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Wednesday, August 21, 2013

What caused the NSEL fiasco? – a guest post

The NSEL fiasco was primarily the result of greed getting the better of good sense. Rules and regulations are made to ensure that common investors are not duped. But without proper monitoring or enforcement, there will always be a few market players who will bend the rules to their own advantage.

Duping investors has been a regular ploy of greedy operators in stock and commodity exchanges the world over. Indian stock exchanges have witnessed a large number of scams despite progressively tightened rules and regulations, and greater authority to SEBI.

Commodity exchanges are a more recent phenomenon in India. FMC - the authority monitoring the NSEL exchange – has perhaps not done as good a job as they should have in stopping some of the blatant rule-bending that was going on. In this month’s guest post, Nishit provides his views on the NSEL crisis.

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The NSEL fiasco has led to a lot of questions in the minds of investors. What actually happened with NSEL?

NSEL is an electronic spot exchange meant for delivery-based trading of commodities at actual (spot) prices. It is a subsidiary of Financial Technologies, a listed company owned by Jignesh Shah. Two other commodities exchanges - NCDEX and MCX (the latter is also a subsidiary of Financial Technologies) – allow trading in futures contracts. Earlier, we only had two stock exchanges - the Bombay Stock Exchange (BSE) led by a consortium of brokers, and the National Stock Exchange (NSE), which is promoted by a group of Public Sector Banks and Institutions.

Now, the primary function of any exchange is to facilitate trading of stocks, currencies or commodities in a smooth manner without the risk of default. Risk of default occurs when one of the parties involved in a trade has made a loss and cannot or does not want to pay up either money or the instrument. The Exchanges have to do strict risk management and collection of margins so that such an event does not occur. All the Exchanges operate on the element of trust and once trust is lost, it is the end of the road.

What was NSEL doing that led to a financial crisis? It was offering contracts that had a settlement of T+2 and T+25, that is cycles of 2 days and 25 days. It was also allowing short-selling, which is against the rules of a spot exchange.

In T+2 contracts, farmers, producers and traders sell commodities for delivery on T+2 days and they get payment on T+2 days. The actual users, processors and exporters, buy commodities in T+25 contracts, make payment on T+25th day and get delivery. An investor buys the commodity in T+2 contract and sells the same in T+25 contract. As a result, trading volume for T+2 and T+25 is identical.

All back-end clearing is handled by the exchange. The problem arises when the actual commodities are not supplied on the 25th day. By doing this arbitrage, investors were getting a risk-free return of 15% and the processors did not have to take a loan at the rate of 30%. Everything was fine, till one day the government asked NSEL not to introduce fresh contracts till regulation was in place.

The exchange suddenly on August 1st stopped trading and the payout process following the government’s order, which led to the crisis. Now, there is an amount of about Rs 5500 Crores to be paid out, which would be done over the next 6 months in installments.

What are the implications:

  • NSEL as an exchange led by Financial Technologies may be shut down or taken over by the Government
  • The Promoters would have to make good the losses, which is why Financial Technologies stock was badly hammered
  • This business happens on trust and this could impact the listed MCX exchange, as people may not be keen to trade with this promoter group anymore

So what should one do?

Wait and watch. Financial Technologies should not be touched at all for buying. Only those who can live with the loss of entire invested amount can take a bet on MCX. Risk is very high but so can be the reward. It may happen that Financial Technologies sells off MCX to new promoters.

Bottomline: better regulation should be in place before new exchanges are allowed to start operations. The culpability ultimately lies at the doorstep of the Government.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

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