Nepal Capital Market Master Plan Supplementary Report on Commodity Markets v2[1]

8/3/2019 Nepal Capital Market Master Plan Supplementary Report on Commodity Markets v2[1]

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Securities Board of Nepal

Five-Year Capital Market Development Master Plan

Supplementary Report on Commodity Markets

Introduction

1. The Government of Nepal is considering an amendment to the

Securities Act that would create a regulatory authority for the

commodity markets in Nepal. It is not yet determined whether or not

this regulatory authority would be the Securities Board of Nepal

(SEBON) or some other body. This supplementary report includes abrief assessment of the commodity markets in Nepal and makes

some proposals for the regulation of those markets.

Commodity Markets

2. The term commodity markets is a broad one that can be used to

describe a number of different kinds of market. In a sense, any

market for a commodity, such as agricultural products, would be

encompassed in such a term. Thus a local market for lentils or

potatoes is, in a real sense, a commodity market.

3. However, at a local farmers market, the quality and nature of the

different products will vary considerably. They can be bought and

sold in different quantities, with different quality attracting different

prices. Buyers and sellers can agree a price taking account of the

nature of the specific commodity in question which both buyer and

seller can see, touch and feel, and about which they can make a

judgement.

4. The nature of a formal commodity market is that the quality andquantity of the product is standardised so that any one unit of the

product within the market is the same as any other unit of the same

product. If the unit of the commodity was, for example, one hundred

kilograms of coffee, all units would be regarded as the same and the

price and quality of any one unit would be the same throughout the

market. When a buyer decided to buy one or more units of the

product, the buyer would be indifferent as to which producer had

produced the commodity in question. To achieve this standardisation,

it is necessary to define the quality and quantity of the unit in such a

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way that it can be tested by inspectors and graders in whom the

market has confidence.

5. It is also necessary to distinguish between commodity spot and

commodity futures markets. In the case of a spot market, a seller

would deposit the commodity in its standardised units and receive

payment for them. The buyer would buy the commodity and receive

delivery of the commodity in question.

6. In the case of a commodity futures market, the buyer and seller

would agree to a contract, whereby the buyer would agree to buy,

and the seller to sell, a standardised unit of the commodity for a price

fixed in the contract at a future date, also fixed in the contract. Such

contracts would themselves also be standardised, so that there would

be a series of contracts each of which related to the same unit of thecommodity to be bought and sold at the same time (for example, one

unit of a fixed amount and quality of coffee to be bought and sold at

the same specified date). Once agreed between buyer and seller, the

contracts could then be traded again repeatedly between different

market participants until such time as they become due for

settlement. Commodity futures markets are one form of commodity

derivatives markets (the price of the futures contract being derived

from that in the spot market). However other forms of derivative

market, such as options markets, or options on futures markets, arenot yet in existence in Nepal and are not discussed further here, save

to say that they provide different ways for market participants to

insure against risk.

7. It is then necessary to distinguish between commodity futures

markets that result in the physical delivery of the commodity in

question and those where there is cash settlement. In the case of

physical delivery, the buyer of a commodity futures contract who

holds the contract at the expiry date will receive the commodity in

question. The seller receives cash. In the case of cash settlement, the

contract includes a reference price and, on the date of settlement,

the reference price is compared with the price in the contract and

one of the parties makes a cash payment to the other, depending on

whether the contract price exceeds or is less than the reference

price.

8. Commodity markets, whether spot or futures, can provide

advantages to producers and consumers of commodities. The spot

market allows both buyers and sellers to trade on a large scale,without the need to check the quality and quantity of the product at

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each stage. Because the product is standardised, the price can also

be harmonised across a national market. Farmers can deliver the

product at the point most convenient to them and the buyer can

collect from the location convenient to them. The price is set as a

result of the national market without local variations. The overallprocess of price formation reflects the national (or in some cases,

global) supply and demand.

9. Commodity futures markets allow buyers and sellers to reduce their

risks. Thus, for example, a farmer may sell a commodities futures

contract that involves the delivery of the commodity at a fixed price

in the future. This gives the farmer certainty as to the price to be

received for the crop. The farmer will forego the prospect of

unexpected profits but will also avoid the risk of unexpected loses.

This process is known as hedging the risk.

