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NSEL Debacle
Jatin Pancholi

Functioning in a regulatory vacuum, the National Spot Exchange went ahead and permitted trading in forward contracts and overlooked the need for physical backing of stock as required in spot trade. The result was a ticking time-bomb. Close to Rs 6,000 crore invested by 13,000 investors found its way to a small group of borrowers, most of whom have since defaulted.

e have another scam that goes by the name of the National Spot Exchange Ltd (NSEL) crisis. The NSEL which claims to be a national level, electronic and transparent spot market, started live trading in October 2008. It is promoted by Financial Technologies India Ltd (FTIL) and National Agricultural Cooperative Marketing Federation of India (NAFED). The NSEL provides a platform for auction and trading of various commodities including agricultural products, grain, bullion, metal and energy. As the name suggests, the NSEL is a spot exchange, meaning it can offer trading for delivery of physical stock of commodities within a short period allowed for settlement. The exchange also created electronic versions of gold, silver and other precious metals, which became investment instruments. Investors were attracted to the NSEL as they were shown high returns (15% to 20%) in the market. The members/brokers of the exchange assured investors that these investments were risk free as there was a collateral stock of commodities in warehouses across India. The funds invested were then channelled by the brokers to borrowers and owners of businesses who spent these funds in their own operations. A Ticking Time-Bomb However, it now transpires that the NSEL permitted 30-40-day forward contracts on the basis of warehouse receipts, without checking if the commodities were in the 17 warehouses across India. This meant that trading on the NSEL became a time-bomb, ticking away to a likely default. The bubble of these transactions that did not have a physical stock of commodities to back them added up to Rs 5,574.31 crore of around 13,000 investors. This money channelled through 148 members/brokers is now in the pockets of 24 borrowers/owners of businesses.
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These 24 borrowers are spread across India and have various types of businesses such as sugar mills, textiles, agricultural products, etc. Out of these 24 borrowers, 19 have recently been declared as defaulters. Many small investors in India think and believe that the word exchange means government and they presume nancial strength and credibility. That is not the case in reality. Though the Government of India gave an approval to the NSEL for trading, the same government suspended trading of all contracts including the e-series at the NSEL in the rst week of August. Jignesh Shah, one of the promoters of NSEL, announced in a media conference in the second week of August a vemonth payout plan starting with Rs 174 crore. However, the rst payout made was only Rs 92 crore. This clearly shows the failure of the NSEL board to have a grip over the situation. Or is it the case that the NSEL already saw this coming? Did it know that the required physical stock did not exist in the warehouses? A number of letters exchanged between the Forward Markets Commission (FMC) and the NSEL clearly bring out the false promises and inconsistent statements made by the exchange. It was the responsibility of the exchange to assure the presence of physical stock. Transactions without having physical stock is like carrying out the badla trading which was stopped in India in 1993. Questions for the Government There are a few difcult questions for the government. Why was the NSEL allowed to thrive in a legal vacuum since 2008? How could the existing laws of the FMC grant an exemption to NSEL to allow one-day forward contracts (as against spot trading)? The 148 brokers are at fault too. Did they audit the stock? How could they agree to the transactions without checking for the presence of physical stock? Settlements took 30 to 40 days in one-day forward contracts. The moment the government put an end to long-dated contracts, the payment crisis was triggered. Indian capital markets are still at a weak stage with

The opinions expressed here are of the author and not of any organisation(s) the author is/was afliated to. Jatin Pancholi ( teaches accounting and nance at Middlesex University, London, the UK. Earlier he was with NMIMS University, Mumbai.
Economic & Political Weekly EPW

