 

Cessation of RT200 Rebate Scheme and Remittance Schemes

In 2021, the Central Bank of Nigeria (CBN) introduced the Naira4Dollar scheme with the objective of encouraging the utilization of official foreign exchange channels by both senders and recipients of foreign currency. Under this initiative, individuals who transmit a single US dollar (USD 1) through approved channels are provided with an incentive of NGN 5.

Subsequently, in 2022, the CBN also initiated the RT200 FX Repatriation program^[14], aimed at amassing a sum exceeding USD 200 billion in foreign currency from non-oil transactions within a span of five years. The primary intention behind this endeavor was to motivate businesses not engaged in petroleum trade to repatriate profits and avail themselves of associated advantages.

However, the most recent adjustment to the foreign exchange framework, as stipulated in the circular, involves the complete elimination of these incentives.

 

Proscription on trading limits

To understand what this entails, we have to take a look at the following concepts:

• Over the Counter (OTC) Futures: OTC signifies a decentralized market where currencies and other instruments are traded without the involvement of a central exchange or broker^[15]. Futures, on the other hand, refer to agreements to purchase a specific currency or financial instrument at a predetermined price on a specified future date^[16]. OTC futures facilitate the trading of currencies at a future date and a predetermined price without any centralized exchange.

 

• FX Positions: FX positioning is a trading strategy where decisions are made based on speculative assessments of currency price movements. When traders anticipate currency appreciation, they assume a long position^[17]. Conversely, if they predict currency depreciation, they assume a short position.

 

• Hedging: This strategy is employed to minimize exposure from currency trading risks.^[18]

 

• General Principle of Demand and Supply: This simply relates to managing oversold and overbought positions in the FX market. The CBN may impose trading limits to ensure market stability. Traders with oversold positions might be allowed to hedge using OTC futures, while limits might be set at zero for overbought positions to prevent excessive speculation. These measures aim to maintain a balanced and healthy FX market environment.

 

To aid comprehension, consider the following scenario: Amid the prevailing circumstances concerning the Naira, widespread expectations of its continued depreciation have led many to accumulate reserves of USD. This strategy positions them to sell for profit should the Naira depreciate further. Now, imagine news breaking that the CBN intends to devalue the Naira to 2000 NGN per USD. In response, traders could seek to capitalize on this situation by selling substantial amounts of Naira to acquire USD, capitalizing on the current lower price. This surge in selling contributes to an oversold position.

Suppose the CBN is planning an official Naira devaluation by January 1, 2024. The intensification of the oversold positions could expedite the devaluation process, causing the Naira’s depreciation to occur sooner. To address this, the CBN enforces trade limits on the quantity of Naira that can be sold within a given period, thereby mitigating the oversold position.

Furthermore, the CBN takes additional measures to alleviate potential trader hardships. In cases where the apex bank intervenes to mitigate oversold positions, the circular permits traders to hedge these positions using OTC futures. This safeguard enables traders to lock in a predetermined exchange rate for a future date, shielding them from potential losses.

Conversely, consider a scenario where the Naira appreciates significantly, leading to an influx of buyers and consequently, an overbought position. To prevent further speculative buying that could artificially inflate the Naira’s value, the CBN would impose a zero limit on additional Naira purchases.

In conclusion, these strategies and changes collectively contribute to maintaining a stable and balanced FX market environment and to limit the further depreciation of the Naira.

 

Daniel Unoke is a Lawyer with expertise in finance, tech, and regulatory compliance. His expertise lies in offering practical solutions that cater to the intricate landscape of finance and technology, ensuring clients are well-equipped to navigate regulatory challenges. 

[1] Press release: Operational Changes to the Foreign Exchange Market

[2] Cap F34, Laws of the Federation of Nigeria, 2004

[3] BSD/DIR/GEN/LAB/08/013 issued on the 17^th of April 2015.

[4] CBN Act 2007

[5] The exchange rate represents the value of one currency in relation to another currency, indicating the amount of one currency needed to acquire a unit of another.

[6] If Nigeria imports more goods and services than it exports, there is higher demand for foreign currencies to pay for those imports, leading to a potential devaluation of the naira against those currencies.

[7] Nigeria heavily relies on oil exports, and when global oil prices drop, it can reduce Nigeria’s foreign exchange earnings, leading to a devaluation of the naira.

[8] If foreign investors lose confidence in Nigeria’s economy and decide to withdraw their investments, they will convert their naira holdings back into their home currencies, exerting downward pressure on the naira’s value.

[9] Persistent high inflation in Nigeria can erode the purchasing power of the naira and make it less attractive to foreign investors, potentially leading to devaluation.

[10]Technext24 16/08/2023, “CBN Cancels I & E Window” https://technext24.com/2023/08/15/cbn-cancels-ie-window/, Accessed on the 16/08/2023.

[11]A managed Float is a combination between a free or total float and a fixed system. In essence, while market forces still determine exchange rate, the CBN will often step-in in certain instances.

[12] Sean Ross, Investopedia, 16/09/2022, “Default Risk vs. Credit Spread Risk” https://www.investopedia.com/ask/answers/022615/what-types-financial-situations-would-credit-spread-risk-be-applied-instead-default-risk.asp    accessed on 13/08/2023

[13]Elvis Picardo 09/09/2022, “Bid-Ask Spread in the Foreign Currency Market “https://technext24.com/2023/08/15/cbn-cancels-ie-window/ accessed on 16/07/2023

[14] Press release: Operating guidelines for RT200 non-oil export precedes Repatriation Rebate Scheme TED/FEM/FPC/GEN/01/002.

[15]Chris B. Murphy, Investopedia 24/04/2023, “Over-The-Counter (OTC) Trading and Security Types Defined, ”https://www.investopedia.com/terms/o/otc.asp, accessed on the 11/08/2023.

[16] Jason Fernando, investopedia, 31/03/2023, “Futures in Stock Market: Definition, Example and How to Trade”, https://www.investopedia.com/terms/f/futures.asp.accessed on the 11/08/2023

[17] David Bradfield, Daily Fx,13/02/2019, “Long vs. Short Positions in Forex trading”, https://www.dailyfx.com/education/beginner/long-vs-short-positions-in-forex-trading.html accessed on the 11/08/2023.

[18]The Investopedia Team, 24/04/2023, “Hedge Definition: what it is and how it works in investing”, https://www.investopedia.com/terms/h/hedge.aspaccessed on the 11/08/2023.