The NSEL case presents an example of bad strategy and poor corporate governance.
It is a bad idea to search for regulatory grey areas with the expectation that the firm will flourish faster in the absence of regulatory constraints. When a firm operates in a twilight zone, it exposes itself to enormous risk of regulatory overdrive when the incentive to the regulator fails to motivate it to turn a blind eye on the operation of the firm. Look at the National Spot Exchange (NSEL) saga.
The Ministry of Consumer Affairs, for a long time, turned a blind eye on the violation of conditions, under which trading on NSEL was exempted from the application of Forward Contract Regulations. Only in mid-July 2013 did it intervened and direct immediate settlement of contracts that were open for more than 11 days and not to allow settlement beyond the 11th day because the Forward Contract (Regulations) Act defines a 'ready delivery contract' (spot contract) as one that is settled immediately or within 11 days (T+10) through physical delivery of the underlying asset.
When the promoter develops a business model with the objective of circumventing regulations, the firm starts on a weak cultural foundation. It signals disregard for laws and regulations. Illegal and unethical transactions thrive, causing ultimate demise of the firm.
There are examples that certain promoters could build business empires on poor ethical foundation, but those are exceptions. The risk that the business model will fall flat sooner than later is genuine. It will not be surprising if investigations reveal that NSEL executives, investors and commodity traders had colluded to perpetrate financial and other types of fraud.
The son-in-law of the chairperson of NSEL (Shankar Lal Guru) too embarrassed his father-in-law. He is the promoter of NK Proteins, a company that owes Rs 920 crore (16.5 per cent of the total payout) to investors. Guru, who was the non-executive chairman, resigned only after the crisis erupted in July 2013. It would have been better had he resigned when NK Proteins used NSEL to finance its working capital needs.
Future contracts are forward contracts routed through an exchange. They are usually settled in cash rather than through the delivery of the underlying asset. In case of NSEL contracts were closed through physical delivery.
The T+ 25 and T+36 settlement cycles gave an opportunity to investors to earn high return by lending money to commodity traders who preferred hassle-free process for raising funds to support working capital needs.
The modality is simple. The investor (say, Y) enters into buy and sell contracts with a trader (say, Z) simultaneously or at a short interval. The buy contract is settled on the third day. Y pays the price to Z and takes ownership of the commodity through the transfer of the warehouse receipt. The commodity remains in the warehouse. The sell contract is settled on the 37th day. Z pays the price to Y and takes back the ownership of the commodity. Thus, the lending by Y is secured by collateral of the commodity in the warehouse. The spread between the buying price and the selling price is the income for Y. Z arranges the fund to pay Y in the second leg of the transaction by selling the commodity to an ultimate user or by arranging finance from another investor. In this arrangement, Z is likely to default if he is unable to liquidate the stock in the warehouse or unable to find another investor.
When the Ministry of Consumer Affairs intervened in July 2013, investors smelled a rat and shied away from NSEL. Traders found it difficult to arrange funds and defaulted. NSEL facilitated financing commodity traders and, thus, enhanced their liquidity. Higher liquidity helps traders to hold stock for a longer period and choose the right time for liquidating the same, which contributed towards stabilising commodity prices. The transparent mechanism of trading on an electronic platform helps in price discovery. Thus, NSEL was serving an important purpose.
The same purpose could be served even if NSEL did not enjoy exemption from Forward Contract Regulations and had operated under the surveillance of the regulatory authority.
A T+10 settlement system might have resulted in increased transaction cost but could serve investors and traders better.