Price Discovery
CBN versus Black Market
Price discovery in the black market and the validity of its pricing as an anchor for the exchange rate.
Is the dollar exchange rate at the black market valid?
This is one question I raise to stir up debates within my circle. Especially when we had a representative of the government unequivocally say at a conference that there are plans in place to eliminate the black market.
Being my usual self – a typical contrarian, I once posited this question during a strategy session and, true to form, I was unanimously shutdown.
I was shut down because everyone belonged to the school of thought that price is always equivalent to value. In other words, the value of the naira is no more and no less, than what someone is willing to pay for it. That process of determining the value is known as Price Discovery.
I have taken the liberty to scout the internet to share two of its definitions:
The price discovery process is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers.
Price discovery refers to the act of determining the proper price of a security, commodity, or good or service by studying market supply and demand and other factors associated with transactions such as size, location and cost of transactions.
To answer the question — is the dollar exchange rate at the black market valid?— this would require determining the efficiency of the black market’s price discovery process. Let's review the main attributes that make price discovery efficient in an active formal market and juxtaposing them with the black market.
Price discovery mechanism for the black market
The black market preferred medium of exchange is cash, so it won’t be an overreach to say that the BDC segment i.e. cash market of the FX market is cardinal to the black market. It is then possible to have a price discovery mechanism if we can identify attributes possessed by the BDC market that are similar to the formal market, such as number of buyers & sellers; the size of market; cost & transparency of dealings; market information, liquidity; regulations, to make a position.
To bring some objectivity, here are important attributes that active formal markets possess as seen in The Economist’s Guide to Financial Markets, i believe should work for general opinion:
Liquidity: the ease with trading can be conducted. In an illiquid market an investor may have difficulty finding another party ready to make the desired trade, and the difference, or “spread”, between the price at which a security can be bought and the price for which it can be sold, may be high. Trading is easier and spreads are narrower in more liquid markets. Because liquidity benefits almost everyone, trading usually concentrates in markets that are already busy.
Transparency: the availability of prompt and complete information about trades and prices. Generally, the less transparent the market, the less willing people are to trade there.
Reliability: particularly when it comes to ensuring that trades are completed quickly according to the terms agreed.
Legal procedures: adequate to settle disputes and enforce contracts.
Suitable investor protection and regulation: Excessive regulation can stifle a market. However, trading will also be deterred if investors lack confidence in the available information about the securities they may wish to trade, the procedures for trading, the ability of trading partners and intermediaries to meet their commitments, and the treatment they will receive as owners of a security or commodity once a trade has been completed.
Low transaction costs: Many financial-market transactions are not tied to a specific geographic location, and the participants will strive to complete them in places where trading costs, regulatory costs and taxes are reasonable.
Let’s start with the first factor — liquidity. The ability to execute trades in the black market is apparent. There are over 3,000 sell-side dealers and about 3 million other active players i.e. individuals, importers, exporters, speculators, and investors; working with the assumption that at least 10% of the banked population need access to foreign exchange (according to EFInA’s findings, that the banked population stands at 36.9m Nigerians in 2016).
And since price discovery is mainly driven by liquidity (although we can argue on the significance of its transaction size), it is only logical for the market with the most active operation right now, and ease of facilitating transactions, to anchor currency direction.
Next up, transparency. The use of social media platforms to broadcast daily rates; the proliferation of price aggregators, in the heat of the currency crisis, to coordinated quotes from numerous dealers (especially mallams) has brought about overall ease of communication between buyers and sellers. The advent of technology has brought about quasi-uniformity to the pricing of the black market which has significantly increased market efficiency.
As for reliability and legal procedures. The BDC market is semi-regulated (i will come back to this when discussing regulations) which makes these attributes peculiar and dynamic to each player. As a result, the perception of reliability and legal procedures will be embedded into pricing among players and that contributes to why multiple quotes exist in the black market. Although, this is where the introductory use of technology has been triumphant in promoting transparency in the black market (as previously mentioned). I will be presumptive and say that there is an inadvertent move towards competitiveness among its players for that reason.
While on regulations, it is the lack thereof that makes the black market thrive. Although the BDCs are regulated, the sheer number of operators makes it hard for the regulatory bodies to completely oversee their activities (this being the reason i earlier stated the market is semi-regulated). And lastly, low transaction cost –the operations of the market are heavily reliant on agents/brokers and not tied to any physical location. That alone eliminates a significant cost to dealing in comparison to what exists in the official market. The FX licensing cost is paltry compared to banks which is evident in the increasing number of operators (currently over 2,000).
In summary, we see that the same important attributes in the formal markets sort of also drive the price discovery process in the black market. So it is understandable why there is a huge debate around its validity. For its pricing to be unquestioned and accepted as an anchor for the exchange rate would require, at the very least, further institutionalisation that will improve accountability such as the digitisation of sales to end-users for effective monitoring.
