Explaining the NSEL crisis

With confusion about spots versus forwards, settlement cycles and exchange regulation, the crisis on the National Spot Exchange this week had our collective heads spinning. Therefore, we decided to address the questions most often asked by investors on the issue.

In what contracts has the trading been suspended by NSEL?

NSEL has suspended trading in all contracts but for the ones on the e-series. E-series contracts will continue to trade on the exchange.

Why did NSEL suspend trading in its contracts and defer settlement?

National Spot Exchange had several contracts where settlement was done beyond eleven days. In fact, some worked to a T+25 and T+35 day settlement cycle.

The Forward Market Commission also found that there was short selling in some of these contracts where an individual sold the contract without actually owning the underlying commodity.

Settlement beyond 11 days and short trades were both not permitted by regulators on spot market transactions. So the regulator sent a notice to NSEL few weeks ago, asking it to immediately bring down the settlement period in its contracts and move all of its existing contracts to ‘trade-for-trade’, meaning every trade has to be settled the same day and couldn’t be netted out. The exchange immediately complied. But as the news triggered panic among traders and many of them wanted to close out their positions immediately, the exchange had to defer settlements.

How were forward trades allowed in a spot market?

Spot exchanges were allowed to conduct forward trading in one-day contracts (where an individual can keep the contract open for two days), through a special Government notification in early 2008. NSEL used this exemption to launch one-day forward contracts with a settlement cycle of 20-30 days.

But this exemption on forward trades came with the condition that the respective exchanges should not allow short selling.

Who was making money?

Talking to people who actually traded in the NSEL’s platform, we understand that high net worth investors and speculators were using the forward contracts to make money.

The forward contracts first involved a set of commodity stockists selling warehouse receipts to investors for an immediate payment. They also entered into a buyback arrangement whereby the investor would sell back the commodity to the stockist after a 25 day or 35 day period, with a ‘return’ element of 12-14 per cent.

Thus the stockist received financing while the investor got his return. But this soon morphed into a system where speculators actually sold commodities without proof of underlying stock and entered into similar buybacks arrangements. They drew in affluent investors who didn’t understand the markets but lent money to fund such trades.

As most of these trades happened in commodities such as raw wool and castorseed that were not widely traded, there was limited public information on them which investors could rely on to check if these trades were indeed working.

With settlement having been deferred, is there a risk of payment default by the exchange?

This will be evident only on settlement day. The MD and CEO of NSEL Anjani Sinha has said the exchange deferred settlement by 5 months because it needed time to estimate the total amount required for the payouts. He estimates that Rs 6,200-crore worth of stocks are lodged in the NSEL’s warehouses, in addition to the settlement guarantee fund.

On settlement day, traders who speculated on the exchange may not be able to cough up the full value of the contract because they probably traded on leveraged positions/ margins. Also, when the exchange liquidates stocks to meet commitments, there is the question of whether the actual price that the commodities fetch would match the estimated value.

Why did the stock of MCX fall? Do traders on this exchange too run a risk?

There is no direct connection between MCX and NSEL, except that both share a promoter — Financial Technologies. However, as MCX too operates in commodities trading, this event could lead to tighter regulatory scrutiny of the latter.

What is the way forward for NSEL?

The Government is said to be readying new regulations to govern spot exchanges to plug these loopholes. Until then NSEL will not be allowed to launch any new contract. The structure of the now suspended contracts could change based on the new regulation. Meanwhile, SEBI has sought details from various brokers on their exposure to contracts on NSEL.

> rajalakshmi.sivam@thehindu.co.in

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