NSEL crisis has in fact opened a Pandora’s Box. There are reports that the government knew about the lapses but did not initiate any action. However, regulatory transformation should be smooth even if some glaring mistakes are found to avoid panic in the market

The concept of novation is being tested like never before in the history of functioning of exchanges in India. There is a crisis of hovering around settlement of transactions in the National Spot Exchange Ltd (NSEL). While it may sound as an exaggeration, nothing explains it better than unprecedented fall in the share price of promoter company and sister concerns of NSEL.  NSEL crisis has in fact opened a Pandora’s Box. There are concerns are all around. The share prices of Financial Technologies Ltd (FT) and Multi Commodity Exchange of India Ltd (MCX) have gone down sharply causing huge loss to the shareholders of these two companies. Systemic issues have also come to the fore with this crisis. In an over-regulated country, this is an example of absence of proper regulation. There are reports that the government knew about the lapses but did not initiate any action. In fact, the entire crisis has raised a number of issues related to the functioning of the spot exchange. Here is a list of five key lapses that come out from the current crisis being faced:
 

Distortion of meaning of spot transaction: What is a spot transaction? For dealers in currency, a spot transaction is one in which the settlement of transaction happens on T+2 basis. In equities, it happens generally on a T+2 or T+3 basis.  In our real life, spot transaction in which we pay money and receive goods immediately. So why did it extend upto T+35 basis on NSEL? Isn’t it complete distortion of concept of spot contract? Even if we look at definition of ready delivery contract under Forward Contract Regulation Act (FCRA), it says, “Ready delivery contract means a contract, which provides for the delivery of goods and the payment of a price therefore, either immediately or within such period not exceeding eleven days after the date of the contract and subject to such conditions as the Central Government may, by notification in the official Gazette, specify in respect of any goods, the period under such contract not being capable of extension by the mutual consent of the parties thereto or otherwise.”  NSEL gave a new concept to the spot transactions in the absence of proper regulatory control.
 

Regulatory Vacuum: While NSEL is to be blamed for the current mess, this case also reflects the regulatory vacuum in context of the how a spot exchange needs to be run. There was no clarity on who should regulate spot exchange. It was not under the control of Forward Markets Commission (FMC) as spot contracts are different from forward contracts. Also, since it is not a not a contract on financial assets, Securities and Exchange Board of India (SEBI) or Reserve Bank of India (RBI) could have regulated it. NSEL knew this better than anybody and exploited the vacuum to float contracts, which created opportunities for transactions in commodities. One sudden day when Ministry of Consumer Affairs (MCA) came out of slumber, it felt the need to regulate the exchange. Why was the regulation of NSEL, never taken seriously? How can an exchange be allowed to trade critical asset like commodities without proper regulation? This is classic case of regulatory vacuum. Or is it that it was known to the government and was being overlooked? This needs to be investigated.
 

Ownership structure issues: This is a point, which no one is raising. It is pertinent to note that the ownership requirements for stock exchanges were notified by Government of India vide SCR (Manner of Increasing and Maintaining Public Shareholding) Regulations, 2006 (MIMPS). If NSEL is not a stock exchange strictly, should not there be a similar regulation of other exchanges as well. Promoters of NSEL are Financial Technologies and National Agricultural Cooperative Marketing Federation of India Ltd. Why not to have clear-cut ownership requirements of all other exchanges in the country whether stock exchange or commodity exchange. The ownership structure of spot exchange needs a change immediately to bring more transparency.
 

Spot exchange promoting speculation: What is the objective of existence of an exchange? Nothing explains this better than the mission statement of National Spot Exchange “To develop a pan-India, institutionalized, electronic, transparent Common Indian Market offering compulsory delivery-based spot contracts in various agricultural and non-agricultural commodities with a reduced cost of intermediation by improving marketing efficiency and, thereby, improving producers’ price realization coupled with reduction in consumer paid price”.
 

Sounds great, isn’t it? However, practically the spot exchange became a place for speculation for investors and commodity holders. People with no direct interest in commodities started speculating in commodities. There are reports, which suggest that the spot exchange became a place where 10% plus returns were guaranteed. While commodity holders deposited commodity in the warehouse to sell commodity, investors bought it and sold a longer settlement period. For example, if the depositor of the commodity sold it on T+2 basis and was bought by an investor, the investor further sold it for T+25 basis. This resulted in creation of repurchase contract, which is also known as repo contract. This was the beginning of speculative activity. Most of the transactions were driven by speculation and the opportunity to make short term and quick money.
 

Poor Audit and transparency issues: Reports in the media suggest that NSEL claimed that it had Rs6200 crores of stocks against the settlement exposure of around Rs5,400-Rs5,500 crore. The exchange also claimed that it had settlement guarantee fund of Rs800 crore. The Economic Times reports that this guarantee fund has dwindled to Rs60 crore today.
 

But the most important question that remains unanswered is, “If there is a mechanism to verify the value of stocks which NSEL claims to have?”  There is no third party verification of this claim available in public domain. Also, if the money is to be realized from sale of these assets, will it get converted into Rs6,200 crore. The transparency of exchange operations is also not very opaque in absence of proper regulation. The audit reports in this regard are still awaited.
 

This crisis is a great learning for regulator, investors as well as exchanges. There is an immediate need to regulate exchanges on a comprehensive basis. In addition, the government needs to ensure that blatant speculative activities are not allowed through exchange platforms especially in case of commodities. Another important lesson learnt is that regulatory transformation should be smooth even if some glaring mistakes are found to avoid panic in the market.