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 25^th 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 1^st 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.)

Was Friday’s ‘flash crash’ in the Nifty an error or a scam?

All seemed well when the stock market opened in the morning on Fri. Oct 5 ‘12. The previous evening’s cabinet meeting had passed the Companies Bill (2011 amendments) and FDI in insurance and pension. The Nifty was expected to open higher, and it did. Out of the blue at 9:50 am, the Nifty crashed by 900 points before you could say ‘Jack Robinson’.

10% circuit filter kicked in and trading was halted at the NSE for 15 minutes, while trading continued at the BSE. When normalcy was restored and trading resumed at NSE, Nifty quickly climbed back almost to the level from which it had fallen. But the bullish sentiment had been badly dented.

What happened? NSE authorities were quick to mention that there were no technical problems with NSE’s software. Instead, fingers were pointed at a particular brokerage house that had entered 59 ‘erroneous’ trades on a basket of Nifty stocks worth Rs 650 Crores. The brokerage house had been ‘disabled for trading’ and the matter was being investigated.

There was no clarification from the brokerage house. All its senior managers apparently left the office in the morning. There were rumours floating around that some of them were at the NSE’s office, trying to sort out payment issues. What about the likely loss that the brokerage house may have suffered due to the ‘error’? Unconfirmed figures in the range of Rs 80 Crores to Rs 200 Crores were being bandied about.

So, was it really an ‘error’ or was it another one of those periodic scams perpetrated to bail out some one who was caught short in a rising market? The truth may never be known – going by the lack of transparency of NSE officials and the poor track record of SEBI in bringing scamsters to justice.

But if I had to make a bet on one or the other, I’d go with a scam. Here are the reasons why:

1. An ‘error’ can occur with one or two trades. But 59 trades – one after the other? It seems too much of a coincidence.
2. The timing of the ‘erroneous trades’ within the first hour of trading, when volumes are typically low in Nifty cash, raises questions. A series of trades worth Rs 650 Crores could bring the Nifty to its knees, though daily volumes top Rs 10000 Crores.
3. The 10% circuit breaker should have been applied as soon as the Nifty dropped by 570 points. Why was it applied only after a 900 points (15%) fall?
4. As per SEBI guidelines, if a circuit breaker is applied before 1 pm, trading ought to be suspended for 1 hour. Why was trading resumed after 15 minutes?
5. When trading is suspended due to circuit breaker in one exchange, the other exchange should also have stopped trading. But no shut down happened at BSE.

All of the above point to some thing more than an ‘error’ by a dealer at a brokerage terminal, entering trades for an institutional investor. Will the SEBI get to the bottom of this? How about cancelling all the trades that took place from 9:45 am to 10:15 am? Surely that would help small traders and investors who got stopped out by the sudden ‘flash crash’ in the Nifty? Who will restore the confidence of small investors – many of whom believe that the stock market is a big casino with the odds always favouring the house?

Related post

Was it a freak ‘error’ trade or a ‘short and distort’ scam?

http://investmentsfordummieslikeme.blogspot.in/2012/04/was-it-freak-error-trade-or-short-and.html