August 1, 2013 was the saddest day in the history of Indian markets. As a market player for the last 30 years, I am deeply saddened to witness a scam of this magnitude, and the absence of any sensitivity on part of government agencies to deal with it.

The default in payment at the National Spot Exchange (NSEL) is an institutional failure of a very high magnitude. It is a scam bigger than the two previous financial market scams put together, namely, the 1992 Harshad Mehta case and the 2001 Ketan Parekh case. The amount of Rs 5,500 crore involved in the present scam is far higher than the payment defaults in the two previous scams combined. While there were high- profile arrests in the two earlier instances (the Finance Minister even made a statement on the floor of the House in connection with them), there’s been no response from the Government or any regulatory agency this time.

The default was announced on August 1. All we have heard until now is that the Forward Markets Commission (FMC) has been empowered to supervise the settlement process. Meetings with FMC are fruitless, since they keep saying they have no powers. All that the FMC has done is write a series of letters to NSEL asking them to appoint surveyors to check on stocks, give pay-out schedules and so on. The implementation of FMC directives has been left to the exchange and non-compliance has not been punished yet.

Earlier, individuals had siphoned funds from the markets. This time around the entire institution, which had taken upon itself the task of settling transactions by taking deliveries from sellers and safeguarding the stock in its custody, has failed horrendously in discharging its duties. Trade Guarantee Funds (TGFs) have their own sanctity. It is impossible to trade in an autonomous matching system without a TGF acting as a counter-party to each trade. In absence of a TGF, brokers would have to assess the counter-party risk and decide whether to transact or not.

The way it was

In the days of the trading ring when there was no TGF, there was a ‘blacklist’ of brokers reputed to be weak and not to be transacted with. In fact, even in the badla system, those with a bad risk tag had to pay double the interest of an otherwise solvent broker.

The assurances given by NSEL that TGF assets were sufficient to cover the losses if assets were to be sold, kept the market going. The margins were in the range of 10-15 per cent, much higher than fluctuations in commodity prices.

During the inspection of the 88 godowns by investors and brokers from time to time, everything seemed normal.

There was no reason for to be alarmed.Apart from NSEL staff, there were at least 300 people working there. Someone would have raised an alarm if something were amiss, but nothing came to light all these years. The conclusion is that the system was working and goods had been moving to the godowns.

We have seen three harvesting cycles in this period during which stocks would have moved in and out of godowns. The sudden disappearance of stocks is difficult to digest. The exchange as well as the FMC has said a security agency had been appointed to safeguard the goods, while another agency was appointed to check the quality and quantity of goods. Yet,at the end of three weeks, the FMC is asking for the appointment letters of these agencies whereas the highest priority was to secure the goods.

The agri business is transacted through warehouse receipts. Turnover worth crores of rupees is handled using warehouse receipts and lot of the transaction is in cash, without cheque and payments trails.

I have seen a warehouse stocking turmeric on the river bank in Sangli and there are no delivery or safety issues.

The Warehouse Development and Regulatory Authority (WDRA) has been managing the business of warehouse receipts for decades without reports of a fraud of this magnitude. Agricultural funding done by banks rides on the same system. If the banks could run the system satisfactorily, why did it fail for NSEL?

Margins of error

In the badla system there was a limit of Rs 25 crore per broker in the early 2000s. Even in derivatives there are scrip-wise limits and per member exposure limits. Margins are as high as 30 per cent.

Hence, to have an exposure of Rs 900 crore, at least Rs 300 crore would be the margin. With fluctuations being less in commodity markets, 20 per cent margins were taken. In stock markets, the margins can be 50 per cent in cash and 50 per cent in securities with a 30 per cent haircut.

NSEL has accepted 5 per cent cash and 95 per cent in the form of goods. The promoters have floated 9 exchanges in India as well as globally and adhered to risk scrutiny in stringent markets such as Singapore. How did NSEL fail so drastically in risk management? How did these commodity borrowers land at the exchange door to reach out to financiers for financing the commodities?

What due diligence process did the exchange follow in enrolling a borrower to tap financiers through the exchange? Was any attempt made to understand the end use of the funds? How was the exchange sure of the borrower’s liquidity position to be able to complete pay-in in case the contract had to be closed?

In the past, certain commodity contracts were suspended in the commodity futures market according to government directives to contain prices. On a similar basis, had NSEL been directed by government to stop the contract on the spot exchange, how would the borrower have repaid? Only the exchange can explain.

There is a golden rule in exchange business: If the pay-in of a particular day is not completed, the next day’s trading cannot start. The TGF assures that if some member defaults it will step in and pay. Therefore, the markets open at 9.15 am and pay-in is completed before that.

The TGF system in stock markets has lived up to its reputation in last 18 or more years of its existence. In the absence of TGF, markets opened at 12 noon so that there was sufficient time to complete the pay-in. Why did NSEL not stop trading at the very first instance of default and initiate the selling process?

Promoters’ inaction

This article would be incomplete without talking about the promoters. Every person that I have met had a lot of faith in Jignesh Shah. He has shown the ability to develop so many exchanges. Why is he shying away from this situation? What has happened in the last three weeks?

Is he not capable of securing a handful of warehouses and taking stocks and disposing of the same? He is known for his networking strengths. They need to be used to solve the crisis. As a key promoter, why did he allow a fraud of this magnitude to happen?

This incident is a big jolt to the government and Finance Ministry. The country already has developed a bad reputation for failing to manage the currency, current account deficit and economic growth. Every step it has taken has backfired and situation is worsening by the day.

Only the government machinery can secure goods and track the money trail of the funds given to the processors. Every agency needs to pull its weight to restore the trust of the entire international community.

(The author is MD, Asit C. Mehta Intermediates Ltd, Mumbai .)

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