Financial System & Markets: Types, Functions & Roles

TAKEAWAYS:

• The financial system connects savers (households) and borrowers (businesses) via markets (primary/secondary) and institutions (banks, NBFCs, NEPSE).
• Money markets (short-term, <1 year) vs. **capital markets** (long-term, >1 year) differ in instruments (T-bills vs. bonds/stocks) and risk.
• Nepal’s foreign exchange market is dominated by NIBL, banks, and NTC, with NIBOR as the benchmark rate for interbank loans.
• Primary markets issue new securities (e.g., NEPSE IPOs), while secondary markets trade existing ones (e.g., Daraz’s stock on NEPSE).
• Regulators (Rastra Bank, SEBON) ensure stability via licensing, disclosure rules, and market surveillance.
• Digital finance (eSewa, Khalti) relies on payment systems (RTGS, NEFT) and fintech (blockchain for Ncell’s mobile wallets).

1. What is a Financial System?

The financial system is the network of institutions, markets, and instruments that facilitate the flow of funds from savers (individuals, businesses with surplus cash) to borrowers (businesses, governments needing capital). It includes:

• Financial markets (where securities like stocks/bonds are bought/sold).
• Financial intermediaries (banks, NBFCs, insurance companies).
• Regulatory bodies (Rastra Bank, SEBON, NIBL).

Key Functions of the Financial System

mindmap

2. Types of Financial Markets

Financial markets are classified based on time horizon, nature of claims, and geography.

A. By Time Horizon

B. By Nature of Claims

C. By Geography

• Domestic Market: Operates within Nepal (e.g., NEPSE, NIBL).
• International Market: Cross-border transactions (e.g., Nepal Rastra Bank’s forex reserves).

WORKED EXAMPLE: eSewa’s Payment System eSewa uses a hybrid financial system:

1. Money Market: Holds customer deposits in partner banks (e.g., NMB, Standard Chartered).
2. Payment System: Processes transactions via RTGS (for large amounts) and NEFT (for retail).
3. Capital Market: Partners with NMB Capital for investment products (e.g., mutual funds).
4. Regulation: Licensed by Nepal Rastra Bank (NRB) under the Payment Systems Act, 2064.

User → eSewa App → Bank (NMB) → NRB Clearing → Merchant (Daraz/NTC).

3. Key Players in Nepal’s Financial System

A. Financial Institutions

B. Regulatory Bodies

NRB → SEBON, NIB, NIBL with arrows to their supervised entities (banks, NEPSE, insurers).

4. How Financial Markets Work

A. Primary Market: Issuing New Securities

1. Company (e.g., Daraz Nepal) decides to raise capital.
2. Underwriter (e.g., NMB Capital) helps design the offering (IPO or bond).
3. Registration: SEBON approves the prospectus.
4. Auction/Subscription: Investors buy shares/bonds (e.g., Ncell’s 2019 IPO).
5. Listing: Securities trade on NEPSE.

WORKED EXAMPLE: Ncell’s IPO (2019)

• Issue Size: Rs. 10 billion.
• Price per Share: Rs. 100 (later traded at Rs. 150+).
• Allocation:
  • Retail investors: 40%
  • Institutional investors: 60%
• Proceeds Used: Expanding 4G network, repaying debt.

B. Secondary Market: Trading Existing Securities

• Auction Market: Orders matched centrally (e.g., NEPSE’s order-driven system).
• Dealer Market (OTC): Dealers quote prices (e.g., NIBL’s forex trading).

Buyer/Seller → Broker (e.g., NMB Securities) → NEPSE Matching Engine → Clearing (CDSC) → Settlement (bank account).

5. Nepal’s Foreign Exchange Market

The forex market facilitates NPR ↔ USD/EUR transactions for:

• Imports (e.g., Daraz ordering from China).
• Exports (e.g., Himalayan herbs sold to India).
• Investments (e.g., Nepali diaspora remittances via Ncell).

Key Players

• Authorized Dealers: Banks (NMB, Standard Chartered), NIBL.
• Nepal Rastra Bank (NRB): Manages forex reserves (~$10 billion in 2023).
• NIBOR: Nepal Interbank Offer Rate (benchmark for forex loans).

How Forex Trading Works

1. Exporter (e.g., Himalayan Coffee Producers) sells coffee to India.
2. Bank (e.g., Global IME) buys USD from exporter at market rate.
3. Importer (e.g., Daraz) needs USD to pay suppliers → buys from bank at NIBOR + spread.
4. NRB intervenes if NPR depreciates too fast (e.g., sold USD reserves in 2022).

