Stock Market of Nepal: A Journey to Automation

April 2017 NRB Samachar

1. Capital Markets

Capital Markets are the markets consisting long-term securities issued by the government or a corporation. Capital Market typically relates with financial assets which have life spans of greater than one year. Capital Market is a means through which scattered saving and investable resources are converted into actual investment. Capital market is one of the several factors that play a prominent role in the economic development of the nation.

The saving institutions such as banks, investment trusts or companies, specialized financial corporations and stock exchanges are some of the important constituents of capital market. The primary role of capital market is to allocate the economy’s capital stock among various productive sectors. Capital invested in such sectors acts as seed money and generates more funds for further investments. No modern corporation of any size can function effectively without ready access to capital markets at the lowest possible cost.

2.     Stock Exchange

Stock exchange is an entity that provides services for stockbrokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and dividends. Securities traded on a stock exchange include shares issued by companies, unit trusts, derivatives, pooled investment products and bonds.

To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there is a central location at least for record keeping; but trade is increasingly less linked to such a physical place, as modern markets are electronic networks, which gives those advantages of increased speed and reduced cost of transactions. Trade on an exchange is by members’ only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market.

A stock exchange is often the most important component of a stock market. Supply and demand in stock markets is driven by various factors that, as in all free markets, affect the price of stocks. There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. However, stock exchanges are part of a global market for securities.

3.     Nepal Stock Exchange Limited (NEPSE)

Nepal Stock Exchange Limited, in short NEPSE, is the only stock exchange of Nepal established under the company act and operating under Securities Exchange Act, 1983. The history of Nepal stock exchange began with the establishment of Securities Marketing Centre in 1976 under Industrial Policy 1974 in order to facilitate the trading of government securities. It was converted into Securities Exchange center in 1984 under the Securities Exchange Act 1983, which started listing and trading corporate securities in from that year. It was again converted into Nepal Stock Exchange Ltd (NEPSE) in 1993 under the stock market reform program, one of the components of financial sector reform program of the Government of Nepal (GON).

The basic objective of NEPSE is to impart free marketability and liquidity to the government and corporate securities by facilitating transactions in its trading floor through member, market intermediaries, such as broker, market makers and clearing agency. Government of Nepal, Nepal Rastra Bank (the central bank of Nepal), Nepal Industrial Development Corporation (NIDC) and members are the shareholders of NEPSE. 

3.1 Members of NEPSE

Members of NEPSE are permitted to act as intermediaries in buying and selling of government bonds and listed corporate securities. At present, there are 50 member brokers, one central depository company (CDC) and 2 market makers, who operate on the trading floor as per the Securities Exchange Act, 1983, rules and bye-laws. In addition, more than 200 sub brokers are working under different member brokers.

Besides this, NEPSE has also granted membership to issue and sales manager securities trader (Dealer). Issue and sales manager works as manager to the issue and underwriter for public issue of securities whereas securities trader (Dealer) works as individual portfolio manager. Although the members are permanent in nature, the tenure of the membership is one year. The license should be renewed within 3 months after the closure of the fiscal year. If not, it can be done within another three months by paying 25% penalty.

4.     Access to the Market

Participants or members are subject to the right to trade on the Exchange. In order to ensure fair and efficient use of market, as well as to ensure its financial integrity, NEPSE has been permitting only those entities with access privileges to trade directly on the exchange. Generally two types of access rights are in practice: Trading Rights, which may be either full or restricted, and Settlement Rights.

An applicant to become an access rights holder of the exchange must file an application with the Exchange and demonstrate its compliance with the applicable minimum legal as well financial requirements. Individuals/ institutional investors that do not hold access rights may trade on the stock market only through an entity having Trading Rights.

4.1 Trading Rights

Trading Rights are the authorities granted by the stock exchange to the different kinds of market participants. Such rights may also be restricted to some categories of products as specifically authorized by the rule of state. For example, access is restricted to, among others, derivatives, foreign exchange, equity indexes, grains, livestock, coffee, energy, and metals. Full and restricted Trading Rights may be held by either individuals, who must be national of the concerned country and should meet the stipulated age bar, or entities, which must be incorporated in the same country and duly authorized under a given instructions. In order to maintain their access, rights holders must meet minimum professional standards with respect to their supervisory and compliance authority. Such personnel must demonstrate their competence through a testing program administered by the authority and by meeting minimum required documentation and educational standards.

