Plug the regulatory gap

Commodity spot trading is becoming a systemic risk

The consumer affairs ministry was fairly quick to respond to the fiasco caused by the decision of the National Spot Exchange Ltd (NSEL) last week to suspend trading in all contracts except "e-series", and to defer settlement. But the response also exposed the clumsy way in which the government has handled the issue. A senior ministry official told the media soon after the crisis hit that "we are all shocked", as the ministry had been telling the NSEL to mend its ways for the last one and a half to two years. It was an extraordinary response, since it amounted to a virtual admission by the government that it was aware of the pitfalls of the practices adopted by the NSEL but did precious little to take corrective action. Investors at risk of losing their money will hardly be consoled by the ministry's expression of "shock".

The fact that the NSEL could carry on with the product that is at the centre of the current problem without the government's approval, and even a year after it received a show-cause notice from the ministry, speaks volumes about the shoddiness of supervision. The only things that happened after the show-cause notice were letters, meetings and representations from the NSEL, which had become a money spinner for its promoter, the Financial Technologies Group. The NSEL has now proposed a settlement mechanism, but several participating members, with dues accounting for more than 50 per cent of the total payment obligation, have opted for a deferred weekly settlement of dues - thereby indicating that a payment crisis is not yet ruled out. While the NSEL's and its promoter's credibility has certainly been dented, regulatory ambiguity is at the heart of the problem. The NSEL was operating independently without any regulatory framework and was provided an exemption by the government under Section 27 of the Forward Contract (Regulation) Act, which allowed it to conduct forward trading in one-day contracts. The exemption, however, came with stiff conditions, including a ban on short selling and the launch of longer contracts, both of which the NSEL has now been accused of violating at will.

It is nobody's case that spot exchanges should stop functioning. But it is obvious that the regulatory vacuum in a market that's continually growing bigger must end without delay. The 40 per cent annual growth in volumes on the commodity futures exchanges was the trigger for setting up nationwide spot exchanges in 2006-07. True, regulating these nationwide spot exchanges is a complex task since they deal in agri-commodities, which is a state subject. Even if the Centre regulates them, these exchanges will have to take permission to trade from state governments. The task becomes even more difficult since there is no global model for regulating nationwide spot exchanges. The large number of regional physical mandis is also an India-specific phenomenon. Things get even more complex: the Warehouse Development and Regulatory Authority has the power to regulate spot exchanges, but it lacks the expertise - while the Forward Markets Commission has the expertise but no power, something for which it has been waiting for several years. In the absence of that, the Forward Markets Commission regulates commodity futures but not spot trades, leaving exchanges such as the NSEL free to push the limits of what spot trading means. The basic point is that the debate has gone on for far too long. The NSEL fiasco should be treated as a wake-up call, if the government wishes to avoid yet another potential systemic risk.