Nepal Rastra Bank (NRB) recently published a report exploring the possibility of a foreign exchange derivative market in Nepal. The study aimed to analyze how derivative instruments are currently being used in Nepal, review the existing legal and regulatory aspects of foreign exchange derivatives, and assess the prospects of a foreign exchange derivative market in the country. Derivatives can be described as contracts or financial instruments whose prices derived from underlying assets ranging from commodities, securities, currency, indexes, events, etc., which are typically used for hedging purposes to mitigate risks arising from price fluctuations of the assets. Financial instruments such as futures, forwards, options and swaps are the most commonly used derivative products, which involves parties entering into a contract to buy/ sell assets at certain prices on a future date or the rights to buy/sell the assets on a future date. Moreover, such derivative contracts are also traded on exchanges and on Over the Counter (OTC) markets. Foreign exchange derivatives for that matter, are derivatives used to hedge against the risk of exchange rate volatility.
Although the concept of foreign exchange derivatives or any type of derivative is not new, Nepal lacks a market or exchange where such derivatives can be traded freely for the purpose of hedging or earning short term gains. The derivatives market in Nepal is currently in a nascent stage, largely controlled by commercial banks with mostly forwards and swaps traded in the OTC market. The Ministry of Finance in 2019 came out with guidelines related to hedging, which gave way to the use of foreign exchange swaps to facilitate risk mitigation for foreign loans taken by banks and investors for large infrastructure development projects like hydropower projects, railways, transmission lines, as such. Currently, non-financial firms involved in manufacturing, exports and imports are permitted to hedge foreign exchange risks through Commercial Banks and national level Development Banks. The Foreign Exchange Management Department of NRB, in 2020, issued a unified circular giving ‘A class’ Commercial Banks and ‘B class’ national level Development Bank’s permission to trade foreign exchange derivatives like futures, forwards, options and swaps.
Current Scenario of Nepal’s Foreign Exchange Derivative Market
As per the provisions in the central bank’s guidelines, the A and B class banks are free to carry out foreign exchange derivative transactions with foreign banks if the forward exchange rates are pre-specified. The banks are also allowed to transact need-based forward contracts with their customers while covering their own risks. Similarly, the banks have also been given permission to trade in proprietary forward contracts in convertible currencies, which gives them the opportunity to make profits from trading in the market. Nevertheless, in order to ensure that the banks refrain from speculative trading, they are not allowed to keep open positions. Such transactions are also only allowed for contracts less than three months. Furthermore, the banks are supposed to keep their outstanding positions including buy and sell positions under 30% of their core capital.
The foreign exchange derivative market study by the NRB also presented the volume of foreign exchange derivatives transactions carried out by commercial banks in Nepal, which summed up to NPR 228.94 billion as of mid-July 2020. The trade volume stood at NPR 143.12 billion in 2018.
The study found that Nepal’s derivative market was mostly limited to Forward contract, and Non-Deliverable Forex Forwards (NDF), a type of derivative contract which only involves exchange of the difference between the contract amount and the prevailing spot rate, was the most popular financial instrument used by commercial banks. NDF trades in 2020 amounted to NPR 138.21 billion, over half of the entire derivative transaction volume.
Challenges and bottlenecks
Despite the increasing popularity of derivatives, the study highlighted that constraints regarding the flexibility of derivative contracts, the lack of exit policies, short term maturity requirement and a relatively high costs were present in the market. Likewise, the available products are mostly used by importers, and the demand for export-based forex hedging in Nepal is quite low. The lack of required legal provisions, regulations and supervision resources, together with absence of the necessary infrastructure and skilled human resources required for running an exchange market remains a challenge. Similarly, poor knowledge of the derivative market among Nepali investors/ stakeholders have also restricted the development of a proper foreign exchange derivative market in the country. The complex nature of trading and settlement of derivative products also complicates the trading of derivatives as it requires a separate exchange and separate clearing agency.
The regulators and market facilitators of Nepal’s capital markets such as the securities board of Nepal (SEBON), Nepal Stock Exchange (NEPSE) and the CDS and Clearing Ltd., when asked about the possibility of introducing derivative markets in the country, ranked Index and Stock Derivatives market the most feasible to establish in the current context followed by Interest Rate Derivatives market. Subsequently, the Foreign Exchange Derivatives market and the Commodities Derivatives market were ranked third and fourth in terms of feasibility of establishment at present.
The way forward
In order for the foreign exchange derivative exchange market to flourish in Nepal, an organized exchange market with standardized derivative instruments is indispensable. This would lower the cost of transactions, ease the availability of hedging instruments and increase flexibility of the transactions. In order to make long term hedging accessible to facilitate risk mitigation for FDIs as well as domestic non-financial firms, the introduction and promotion of long-term forwards, options and swaps would be required. As per the market regulators and facilitators, an organized foreign exchange derivatives exchange market in Nepal could only be feasible after three to five years due to the lack of the required level of knowledge, infrastructure and resources at the moment. Therefore, NRB, SEBON and other concerned authorities need to work towards increasing awareness and education to promote the use of derivatives among investors and other stakeholders. Likewise, the development of highly skilled human resources and subject matter experts is also required, which may be achieved through academic courses and certification programs. Establishment of a secondary debt market to provide a general overview of long-run market interest rates would also be required. Furthermore, acquiring the necessary physical and digital infrastructure for the smooth facilitation of derivative market transactions would be essential.
Sugam Nanda Bajracharya is an MBA graduate from Stamford International University. He has worked in the financial accounting field for a couple of years and has keen interest in corporate finance, financial planning, and investment management. Currently, he is working as a Beed fellow at Beed management.