Why Henry Rotich has banned Binary options in Kenya

Binary option
Photo: Courtesy

Rotich Henry, Treasury Cabinet Secretary, has made capital markets Regulations to regulate online foreign Forex traders in Kenya. In the Regulations, Rotich has banned binary options.

Many have been left wondering. What are binary options? Why should they be banned? We shall explain.

An option is a contract, that gives a buyer a right, but not an obligation, to buy (call option) or sell (put option) a financial asset (such as shares) at an agreed date (exercise) or other date (strike).

It may sound simple. For this is just an ordinary option. But Binary options, especially in currency exchange trading, are different.

Binary means two. Thus, in binary option, there only two possibilities. Of Yes or no.

How it works, is this way. You place a bet, by answering either yes or no, that during a certain time, a certain currency will go up, from a specified fixed price.

If you answered it the price will go up, and it goes down, you lose everything. This is unlike the normal option where a trader loses only the value of underlying assets.

Warren Buffet, the sage of Omaha, hates derivatives, options included. He says they are financial weapons of mass destruction. We do not disagree. Whereas equities are the sedatives of the market, derivatives are the aphrodisiacs. They hype trading.

But Warren maybe right. Indeed, binary options are lethal. To the market, they present a zero sum game. A Pareto efficiency, where for one to gain, another must lose. This is lousy.

But they make markets liquid. They promote activity by raising adrenaline. More so, during these called turbo trading, where trading is finalized in just a minute.

People from Jerusalem love binary options nevertheless. They have so many binary options dealers over there. But the frauds and scam dealers have equally nourished, spreading their crooked ways from Jerusalem to elsewhere, then everywhere.

Apart from giving market a hype, binary options serve no economic purpose. Rotich was right, to ban them.

New accounting standards could affect bank lending

By Gatuyu Justice

loans
Photo: Courtesy

This piece was first published in the Business Daily on Wednesday, September 20, 2017. It’s available here

One of Kenya’s biggest lenders has recently announced it was weighing the prospect of cutting back on disbursement of personal loans guaranteed by salaries.

This impending change in lending strategy is apparently being driven by expected coming into force of International Financial Reporting Standards (IFRS) 9, a new accounting guideline for financial instruments in January 2018.

IFRS 9 is expected to significantly alter the accounting treatment of financial instruments — these being contracts that give rise to a financial asset of one entity and equity instrument of another entity and includes cash and derivative instruments.It increases levels of required disclosures and has a bearing on firms in financial markets, legal approach to corporate transactions as well as taxation.

Mckinsey & Company, a strategy consulting firm, has predicted that the standard will specifically trigger a silent revolution in the banking industry and banks’ models.

Indeed, the revolution in banking has started as seen from the considerations of the Kenyan bank.

As a background, the accounting treatment for financial instruments such as collateralised debts, derivatives, has been blamed for triggering the financial crisis of 2007/08. The instruments were recognised in financial statements through their fair value, ordinarily determined in accordance with the intention of the company.

Such intention would be holding the instruments to maturity, for sale, recognising them through profit and loss, or having them as loans and receivables.

In the event the instruments are held for sale, the practice was that a company would always value them at market value. Where a firm intends to hold them to maturity, they would carry the instruments at cost, adjusting for impairment.

This accounting practice is messy. It results into a company having different values for one instrument depending on the intention.

Thus, companies kept on marking the instruments to market, sometimes on wishful valuations. Where panic hits the market as happened in 2007, firms rush to dispose of the instruments marked to market in rapid fire-sale, resulting to decline in prices that trigger collapse of the markets.

For these reasons, the International Accounting Standards Board decided to change the practice of financial instruments

The board introduced IFRS 9, which generally introduces three issues. First, is the classification and measurement of financial instruments. Second, hedge accounting and third, impairment of financial instruments.

On classification, the standard requires financial liabilities to be categories either at “fair value” or at “amortised cost.” The latter is where amortisation loss has been factored into the value of the instrument.

However, a rider is, a financial instrument will only be categorised at amortised cost where the business model of an entity is to hold that instrument until its maturity for the purpose of collecting contractual cash flows, which should constitute “solely payment of principal and interest.”

Such a treatment will impact more on classifying instruments such as exchange traded derivatives that have historically been used for trade speculation.

On hedge accounting, the standard has streamlined how hedge instruments are accounted for. This is geared to reduce volatility caused by marking-to-market of instruments such as derivatives, which result to large to price fluctuations.

The standard aims at aligning entities’ hedging practice with their risk management activities. It further improves hedge effectiveness on account of enhanced disclosures.

Entities such as Kenya Airways , which recently suffered the wrath of hedging instruments on oil forward contracts, will take note of this development.

On impairment, the standard has changed the practice where firms account for loss on credit exposures only when such loss has been incurred.

