Spot contracts that were really forwards; an exchange without regulators; affluent investors punting on castor seed — the crisis on the National Spot Exchange Ltd (NSEL) this week threw up more questions than answers.

Here’s how the crisis came about. Spot contracts launched by NSEL ranged from metals to agricultural commodities. The problem arose in the context of a series of contracts that were traded in pairs of T+2 and T+25 as well as T+2 and T+35.

What were these paired contracts? The processor/stockist of the commodity deposited the commodity into the exchange-accredited warehouse and received a warehouse receipt. He put up these contracts for sale (T+2) on the exchange, which were bought by financial investors.

At the same time, the financial investors put up the same commodity for sale on a T+25 basis, which were bought by processors/stockists. The transaction worked like a repo transaction. Thus, the processor/stockist got the financing he needed and the financial investor got the rate of return offered by the processors/stockist, basis the demand/supply of funds. It is believed that 12-14 percent returns were guaranteed.

Questions raised

Gradually, the exchange expanded its portfolio of commodities to cover castor seed, paddy, sugar and even raw wool. Even as the daily turnover reached close to Rs 1,000 crore in this market, questions began to be raised. The most critical was, if the second leg of the transaction was settled on a T+25 basis, should it not be considered a forward contract and brought under the purview of Forward Contracts (Regulation) Act, 1952 (FCRA) and regulated by the Forward Markets Commission (FMC)?

Worse, over course of time, it became clear that the spot exchange disregarded short-selling (sale without back up of physical goods) by operators. Short sales are anathema to spot transactions. But it is believed, processors/stockists were allowed to sell the commodity on a T+2 basis without actually depositing the commodity in the exchange-accredited warehouse. There were also doubts about the genuine presence of physical goods in the warehouse and the quality of material, if any, stored.

Admittedly, there is no official designated regulator for commodity spot exchanges. So, at the instance of the Union Ministry of Consumer Affairs, the FMC investigated and submitted a report to the Government. Following a show-cause notice issued by the Ministry, the exchange submitted an undertaking to the Government that it would make changes to the contracts, essentially reducing the contract duration from T+25 to T+10.

Under FCRA, ready delivery contracts should have delivery of goods and payment taking place within 11 days of the contract date. So, technically, a T+10 contract will fall outside the purview of FCRA.

These developments sent shock waves across the commodity space. No wonder, financial investors were quick to begin to exit the market in the absence of adequate market transparency.

Processors/stockists whose commodities were held in the exchange-accredited warehouses suddenly found themselves in an awkward situation of having to arrange alternative sources o financing or sell the commodity in the spot market and raise the necessary resources to pay back the financial investors.

Obviously, this created a sudden ‘disequilibrium’ in the market and the exchange suspended trading due to rapidly waning interest in the product from financial investors. Quite apart from the specifics of who gained and who lost or the mechanics of spot market operations, the NSEL imbroglio raises some disturbing questions for the policymakers.

Can approvals for such important economic activity be ambiguous or less-tightly worded, allowing the promoters of such spot business to run amuck with public money? Should markets, especially where huge funds from a large number of public are involved, be allowed to operate in a regulatory vacuum?

In a tight spot

On balance, the spot exchange business under discussion seems to be a case of financial engineering far exceeding the capacity of the Government to manage. In the immediate context, the market is waiting for a series of rapid fire actions covering independent verification of stocks said to be in accredited warehouses; details of margins collected from processors/stockists and their net indebtedness; and steps being taken by the exchange to secure the outstanding amounts.

Additionally, are the stockists/processors able to find alternative means of financing? And, are they able to sell the commodity in the spot market to raise cash?

In the absence of this information, what everyone is keen to know is how soon NSEL can sell the commodities and raise necessary resources to fulfil the settlement process and complete the payouts to the financial investors. The market is awaiting answers.

From another level, the unfolding story is much less about FT or NSEL; the real story is that market integrity and credibility of unregulated exchanges has taken a beating. The massive loss of confidence will take a long time to restore.

In a country like India, where the rule of law is often observed in breach, self-regulation does not work.

It may feel good to debate self-regulation in seminars, but in the dog-eat-dog marketplace, strict regulatory oversight is the only way forward.

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