4.2 Settlement Rights

Settlement Rights are the authorities granted by the exchange and regulator to enable the participants or trading right holders to use the clearing and settlement systems managed by the exchange or the Clearing House (CH) permitting the clearance and settlement of transactions. All Settlement Rights Holders must be national legal entities with their headquarters or offices in stipulated place. Settlement Rights can further be divided into different types which keep on changing time and again according to the requirement.

5.     Trading System of NEPSE

The trading mechanism of stock exchange differs from one exchange to another based on the government policy, availability of resources, infrastructures and technology. Similarly, some limits might also be placed on how they operate by government. The mechanism of trading that an exchange uses is important to investors because different mechanisms lend themselves to different trading volume limitations and pricing behaviors. The trading mechanism/system of NEPSE has been evolved from very primitive form to internet based semi-automated and in the verge of converted into fully-automated one.

5.1 Open-Out-Cry (Manual) System

Open-out-cry is the name of a method of communication between professionals on a stock exchange typically on a trading floor. It involves shouting and the use of hand signals to transfer information primarily about buy and sell orders. The part of the trading floor where this takes place is called a pit.

In an open-out-cry system auction, bids and offers must be made out in the open market giving all participants a chance to compete for the order with the best price. New bids or offers would be made if better than previous pricing for efficient price discovery. Exchanges also value positions marked to these public market prices on a daily basis. In contrast, over-the-counter system (market) is one where bids and offers are negotiated privately between buyers and sellers.

Since the establishment of Security Exchange Centre in 1976 to its conversion into NEPSE in 1993, securities (stocks) were used to be traded on over-the-counter system. Once the trading floor of NEPSE was developed open-out-cry system replaced the over-the-counter for regular trading. However, since late 1990s, the main method used to communicate between traders was telephone and email to some extent. NEPSE has replaced “Open-Out-Cry” system by semi-automated computerized trading system on 2007. 

5.2 Semi-automated Trading System

NEPSE introduced semi-automated screen based online trading system since 24th August, 2007. In this system transactions of securities are conducted using internet. The NEPSE trading system is operated through Local Area Network (LAN) which is called ‘NEPSE Automated Trading System ‘(NATS). As a result, open auction based stock market of Nepal upgraded to an order driven market.

In this trading system, the buying broker with the highest bid will post the price and his code number on the buying column, while the selling broker with the lowest offer will post the price and code number on the selling column on the platform (window). The market makers quote their bid and offer price through their own window before the system starts. Once the bid and offer price match, transactions between the buying and selling brokers or between the brokers and market makers are concluded on the system.

6.     Trading Engine/Software  

Electronic trading systems, developed by various software venders have been using in stock exchanges throughout the globe. Some popular fully automated trading systems are based on the ATOS/Euro next trading platform, MT/4 trading platform etc. Some exchanges have internally developed their own trading system, which may include all of the trading features that were available on the original trading system.

NEPSE has been using the trading system which was developed by Nepali engineers in cooperation with a South Korean consultant. NEPSE is providing the central order processing facilities for its trading system and authorized users are required to trade through their own workstations by purchasing front-end software supplied by the exchange and verified by the country’s respective authority. Users are able to link their workstations directly to the systems to facilitate more efficient processing.

The current trading engine provides the order matching service that has to be through a technical testing before the software is declared operational. The trading engine has to be approved from the Financial Information Exchange (FIX) Protocol.  Access to the trading engine is limited to the authorized trading rights holders only. Each trading rights holder of the exchange is required to place filters on the gateway that apply to the trades of each market participant. If such a filter is set at zero, the market participant’s orders are systemically prevented from entering the matching engine. Thus, the exchange would be able to prevent executing any and all transactions in contracts which they are not permitted to trade on the market.

