COLUMN: Decoding the National Spot Exchange fiasco
NSEIL should understand that it is not possible to do big business when the activity of the company is in a gray legal area. NSEIL will however have to earn the confidence of regulators and participants by resolving the crisis in shortest possible time.
August 05, 2013 / 13:25 IST
By Deena Mehta
Failure to execute the settlements and closing the markets as a result of the same has been in news recently. Allegations are being thrown all around. There has been a fall in share price of Financial Technologies, MCX and even some listed broking firms. This piece makes an attempt to understand the real issues and suggest remedies to avert such mishaps in future. NSEIL was set up in 2008 to provide a technology platform for trading in precious metals initially. The unique feature was that you could buy gold / silver in as small a quantity as one gram and get the same in demat form. An excellent concept, for a country crazed with gold. Silver was first time available on exchanges, since there were no silver ETFs. A study of prices in physical markets, ETF, MCX exchange and spot exchange showed that gold was cheapest available on NSEL. In fact I have seen ads from jewelers stating that they will accept demat slips instead of physical gold. NSEL proposes settlement; says members will pay Rs 2181crA year or so later NSEIL came out with an agri based financing product. The product was as follows, there were several investors who wanted to invest in fixed income products and there were large agri commodity traders/ companies who wanted to fund their purchases. Banks have limited appetite for funding agri commodities; hence these traders were at the mercy of private financiers who charged as high as 18% and 20%. Finance was available on NSEIL at a rate of 13%- 14% due to transparent price discovery method. The investors who put money are those who were familiar with erstwhile Badla system. These were essentially high net worth individuals who parked their liquid funds for short period of time ie. 34 days, this was the contract period. The returns were superior to 4% earned from banks for short term funds.The Agri traders deposited their physical stocks in godowns designated by NSEIL. These stocks were certified as of standard quality by recognized laboratories and there was continuous check on the godowns. Once the goods were moved into the godowns and certified as of fit grade warehouse receipt was issued. The traders offered these goods and finance was available against these goods through the exchange mechanism wherein a financing session was held and finance was offered at mutually acceptable interest rates. The stocks ownership would move in favour of the financier once the pay-in gets completed on T+2 day. The investor could exit the market by not rolling over the transaction and would get the money back on T+2 day after the day of roll over. The issue here is was this contract within the legal permission of Forward Market Commission? The FMC is supposed to regulate Forward markets and not Spot market. Hence though the Spot Exchange was doing a forward market transaction the FMC chose to ignore by stating that since the entity is not regulated they will not regulate the transaction done by the entity, though the forward transactions were very much in purview of FMC. In fact this is not something odd, since in past also the issue of regulation of Plantation schemes, Chit funds, ULIPs etc have been have been under cloud and it took several scams for the government to act and provide clear cut responsibility. This is a clear regulatory arbitrage which happens in case of NBFC also. NBFC are regulated by RBI but they do Margin funding which is under purview of SEBI and this activity of NBFC goes unchecked. This was the root of Prime securities fiasco recently. In this case also the FMC issued a letter at the instance of Consumer affairs Ministry on 15th July to NSEIL and asked them to give an undertaking that they were not violating the Spot trading guidelines. They were also asked not to issue any fresh contracts. The Spot trading guidelines provide that any Spot transaction should be settled within 10 days, ie delivery should be completed within 10 days. This condition was interpreted by NSEIL as stating that contract should be open for 10 days, which was of course not the spirit of law. The contract was a SPOT contract ie delivery vs payment but due to physical nature of commodities 10 days time was provided to the seller to arrange for the goods and deliver them as per the satisfaction of the buyer. These 10 days are provided for geographical distances. NSEIL gave the undertaking and reduced the contract from 34 days to 10 days. Actually this was a better contact then 34 days contract since money would roll over in 10 days and exit was also available early and compounding of interest would happen in shorter time and more frequently. However the investors smelled a rat and chose not to go with the financing since the legality of the transaction was suspect. It was also evident that there would be not regulatory support in event of crisis.The financing support started coming down and funds were withdrawn