LESS than five years back, in October 2008, India’s experiments with economic and financial deregulation led to the creation of one more new market: a commodity exchange called National Spot Exchange Limited (NSEL). The promoters of the NSEL had declared their mission as follows: “To develop a pan-India, institutionalised, electronic, transparent Common Indian Market offering compulsory delivery-based spot contracts in various agricultural and non-agricultural commodities with a reduced cost of intermediation by improving marketing efficiency and, thereby, improving producers’ price realisation coupled with reduction in consumer paid price.” Taken at face value, that was indeed a laudable objective.
Early in August 2013 this description turned out to be a myth, with the NSEL appearing as an institutionalised but opaque and secretive den of speculation and possibly fraud. To understand that we need to examine what the NSEL was supposed to do and what it was actually encouraging. As its name indicates, the NSEL was meant to be a “spot exchange”. The term “spot” is of relevance here. A commodities exchange can be the location for trade in the commodities themselves or in forward and/or futures contracts relating to those commodities. When a buyer and seller transact in a commodity, with the former making a payment against delivery of the said commodity by the latter, the trade is in the nature of a spot trade. A forward trade is when a potential seller contracts with a buyer to deliver and accept payment for a certain quantity of a commodity at a specified price on a specified date in the future.
Forward contracts, however, are cumbersome. They require intending sellers of specific quantities of specific quality at specified times to find the appropriate number of buyers. This entails costs of search and inspection. Further, since there is no centralised market or exchange where the contract is drawn up, prices tend to vary and there is uncertainty about delivery. It is for this reason that futures contracts were evolved.
Futures contracts differ from forward contracts in important respects. Futures contracts are standardised contracts to buy or sell a standard quantity of a standard quality of a commodity. These are traded in exchanges, through brokers, with no need for the buyer and seller to meet and negotiate. An important feature is that a contract need not be settled by actual delivery. It can be matched by an offsetting contract taken by the buyer or seller, and the two can be squared at any point at some gain or loss. The administration of the exchange guarantees that contracts will be settled, and requires traders to pay up margins to cover ongoing losses, if any, to secure the viability of the exchange.
To return to our story, the NSEL was a spot exchange, and therefore unlike a futures exchange had to combine a trading platform with facilities such as warehousing and inspection because all contracts that were being reported on the exchange were expected to be backed with actual supplies of the commodity concerned. These were required to be stored in the warehouses of the exchange and the trades were to be settled with delivery of the commodity. Sellers deliver their produce to the warehouses of the exchange, which checks for quality and issues a warehouse receipt. This receipt is then posted on the electronic exchange allowing buyers to make bids. Having won a bid they obtain the warehouse receipt that is exchanged for the commodity at a warehouse located close to them. Around 800 members at the NSEL, which had warehouses in 16 States, were reportedly trading more than 50 commodities.
Interestingly, the government decided to allow spot contracts to be settled with a lag. For example, spot transactions in currency and equity markets may require to be settled in two to three days (T+2 or T+3 in exchange jargon). In the case of commodities, however, a liberalising government defined a “ready delivery” contract under the Forward Contracts (Regulation) Act as “a contract which provides for the delivery of goods and the payment of a price therefore, either immediately or within such period not exceeding eleven days after the date of the contract”. In fact, The Forward Contracts (Regulation) Amendment Bill, 2010, which is yet to be passed, extends the ready delivery period to 30 days.
Regulatory vacuum The NSEL, being a spot exchange, was not subjected to such rules by any regulator. As a spot exchange is not supposed to engage in mediating forward contracts, the NSEL was not under the scrutiny of the Forward Markets Commission. As it was not a financial market, it was not regulated either by the Securities and Exchange Board of India (SEBI) or by the Reserve Bank of India (RBI). While it cannot be established that the spot exchange was set up to exploit this regulatory vacuum, the fact remains that it did, in practice, exploit that advantage. The NSEL not only adopted the 11-day settlement definition, but it permitted contracts that had settlement periods in excess of 11 days, going up to 36 days, making it an unregulated futures market.
