Death Of A Spot Exchange?

Published on Sat, Aug 10,2013 | 15:12, Updated at Sat, Aug 10 at 15:12Source : CNBC-TV18 | Watch Video :

Till a few weeks ago most of you had probably not even heard of the National Spot Exchange (NSEL). And barely did you find out about it that its very existence is in peril. Illegal trades and a regulatory vacuum – the very features that helped NSEL become a market leader in spot trading are now forcing its decline. Sajeet Manghat investigates the death of a spot exchange.

Over 20 lakh crore agricultural commodities are traded in India every year. Spot trading at the mandi is done under state laws and trading licenses are provided by state agricultural produce market committees. The more sophisticated commodity derivative trading is done on commodity exchanges under the Forward Contracts Regulation Act, 1952 and is regulated by the FMC or Forward Market Commission. Set up in 2003, MCX was the first commodity exchange in India. Four years later came commodity spot exchanges.

Spot exchanges are electronic platforms similar to mandis where the buyer and seller exchange goods for money. All transportable commodities and which can be stored in warehouses can be traded on commodity spot exchanges, though castor seeds, jeera, paddy and castor oil are among those that have found most favor on spot exchanges.

When in June 2007, the government granted three entities - NSEL, NCDEX Spot and R-Next approval to set-up spot exchanges, it stipulated that they undertake only 'ready contracts'.

A ready contract is a spot transaction with delivery of goods within 11 days. In trade parlance it's called a T+10 contract. Spot exchanges are also allowed to offer 1 day forward contracts – that is, trading in warehouse receipts and intra-day netting of transactions – but since these are forward contracts and forward contracts are not permitted on spot exchanges, the exchanges have been given a specific exemption to allow 1 day forward contracts.

Spot exchanges have also to adhere to the conditions that all outstanding positions will result in physical delivery and that the exchange will not allow any short selling on its platform. Oddly, even though spot exchanges have a set of rules to play by, no regulator was given the task to enforce them.

Ramesh Abhishek
Chairman, Forward Markets Commission

"There is a regulatory vacuum with respect of spot exchanges. Three spot exchanges were exempted by the government under Section 27 of FCRA to conduct forward trading in one day contracts. This was done to boost volumes so that their economic viability improved. However there were many conditions also like they cannot do short selling etc and we were seeking information about their trades and as required we are advising the government."

National Spot Exchange or NSEL was set up by the Jignesh Shah promoted MCX group. It began trading in 2008 and within months captured a bulk of the electronic spot market. Much of the credit goes to its most popular product - the Vyaz Badla product. Here's how it works or worked I should say!

The transaction involves mill owners or planters, the spot exchange and brokers acting as financiers on behalf of their retail and HNI clients. In the first phase a mill owner buy the produce on the NSEL or from mandis using cash or agri financing largely from PSU Banks. The stocks bought are stored at warehouses owned or rented by the mill owners.Once this first step of the transaction is completed, the 'Vyaz badla' cycle starts.

In what is called a pair trade - the Mill owner sells the produce to the financier on the exchange platform under a T+3 or T+5 settlement cycle. The mill owner simultaneously enters a long term higher price forward contract to buy the stock from the financier at the end of 25 days or 30 days or 36 days. At the end of the tenure these contracts are rolled over.

The mill owner recovers his money, the financier get the difference between the two contract prices amounting to an approximately 14-16 percent return per annum. It's a risk free return as the financier holds a warehouse receipt for the goods and NSEL stands counter-party guarantee to any transaction failure.

This vyaz badla product and its many cousins survived on continuous rollovers or new money. Castor seed, castor oil, cotton wash oil, paddy, steel were the 5 commodities that witnessed huge investor interest with minimum investments ranging from Rs 3 to 10 lakhs. Brokers marketed it as a risk free, assured return using none other than a NSEL presentation to make the pitch and pointing to the exchanges counter guarantee as a fall back. Brokers say NSEL played facilitator in more ways than one; even though owner Jignesh Shah denies that.

