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 a brief 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. 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. The nature of a formal commodity market is that the quality and quantity 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. 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 the commodity 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, are not 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. 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. 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 2

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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 overall process 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 may rise 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.

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 the Nepali 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 4

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 the following 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 the contract by selling it on the exchange. If the value of the 5

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 risk management 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 6

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 the settlement 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 well developed 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 the trades 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 would be reluctant to enforce their rules that limit the trading capacity of 7

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 makers as 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 the market 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. 8

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 of the 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 insolvency administrator 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 variation margin 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. 9

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 warehouse and 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 prevents capital 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 Nepali commodities. 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 11

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 regulatory resources 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 the commodity 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 would have to have the powers and staff to license warehouses and 13

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 and independent; 14

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 should themselves 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 is unlikely 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 15

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. The commodity 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 for markets 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 described above 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 commodity markets; 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 technical assistance for training and for the establishment and 17

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 to be SEBON, it should seek technical assistance at the earliest opportunity.

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