10. This reduction in risk allows the farmer greater confidence in

investing in the seeds and equipment necessary to grow the

commodity. Similarly, the consumer who may have invested in

machinery to process the product can also, in effect, fix the price and

then invest with confidence, with the knowledge that the net outlays

(allowing for the profit or loss on the futures contract and the

changes in the spot commodity price) will be fixed. Commodity

futures markets also provide scope for those who believe prices mayrise or fall in the future to test their belief in the market through

speculation which provides the liquidity in the market that enables

the producers and consumers to reap the benefits of the commodity

markets as described above.

11. Commodity markets also create risks. In the spot market, there is a

risk that any one unit of the commodity, despite the controls

designed to achieve standardisation, may not in fact meet the

standard quality or quantity. The buyer may suffer. Those trading in

the commodity futures markets may not fully understand the risks

involved and may find that they have suffered losses they did not

expect. There are also risks that some of the parties to contracts may

fail to meet their obligations. As is the case with any market,

commodity markets (both spot and futures) can be subject to

conflicts of interest, manipulation or other forms of market abuse.

Commodity markets have established risk management techniques

to address these risks. Regulation is designed to ensure the risk

management is adequate and properly maintained.

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Commodity Markets in Nepal.

12. At the time of writing this supplementary report, there are four

established commodity markets in Nepal. Two are trading commodity

futures contracts that are cash settled by reference to prices that are

set on foreign markets. The commodities include agricultural

products, such as soya and soya oil, precious metals such as gold and

silver, other metals, and minerals, such as oil. A third exchange is a

spot exchange. It trades certificates that represent a standard

quantity of a commodity such as gold. The buyer may hold the

certificate for up to six months but may trade it at any time. The

price for buying and selling the certificate is based on the world

market for gold as set in global markets such as the London Gold

Market, or COMEX, which is operated by the Chicago Mercantile

Exchange in the USA. The fourth exchange is yet to start operation.

13. The size and depth of the markets is difficult to determine but the

exchanges estimate that the average daily trading volume is 50

million NPRs.

14. All of the Nepali commodity markets operate on the basis of cash

settlement and thus none of them provide for the physical delivery of

the commodity in question. All of them use reference prices based on

global markets, such as COMEX, as noted above, the London Metal

Exchange, or the world oil markets in London and the US. None of

them involve Nepali commodities.

15. However, all of the exchanges state that, in the future, they would

wish to trade commodity spot or futures contracts that are based on

Nepali commodities. One exchange, the Nepal Spot Exchange, is

seeking to develop spot markets in Nepali commodities such as

wheat, lentils and potatoes. The other exchanges see the scope for

developing derivatives markets based on the prices of the spot

exchange. Such markets would be of more direct benefit to theNepali economy by providing a means by which producers of

commodities could insure against (or hedge) their risks.

16. Each of the markets operates broadly on the following basis:

a. The exchanges provide facilities for the buyers and sellers of

the contracts to see the best bid and offer price currently in

the market. Each of the markets also has one or more liquidity

providers in the form of one or more market makers dealers

that deal in the commodities and provide bid and offer prices

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to customers. Most of the trading is done through the market

makers.

b. Buyers and sellers access the market through brokers who are

licensed by the exchange and may trade on the exchanges as

agents for the clients. None of the brokers engage in

proprietary trading on their own account.

c. Trading is done by buying and selling contracts designed by

the exchange. Each of the exchanges design their own

contracts and the contracts for any one exchange are

different from those in other exchanges. The contracts give

details of the commodity to be traded and the date of

settlement, together with other features but not the reference

price of the contract (a point discussed further below).

d. Each exchange has one or more clearing members. A

clearing member is responsible for making sure that a trade is

settled (i.e. that payments are made on the expiry of the

contract). The clearing member (or members) establish

between themselves the overall net obligations of each of the

clients of the brokers and make payments between

themselves through a settlement bank to settle the accounts.

e. The risks of default by any one party are reduced by thefollowing mechanism:

i. Once a trade is made, the client, through the broker,

must make a deposit (known as initial margin) of

between 1 - 3 percent of the nominal value of the

commodity.

ii. Every day, the value of the contract is assessed on the

basis of movements in the underlying reference price

(known as marking to market). If the value of the

contract has declined during the day, the client is

required to pay, via the broker to the clearing member,

an amount equivalent to the reduction in the value of

the contract during the day. The reverse is also true, if

the market price of the contract rises. These payments

are known as variation margin.

