Nepal’s BB- rating has disseminated a message to global markets that despite past challenges, the country now presents a medium default risk while showing signs of growing financial stability. This rating not only reflects Nepal’s stronger economic position but also clearly identifies areas requiring further financial development to sustain progress.

The development of a derivative market stands out as a significant gap in Nepal’s financial landscape. While many countries are advancing their financial systems through innovations like the Central Bank Digital Currency (CBDC), Nepal’s investment ecosystem lacks several financial instruments which has limited the whole of its arena for investments.

The global derivatives market has evolved through several milestones since its origins in the 17th century in the Netherlands where options on tulips marked the earliest examples of speculative trading. The call and put options, a type of derivative, then emerged in London's financial markets as the first example of organized options trading on the exchange market. The modern era of derivatives began in 1872 when the US pioneered over-the-counter options through Russel Sage’s financial innovations. Although the earlier form of options trading was less standardized and lacked liquidity, the establishment of the Chicago Board Options Exchange (CBOE) standardized options trading. More recently, India entered the derivative market in 2001 with the introduction of index futures.

In contrast, Nepal's derivative market remains significantly underdeveloped. Currently dominated by commercial banks using basic Swaps and Non-Delivery Forwards (NDFs), the market suffers from limited participation of other market players. A lack of proper exchange mechanism poses a major obstacle to the country’s derivatives market with trading limited only in the over-the-counter (OTC) market. The Nepal Rastra Bank’s 2021 report acknowledged these limitations and emphasized the urgent need for developing a more organized exchange system.

Compounding these challenges, Nepal currently faces a liquidity surplus situation reminiscent of earlier financial periods particularly the 1990s and 2007 when the central bank had to introduce special bonds to manage excess liquidity. While recent measures like the Statutory Deposit Facility (SDF) have established better interest rate corridors, the development of more sophisticated financial instruments, particularly a strong derivatives market, would provide multiple benefits.

While derivatives offer significant economic benefits, they inherently carry complexity and risk—particularly for developing economies like Nepal that lack sophisticated risk management systems. The primary concern lies in the lack of local expertise to properly manage exposure to speculative and systematic risks. Derivatives misuse contributed to both the 2008 global financial crisis and 1997 Asian Financial Crisis, where currency derivative speculation triggered chain reactions across Thailand, Indonesia, South Korea and Malaysia. This led to currency devaluation and stock market crashes, and even a regime change in Indonesia. However, these risks should not prevent Nepal from developing regulated derivative markets. Japan’s experience proves how strategic use of derivatives, particularly hedging instruments, can enhance market efficiency, attract foreign investment, and stimulate economic growth and international trade.

Options trading democratizes market participation by enabling investors to engage with relatively modest capital while simultaneously increasing overall market liquidity. It benefits retail investors as well as brokerages and financial institutions. In India, brokerages like Angel One Ltd experienced significant growth in revenue and profitability because of its surge in options trading, while major exchanges like the Bombay Stock Exchange (BSE) benefited from significantly increased trading volumes and revenue. This model offers transformative potential for Nepal’s financial sector. Commercial banks could deploy their substantial liquidity more effectively, while institutional investors gain access to sophisticated tools for risk management and portfolio stabilization.

Nepal’s unique geographical position between economic giants India and China makes financial markets modernization particularly urgent. Without developing contemporary financial instruments like derivatives, Nepal risks becoming increasingly uncompetitive for regional investment and may face barriers to global financial integration. This concern is particularly important given Nepal’s import-driven economy, where options trading could provide businesses with vital tools to manage foreign exchange volatility.

Options trading would be able to attract more FDIs by promoting an investment-friendly environment. The Nepal Stock Exchange (NEPSE) would benefit from enhanced liquidity and sophistication. Market participants would gain the ability to profit from both rising and falling markets from diverse trading strategies. Most significantly, the introduction of options trading could support Nepal’s critical hydropower and infrastructure development by providing investors with better risk management tools for long-term projects.

While the central bank has taken progressive steps in foreign exchange derivatives, notably increasing the Non-Delivery Forward (NDF) limit to 20% of bank capital in its recent monetary policy, the current framework remains insufficient to the development of a competitive financial market. The existing Non-Delivery FX option (NDO) mechanism, while operational, has failed to gain significant traction. It is high time Nepal considered implementing full-scale options trading to advance its financial markets.

The constraints facing Nepal’s derivative market development are multifaceted. This is neither due to a lack of competent professionals nor the absence of economic will, but rather stems from systemic barriers that require urgent examination. While prudent risk management by the central bank is necessary, regulations must simultaneously evolve to meet international standards. The financial dominance of the USA, for example, was achieved through calculated risk-taking. Nepal can learn a valuable lesson from this. Strategic investment in financial research and development is crucial, even if it demands new institutional frameworks and training regimes.

The transformative impact of options trading has been seen globally. In financial markets ranging from the US to Brazil and India, options trading has proven catalytic - not just for the derivative market but for the overall financial sector development. It is agreeable that there equally lies spaces in the development of the Swap and Forward markets - making it more organized and systematic. Futures trading has a whole set of areas to explore, but the introduction of options trading would represent a quantum leap in market sophistication.

Admittedly, all financial innovations carry inherent risks that necessitate robust regulatory oversight. However, continued delay in modernizing financial instruments risks leaving the country behind. The time has come for Nepal to embrace options trading as the next evolutionary steps in its financial market development.

(Regmi is Deputy Manager at Rastriya Banijya Bank Ltd., currently working in the Treasury Department.)

(This opinion article was originally published in  May 2025  issue of New Business Age Magazine.)