6.1 Software Trail and Audit

The trading system of stock exchanges should complete an audit trail of all orders entered into the trading engine and all trades that are executed before starting live trading. In this regard, the following information is required to be included on orders submitted to the trading system: (1) security category; (2) company; (3) purchase or sale; (4) customer ID; (5) quantity; (6) limit price (except for market orders, and other similar order-types). The trading system should automatically records the time of, and retains a record of, each entry into the system.

Thus, the trading system retained a complete and accurate audit trail of all activity on the engine. All relevant data are retained for a years in an electronic storage medium. Confirmations of orders successfully entered into the trading system are automatically generated and sent to the authorized traders, as are confirmations of all matched trades. These confirmations should also be captured automatically and retained as part of the permanent audit trail. And the trading engine (software) is audited and verified on regular basis.  

6.2 Reliability and Security

The hardware specification for the trading engine should include spare, backup power sources, which are provided for the data centers where the servers are hosted. Trading system provides reliability functionality, making it possible for system administrators to configure multiple instances of a matching engine for an instrument or group of instruments.

Likewise, the trading system should include a security system that provides for user authentication, confidentiality and information integrity. The security system is responsible for: (1) maintaining the database of currently certified users; (2) authenticating certified users as they log on; (3) distributing session keys as part of the login process; and (4) maintaining a list of currently logged-on trading applications.

7.     Information Dissemination   

Stock Exchange should disseminates trading data (prices/quotes/market depth) to authorized users and general investors via the trading system and, more generally, through third party vendors, such as Bloomberg and Reuters (in western markets). Authorized market users also have available to them a summary of the market user’s activity during that session, including the market user’s orders entered during the current trading session and completed trades. Additional information such as daily high, low, open interest and volume should be distributed publicly.

7.1 NEPSE Website

Such information of NEPSE is being distributed and also being archived on an interactive website, on which intra-day last sale, quote and volume information including vital information have been incorporated. At the same time, the website has inbuilt features to create graphs and charts of different indices and price of individual companies.

Apart from official website of NEPSE, data and information of Nepali stock market are being disseminated through a variety of channels such as private website promoted by banks, investment companies and some professional institutions (one best example is www.sharesansar.coom) and media. First, the economic and financial newspapers were connected to the NEPSE as well as all brokerage firms including some distributor and other interested clients. Alternatively, pursuant to the no-action relief provided herein, various electronic flash boards have directly been connected with the exchange and displayed in major malls and corporate streets of the Kathmandu Valley.

7.2 NEPSE Mobile App

NEPSE has launched its own official mobile application called NEPSE MOBILE APP that facilitates easy dissemination of information to the users. The application is being very much instrumental as the number of smartphone is ever increasing. The App is being convenient means to provide right and timely information to prospective investors so that they can get information about the major indicators of the stock market and to boost investment. The app enables users to view live trading and stay updated with events, profiles and index fluctuations of individual companies, and details of the stocks traded by brokers on a daily basis.

Semi-Automated Trading Mechanism of Stock Exchange (NATS)

8.     Future Plan

Nepali Stock Market is very small as compared to other neighbor countries. However, capital market plays a vital role in the economic development of a country. Being a capital deficient country, Nepal has to make every endeavor to mobilize available capital effectively. Securities are financial assets and securities (stock) markets are mechanism created to facilitate the exchange of financial assets. Therefore, the market exists in order to bring together the buyers and sellers of Securities. Capital market is the mechanism designed to facilitate the exchange of financial assets by bringing orders from buyers and sellers of securities together. Stock market has been global phenomenon in the present world regardless of the size of any particular region.

Keeping the importance of capital market for economic development of the country NEPSE has been working to upgrade its trading system into a fully automated one. In this regard, NEPSE has already paved the way to develop automated online trading system. If everything goes as per the planning the project will be completed within the one year. Once the automated trading system is developed authorized users of trading engine may transmit orders directly to the Trading Engine by their own computer and even mobile device through internet. A non-Trading Rights Holder may transmit orders directly to the Trading Engine if authorized by a Trading Rights Holder. Non-access rights holders may also transmit orders using the automated order routing system (AORS) of the Trading Rights Holder. Trading Rights Holders providing or using an AORS must comply with certain order validation and recording requirements.

Trading Process in Fully Automated Stock Exchange