Coming soon on the heels of the problems in the chit funds segment in West Bengal, the problems at the National Spot Exchange Ltd (NSEL)?a private entity whose mandate is to facilitate spot transactions in commodities?have brought to the fore the urgent need to revisit the gaps in the current regulatory structure in the financial services. This is extremely vital because financial services are no longer the plain services they were two decades ago. Commodities, non-physical contracts like carbon credits, indices and the like have become financial instruments today. Gold, petroleum, silver and increasingly edibles oils, guar, etc, have been converted into financial instruments under a variety of structures. It is not long before sugar, coffee, cocoa, coal and electricity also join list of the ?financialised? underlyings.
Based on reports and my own personal interfaces, it would seem that the effort in this particular case was (1) raising funds from high net worth individuals (HNIs); (2) under certain structures which on paper involved commodities. Both are either not supported by current legal frame work or violative of existing legal framework.
Unlike in the case of chit funds in West Bengal, most of the investors who have invested funds under NSEL structures are HNIs. I would therefore have least sympathy for these investors even if they lose their money. They were looking for 14-16% annualised returns in a market (under what was marketed to them as supposedly risk-proof structures) when corresponding returns for similar risk profile structures did not exceed 10% in the market. The modus operandi (based on what was presented to me by a wealth management group) was that the investor would buy on NSEL a commodity today, say, for R100; today itself, a second simultaneous reverse transaction would take place for sale of exactly same quantity of the commodity for, say, R102 but with a settlement date which is 45 days later. Since a financial year has 8 cycles of 45 days (360 days), the R2 gain would translate to a 16% annualised return (8×2).
The structure suffered from a series of legal infirmities. First, NSEL cannot deal in transaction beyond 11 days. Only commodities futures exchanges accredited and regulated by Forward Markets Commission (FMC) could undertake such futures contracts. NSEL is not so accredited. Second, the structure is simply nothing but a swap but with a commodity as an underlying. Such commodity swaps are not permissible under the current legal structures. Third, in case of currency and security swaps, current mechanisms ensure that the concerned currency/security indeed exists. Lastly, the whole transaction is tantamount to acceptance of public deposits from individuals by an entity not so licensed to do by RBI. While some aspects of these structured commodity transactions are not specifically prohibited, they are also not regulated by anyone today. The problems have arisen because the market participants have developed, in the wake of events that have unfolded, a fear that the underlying commodities may not exist but are only a front.
There have been attempts to project that in the example above the client is actually settling both the legs of transaction on the same day but is only allowing a 45-day credit to the buyer under the second leg of the transactions. My discussions with two investors whose money is stuck revealed that (1) they never agreed to such provision of credit to the buyer in the second leg of the transaction and (2) neither NSEL not the intermediary ever brought this aspect of the structure specifically to their attention; they were always told that NSEL guarantees the entire set of transactions. Only an investigation would reveal where the money went finally?into commodities or elsewhere.
The issues relating to the intermediaries who marketed these products to the HNIs are the ones that require maximum scrutiny. Their role is exactly like the mis-selling which has taken place in life insurance. (1) Do these intermediaries have a responsibility to their HNI clients whom they persuaded to invest in these structures of NSEL. (2) Did they verify the fundamental legality of these structures? I have been personally marketed the structured product of NSEL by the wealth management arm of a leading NBFC whose ownership recently changed hands. I wanted a confirmation from its compliance officer certifying that they find the structures legal. The team did not come back to me. (3) More interesting would be for the investigating team to examine whether these wealth management groups had also invested their proprietary funds in these structures but withdrew their proprietary funds sensing trouble, leaving their clients to face the music.
Sebi/RBI would need to change the rules of the game for these groups at least where marketing of structured products is concerned. In all structured products recommended by the wealth management groups, their proprietary money (say, 10-15% of the money mobilised under the structure) should come from the wealth management group. This amount should stay invested pro rata so long as the clients stay invested. But the most important changes that are needed are on the regulatory side. Spot markets in commodities must be brought under the regulatory oversight of FMC. I am aware that there are issues involving Constitutional changes. One must however also realise that in case of cooperative banks regulatory oversight by RBI was achieved without having to amend the Constitution of India. FMC must insist that intermediaries offering structured products with commodities as an underlying must need recognition from FMC.
To its credit, the events would not have unravelled but for the firmness of the FMC. Unlike in the securities markets, spot markets in commodities and hence entities like NSEL are not under the jurisdiction of FMC. Nevertheless, it would be interesting if FMC places in public domain the rationale which prompted it to exempt NSEL (and possibly a few other similar entities) from some of the provisions of the governing Act?FCRA?when FMC knew that these exempted entities were not going to be later regulated by them. It is this permission that opened the gates for these products based on regulatory arbitrage. FMC must also stipulate in this regard that those officials who have worked in the regulatory body cannot later join any group that FMC regulates, without at least a two- or three-year gap.
It must insist that both futures as well spot entities place on their websites centre-wise availability of the commodity stock for a participant to view the details prior to trading on an entity. FMC must also undertake periodic surprise inspections of warehouses. These events also underscore the urgency for amendments to FCRA (which has been in Parliament for a decade now), which will strengthen FMC to regulate a rapidly evolving market place that is getting ahead of regulatory structures in place.
There is a strong possibility that the next such problem will indeed be in the area of wealth management. While RBI has recently mandated that such activities would need to be housed by banks in a separate subsidiary and many of their activities are under Sebi jurisdiction, these are under-regulated today.
The author, former MD & CEO of NCDEX, is non-executive chairperson, SKS Microfinance. Views are personal
