Forward Markets Commission has a lot to answer for
A spot exchange, like the leopard, cannot change its spots. Trying to do so, will land it in a spot of bother, as the National Spot Exchange Ltd. (NSEL) is now finding out. The NSEL’s mandate is to offer a national electronic spot trading platform for commodities. Yet, by deciding to go well beyond its brief into forward trading of commodities, something that was neither in its charter nor supposed to be its mission, the exchange has landed in grief and has set off what may turn out to be the biggest markets crisis in recent times.
What exactly is the fuss all about and how did it come to this? First, a brief look at NSEL and what it does. NSEL is part of Financial Technologies (India) Ltd., (FTIL), which has also promoted Multi-Commodity Exchange (MCX) and MCX-SX, a stock exchange. FTIL and MCX are listed on the exchanges.
NSEL is the premier spot exchange for trading of commodities with a 99 per cent share of the market and deals in agri-commodities and metals. It has 817 members with over 56,000 trader work stations across the country and in 2012-13 it turned over Rs.2.95 lakh crore. Spot contracts have to be settled within 11 days as per provisions of the Forward Contracts Regulation Act (FCRA), that is, delivery of the commodity and cash settlement has to be completed within this period.
Agri-commodities were the dominant products traded on the exchange accounting for three-fourths of the daily turnover of around Rs.600 crore. NSEL, which has warehouses in Delhi, Madhya Pradesh, Gujarat, Rajasthan, Maharashtra, Bihar and Orissa, counts organisations such as Food Corporation of India, MMTC, Cotton Corporation of India and NAFED among its members.
Though it was founded mainly to offer a national spot market for commodities, the exchange secured specific approval from the government in 2007 to offer one-day forward contracts. The conditions were that there would be no short-sales and that all outstanding positions will be settled by delivery. However, NSEL allowed forward contracts to be rolled over under the excuse that the FCRA does not prescribe a period for delivery. It also appears to have turned a blind eye to short-sales by traders speculating in the forward market.
Spotting the opportunity, brokers and traders started offering “products” tailored for their clients with assured returns of 15 per cent and more for speculating in commodities on NSEL. And with equity markets listless, business started booming with turnover zooming from Rs.2,182 crore at the end of its first year of operations in 2009 to the present level of close to Rs.2.95 lakh crore. Forward contracts became the mainstay of its business with spot trading being the poor sibling.
In February, 2012, the government, probably noticing what was happening, brought the NSEL under the purview of the commodities market regulator, Forward Markets Commission (FMC). But that changed little on the ground. The party was well and truly on until the Ministry of Consumer Affairs (MCA), which oversees commodities bourses, and the FMC snatched the punch bowl away on July 12 by asking NSEL to stop launching new contracts until further orders. The FMC also sought an undertaking that all existing contracts will be settled on their due dates.
Bowing to the directives, NSEL told its members that contracts have to be settled within 11 days and it would be on a trade-to-trade basis, that is, payment against delivery of the commodity. This lead to a fall in trading volumes as traders, who were active in forwards, lost interest in spot trading. As traders failed to roll-over their contracts and demanded settlement, the exchange ran into trouble leading to its July 31 decision of a 15-day moratorium on settlement of existing contracts. NSEL was also forced to down its shutters by suspending trading in order to counter speculation of a payments crisis.
Now, to the questions: First, how did the government give permission for one-day forward contracts to a spot exchange, especially when it was outside the purview of the regulator, FMC? From 2007 and till February, 2012, NSEL’s forward trading was practically operating in a regulatory vacuum.
Second, how is it that the FMC failed to notice the raucous party that was on at NSEL even if it was not under its watch?
Drawing a parallel
To draw a parallel, stock market regulator, SEBI, hauled Sahara over the coals for raising funds through optional fully convertible debentures even though the company in question was not listed and claimed it wasn’t making a public offer. Similarly, SEBI has also been active in watching over collective investment schemes (with mixed success, of course) even though it does not come under its regulatory watch, strictly speaking. Shouldn’t the FMC have similarly reined in NSEL before things came to this pass? Third, having let the party go on, the government appears to have acted clumsily by stopping the music suddenly. The drunks have thus been let loose on the streets causing mayhem. Instead of asking NSEL to stop new contracts forthwith, the MCA could have told the exchange to gradually wind down all forward contracts which would have been more orderly and not shocked the system.
A number of big broking houses, active in the stock market, are said to also have exposures in NSEL. In the worst case scenario, a payments crisis in NSEL (though unlikely as of now) could thus spread to the stock market too. This is quite apart from the losses to investors caused by the precipitous fall in the stock prices of Financial Technologies and MCX. An orderly wind down would have contained the damage.
Finally, it is indeed shocking to note the extent of lax regulation of a market institution with a daily business of Rs.600 crore. It is clear that the FMC either did not notice or chose to look the other way after the NSEL was brought under its watch in February 2012. Either which way, it has a lot to answer for.