Firms will now adopt “expected loss model” which involves approximating expected credit loss for the whole life of the exposure of the instrument.

The requirement of approximating “expected loss” on credit exposures is one proving to be a hard pill to swallow for banks. For instance, on loans, banks must approximate anticipated losses from their lending.

With such a requirement, Kenyan banks will generally have the following options:

One, for loans not backed by sound collateral, banks could lend at high interest rates to limit credit default exposures. Due to interest rates caps, this may not be tenable. In such case, banks may reduce lending periods for high-risk borrowers to limit probability of default.

Second, banks may increase the provisioning or increase the insurance cover for approximated defaults on unsecured loans. This will certainly increase expenses and reduce recognised profits. StanChart  seems to have taken this option.

Third, banks would abandon extending personal loans or on collaterals that cannot be foreclosed on default. Equity Bank  seems to moving towards this strategy.

Further, IFRS 9’s introduction of a universal way of classifying financial instruments should help in combating international tax avoidance by multinationals.

This will help to reduce hybrid mismatches, which arise where firms classify financial instrument differently, either as a debt in one jurisdiction and as equity in another.

This exacerbates the problem of base erosion and profit shifting, especially in countries where instruments are classified as debt, which is tax deductible.

Banks and other firms operating in financial markets will need to review their operating framework and rethink strategies in line with this new accounting standard.

Ingenuity in Structuring Islamic Banking Products

By gatuyu t.j

Teach them, the Sunnah. Read them, the Quran. And they, will be commercially inspired.

In the year 1998, the Islamic board of the Dow Jones Index issued a fatwa. It decreed certain “permissible impurities” in issuance of equity Islamic instruments and set out methods of cleansing them. With that, modern Islamic financial markets breathed.

Islamic finance, differs from ordinary finance, by being insulated from the rough hedges of capitalism. It must be shari’ah principles. The shari’ah principles ban elements such as interest (riba), speculation (gimar), gambling (mysir) and uncertainly (gharar) in Islamic financing.

Islam

In any structuring of Islamic finance product, these condemned elements should not be present. But in both banking and long term financing, the industry has adopted a practices that navigates through, and emerges clean and compliant.

What elsewhere is secured lending, in an Islamic banking it will be “diminishing musharakah”.

You want a loan from the bank, secured by your land. The arrangement shouldn’t have interest. Let’s structure.

You will sell the land to the bank at the spot price. The bank will immediately sell it back to you, at a higher price, on deferred payment terms. Then secure land by registering a charge. You have your loan. The bank has profit. And Allah is happy, there is no riba.

What if I have no collateral such as land. I want a loan on personal guarantee. Can I be helped? Yes. Let’s structure.

We will still have diminishing musharakah. But this is bay al’ inah, meaning the customer has nothing. Here it is the bank which will take one of their asset and sell it to the customer at a spot price payable on deferred payment terms.

Then the customer, now a owner, will immediately sell the asset back to the bank, at a price lower that spot price, and the bank will pay. Customer now has money, secured by a pledge or personal guarantee.He will repay up the spot price.

Islamic banking is spreading, for it is more ethical than the ordinary banking, hinged on exploitative tendencies.

In international Islamic capital markets, the issuance of Sukuk al ijara has become popular. Kenya recently amended the tax statutes to ensure any possible flotation by the country of Sukuk products will be offered tax neutrality.

Sukuk, due to the nature of structuring, in view that it is guaranteed by real assets, cannot trigger sovereign debt crisis, like other international debt instruments such as Eurobond.

Neutralizing the Effects of Hybrid Mismatches in Cross Boarder Taxation

 

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Alibaba Group Corporate Structure, which exploits hybrid mismatches 

By gatuyu Justice

Multinationals look at tax treatment of an entity or instrument under the laws of various tax jurisdictions and use the one that would lead to double non-taxation or long-term deferral. 

Introduction

Sovereign states do set their municipal tax systems as they deem fit. They determine entities or instruments which are subject to income taxation, which are exempt and the manner of taxation.

In this sovereignty of determination, arises a problem. It leads to differing arrangements between countries in regard to characterization of instruments or entities under jurisdictional laws. Varying characterization results to a mismatch in tax outcomes.

One of the instrument which is notorious for receiving mixed characterization is the preferred share. Here it is an equity instrument. There it is a debt instrument. It matters, for where is a debt instrument, interest on debt is, for tax purposes, an allowable expense, subject to thin capitalization rules.

This, in international tax law, will be called Hybrid mismatches. Countries are just holding different views on the qualification of an entity or instrument for taxation. It has impact on cross boarder trade. It has become a facilitator of international tax evasion schemes.

