NSEL Collapse: Why Savvy Brokers Got Trapped?

There was the Rs 250 crore Harshad Mehta scam built on fake bank receipts and now there is the Rs 5600 crore NSEL scam built on fake warehouse receipts and illegal trades. It's been almost 2 months since the National Spot Exchange started to unravel but we are still in government committee territory.

Not only did the government allow an unregistered, unregulated exchange to function but it also ignored early signs of trouble. NSEL's former CEO says in his affidavit that the exchange faced payment issues way back in 2011-12. FSDC was alerted to this in 2012. FMC Chairman Ramesh Abhishek told this show that when it discovered the illegal trades last year the exchange turnover was at Rs 2000 crores.
But nobody did nothing till mid this year when the turnover had jumped to Rs 6000 crores. Only in this country do we take an exchange default lightly. but today's story is not about NSEL's violations, it's parent FTIL's status as fit and proper to run other commodity exchanges, nor is it about the future of FTIL founder Jignesh Shah.
Today we are going to focus on those that got suckered into trading on NSEL- brokers and their investors who are now crying foul. Sajeet Manghat finds out if its a failed case of buyers beware.
The Latin term Caveat Emptor loosely translates to Let the buyer beware. A warning that notifies a buyer that the goods he or she is buying are "as is," or subject to all defects. It’s a pity that NSEL’s trades didn’t carry that label. Or did they?  
Over 13000 investors including 250 brokers have taken to the streets demanding their money back. They were all lured by the promise of 14-18% assured, risk-free returns. That’s twice what a bank fixed deposit pays out. The trades were predicated on perpetually gaining commodity prices – like an eternal bull run. You’d think when something appears too good to be true – it most likely is. Why then did these high networth individuals and savvy brokers stake their money? Arun Dalmia
Secretary, NSEL Investor Forum
"If I am giving to individual, just like I am giving to any builder or a particular company, there we see that if he is giving more than 12 percent there must be some risk. But here we are putting to the exchange collateralised by the commodity, insurance, Forward Markets Commission (FMC), advertisement, government, so where we can find the risk." Rajnikant Patel
Former CEO, BSE
“It is a perennial thing when we look at the greed factor in terms of everybody tries to go for a profit maximisation or a Return on Investment (ROI) maximisation and therefore that becomes a little bit of a trap which one can easily fall into.” Anand Rathi
Founder & Chairman, Anand Rathi Financial Services
"I do not think any return was assured or guaranteed. It said that your revenue, your returns could be in the range of such and such. What a broker does is we have multiple products. Every product has a separate risk-reward ratio, risk profile, separate return profile, separate liquidity profile and our job is to explain the profile of product and other features and risks associated with every product."
Anand Rathi is the founder of an eponymous financial services firm operating across equity, derivative and commodity markets. He along with Motilal Oswal- Founder of Motilal Oswal Financial Servies and Nirmal Jain- Chairman-India Infoline are among the 3 biggest brokerages trapped in NSEL's collapse.  They each stand to lose between 200 to 600 crores rupees – Rathi stands to lose the most. Typically in the equity markets, a brokers' ethics code requires them to warn investors to trade only with a broker recognised and registered with SEBI. But similar diligence was missing when selling NSEL products. Why did these brokers actively encourage their clients to invest in products, that were not just too good to be true, but being traded on an unregistered, unregulated exchange? Rajnikant Patel
Former CEO, BSE
"Due diligence should have been on top of the mind of all intermediaries in order to realise that there are certain regulatory gaps and which need to be either clarified before marketing such products."
On regulated Exchanges, sophisticated products such as the NSEL pair trade scheme, are vetted by the designated regulator, and when brokers market these products, there are caveats imposed by the regulator. But NSEL had none of this, since its products were designed and cleared internally. That in itself should have served as a warning.. Despite large compliance departments, all the brokerages failed to recognize the inherent risks of trading on NSEL. Or chose to ignore them. Rajnikant Patel
Former CEO, BSE
"Here because of lack of a clear mandated regulatory regime the products would have just got bit of an approval in terms of very fundamental principles and therefore one, whether every intermediary should have paid attention to the structure of the product. Our normal due diligence would say that yes one would be expected to carry out that due diligence." H Jayesh
Founder Partner, Juris Corp
"The context of NSEL offering a particular product, the brokers would have taken an approach that FMC is allowing them to do this. The Government of India exempted them from the purview of the Forward Contracts Regulation Act (FCRA) which was on the basis of spot trading and then you have a Circular which says that one day forward contracts can be entered into and those will be allowed on this Exchange. So that I think is a question of what did the government do when they allowed such a contract."
