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The strong case for an alternative FX market

The current structure of the foreign exchange market is inefficient and unfit for purpose given that sourcing foreign exchange (FX) for personal and business transactions is still challenging. Also, monitoring the end-uses as well as the supply and demand for FX is difficult for regulators. Equally, the room for arbitrage across FX markets remains ever present, indicating inefficiencies. Putting all together, it becomes clear that the current FX policies and markets will not have a positive impact on the economy. This reality should force the Central Bank of Nigeria (CBN) to change its approach to FX management and the entire market structure.

Before we look at the options available to the CBN, it is important to understand the current market structure. The FX market includes formal players such as the CBN with its Investors and Exporters’ ( I&E) FX Window, commercial banks, International Money Transfer Operators (IMTOs) and Bureau de Changes (BDCs). Participants in the formal market are licenced and supervised by the CBN, with the institution having a strong influence on their activities. Players in the formal segment conduct FX transactions with the CBN and they report data on their activities.

However, there is a huge unregulated and unsupervised parallel market which operates in the dark. The parallel market serves most Nigerians who cannot be bothered to conduct business with formal channels that are often inaccessible. It is therefore the richest source of data on how individuals buy and sell FX.

Businesses without access to the formal FX markets due to CBN restrictions, such as the items unqualified for official FX, also find reprieve in the parallel market. In times of FX supply challenges in the formal segments, the parallel market provides liquidity because it attracts the FX suppliers who are searching for the best exchange rate. The current parallel market rate of between N485/$1 and N495 per dollar is preferred by FX suppliers to the N410/$ available in the I&E window. In the case that CBN restrictions prevent institutions such as non-oil exporters from selling directly to the parallel market instead of the I&E window, there have been reports that buyers eventually pay the differential off market.

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While the parallel market serves an important role during periods of FX stability, its impact is more pronounced during an FX crisis, which is the case since the emergence of the COVID-19 pandemic. However, the extent of its activities cannot be fully known because players in the segment do not provide data to the CBN. Neither does the parallel market have an umbrella body that aggregates transaction data. This means that a lot of business is being done outside the CBN’s regulatory purview, thus limiting its ability to fully understand FX supply and demand patterns in the country. If the CBN does not understand the market well enough, its intervention would have limited impact. This is perhaps why the CBN has been a strong critic of the parallel market, discrediting the exchange rate in the segment and wrongly classifying it as a market which promotes illicit activities.

In the light of the aforementioned challenges, a reorganisation of the current market structure to include a regulated alternative FX market will be helpful in understanding the parallel market. The focus should be on providing formal channels which are distributed like the current agent network for banking services. A strong counter argument is that regulating it would hinder the current flexibility provided by the current structure. However, restrictions in the formal market should not be extended to the alternative market for it to work well. The purpose for the alternative market is to collect and track data which would help with FX policies and interventions. There is also the case that retail FX transactions are mostly in small amounts that would ordinarily not raise suspicions of money laundering and other illicit activities. So even if regulation means that a shadow market will eventually exist, as it does everywhere in the world, the majority of the retail market would be captured nonetheless.

This approach is common practice in peer economies and around the world. In peer countries of South Africa and Egypt as well as in advanced economies of the US and UK, the FX market is regulated lightly. There are different categories of operators and limits on the customers than can be served as well as services that can be offered. Regulation is focused mainly on preventing money laundering and terrorist financing. The determination of exchange rates is also flexible, which means the Central Banks are not focused on maintaining a fixed peg. While the CBN is quick to point at illicit activities in the parallel market, there is a huge room for flexibility between ensuring convenient access to FX trades and preventing money laundering and terrorist financing. Ultimately, the existence of a parallel market rate which is preferred to the official rate is a symptom of the dysfunction in the Nigerian FX markets. If the market works as it should, the difference in rates would be negligible and one single rate will be quoted both for transactions locally and internationally.

There is a strong reason to believe this framework would work as intended, considering the recent steps the CBN has taken to increase confidence and deliver better value to remittance recipients. The previous system converted remittance receipts at the official rate, which was way below the parallel market rate and discouraged the use of official channels. With the recent CBN regulation allowing recipients to receive remittance in US dollars which can then be sold in the market that gives them the best rate, confidence has been restored without sacrificing flexibility.

To ensure that the FX market is fit for purpose, creating an alternative FX market, relaxing the current rigid rules around FX sourcing and allowing exchange rate flexibility for converting USD proceeds would be required. This way, policy interventions would have a more significant impact, arbitrage opportunities would be eradicated and investor confidence would be restored. All these would promote efficiencies needed to support the economy.

*Ogundele is a Lagos-based analyst.

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