Multinationals exploit hybrid mismatches. They look at tax treatment of an entity or instrument under the laws of various tax jurisdictions and use the one that would lead to double non-taxation or long-term deferral.

These arrangements have in recent years become widespread, resulting in substantial erosion of the taxable bases of the countries concerned. The result has been impacting negatively on competition, efficiency, transparency and fairness in international trade.

Illustration

There is a companies X. It has two subsidiaries; intermediary Subsidiary 1 and a local subsidiary 2 in countries A and B respectively. Let’s say intermediary Sub 1 provides funds to Local Sub 2. Country A may qualify such funds as a capital investment and any return on that investment is likely to be non-taxable there. However, country B might qualify the investment as a loan under its domestic tax rules resulting to any return paid on the investment to be considered as interest. The interest payments would consequently reduce the taxable base of Local Sub 2. These arrangements on different qualification on what qualifies as ‘investment’ or as a ‘loan’ brings is a case of hybrid mismatch. It creates tax deductible payment in country A. It avoids a corresponding inclusion in country B.

We have seen from our illustration. One of the key factors in determining the issue of mismatches is the qualification rules. Given the complex nature of qualification rules, many countries offer companies the possibility to get upfront certainty about a country’s qualification of an international element for corporate income tax purposes.

This certainty could be obtained from the local tax authorities, such as our Kenya Revenue Authority, either through a tax ruling, tax agreement or comfort letter setting out the tax consequences in the country that prescribes the rule.Our Tax Procedures Act 2015 allow this.

Hybrid Mismatch structures

Countries are not obligated to adopt the outcome of another country’s qualification rule. They are free to determine their own set of qualification standards. The different qualification rules between countries may result in “qualification mismatches” which lead to either non-or double taxation of income.

Such a situation is not in line with an ideal corporate tax system from a tax planning perspective. In tax planning, several strategies have developed which leverage on hybrid mismatches that result in non-taxation. As we have seen in the illustration, financing arrangement was used to reduce the taxable base in Country B.

It is for these reasons whey the OECD,a club of rich countries, in their 2015 Base Erosion and Profit Shifting (BEPS) Project report classified ending the problem of hybrid mismatches as an action plan number 2. The report identified the following arrangements as typical hybrid mismatches used in international tax planning structures. These include:

a) Hybrid entities: these are entities that are treated as transparent (non-taxable partnerships) for tax purposes in one country and as non-transparent (companies)in another country;

b) Hybrid instruments: these are instruments which are treated differently for tax purposes in the countries involved, most often as debt in one country and as equity in another country. We gave preference shares as an example;

c) Hybrid transfers: these are arrangements that are treated as transfer of ownership of an asset for one country’s tax purposes but not for tax purposes of another country, which generally sees it as a collateralized loan; and

d) Dual residence entities: this is where entities are resident in two different countries for tax purposes. Dual residence is typically based on the fact that some countries tax system are based on incorporation and some other countries tax based on place of establishment.

Neutralizing the mismatches

The effect of hybrid mismatch arrangements is they it leads into double deduction schemes, where a deduction related to the same contractual obligation is claimed for income tax purposes in two different countries.

Such a situation may arise where the hybrid mismatch arrangement is a result of dual residence companies, which are considered subject to tax in two different countries. If a dual residence entity is in a loss situation and benefits from a tax consolidation or group relief system is in two countries, the loss can be offset against the income in both countries.

Secondly, the arrangements may lead to ‘deduction and no inclusion schemes’. These arise in circumstances where there is a deduction in one country, typically a deduction for interest expenses, but no corresponding inclusion in the taxable income in another country.

The Starbucks has used this structure by having several types of partnerships in various countries which are transparent for corporate income tax purposes.

Neutralizing effects of hybrid mismatch arrangements, in particular on non-taxation, as we have earlier explained, is a key action point under the OECD BEPS projects. Under Action point 2, Neutralizing the Effect of Hybrid Mismatch Arrangements detail various recommendations to address hybrid mismatch arrangements. Part I of the recommendations is on domestic law rules to address hybrid mismatch arrangements and Part II contains recommended changes to the OECD Model Tax Convention.

The recommendations in Part I include “specific recommendations” and “hybrid mismatch rules.” The specific recommendations are modifications to provisions of domestic law to avoid hybrid mismatches and achieving alignment between domestic law provisions and their intended tax policy outcomes.

Hybrid mismatch rules aim at neutralizing one of the following three mismatches in tax outcomes:

  • Payments that give rise to a deduction with no taxable inclusion arising from a hybrid financial instrument (including a hybrid transfer), a disregarded payment made by a hybrid entity or a payment made to a reverse hybrid;
  • Payments that give rise to a double deduction arising from a deductible payment made by a hybrid entity or a dual resident; and
  • Payments that give rise to an indirect deduction with no inclusion arising from an imported mismatch.

