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 on paper without involving a change in possession. Sugar, castor seed, paddy and raw cotton were amongst the 11 commodities on which these trades gained popularity. The extent of money involved in these trades ballooned as most of the times the positions were rolled over for another trade cycle and lenders collected the interest amount from each preceding trade.

What led to the crisis at NSEL?

While the NSEL’s financing product had gained popularity since 2010, it was in February 2012 that the government got wind of such trading activity and asked the FMC to look into the matter. The FMC found a number of irregularities, most importantly violations of the FCRA Act due to trades with settlement periods of more than 11 days and effective short-selling in the spot market. Based on this, the consumer affairs ministry issued a show-cause notice to NSEL in April 2012.

Eventually, in mid-July this year, the ministry asked NSEL to give an undertaking that no fresh contracts would be launched till further instructions and all existing contracts would be settled on the due dates of less than 11 settlement days. However, nearly a week after submitting the required undertaking on July 31, NSEL announced that trading in all contracts other than e-series contracts will be suspended. At the same time, delivery and settlement of the pending contracts were deferred by 15 days.

So, why did NSEL suspend all settlements?

NSEL cited “market disequilibrium” as a reason for postponing the settlement of R5,600 crore of outstanding contracts. It argued that abrupt changes in policy had created uncertainty and doubts about continuity of trading on the exchange resulting in a sudden withdrawal of participants from the market.

However, market observers say that the decision was taken after an increasing number of commodity producers that used the NSEL platform for working capital financing faced problems in adjusting to the changed settlement cycle. While investors were keen to exit such contracts, some of these members refused to honour their settlement dues.

At the time of suspension, NSEL said that it had access to stocks of commodities worth R6,200 crore over and above its settlement guarantee fund (SGF)—a contingency fund created from members’ initial margins that should help it arrest liquidity concerns.

What was NSEL’s proposed settlement solution?

Since it decided to suspended all settlements for a period of 15 days on July 31, 2013, NSEL proposed two settlement plans for the outstanding dues.

After day-long discussions with the producer members along with FMC officials and brokers on August 4, 2013, NSEL proposed its first settlement plan spread over five months. It said that eight of its members agreed to pay their dues of R2,181 crore by due dates or earlier. As per broker estimates these funds were likely to come through by mid-September given the settlement dates of their trades. Another set of 13 members offered to pay 5% of their outstanding every week effectively paying R3,107 crore of their total dues over five months. The delayed payments attracted a 16% penalty as per NSEL. The rest of the outstanding amount pinned at R311 crore is owed by three entities that are still in negotiations with NSEL. The exchange has asserted that members who do not cooperate with the exchange may face FMC action and all possible legal recourse would be taken.

On August 14, 2013, NSEL announced a second settlement plan under the direction of the FMC. The plan included the settlement of R4,200 crore in dues over a period of 20 weeks with each week seeing a payout of R174.72 crore. This would be followed by R86 crore in settlement over the next 10 weeks. NSEL also said that over this 30-week period, the remaining dues of R1,219.71 crore would be settled via sale of commodities, fixed assets and land by some members.

Has NSEL stuck to the settlement plan?

NSEL has partially defaulted on the first three scheduled payouts. It disbursed R92.73 crore as part of the first payout. And R12.05 crore and R15.32 crore were disbursed in the second and the third payouts, respectively.

Meanwhile, NSEL decided to pay R177.23 crore to small investors by taking a bridge loan taken from its parent company Financial Technologies India Ltd (FTIL). As part of this plan, 608 small investors who were to receive up to R2 lakh each will be paid in full. Another 6,380 investors who had to be paid R2 lakh to R10 lakh will receive 50% of the amount. These investors will receive the remaining amount proportionately as per the settlement plan.

SGS, the Swiss firm appointed by NSEL in early August in its preliminary findings, is believed to have found only 15% of the reported stocks at 23-odd warehouses inspected. NSEL has declared 19 entities as defaulters and initiated default proceedings against them.

How far have the investigations on the NSEL crisis proceeded?

The NSEL board has sacked its MD and CEO Anjani Sinha along six other heads of departments and filed a complaint against them in the Economic Offences Wing. Two special groups have been set up under the Department of Economic Affairs to look into the issue and submit their reports by September 12. At the behest of the FMC, NSEL appointed Grant Thornton as the forensic auditors on August 27, 2013, and the final report on the auditor’s findings is expected to be submitted to the FMC by mid-September.

Meanwhile, the FMC is rethinking on the “fit and proper”status of promoters of Multi Commodity Exchange (MCX), a group entity directly regulated by the commodity regulator. A final decision on this is pending.

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