Nepal Stock Market at a Crossroads: Short Selling and Derivatives Set to Transform a One-Way Street

Nepal's capital market is on the cusp of a monumental transformation, poised to shed its long-standing identity as a 'one-way' market. Following recent investor frustrations that culminated in protests outside the securities regulator, the Nepal Stock Exchange (NEPSE) is finally embracing a future where investors can profit from both rising and falling markets. This pivotal shift, spearheaded by the Securities Board of Nepal (SEBON) and aligned with the government's broader economic vision, promises to introduce sophisticated instruments like short selling and derivatives, fundamentally altering the investment landscape.

The catalyst for this change was a candid admission from Dr. Gopal Prasad Bhatta, Chairman of SEBON, who, in response to investor demands, promised the imminent introduction of short selling. This marks a significant departure from previous responses, which often involved temporary fixes or vague assurances. Dr. Bhatta's acknowledgment that the market's design flaw—where 7.7 million demat account holders can only profit when prices rise—creates an inherent pressure group for upward movement, underscores the depth of the problem and the necessity of a two-way market mechanism. Unlike mature markets where a falling index sees half of Wall Street positioned for profit, NEPSE's current structure leaves only 'victims' and 'blame' in a downturn.

This isn't merely a talking point; it's a concerted effort reflected across key policy documents. The Finance Minister, Dr. Swarnim Wagle, in the FY 2083/84 budget, committed to restructuring NEPSE and phasing in intraday trading, short selling, and derivatives, alongside a zero-tolerance stance on market manipulation. Complementing this, SEBON's Capital Market Development Roadmap 2083 and its annual policy outline a detailed 'build order': a gradual move towards T+1 settlement, legal and institutional groundwork for a central counterparty (CCP), full straight-through processing (STP), an auction market for failed trades, trial intraday trading, and the gradual introduction of securities lending and borrowing (SLB) paving the way for short selling, supported by market makers and authorized participants. This unprecedented alignment across government and regulatory bodies signals a serious intent for modernization.

However, the path to a sophisticated market is fraught with historical pitfalls. Nepal's market history is replete with good ideas launched prematurely, lacking the necessary 'plumbing.' The decade-long permission for margin trading, for instance, never fully materialized due to unresolved financing chains, broker capacity issues, and unfavorable economics. Even more cautionary is the uncontrolled experiment with commodity derivatives in the late 2000s, which led to collapsed platforms and burnt savings, highlighting that derivatives without robust clearing, capital, and surveillance are a recipe for disaster.

The successful implementation of short selling hinges on a fully functional securities lending and borrowing (SLB) market. This requires institutional lenders—such as the Employees Provident Fund, Citizen Investment Trust, insurers, and mutual funds—to be willing and able to lend shares. This, in turn, necessitates supervisory permission, attractive lending fees, and robust legal certainty regarding share ownership during a loan, dividend rights, collateral requirements, and recall mechanisms. Without this foundational architecture, any short selling framework remains an empty promise.

Furthermore, NEPSE's unique market structure presents challenges. The dominance of promoter holdings means the freely tradable 'float' in many scrips is minimal. Thin float, while enabling cornering on the long side, makes a short squeeze lethal. Imagine a trapped short seller in a market with daily price bands; losses could compound rapidly behind restrictive movement limits. To mitigate this, SEBON must implement safeguards such as covered shorts only, a hard ban on naked selling, a 'locate' requirement before sale, an initial list restricted to high-float, high-liquidity scrips, and published short interest data. Learning from global market experiences can prevent costly 'bleeding' lessons.

The introduction of intraday trading and short positions also necessitates a central counterparty (CCP). Currently, NEPSE settles trades bilaterally, a system designed for a slower, long-only market. Increased velocity and two-way exposure mean a single broker failure could trigger systemic collapse. SEBON's explicit mention of CCP preparation is encouraging, but its arrival before new instruments, rather than after the first crisis, is critical. Similarly, intraday trading without automated pre-trade risk checks at the broker level—especially given the thin capital and overnight reconciliation practices of some brokerages—could lead to a cascade of defaults. Robust back-office infrastructure is unglamorous but essential.

Finally, the tax implications of these new instruments cannot be overlooked. While the FY 2083/84 budget's move to make capital gains tax final is positive, the existing CGT framework assumes a buy-hold-sell sequence. Short sales reverse this, with the sale preceding the purchase, creating ambiguity about withholding tax and cost basis. Moreover, an intraday trader completing dozens of round trips daily raises questions about whether profits constitute capital gains or business income. These are not mere accounting quibbles; if the Finance Act doesn't provide clarity pre-launch, retrospective tax treatment could stifle these promising reforms.

Investors should monitor the sequence of implementation rather than just the announcements. Real progress will be marked by the completion of straight-through processing, actual T+1 settlement, a genuinely capitalized clearing backstop with a defined default waterfall, and a workable SLB regulation. Only then should covered shorts on liquid scrips, followed by intraday trials with real pre-trade margining, and finally, derivatives (starting with index futures based on a free-float, investable index) be introduced. If this phased, orderly approach is followed, it will represent the most significant modernization of Nepal's market since dematerialization. Rushing instruments ahead of the necessary infrastructure, however, risks scandal, suspension, and institutional scar tissue that could set back future reforms by decades. The siege outside SEBON will truly end not when the market rises, but when investors have robust, reliable machinery to profit in both directions.