Forward trading: Then and now

Forward trading, which was at the core of the operations of National Spot Exchange Ltd (NSEL), also became the centre of a controversy later. The payment issue at NSEL might not have risen to the level of a crisis if there was a proper regulatory mechanism to govern forward trades. The Forward Markets Commission (FMC), which then said it was not regulating NSEL, has now permitted forward trades on national exchanges. Two exchanges have already launched such trades.

Forward trading, which NSEL had introduced successfully for commodities, continues to have a huge growth potential. These trades involve deals for sale of goods with delivery scheduled at later dates.

Under NSEL, forward trading had started around 2010 in an unregulated manner. Later, when FMC found NSEL's practices needed investigations, it wrote to the department of consumer affairs to probe the matter.

On the basis of its probe, the department served showcause notices on NSEL, seeking explanations on forward trades settled in cycles of more than T+10. Anjani Sinha, then managing director of NSEL, replied by saying there was nothing illegal in these trades, as T+10 norms were not defined anywhere. Later, after 11 months, the government issued notices to the exchange to settle all contracts. This ultimately resulted in suspension of trading and a huge payment default.

Forwards deals on NSEL had different maturities - from T+2 to T+30 - and were used only for borrowing money. These deals were priced to ensure lenders got 15-18 per cent annualised returns. The contracts were renewed on every settlement.

In today's forwards, two parties decide their terms of trade and report those on the exchange's platform; pay margins and contracts are settled on delivery. All forward trades are at present regulated by FMC, but these will come under the purview of the Securities and Exchange Board of India (Sebi) after the regulators' merger.

NCDEX says: "Forward contracts launched by the exchange are compensation-guarantee contracts, where, in case of a default by either party, the counter party is guaranteed a compensation to the extent of 90 per cent of the margin collected. Forward contracts transacted in the OTC (physical) market do not have any such provision/practice."

As for differences in the nature of forward trading, these trades were not regulated during the time of NSEL and were used as a mechanism to borrow money against commodities that were not there. An official says: "Sebi has issues in regulating forwards as it involves physical deliveries." Exchanges and FMC are understood to have clarified to Sebi that forward trading in its new form is safe and any default can be taken care of by margins deposited by the parties involved. Sebi will clarify its stand when commodity-derivative regulations actually come under its purview, probably from October.