WORKED EXAMPLE: Daraz’s USD Purchase

• Scenario: Daraz needs $100,000 to pay a Chinese supplier.
• Exchange Rate: NIBOR = 1.10%, Bank spread = 0.5% → Effective rate = 1.6%.
• Cost:
  • USD 100,000 × 130 NPR/USD = Rs. 13,000,000.
  • Plus 1.6% financing cost = Rs. 13,208,000.
• Alternative: Use NIBL’s forex futures to lock in rate.

Exporters → Banks (NMB, NIBL) ↔ NRB ↔ Importers with arrows for USD buys/sells.

6. Digital Finance and Fintech in Nepal

WORKED EXAMPLE: Khalti’s Role in the Financial System

1. Money Market: Holds user funds in partner banks (e.g., NMB).
2. Payment System: Processes RTGS/NEFT for merchant settlements.
3. Capital Market: Offers Khalti Gold (digital gold investment).
4. Regulation: Licensed by NRB under Payment Systems Act.

User → Khalti App → Bank (NMB) → Merchant (NTC/Daraz) → Bank Settlement.

7. Challenges in Nepal’s Financial System

8. The Accounting Cycle of Financial Markets

flowchart LR
    A["Savers<br/>(Households, Firms)"] -->|"Deposit"| B["Financial Institutions<br/>(Banks, NBFCs)"]
    B -->|"Lend"| C["Borrowers<br/>(Businesses, Government)"]
    C -->|"Repay + Interest"| B
    B -->|"Issue Securities"| D["Primary Market<br/>(NEPSE IPO)"]
    D -->|"Trade"| E["Secondary Market<br/>(NEPSE Trading)"]
    E -->|"Dividends/Interest"| A
    F["Nepal Rastra Bank"] -->|"Regulate"| B & D & E
    G["NIBL"] -->|"Set NIBOR"| B

## In the Real World

1. eSewa’s Payment System

   • Idea Used: Retail Payment System + Money Market.
   • How: eSewa partners with banks (NMB, Standard Chartered) to hold customer deposits (money market) and processes transactions via RTGS/NEFT (payment system). When you pay your NTC bill via eSewa, the funds move from your bank account (via eSewa) to NTC’s account in real-time.

2. Ncell’s Stock on NEPSE

   • Idea Used: Primary Market (IPO) + Secondary Market (Trading).
   • How: In 2019, Ncell raised Rs. 10 billion via an IPO (primary market). Today, its shares trade on NEPSE (secondary market), allowing retail investors to buy/sell. The stock price reflects risk and return—when Ncell announced 5G plans, its share price rose from Rs. 100 to Rs. 150+.

3. Daraz’s Supply Chain Financing

   • Idea Used: Capital Market (Bonds) + Forex Market.
   • How: Daraz issues corporate bonds (capital market) to fund inventory. When ordering from Chinese suppliers, it uses forex futures (via NIBL) to lock in USD rates, avoiding exchange rate risks. If NPR weakens, Daraz’s costs rise, but hedging limits losses.

## Exam Tip

How This Unit is Tested in PU Exams:

1. Definitions & Classifications (10 marks):

   • Differentiate money market vs. capital market.
   • Explain primary vs. secondary markets with Nepal examples (NEPSE IPO vs. trading).
   • Define NIBOR and its role in forex lending.

2. Worked Numerical Problems (15 marks):

   • Calculate forex costs for an importer (e.g., Daraz buying USD at NIBOR + spread).
   • Compute return on investment for a NEPSE stock (e.g., NMB’s dividend yield).
   • Trace the flow of funds in a transaction (e.g., eSewa payment to NTC).

3. Case Studies (10 marks):

   • Analyze Nepal’s forex crisis (2022–23) and NRB’s interventions.
   • Evaluate digital finance adoption (eSewa vs. traditional banking).
   • Critique NEPSE’s market manipulation cases (e.g., insider trading).

4. Diagrams & Flowcharts (5 marks):

   • Draw the accounting cycle of financial markets (savers → banks → borrowers → markets).
   • Sketch Nepal’s regulatory framework (NRB → SEBON → NIBL).

Common Mistakes to Avoid:

• Confusing NIBOR (interbank rate) with base rate (bank lending rate).
• Forgetting SEBON regulates NEPSE, not NRB.
• Ignoring digital finance (eSewa, Khalti) in answers—it’s a major focus in PU exams.
• Not linking theory to real-world examples (e.g., Daraz’s forex hedging).

High-Scoring Strategy:

• Use tables to compare markets (money vs. capital).
• Label diagrams clearly (e.g., "NEPSE Trading Process").
• Quantify examples (e.g., "Ncell’s IPO raised Rs. 10 billion at Rs. 100/share").
• Critique challenges (e.g., "Forex scarcity hurts importers like Daraz").