iii. If a client fails to make a variation margin payment, the

clearing member will (subject to a short delay) close thecontract by selling it on the exchange. If the value of the

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contract has increased, the clearing member makes a

payment to the client via the broker, of the amount of

the gain.

iv. This mechanism ensures that, on settlement day, the

only outstanding payments that are due from or to the

clients are the result of the movement of prices on the

last day (all previous price movements having resulted

in daily variation margin payments as noted above). The

clearing members ability to make these final payments,

even in the event of a default by one or more of the

parties, rests on the clearing members own capital and

the initial margin collected as described in (i) above. If

all payments are properly made, the initial margin is

returned.

f. The reference price is based on the prices on world markets

that tend to be denominated in US dollars, with a Nepali

equivalent being calculated by an exchange rate that is fixed

in the contract. While this may appear to protect the investor

from exchange rate risk, in fact, the exchange rate risk

remains insofar as the market exchange rate, on settlement

date, may differ from that in the contract.

17. These arrangements, albeit briefly described, have some of the

characteristics of international best practice for derivative markets.

Marking contracts to market on a daily basis so that clients whose

contracts have reduced in value are required to make payments to

the clearing members is a standard practice on international markets.

Risk management

18. However, there are a number of ways in which the commodity

markets in Nepal depart from best practice, particularly in the riskmanagement practices.

19. The contracts designed by the exchanges do not specify precisely

how the reference price will be determined on the settlement day of

the contract. It is noted above that all futures contracts in Nepal

have, as their reference price, the price traded on a particular foreign

exchange. In principle, it should be straightforward to specify that the

base reference market price of the commodity in question is that

published at the close of business on settlement day on the reference

exchange. Thus for example, the reference price for a gold contract

could be the closing price of gold on COMEX on the settlement date

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of the contract. However, the contracts used by Nepali exchanges do

not specify the basis of the reference price and the brokers point out

that the clients do not know exactly how the price is determined. In

practice, the price is determined in at least one exchange by the

clearing members. It is quite contrary to best practice for thesettlement price to be determined by a clearing member who is a

party to the contract, since this creates a clear conflict of interest.

The way the price is set should be specified in the contract and

should be finally determined by an independent party.

20. The Nepali commodity markets do not have central counterparties

(CCPs). Commodity futures markets elsewhere typically use a CCP

which is the counterparty to every buyer and the counterparty to

every seller. Because it would have substantial capital and because it

would use risk management techniques that have been welldeveloped in world futures markets, the risk of failure by a CCP is

very low. The clients therefore do not need to fear that, when it

becomes time for the settlement of a contract, the counterparty

might be unable to meet the obligations. The elimination of

counterparty risk in this way is one of the considerable advantages of

commodity futures markets. However, with no central counterparty,

this advantage is missing from the Nepali commodity markets.

21. Instead, in Nepal, the clearing members are the counterparties to thetrades by clients. The brokers maintain that there are, in some cases,

considerable doubts about who the counterparty may be in a

particular case.

22. Moreover, the clearing members have only limited capital (50 million

NPRs, or less than $1 million). The exchanges point out that this is

sufficient for the level of markets as they now exist and that there

are limits on the ability of the clearing members to take on trades

beyond the amount that can be properly absorbed by their capital.

However, since the clearing members are essential to the functioning

of the market (being, in effect, the counterparty to all trades) it is

difficult to see how the markets could continue if the clearing

members were not permitted to accept further trades. Where an

exchange has only a single clearing member, any decision to enforce

a rule preventing that clearing member from taking on more trades

because of inadequate capital would, in effect, mean closing down

the exchange. Even where there is more than one clearing member,

the removal of one would severely constrain the capacity of the

exchange. In practice, therefore, there is a risk that exchanges wouldbe reluctant to enforce their rules that limit the trading capacity of

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clearing members by reference to their capital. This reluctance would

increase the risk to the client that a clearing member may fail.

23. None of the Nepali commodity markets uses a clearing house. A

clearing house is responsible for establishing the net obligations paid

by and due to each participant. The clearing house may also be the

CCP but would not be an active participant in the market as market

maker. This separation of functions removes some of the potential

conflicts of interest and provides greater confidence that the system

is robust in the event of a default. Without this facility in Nepal, there

is a greater problem of conflicts of interest and of vulnerability to

default. In effect, the clearing house function in Nepal is performed

by the clearing members.