from the market. The agri traders who had built the positions over 3 years were forced to return the funds within days and obviously it was impossible to liquidate the goods overnight and return the money. In fact they have to first raise the money, pay to exchange, release the stocks and then sell the stocks and deliver to the buyers and get their money. This process needed time. Secondly these contracts are open till middle of September, the rollovers which are supposed to happen till then were terminated immediately and expected to be honoured.The question before us is was the Trade Guarantee Fund not able to handle the settlements. The Trade Guarantee Fund is normally used to pay the losses arising out of liquidation of assets. On day of settlement the fund is used to make good the settlement obligation of the defaulter and then immediately recover by sale of assets lying in margin account. In case of equity markets it is easier to liquidate the stocks since the markets are very liquid and delivery is complete by delivery the DIS slips, same is not true for physical markets. Liquidation of commodity stocks is time consuming and delivery process is further cumbersome.NSEIL saw this impossible situation and threw in the hat and suspended all settlements and decided to club the entire outstanding and settle them piecemeal. In fact the biggest mistake here is not allowing the time to unwind a three year old position. Atleast 3 months should have been allowed to close the entire Badla. In fact in stock exchanges also Badla has been suspended on three occasions in 1992, 1994 and then in 2001, each time 6 months time was provided to the market to wind up the whole position. This was done in stages by reduction of 10% in each cycle. The solution to this problem will come when the Commodity traders arrange funds for their stocks, pay the exchange, take the delivery and funds are returned to the financiers. Once whatever money that can be paid is paid then the exchange will auction the stocks that are not lifted from the godowns and obtain the funds. The losses will be funded by Trade Guarantee fund. 20% loss on a commodity that is daily marked to market is too high; hence there is reasonable assurance about the adequacy of Trade Guarantee fund.The numbers available in public domain are , Total funding Rs 5500 crorers million, stocks in godowns worth appx Rs. 6200 Cr., Trade Guarantee Fund Rs. 900 Cr. , 25 traders financed by about 15,000 investors, average exposure per investor 37 lacs. These are HNI investors. Commodities are Sugar, Castor seeds and Oil, Cotton wool etc. The value of the goods is a fraction of the total agri commodities traded in the country. The numbers are not scary, given time this is a solvable problem. There are fears about goods not being there in the godowns, these can be addressed only after we reach the bottom of the problem ie exchanges having to sell the goods and they not being of desired quality. So long as the goods are lifted by the traders in whatever form they are, quality is not the immediate problem. It is too late in the day for the investors to complain about the quality since dealing in physical commodities is a risky proposition and adequate steps should be taken to ensure the quality of assets. Several brokers have sent their representatives to check on the goods and have been satisfied.Support from Government will also help in this matter. Government financing organizations such as NABARD etc can take the stocks and provide funds till the time they are liquidated in a time bound manner. This will ensure that the losses are minimized due to distress sale. In past also whenever there is crisis in banking or mutual fund industry liquidity support has been provided by the RBI and government. As it is procurement is happening on regular basis to feed the public distribution system, same could be extended to support this crisis.This is about the integrity of public institutions. No one believes that there is no regulator for NSEIL or an illegal activity can be carried on for years together. The Ministry of Consumer Affairs and Agriculture ministry have blessed this institution. It adds a lot to international prestige if such problems are handled expeditiously. This is after all a liquidity problem which is being converted into a fraud which is denting the prestige of Indian markets.To conclude, National Spot Exchange can be used to serve an economic purpose. It has demonstrated that agricultural credit can be provided in an efficient manner. This platform if popularized throughout the country can bring lot of transparency to agriculture business and we can convert this cash economy into the mainstream transparent contributor to GDP. Information on stocks can help the government in understanding inflation and regulating prices of agri commodities. NSEIL should understand that it is not possible to do big business when the activity of the company is in a gray legal area. NSEIL will however have to earn the confidence of regulators and participants by resolving the crisis in shortest possible time.The author is MD, Asit C Mehta Investment Interrmediates Ltd Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