Among the questionable transactions that emerged were a set of arbitrage transactions involving investors buying a commodity on the basis of a T+2 contract and simultaneously selling it under a T+25 contract. The investor in a T+2 contract is expected to advance 10 per cent of the cost of the commodity bought on the trading day and the entire purchase value on settlement day, which is two days later. But settlement here is only the acquisition of the relevant warehouse receipt, which is held until the T+25 sale is executed. This amounts to the investor meeting the transaction charges for transportation and warehousing, insurance, etc., for the period between purchase and sale. But it transpires that despite incurring these costs investors were reportedly earning a return of around 14 per cent because of the difference in price between the T+2 purchase and the T+25 sale. Why such a large price difference existed is not clear. The presumption was that in all such trades physical goods in warehouses backed the warehouse receipts. This, it appears, was not true.
There are also suspicions that trades were conducted against what were, in effect, fake warehouse receipts, which permitted traders to indulge in “short selling”, or the sale of commodities that the seller did not own or possess at the time of signing the contract, in the hope that they can acquire the required stocks at a lower price before the delivery date.
It appears now that the government was not unaware that the NSEL was engaging in transactions that were in the nature of futures and, therefore, illegal. But since the promotion of successful commodity exchanges was a key element of the liberalisation agenda, it chose to ignore this for long. Until, of course, it became clear that the volume of transactions in the exchange implied that some of the so-called spot contracts were “naked contracts”, in the sense that they were not backed by actual commodities.
This appears to have occurred because a web of companies (N.K. Proteins, ARK Imports, P.D. Agroprocessors, Mohan India, Yathuri Associates, Lotus Refineries and Juggernaut Projects among them), presumably acting on behalf of the NSEL, brokered contracts with warehouse receipts and collected their fees and commissions without the statutory responsibility of backing the contracts with physical stocks and financial guarantees. Payouts to investors reaching their sell dates were possibly being made from investors putting in money into new trades. If true this was nothing more than a Ponzi scheme.
Ministry steps in Problems arose when the Consumer Affairs Ministry intervened in mid-July and put a stop to contracts with settlement periods in excess of 11 days and required the NSEL to settle all such contracts, since, legally, it was the NSEL that was responsible. The result was a sharp fall in the volume of trading on the NSEL, which obviously made it impossible to keep the Ponzi-type scheme going and settle all due trades.
On August 1, the NSEL suspended all excepting e-Series trades in the exchange and deferred settlement of contracts by 15 days. At that point the NSEL claimed that it had collateral (in the form of physical stocks and monies in the settlement guarantee fund) worth Rs. 6,200 crore against a settlement liability of Rs.5,400 crore and was deferring settlement only to ensure an orderly unwinding of positions. Soon, the settlement period required was raised to 20 weeks and subsequently to 30 weeks, with the NSEL claiming that it would occur in instalments. As of now, payments against the first two instalments due have fallen far short of the required sum, and reports are that the NSEL is asking investors to take a large “hair cut” of around Rs.1,100 crore.
Even as of now, the sums involved in this scam, which occurred either with or without the connivance of sections of the government, seem bigger than the Harshad Mehta or Ketan Parekh scams. But the government does not seem to be giving it the notoriety it deserves, possibly because of the role of its own acts of omission and commission. But the scale of the scam may be bigger than known thus far because of the interpenetration of actors involved here with those in other commodity exchanges in the country.
The NSEL was co-promoted by the private sector Financial Technologies (India) Ltd (FTIL) and the National Agricultural Cooperative Marketing Federation of India Ltd (NAFED). The FTIL was promoted by wonder boy Jignesh Shah in 1988 as a technology company engaged in providing technology products for financial markets. But it has since grown into a financial services company, which, in its own words, “operates a network of nine exchanges” and “ecosystem ventures… in areas such as clearing and depository, information dissemination, warehousing and collateral management, payments processing and financial market education”.
Among the exchanges operated by the FTIL is Multi Commodity Exchange of India Ltd (MCX). Not surprisingly, there are apprehensions that there could have been some cross-exposures between these markets, resulting in increased scrutiny of the MCX as well. Losses could emerge at other locations linked to the FTIL. Whether that occurs or not, the integration of markets and services such as warehousing in the hands of a single promoter can quite likely result in a significant escalation of the scale of fraud when it occurs.
What is unclear is the extent to which the matter will be investigated and details placed in the public domain and violators brought to book, given the fact that the government’s own unthinking deregulation and its own actions proved to be fertile ground for this scam. With an election impending much could be swept under the carpet.
COMMents
COMMents
SHARE