24. It should also be noted that the clearing members are market makersas well. In effect, therefore, the clearing members set the price of the

contract when it is bought and when it is traded. They also determine

the reference price at expiry. They are also the counterparties to the

contracts. There is clearly a very substantial conflict of interest in this

arrangement.

25. The transparency of the market is not sufficient. The client is only

aware of the best bid and offer price but does not know the depth of

the market (i.e. how much of the commodity is being offered at any

one price). The client does not know what other bids and offers are in

the exchange and therefore cannot know whether or not a bid or

offer might be of such weight as to result in a movement of the price.

The exchanges do not publish the open interest (the amount of

contracts outstanding) and so the customers cannot know the size or

depth of the market. To this lack of transparency should be added the

obscurity of the process by which the settlement price is determined

and the uncertainty as to the identity of the counterparty.

26. There is limited capacity for individuals to provide liquidity in themarket by becoming proprietary traders. Markets require liquidity in

order to provide efficient risk management for the end users and in

most markets, this is facilitated by encouraging intermediaries who

are proprietary traders.

27. The limited information in the contracts, particularly about the

reference price, leaves room for manipulation. Moreover, the

contracts are different in different exchanges, which results in

different prices for reasons that are not always understood. The

scope for arbitrage is limited and this reduces liquidity.

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28. There also appears to be some uncertainty about the precise nature

of the actions to be taken in the event of default. The exchanges all

say that they have facilities to monitor the market and to take action

in the event that a market participant may become a threat to the

market. However, none of the exchanges are clear as to the nature ofthe action to be taken if they were to conclude that a market

participant posed such a threat. There is also some uncertainty as to

the consequences of a client failing to make a daily variation margin

payment as a result of the process of marking to market described

above. Different participants have different views as to the

appropriate obligations and penalties.

29. There is no exemption from Nepali insolvency law in the case of the

default of a commodity broker and thus, if such a default took place,

the entire settlement system could be disrupted as an insolvencyadministrator would be obliged to cease making payments to meet

obligations arising from commodity contracts. Since the commodity

markets work on the basis of the net obligations between different

participants on settlement day, this absence of certainty in the event

of a failure would be extremely disruptive.

30. The amount of the first deposit paid by the client on making a trade

(initial margin) is not based on a calculation of price volatility. The

purpose of the process of marking to market and making variationmargin payments (described in paragraph above) is to limit the

outstanding obligations of any participant, at any one time, to the

effect of one days price movement. For this reason, best practice is

to determine the amount of initial margin by reference to the likely

maximum price movement in a single day, given previous

experience. In the case of the Nepali markets, initial margin is set at

between 1 3 percent and this would appear to be considerably less

than the maximum likely volatility in the world markets for the

commodities in question.

31. There is no settlement guarantee fund. In the event of a failure by a

market participant which was of a size that could not be met by the

margin payments already paid by the defaulting participant, the loss

would have to be borne by the clearing member (whose capital is, as

already noted, limited). Many commodity futures markets create a

settlement fund based on contributions from market participants that

would be used in such circumstances. The exchanges are seeking to

create such funds but they are not yet at a level sufficient to provide

comfort that defaults could be accommodated.

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Physical delivery

32. The commodity markets in Nepal are interested in developing the

facility to offer physical delivery in both spot and futures markets.

Physical delivery of commodities would enable Nepali producers and

consumers to use the commodity markets in a more direct way to

trade the commodities and to manage risk. It is a development to be

desired. However, it requires substantial infrastructure.

33. In order to ensure that a commodity is truly standardised, it is

necessary to establish a network of warehouses and inspectors who

would be responsible for accepting the commodity (whether wheat,

potatoes, lentils or any other commodity) and checking that the

quality and quantity met the established standards. For the market to

work, it is essential that the standards adopted by each warehouseand inspector should be the same. There is always a temptation for a

producer to attempt to persuade, bribe or intimidate an inspector or

warehouse to accept a delivery that did not meet the standards.

There must therefore be an oversight system that can be trusted

rigorously to enforce common standards and take firm action against

any person who departed from them. Given that the warehouses and

inspectors are, of necessity, located around the country, enforcement

is extremely difficult. The exchanges will look to the commodity

regulator to achieve this level of enforcement.

34. For this to be possible, it will be necessary to enact a Warehouse Act

that creates an obligation on warehouse keepers and inspectors to

maintain standards and gives the regulator the powers to carry out

inspections. There should be strong enforcement powers and

sufficient human and other resources to use the powers to ensure

that commodities are delivered according to the standards in the

contracts.

