NSEL fiasco: When buyer and seller are the same...

For buyers, it was cheap finance, the seller earned good returns and the goods never had to be delivered

The National Spot Exchange (NSEL) fiasco has put the spotlight on the way commodity prices were artificially raised or even brought down. According to industry players, the mechanism was used to make a quick buck by high networth individuals (HNIs) and commodity buyers got cheap finance.

Exporters and commodity traders bought the commodity such as paddy or castor seed from the farm for say, Rs 100. After that they sold it at the spot market on NSEL at Rs 105. Big brokers bought the goods at the price and sold it in the forward deals (T+20 or more) for say Rs 108 to the same exporter or commodity trader.

In this way, the trader who had bought it from the farm at Rs 100 first acquired the same goods for Rs 108. His profit: Rs 2 within just 10 days. The brokers, who bought for Rs 105 and sold it at Rs 108 profited by Rs 3. In this way, the price of the commodity was raised artificially. For the original trader, this is a good way to finance the stock at the rate which is competitive to banks.

Big brokers, who took positions in the future market, goaded their high networth individuals to invest in commodities by promising high returns of 30-40% annually. These brokers also funded the HNIs to invest in these commodities. The HNIs were given allocation letters by the exchange. However, they never took the delivery in goods. The position was squared off in cash. 'This was a good opportunity for everyone. With the stock market not really looking too good, HNIs are looking at other opportunities to make money.', according to a commodity broker.

The mechanism worked quite smoothly for a long time. Also, the commodities never had to leave the warehouse of the original buyer, thereby saving transaction costs. When there was a huge mismatch between the price in the spot and forward market, the forward contract would simply be rolled over.

But then, came the Ministry of Consumer Affairs. By raising objections about the transaction – which was short selling or going long in the market – & calling it self-defeating, it forced the exchange to stop the forwards' contract. NSEL shifted all contracts to trade-to-trade, meaning that clients would have to compulsorily settle transactions either by cash or delivery of goods by the end of the cycle. In addition to suspension of contracts, NSEL merged the delivery and settlement of all pending contracts.

The moment, there was a realisation that this contract will be stopped and cannot be rolled over anymore, people rushed to square off. And due to pricing mismatch in the spot and forwards market, buyers, who were the original sellers, did not have the money to cover for the payout. On the other hand, HNIs, who were in the market for quick profits refused to take delivery of the goods.

This caused the payment crisis. A number of brokerages namely, Motilal Oswal, Anand Rathi and others suddenly found themselves in a crisis situation because their client's money was completely stuck. HNIS were mainly coming to the market because the income from this was considered business gains which could be set off against other incomes.

While the exchange has sought five months to settle the issue, this is another lesson for HNIs and brokerages who have been investing in commodities for a quick buck.