september 14, 2013


insider information playing a pivotal role in the market and a privileged few able to make abnormal prots. The Securities and Exchange Board of India (SEBI) declared on 3 August that the NSEL crisis posed no risk to the system. Did SEBI make a thorough investigation before making such a declaration? Surprisingly, the NSEL was not closely regulated by the FMC until this month. While peeling off the onion of the NSEL episode, I feel that the crisis reects a complete failure of the governments ability to regulate and control the commodities market and the operations of the NSEL. Neither SEBI nor the FMC could have waved a warning red ag earlier. We do not have an autonomous regulatory body for commodities. The FMC is a part of the Department of Consumer Affairs and Food and Public Distribution of the Government of India. The FMC is not a part of SEBI nor of the Ministry of Finance since 1952. Lessons from Other Countries What lessons in India can we learn from other countries? Another emerging south Asian economy, Hong Kong, recently faced a similar issue. The Hong Kong Mercantile Exchange (HKMex), which was started in June 2008, was closed in May 2013 on account of nancial irregularities and issue of false instruments. The Chicago Board of Trade (CBOT), now known as the Chicago Mercantile Exchange (CME), is the worlds oldest futures and options exchange and has been in operation since 1848. The trading here is by both open-outcry and electronic methods. The CME is regulated by rules and regulations of the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). In addition, the CME is regulated by the US Commodity Futures Trading Commission (CFTC), an independent agency of the United States government. Post the 2008 nancial crisis, in the US the Dodd-Frank Wall Street Reform and Consumer Protection Act has brought comprehensive reforms in the commodities and swaps markets. The London International Financial Futures and Options Exchange (LIFFE), formerly known as the London Commodity

Exchange, is now a part of the New York Stock Exchange. LIFFE is the biggest futures exchanges in Europe and is recognised by the Financial Conduct Authority (FCA), the new name of the Financial Services Authority, which is a part of the UK government. The London Metal Exchange (LME) based in the UK has both market and member surveillance systems. In November 2007, a European Union (EU) law the Markets in Financial Instruments Directive (MiFID) was passed to provide harmonised regulation for investment services across 31 countries (28 members of the EU, and Iceland, Norway and Liechtenstein). The MiFID has attempted to strike a balance between controlled regulation and harmonious transactions. The MiFID provides for position limits on commodity derivatives, prevents market abuse and supports orderly pricing and settlement conditions. The entire European market is being watched and regulated by the European Securities and Markets Authority (ESMA), based in Paris. Need for Introspection I am certainly not arguing that the commodities markets in the Chicagos and the Londons of the world are scam-proof and correctly regulated. However, we in India have to introspect and enact

legislation that will prevent abusive practices and raise the alarm when irregularities begin to surface in the markets. What about enacting stringent laws on conict of interest and related party contracts that the new Companies Act has proposed? The evidence in the NSEL saga suggests that Rs 920 crore (16.5%) of the Rs 5,574.31 of the total payout is from a company named N K Proteins. The chairperson of the NSEL happens to be the father-in-law of the promoter of N K Proteins! And then there are allegations that NSEL has a coterie of its own people among the 24 borrowers. Critics have also asked if the NSEL merely operated as a sophisticated unregulated moneylending mechanism under the disguise of a commodity exchange. Will the promoters of the NSEL now be set free in the market to discover one more legal vacuum and orchestrate another scam? We do have some tough questions to answer. One of the fundamental aws in the Indian legal system is that we wait for a scam to happen before we frame a law. This is more of a reactive rather than a proactive approach. Unfortunately, we do not have the luxury of time nor does India have unlimited options. The Government of India has failed to create effective legislation for the efcient operation of commodities and forward

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markets. I wonder if economic and nance experts, and the political leaders in power really understand the intricacies of the commodities market? If the government ofcials and netas themselves do not have a grip over the market, what else can one expect from novice small investors? Corporate Terrorism In September 2008 when Lehman Brothers declared bankruptcy, I spoke in the classroom about the concept of Corporate Terrorism. These corporate terrorists erode mass savings and capital, destroy development sentiments in the

market and take the economy back by a few years. Will the sacking of the NSEL chief executive ofcer (CEO), Anjani Sinha, solve the NSEL crisis? Why not then sack the entire board of NSEL that appointed the CEO in the rst place. Who will bear the loss of Rs 5,574.31 crore? The only option now seems to be for the government to use the taxpayers money for a bailout. But then the question is, why should taxpayers money be used to nance scams? Some psychologists may blame the NSEL debacle on the delusions and madness of investing crowds, which may not be totally untrue. However,

the absence of a regulatory mechanism, poor nancial literacy and the lack of integrity of highly educated and qualied nance and law professionals are certainly at the cornerstone of this crisis. With an insufcient legal framework and a lack of tough legislation, it should not surprise us if some other nancial scam surfaces soon. Indian nancial markets are evolving and are prone to irregularities, lack of transparency and a close nexus between fraudsters masking themselves as entrepreneurs and corrupt politicians. Which hidden scam is going to unfold next?

Economic & Political Weekly


september 14, 2013

vol xlviII no 37