Unfolding of the NSEL episode

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SummaryOutcome of Rs 5,600 cr payments crisis will have its bearing on NSEL promoters being 'fit' to run other exchanges.

The National Spot Exchange Ltd (NSEL) episode highlights the need to strengthen regulatory framework across sectors and in commodities market in particular where there is no statutory regulator. As the government panel set up under economic affairs secretary Arvind Mayaram studies the reasons for the payment fiasco, here is how the NSEL crisis took shape.

What is NSEL’s functioning model?

NSEL is one of the three electronic spot exchanges that offer trading in various agricultural commodities, precious metals and base metals. The other two spot exchanges are NCDEX Spot Exchange (N Spot) and National APMC Spot Exchange. These exchanges are a modern version of the traditional mandis where buyers and sellers meet to trade goods. NSEL also offered lower denominated demat contracts on precious metals and industrial metals called e-series contracts.

What was the origin of the payment crisis at NSEL?

A regulatory vacuum for the spot exchange space for nearly five years led to NSEL offering products which were not really spot contracts.

The root of the crisis lies in the long-dated contracts offered by NSEL that along with spot contracts facilitated financing of commodity producers while offering 15-16% annualised returns to the investors or lenders. As the spot exchanges were not regulated by any authority, NSEL could push such forward contract based funding schemes. In the wake of slowing activity in the equity markets, brokers found it lucrative to aggressively market this product especially to high net worth individuals who could invest a sum of R2 lakh to R8 lakh in individual commodities.

How did NSEL-backed financing product work?

While operating as a spot exchange where contracts are settled within one or two days of a trade (T+1, T+2), NSEL also offered contracts for which the settlement cycle ranged anywhere between 25 to 36 days for various commodities. Such long-period contracts effectively acted as forward contracts which are long-dated derivative products typically provided by an over-the-counter market.

For example, in a commodity where prices were trending up, the investor would buy a contract while simultaneously selling a contract of the T+25 settlement cycle. The supplier or processor of the commodity acted as the counter-party to both these trades.

As a result, the supplier could utilise the money earned in the first tranche of the trade for financing working capital requirements while the investor could execute an arbitrage trade which offered 1% to 2% of returns over the duration.

In effect, the ownership of the commodity just changes hands

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