The Sustainability of Nepali Commodity Markets

35. As already noted, the commodity markets in Nepal currently operate

on the basis of a reference price derived from world markets. The

commodities in question are not Nepali commodities and there is

therefore little direct advantage to producers and consumers of

Nepali commodities. The markets at present meet a demand within

Nepal for speculation on world commodity markets. However, beyond

the fees and profits earned by the clearing members, exchanges and

brokers, there is no direct benefit to the Nepalese economy.

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36. If there is a demand within Nepal for facilities for speculation, it is

reasonable for Nepali entities to be formed to meet that demand.

However, it is also reasonable to assume that, if Nepali citizens were

permitted to trade directly on foreign commodity markets, they

would do so. By trading direct on COMEX or other world markets,Nepali citizens could benefit from the more advanced risk

management arrangements that provide greater protection against

the failure of market participants than is afforded by the existing

Nepali commodity markets. The effect of Nepali foreign exchange

controls, in this instance, is to oblige Nepali citizens, who wish to

speculate on world commodity prices, to do so on exchanges that

offer less protection than would be given by the world markets.

37. It has been argued that the existence of Nepali commodity markets

as an alternative to direct trading on foreign markets preventscapital flight. The term capital flight refers to the decision by

investors to invest in foreign countries rather than investing in the

productive capacity of Nepal. In fact, trading in the Nepali commodity

exchanges does not result in any direct investment in Nepal.

38. Although it is difficult to see much economic value being provided to

Nepal at present by the commodity markets (other than the fees and

profits of exchanges and intermediaries), this may change if the

commodity markets were to trade contracts based on Nepalicommodities. The commodity markets would then provide an

opportunity for producers and consumers of Nepali commodities to

insure against the risks arising from price volatility and this, in turn, is

likely to increase investment by both producers and consumers of

Nepali commodities. Until this development takes place (which would

require the extensive infrastructure described above), the

sustainability of Nepali markets will depend on the continued

retention of restrictions that prevent Nepali citizens from investing

abroad.

Should Nepali Commodity Markets be Regulated?

39. The Government has taken the decision to bring the commodity

markets into regulation. The normal justification for regulation is to

ensure fair markets, to protect investors and to guard against

systemic risk.

40. The commodity markets in Nepal are not big enough to create any

systemic issues for the Nepali economy at this time and this

justification therefore does not apply. However, there is a risk that

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clients of the Nepali commodity markets may suffer as a result of

conflicts of interest, defaults, poor service by brokers or other market

failings. Moreover, there is a further risk of market abuse. These

justifications for regulation therefore exist in Nepal.

41. However, Nepali citizens who wish to speculate about the price of

world commodities could have better protection if they were

permitted to trade directly on international markets which meet

international standards of investor protection and risk management.

The current position therefore is that:

a. Nepali citizens are subject to restrictions on their ability to

invest in foreign markets a restriction that imposes a cost to

the economy;

b. Those restrictions mean that Nepali citizens who wish to trade

on world commodity markets have to use Nepali exchanges

which provide less protection to the investor than is provided

by international markets;

c. The Government is then obliged to incur yet further cost to

protect investors from the consequences of using the Nepali

exchanges with their lower standards of risk management.

42. Regulation of commodity markets is likely to divert regulatoryresources that should be focussed on the more important Nepali

equity and bond markets. It is difficult to see how such regulatory

costs would be justified at present given that the commodity markets

currently provide little benefit to the Nepali economy and that the

costs are only necessary because of the restrictions that prevent

Nepali speculators from trading direct on foreign markets.

43. This position could change if the Nepali markets were to trade

contracts that provided hedging opportunities to Nepali commodity

producers and consumers. When considering the regulation of

commodity markets, the Government should distinguish between the

present position, where markets provide little direct benefit to Nepal

and only exist because of foreign exchange restrictions, and a future

time, when the commodity markets could offer contracts in Nepali

commodities and thereby provide an advantage to the Nepali

economy and to economic development. This distinction is discussed

further below.

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The Appropriate Regulatory Authority

44. In many respects, the risk management of commodity markets bears

a close relationship to the risk management of securities exchanges.