The hybrid mismatch rules are divided into a primary response and a secondary or defensive rule. The defensive rule only applies where there is no hybrid mismatch rule in the counter-party jurisdiction or where the rule is not applied to the particular entity or arrangement. Each of the hybrid mismatch rules has its own specified scope of application.

The United Kingdom has already proposed to introduce new ‘hybrid mismatch’ rules as from 2017 in response to Action 2 of the OECD BEPS project. The rules provide that: the UK to impose additional taxable income when a UK corporate taxpayer receives a payment that would otherwise give rise to a mismatch; or the UK to deny tax deductions, or limit their use, when a UK corporate taxpayer makes such a payment. This will impact on multinational groups and have them make less use of hybrid mismatch arrangements.

Conclusion

Once translated into domestic and treaty law, the OECD recommendations under Action 2 of the BEPS Project will neutralize hybrid mismatches by putting an end to multiple deductions for a single expense, deductions without corresponding taxation or the generation of multiple foreign tax credits for one amount of foreign tax paid.

By neutralizing the mismatch in tax outcomes, the rules will prevent these arrangements from being used as a tool for base erosion and profit shifting without adversely impacting on cross-border trade and investment.

Temporary Apocalypse of the Nairobi Securities Exchange

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Trading floor at the Nairobi Securities Exchange. Photo, Courtesy

By Gatuyu J.

On Friday 1 September 2017, shortly after the Supreme Court pronounced its verdict on the petition on presidential election, trading at the Nairobi Securities Exchange (NSE) experienced a large intra-day trading price swing, causing a temporary trading halt.

The last time trading was halted due to the index going below the permissible levels was in late 2007, on the heat of post election violence. The event has left market enthusiast wondering. In this post, we shall explain the triggers of market apocalypse.

The Black Monday and the Black Tuesday

The Tuesday of October 29, 1929 is a bad day. There at Dow Jones, there was panic trading. The rapid fire sale of stocks led to the largest one-day price drops in stock market history. The consequence was the great depression of 1930.

We now call it the Black Tuesday. Such an event would occur again in Monday October 19, 1987, when there was a worldwide market crushes. They have called it the the Black Monday.

Behavioral economics and efficient markets

There are contrasting views on why the markets would experience huge price swings. Even the Nobel Prize Committee grappled with the issue in the year 2013, when they awarded the prize to Eugene Fama and Professor Robert Shiller

Eugene Fama formulated the efficient Capital Market hypothesis. He argues that markets are perfect, factor in all information and cannot be manipulated. You cannot beat the market.

Robert Shiller disagrees, arguing that markets are marked by human behavior, more specifically by what he called “irrational exuberance” of traders. Shiller’s theory has led to the rise of discipline that is behavioral economics.

This journal respects Eugene Fama and his efficient markets hypothesis. But we agrees with Prof Shiller “irrational exuberance” theory.

Individuals just make decisions depending on the prospect of gain or loss, the prospect theory. Full stop. For people are in the market to increase value and maximize wealth.

Paper losses and paper gains

So that yesterday, the NSE experienced its own taste of irrational exuberance, leading to huge disposal of stocks by investors, triggered by electoral outcome uncertainty, leading to market hemorrhage.

Our press has reported investors lost over Ksh 50 Billion. Cockamamie, there were no losses. These were just PAPER losses. One would experience actual loses only after a realization event, that is disposal of shares. Dips and ups are usual in market trade gyration.

The market signalling

But there is aspect of contagion in the markets. When one counter is in demand, there is a rally to acquire stocks in that counter. Equally, when there is a rally to sell, everybody just want to sell that counter.

There is element of sheepfold in market trading. Its an issue of market signalling. If this is not checked, it would result to market crash especially in rapid fire panic selling.

To prevent such scenario, the following mechanisms are applied in regulating the markets. We take those for Kenya.

One, the NSE trading rules require that when the NSE 20 share index plummets by over 5%, it be taken as an indicator of negative market signalling and an adverse trading contagion. In that case, trading is usually suspended.

Note: The NSE 20 Share index are 20 selected stocks of supposedly stable companies to measure the performance of the entire market.

Two, the price of any stock can only move up or down in a single trading by only ten percent. These are called the price ceilings and the price floors.

For example, Company Y trades at Ksh 10. This means the maximum it can move in a single day is ksh 11 and the lowest is Ksh 9.

Fortunately, the NSE experienced a correction, and it is expected normal trading will be experienced on Monday.

When is the best time to invest? Anytime. But the secret to value gain from the market, is not necessarily speculative timing of buying, but appropriate portfolio diversification. The market timers are just gamblers. The market has a way of proving them wrong. Where to invest? In an issuer with solid business model and right “fundamentals”