The one day forward transaction may have not raised an alarm, but it was paired with a T+15/20/35 day product. No broker could have believed that a T+25 trade is a one-day forward. Former NSEL CEO Anjani Sinha, in a confessional letter acknowledges that NSEL’s business model became ‘more of a financing model rather than just offering deliverable physical commodities...and that is what attracted large number of investors’. Anand Rathi
Founder & Chairman, Anand Rathi Financial Services
"The compliance is required to be done to meet the obligations put up by the regulatory authorities. That is what is compliance. That has been done. Yes, it is very much possible that in this case the level of compliances might be lower than what you will have in SEBI and that is what needs to be looked at." H Jayesh
Founder Partner, Juris Corp
"When we say compliance has been weaker, compliance as regards to what. One of the questions being raised is about this entire framework of warehouse receipts. What prevented the government from stipulating that the warehouses that will be used have to be certified by the warehousing authority under the central law applicable to warehouses, the government chose not to do so, which again goes back to the point that the broker is supposed to be suspicious of the Government of India."
But former SEBI executive director J N Gupta says there were enough red flags that should have made investors, especially market savvy brokers, suspicious of the legality of NSEL’s pair trades. JN Gupta
Founder and MD of Stakeholders Empowerment Services
"If you look at the product of wool, T+2 and T+25 wool product, they are on the website of the NSEL. They had very clearly indicated that if you buy under T+2 and deliver the same goods under T+25, then warehouse rent is waived. This transaction is happening on a stock exchange or a spot exchange where there is a buyer, there is a seller, there is an exchange and there is a warehouse. How can the exchange waive out the warehouse rent of a third party and what for. Secondly if you look at it the rent for the warehouse, in case of wool it is Rs 5/kg per day and if you see the stock statement of the wool there is supposed to be 10,000 odd tonnes of stock. This Rs 5/kg per day per tonne amounts to Rs 160 crore per month rent on a stock which is valued at Rs 770 crore. Imagine on a Rs 770 crore stock if somebody has to pay Rs 160 crore per month of warehouse rent then what type of price rise you are expecting in future, one and secondly which warehouse in India would be earning a Rs 160 crore rent? Leaving aside all these things how can an Exchange which is earning 0.01 percent of whatever little from the transaction would waive such a massive rent."
For missing all these warning signs, can investors take their brokers to court? Especially because many of the 250 brokers also doubled up as clearing agents – making them responsible for trade settlement and payout to clients. But to defend themselves brokers are now taking refuge in the byelaws of a lawless Exchange. H Jayesh
Founder Partner, Juris Corp
"I really doubt if there is any duty owed by the brokers. Having said that I am aware that some of the brokers did the due diligence, did take steps to cross-check certain aspects and satisfy themselves that there is a system which seems to be robust enough etc. but if you are asking me is there any legal ground on which somebody can sue a broker and succeed, I really doubt that."
That's not the only reason court cases may not ensue. Social bonds may also stand in the way. Because many, if not most, of the investors belong to the marwadi community. Traders by tradition; entrepreneurial but conservative. And suspicious of any product offering extraordinary returns. Arun Dalmia
Secretary, NSEL Investor Forum
"Maximum brokers are marwadis and their clients also are marwadis and number of marwadis who were invested in this do not want to take risk in the equity market. They wanted some assured type of scheme. We have burnt fingers in real estate funding and number of places, though some money, some stake should be there and assured return will be coming. That is why maximum marwadis are there because our brokers are also marwadis. Rajnikant Patel
Former CEO, BSE
"If you look at it from that perspective in terms of the underlying commodities, agriculture commodities etc. the trading is based mostly in part of MP, Gujarat and Rajasthan and traditionally most of Guajarati and marwadi traders have been involved into this trade for ages."
But here's what's surprising. NSEL’s former ceo Anjani Sinha admits the pair trades amounted to a ponzi scheme. It needed continuous rollovers to survive or new investors to take the place of those who decided they had had their fill. And yet none of the exiting investors warned the incoming ones? Sinha indicates the payment problem dates back to 2011-12 – and yet no one caught whiff of it.
Many people told us the marketing of the trades was aggressive, bordering on desperate. For some that was a clear give away of the ponzi nature and yet others remained unwarned. All this despite it being the close knit community that it is. JN Gupta
Founder and MD of Stakeholders Empowerment Services
"I would say the fault with investor lies because they are greedy and they fell into the trap, but the fault of the broker is much more than the investor, because brokers are supposed to have a fiduciary duty as well as they have to act as a advisor or guide. If they did not see and they entrap the investors also along with themselves then I would say that they failed as a guardian."
It is not our case that NSEL and the Government are blameless for allowing the illegal trades to start and persist for so many years! Caveat emptor has in modern times been replaced by caveat venditor or "let the seller beware".
But given that brokers were also aggressively selling the pair trades - it’s worth asking whether they did as much diligence as they should have? For many brokerages the amounts NSEL owes them exceeds their networth; their very existence could be at risk. And given that these financial services firms trade across products and exchanges, that also has the potential of posing systemic risk. In Mumbai, Sajeet Manghat.