The exchanges must be run by operators who are fit and proper (who

have the skills, integrity and financial resources to operate an

exchange). The market rules must promote a fair market. There must

be sound and robust clearing and settlement. The intermediaries

should also be fit and proper and should be subject to corporate

governance and conduct of business requirements that ensure they

comply with the regulations and manage their relations with their

customers with due care and diligence. There would therefore be

some synergies to be gained by giving the task of regulating the

commodity exchanges to the Securities Board of Nepal (SEBON).

45. On the other hand, the regulatory task differs in some important

respects, particularly the regulation of warehouses and inspectors.

There is no equivalent, in a futures market, of an issuer of securities

and there must be regulatory focus on contract design, rather than

the disclosure of information by issuers. These factors would indicate

that there are some advantages in giving the regulatory task to a

separate body.

46. International practice varies. Because SEBON exists at present, there

are obvious reasons for giving SEBON responsibility for regulating

commodities markets rather than incurring the cost of establishing a

new agency. However, if SEBON is to be given the regulatory task, it

is essential that it should have sufficient staff and that the staff

should have the skills and experience required for dealing with these

kinds of markets.

47. The skills and experience must include a sound understanding of the

risk management of commodity markets. The regulator will have to

determine what risk management standards it expects from thecommodity markets, in terms of contract design, the use of central

counterparties, the separation of clearing houses from clearing

members, the calculation of margin payments, the establishment of

settlement guarantee funds, the management of conflicts of interest,

the capital requirements of participants, the obligations on

intermediaries and so on. Once the commodity markets begin to

trade contracts involving the physical delivery of Nepali commodities,

SEBON (or, if the Government prefers, another agency) must also

have the capacity to enforce a Warehouse Act. The agency wouldhave to have the powers and staff to license warehouses and

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warehouse keepers. There would have to be capacity to inspect

warehouses and the activities of warehouse keepers regularly to

ensure that they can be relied upon to enforce the quality and

quantity of commodities rigorously.

48. These are complex issues. It is important to meet international best

practice to ensure that Nepal can have the commodity markets it

needs but it will also be important to avoid imposing requirements

that are so burdensome that the markets cannot survive. Striking the

right balance will involve difficult judgments and the regulator of the

commodity markets is advised to seek technical assistance in

establishing the regulatory regime.

The Principles Governing the Regulation of Nepali Commodity

Markets

49. In order to create a regulatory regime for the Nepali commodity

markets, the regulatory authority will have to ensure that the

following elements are in place:

a. There should be licensing, conduct of business and corporate

governance requirements for exchanges that ensure that

those operating the exchanges have the necessary skills,

integrity and financial standing;

b. The exchanges should publish and enforce trading rules and

procedures that provide full pre and post trade transparency

on the prices and volumes traded in the market and limits, so

far as possible, the scope for market manipulation and abuse;

c. There should be adequate requirements for contract design so

that parties to the contracts are quite clear about all aspects

of their obligations and can see the basis for different prices in

the markets (greater transparency of contract design is likely

to create a demand for convergence in contract terms and

this will encourage arbitrage and liquidity);

d. Where market makers are used, their obligations in respect of

the maximum spread between the bid and offer price that

they quote and the minimum order size that they must meet,

should be fully disclosed;

e. The process of settlement should be clearly defined, and the

basis of the settlement price should be objective andindependent;

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f. Where the contract provides for physical delivery of the

commodity, the contract should clearly specify the quality and

quantity of the commodity to be delivered and these

specifications should be enforced by means of an

infrastructure of warehouses and inspectors, who shouldthemselves be subject to supervision under powers granted

by a Warehouse Act;

g. The exchange should have robust procedures for clearing and

settlement that reduce to a minimum the risk that settlement

could be interrupted by the default of a market participant

and such risk management should include adequate capital

for clearing houses, CCPs, clearing members and other market

participants as well as margin payments that are properly

calculated and enforced and a settlement guarantee fund;

h. The powers of the exchanges and / or clearing houses to

intervene to protect the markets should be clearly specified;

i. Brokers, clearing members and other market participants

should be subject to licensing, conduct of business and

corporate governance requirements that ensure that those

who supply market services have the skills, integrity and

financial resources necessary for their role;

j. The regulatory requirements should include adequate

safeguards against money laundering.