Jignesh Shah
Vice Chairman, NSEL and Chairman & Group CEO, Financial Technologies Group

"Please follow the Circular which has been released by the exchange. Exchanges can never and exchanges never; members would have marketed and that also could have been indicative things. But if you see we have strictly prohibited that you cannot. It is a buyer-seller platform. It might evolve - people might calculate what the return, which comes is but otherwise if you ask me exchanges never do it and please see the circular."

The vyaz badla product may have been ingenious but it was also illegal. Because as mentioned earlier, spot exchanges can trade only in ready contracts and one day forward contracts. Under the FCRA the second part of the pair trade or the T+25, T+30 and T+36 contracts amounted to forward contracts – and spot exchanges are not allowed to trade those.

The NSEL violations were first noticed by the FSDC in May 2011. A sub-committee consisting of representatives from the consumer affairs ministry and RBI was apprised of the lack of regulatory oversight on spot exchanges and its products.

Eight months later in February 2012, the DCA or the department of consumer affairs appointed FMC as the designated regulator of spot exchanges - but the Commission was only empowered to seek information and periodic submission of trading data by spot exchanges.

Within days-Feb 21- FMC raised the first alarm. It asked NSEL to explain how 55 contracts on its platform have a settlement period of more than 11 days. It also highlighted instances of short-selling by entities.

On April 27th the DCA swung to action - also issuing a show cause notice to NSEL. The investigation continued for a year during which FMC submitted to the ministry a draft legislation to regulate spot exchanges. And then on July 13, 2013 the endgame began – the DCA ordered NSEL to settle all existing contracts by their due dates and not issue any further contracts.

Ramesh Abhishek
Chairman, Forward Markets Commission

"We were empowered last year to seek information from the exchange. We started seeking information in specific formats and when we got their reports we actually found that this exchange was violating some of the conditions like no short sell, delivery of the outstanding positions after 11 days and we reported to the government and actually government has taken action on that and the recent interim order of the government that they should not launch any fresh contract was actually in response to the report that we had sent."

But NSEL was stuck with products that either needed to be rolled over or refinanced. With a freeze on new contracts mill owners had no new source of funds and the threat of default loomed large. July 29 marked NSEL's last successful payout. The July 30th and 31st payouts failed forcing the exchange to stop all trading and merge delivery and settlement of all contracts with 15 day deferment. An estimated 10000 investors were impacted. On August 1st the NSEL management claimed that the exchange has stocks worth Rs 6, 200 cr enough to cover the outstanding obligations of Rs 5,500 crore. It also declared that the settlement guarantee fund had Rs 839 crore. That number was subsequently revised down to Rs 65 crore. That same day NSEL worked out a settlement plan of 5% payments every week for 20 weeks.

Jignesh Shah
Vice Chairman, NSEL and Chairman & Group CEO, Financial Technologies Group

"I think 18 plant owners came; the meeting lasted for seven hours, each one of them spoke about themselves and then members also came. There was a joint discussion between them. I think this challenge was there and I sincerely feel yes, there was a challenge but with mutual dialogue majority of them said that they want to settle even before five months. So, it's possible that they will do that. Thirteen of them said that they will be taking the same time and if anyone delays, in the sense in this period also then there is a penalty that 16 percent interest has to be paid, so there is an incentive to pay early."

Ramesh Abhishek
Chairman, Forward Markets Commission

"FMC has also impressed upon these borrowers, entities to compress their schedules, mobilise funds and repay as soon as they can and most of them are very keen to do that themselves."

The exchange as it stands today has suspended all operations and its future will be decided once the settlement process is complete and new guidelines for spot exchanges are notified. Till then it's a waiting game...to verify if NSEL indeed has Rs 6,200 crore worth of stock, to watch if mill owners pay up in installments of 5 percent and to check if Jignesh Shah is able to contain the collateral impact on his other exchanges?

Since July 13 Shah's company FTIL has lost thousands of crores in market capitalization; his listed commodity exchange MCX has suffered the same fate. His newest venture MCX SX has yet to find its feet. Not long ago Shah & FTIL failed SEBI's fit and proper test. That red ink may come back to haunt his exchange empire.

Will Jignesh Shah go unscathed even as his spot exchange self destructs? And will new regulations prevent another NSEL? Answers to those questions are still blowing in the wind.