AvantGarde

The NSEL(National Spot Exchange Limited) settlement crisis has brought Jignesh Shah and his FT(Financial Technologies) group into the limelight one more time. However, this time it is for all the wrong reasons. Last he hit the headlines, was by the virtue of his heroics in waging a successful battle with SEBI to open equity exchange MCX-SX. He currently holds membership of boards of around 9 exchanges worldwide. Not to mention that most of these exchanges are using technology services provided by FT. If reports are to be believed, FT group is planning to sell their 44% stake in DGCX(Dubai Gold and Commodity Exchange), as the exchange has partnered with Cinnober (FT’s competitor) for their technology services. As regards NSEL, not many of us had an idea as to what it is all about until recently. But the whole crisis was so alarming that it could have hardly gone unnoticed.

Spot markets are best represented by what are commonly known as ‘Mandis’ across the country. Generally, what happens in a typical Mandi is, the farmers bring their produce, and the traders (commission agents or ‘aadhatiyas’) inspect the quality by just looking at the produce and start bidding for the same. Certainly, the agent with the highest bid would acquire the produce. Thus, the ‘Mandi’ system, leaves the farmer with no bargaining power as the price setting power completely rests in the hands of the agents. This results in a very inefficient price discovery mechanism. Whenever, the farmers require finances to raise the harvest, they borrow money from the traders, who conveniently lend at very high interest rates. So invariably, they end up selling their commodities to their moneylenders at whatever price is offered to them. The agents’ commission is decided by the state APMC(Agriculture Produce and Marketing Committee) acts. Occasionally, farmers expect that price of a certain grain will increase in the near future. However, due to the lack of warehousing facilities in the mandis, they cannot afford to wait, and are consequently forced to sell at the current price. So the whole mandi system left the farmers with few avenues. To get rid of such inefficiencies, a nationalized and transparent spot market was set up in the form of NSEL by the FT group. On June 5, 2007, NSEL was allowed to conduct trading in ‘One-day duration forward contracts’ in commodities by the Ministry of Consumer Affairs, Government of India. Subsequently, NSEL commenced live trading on October 15, 2008. At present, NSEL is operational in 16 States in India, providing delivery-based spot trading in 52 commodities.

Basically, ‘One-day duration forward contract’ means that the contracts open every day for trading and the position open at the end of the trading session results in compulsory delivery of the commodity traded. For various contracts, exchange has notified particular delivery locations or additional warehouses where the commodities can be delivered and lifted by the sellers and buyers respectively. The seller willing to sell any particular commodity on the exchange platform is required to bring the commodity to the exchange warehouse where weighing and quality checking is done. The quality assessment is done by a quality certifying agent based at the exchange warehouse. For withdrawal of the commodity from the exchange designated warehouse, the buyers are required to give at least 1 day prior intimation to the warehouse for necessary arrangements. Based on the intimation received from the buyer, delivery schedule is communicated by the warehouse supervisor to the buyer.

NSEL obtained licenses from State Governments under respective State APMC Acts, where it intended to launch contracts for agricultural commodities. It was operating in a complete regulatory vacuum though. On February 6, 2012, Forward Markets Commission (FMC) was appointed as the designated agency to which all information or returns, relating to the trade, as and when asked for, shall be provided by the NSEL.

Meanwhile, NSEL launched various contracts with settlement cycles ranging from 1 day to 36 days (T+0 to T+35). That is, if the settlement cycle for a contract is T+3, then it implies that payment and the physical delivery must take place no later than three business days, immediately after the trade is executed. Because of the longer settlement cycles, traders were able to re-trade without taking delivery of the goods. Last December, Department of Consumer Affairs received a complaint stating NSEL’s involvement in illegal financing operations. Subsequently, an investigation was initiated to look into the matter. On July 23, 2013, NSEL reduced delivery, payment and settlement period for 40 live contracts of various commodities to less than 11 (T+10 or less) days in accordance with the orders of the ministry. The government believed that allowing any settlement beyond 11 days was like futures trading, which can be driven by speculators rather than genuine traders. As a result of this, daily trading volume on NSEL halved to around 3 billion rupees. On 31 July, 2013 the exchange notified that it will suspend trading in most of the contracts for an indefinite period owing to the plunge in trading volumes. It also merged all the outstanding contracts and declared that the settlement will take place after 15 days.

The total value of suspended contracts stands at 55 billion rupees. NSEL claimed that the exchange has commodities worth about 62 billion rupees to meet the outstanding payment obligations. However, investors fear that NSEL’s warehouses do not have the full value of commodities to cover all the contracts that have been sold on the exchange. Broker houses and investors are accusing the FT group and Jignesh Shah of keeping them in the dark. Facing the wrath of the investors and threatened with legal action by brokers, NSEL announced the detailed settlement plan on 14 August, 2013. NSEL stated that it will clear all the dues in the coming 30 weeks. However, according to the NSEL, there are only 24 buyers who are liable to pay these obligations. This clearly suggests that something was seriously wrong in the exchange operations. It is suspected that the exchange allowed a small group of people to collect money from a large number of investors, assuring them high returns by allowing them to sell commodities which they did not own. Because of long settlement cycles, contracts were re-traded without actual deliveries. As small investors continued investing money in the want of high returns, new money that was being collected by the buyers, was probably being used to pay off the returns due to the older investors. Once the inflow of new money ceased due to banning of trades in long-cycle contracts, borrowers could not pay their liabilities. It is estimated that there are around 8000-15000 small investors, whose investments are in quagmire due to the crisis. In a nutshell, the investors were taken for a ride by the exchange by promising high returns to them. This double-cross could be executed by exploiting the existing loopholes in our financial system. This time it was a complete lack of regulation by the government which led to the crisis. The least the government can do is, monitor the whole settlement process and try to ensure that all the investors get their money back in due time. Further, it is high time that all the spots tainting the spot market be erased by an efficient and watchful regulatory mechanism. Undoubtedly, the investors should take this as a lesson to refrain from investing in schemes or products promising exceptionally high returns. Of course, high returns are irresistible for any investor, but a careful and practical approach in dealing with such contracts could safeguard them. After all, as the saying goes, ‘There is no such thing as a free lunch!!’
Time to remember Harshad Mehta, yet again!!!!

References:
1. www.businessstandard.com
2. www.nationalspotexchange.com

Sunny Goyal

MBA Batch 2012-14