50. It is noted above that the Government should distinguish between

the position as it currently exists, where the commodity markets are

providing facilities for speculating on world commodity markets, and

a future time, when the exchanges could be offering facilities for

trading Nepali commodities. Although some of the exchanges are

currently developing the facilities for trading Nepali commodities, it isunlikely that this will, in practice, be feasible until the authorities

have enacted a Warehouse Act and have the capacity to enforce such

an Act. Although naturally the exchanges wish to move ahead very

quickly, the Government will wish to satisfy itself that there is

genuine demand for commodity markets amongst the producers and

consumers of Nepali commodities, before incurring the cost of

creating the extensive regulatory infrastructure that will be required

(bearing in mind that, with limited capacity, the creation of that

regulatory infrastructure is likely to divert resources from the more

immediate task of bringing the regulation of equity and bond markets

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up to international standards). The Government may wish, therefore,

to commission a study of potential users of the market, to see which

consumers and producers of Nepali commodities would find it useful

to use Nepali commodity markets to hedge risk and to what extent

they would be used.

51. In order to minimise the costs of regulation in the short term, SEBON

(or any other regulatory agency to which the government may

choose to allocate the task) should issue regulations that prohibits

any commodity market participant from accepting a client unless

they are an institutional investor or a high net worth individual, who

has assets of at least the equivalent of US$1 million to invest.

Moreover, SEBON should prohibit any mutual fund from investing in

the commodity markets unless they are issuing units in the fund

solely to institutional investors or high net worth individuals. Thecommodity markets in Nepal do not yet meet international best

practice in terms of investor protection and, until the regulatory

regime has ensured that they are brought up to best practice, they

should be restricted to those who are in a position to make their own

assessment of risk and who could afford to make losses on the

commodity markets.

52. If the authorities then choose to enact a Warehouse Act and if there

is demand from Nepali commodity producers and consumers formarkets in Nepali commodities, the Government should then review

whether or not SEBON should continue to have regulatory

responsibility or whether it should be passed to another agency.

SEBON (or another agency if the Government prefer) can then (with

the technical assistance recommended above) create the more

extensive regulatory regime necessary to protect investors. Access to

the commodity markets could be extended to the major producers

and consumers of Nepali commodities, including large agribusinesses

and co-operatives. If such an extension of access is successful, there

could be a further movement to allow other investors to use the

markets. The cautious, step-by-step approach would enable the

markets to improve their risk management practices over time and

for the Nepali authorities to acquire expertise in the markets while

minimising the risk to the Nepali economy and to investors more

generally.

53. The recommendations of this supplementary report are that:

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a. The Government should commission a study into the demand

for markets in Nepali commodities, by Nepali commodity

producers and consumers of commodities;

b. The Government should give the task of regulating commodity

markets, at least initially, to SEBON and commit itself to

providing the staff required to develop and enforce an

appropriate regulatory regime with salaries and training

sufficient to ensure that the staff are capable of regulating the

markets;

c. As soon as the regulatory authority acquires the statutory

regulatory powers, it should issue regulations that insist that

no commodity broker accepts as a client any person who does

not meet the definition of a professional investor as describedabove and in the master plan.

d. Once it becomes clear that there is a demand for markets in

Nepali commodities, the government should review again

whether or not the regulatory task should be performed by

SEBON or a separate authority.

e. The commodity market regulatory authority should seek

technical assistance for the establishment of a regulatory

regime that properly addresses the risks of the commoditymarkets;

f. The technical assistance should cover all of the necessary

legislative changes, including a Warehouse Act and an

amendment to the Insolvency Law;

54. The responsible authorities are:

a. The Government:

i. to determine the appropriate regulatory authority and

to ensure that there is sufficient capacity within that

authority;

ii. to commission a study into the demand for commodity

futures markets trading Nepali commodities.

b. The commodity regulatory authority:

i. to acquire the necessary staff, and to seek technicalassistance for training and for the establishment and

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enforcement of the regulatory regime, including a

Warehouse Act;

ii. to restrict clients to professional investors until such

time as a full regulatory regime is established that

addresses the risks posed by the markets to other

investors.

c. Parliament, to enact the relevant legislation giving regulatory

powers and a Warehouse Act.

55. The timing of these actions is for the Government to determine,

given its other priorities. Changes to the Securities Act have

apparently been drafted and, in that case, it makes sense to secure

their enactment as soon as possible. If the regulatory authority is tobe SEBON, it should seek technical assistance at the earliest

opportunity.

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Documents

Nepal Capital Market Master Plan Supplementary Report on Commodity Markets v2[1]