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NSEL: Anatomy of a trade gone sour

Investors were lured by hefty returns at a time with markets were volatile

Clifford Alvares & Dev Chatterjee  |  Mumbai 

Jignesh Shah
Jignesh Shah

Like many small investors, P Dharnidharka, 54, invested in the commodity trades on the National Spot Exchange Ltd. Dharnidharka was promised hefty returns by his broker at a time when market was volatile and fixed deposit returns were not very attractive.

It looked too good to be true. Thousands of investors like Dharnidharka were lured into trading what looked like exotic derivative contracts on the National Spot Exchange Ltd (NSEL) that promised an assured return of anywhere between 15 and 18% per annum. Every trade would result in earnings of 1-2% in a month or so - guaranteed.

Dharnidharka was delighted at the prospect of earning business income from trading in commodities. No trade could go wrong. Investors and brokers flocked in droves to a well-crafted commodities-trading strategy that was simple to execute and immensely profitable. In the end, it turned out too good to be true.

Nobody asked crucial questions. How can commodities traded on an exchange always turn a profit for investors? How did the trade work? Who were the commodity Where were the warehouses? Nobody knew that one day the music will stop. And it did.

Looking back, when the commenced operations in October 2008, it started as an exchange to facilitate commodity producers to find buyers for their products. Spot exchanges normally offer T+2 or T+3 delivery. Any buy or sell transaction should be settled within a few days. If you purchased on the exchange, you paid your dues in two or three days and took delivery the next day of whatever you had bought whether castorseed or wool.

But as that didn’t bring volumes to the exchange and trading was relatively thin, sometime in 2010, according to market reports, Jignesh Shah introduced forward contracts that could be executed over 30-45 days. In other words, the settlement cycle was given another dimension. Now there were two settlement cycles for the same castor seed: a three-day cycle and a, say, thirty day-one.

As trades between two contracts go, arbitrageurs enter only when there is a huge difference in what they buy and sell.

But there was a crucial difference in the NSEL's price-discovery mechanism. The 45-day forward contract, for instance, of all commodities was always higher than a three-day forward contract. Says Shankar Raman, Head - Investment Products & Advisory Services, Centrum Wealth Management: “The prices were so funny that all the time there was a 15-18% forward gap. There will always be a carrying cost, but a fixed 15-18% is unheard off.”

Commodity prices should fluctuate and they were not fluctuating. On the they were "fixed". If the spot or three-day contract was “x”, the thirty-day contract was one or 2% plus “x” depending on the commodity. One simply bought the three-day forward contract and sold the thirty-day contract. You paid for the two-day contract. You waited for the 30-day contract to end that you sold at a higher price. And pocketed the difference.

That changed the fortunes of the and volumes perked up. Average monthly trading volumes shot up from Rs 1000 crore to Rs 28,000 crore till May 2013. Financial Technologies derived 57% of its profits from NSEL. The higher the trading turnover, the higher the revenues an exchange makes.

In a normal exchange, price-discovery is a continuous process. Forward contracts can go way above a spot price or way below. Short-term contracts can trade at a premium to long-term contracts, and vice versa. But at NSEL the longer-term contracts were always at a premium.

Always. Says Shankar: “If you look at equity markets, there are periods when there will be huge arbitrage in buying on spot and selling in futures.

Who made money and how

The Exchange
Revenues through charging a transaction cost as a percentage of turnover. The more the turnover, the higher the earning.

The Broker

Brokerage fees of 2-3% on the gross amount invested. A typical AUM of Rs 100 crore nets the broker Rs 1-3 crore per annum.

The Investor

Earned 1-1.5% a month buy short-term contracts at lower price and selling long-dated contracts at higher price. Pocketed the difference.

The Trader

Bought long-dated contracts at higher price and sold short-date contracts at a lower price and a paid a net difference of 1-1.5%. In the process received easy funding at a very low cost.

There are times when reverse arbitrage works and times when arbitrage is minimal. It all depends on the market mood. NSEL did not seem to have a mood at all.”

On NSEL, it didn’t seem like anonymous trades were happening between anonymous investors. But as profits were always assured, trading took off. Close to Rs 6000 crore was invested, and Rs 28,000 crore was traded in May 2013. Trading volumes even surged to Rs 40,000 crore in some months. More investors started getting in till as late as a few months ago. This golden opportunity spread through word of mouth among top investors and brokers and spawned coffee-time conversations.

Brokers and high net worth individuals started to see more business, and more opportunities. Dozens of investor presentations by brokers started flying around thick and fast. All brokerage presentations were essentially saying the same thing. They touted the benefits of exotic commodity trading, about the safety of the exchange, about stocks in warehouses, about the rag-to-riches story of NSEL promoter Jignesh Shah, and about how to trade and make easy profit.

As investors started to pour in money, brokers began to finance some high net worth individuals against these trades.

The NSEL trade was an arrangement that brokers should have been familiar with. “It was a financing scheme and there was an arbitrage much like the badla system,” says Motilal Oswal, chairman and managing director, Motilal Oswal Securities. The age-old badla system was banned in back in 2000, after futures trading was introduced. Trading in forward contracts on the NSE is exactly the same. Back then, investors funded those who didn’t have shares to sell, and pocketed a difference called “badla”. Because of the badla-system any short-sale could be carried on in perpetuity as all the borrower had to was a transaction cost.


A typical broker sales pitch
Commodity Duration Lot Size Days (Approx) Investment Yield*
Castor Seed T+3 & T+36 300 bags 52 Rs 10 lakh 16%
Castor Oil T+5 & T+30 10 MT 38 days Rs 10 lakh 15%
Paddy T+2 & T+25 300 bags 35 days Rs 3-4 lakh 14%
Steel T+2 & T+25 10 MT 35 days Rs 5-6 lakh 14%

The same thing happened on the NSEL. Investors started rolling over positions and pocketing a difference of 1-1.5 percent every month. Brokerages skimmed about 1 to 3% of the gross investment per annum, and furnished the net difference -- of about 12-15% per annum -- to investors.

One crucial difference that everybody overlooked was that these contracts should have been guaranteed by goods in the warehouses. Nobody seemed to verify whether the goods actually existed or not. Brokers started giving out contract notes to hundreds of investors backed against just one warehouse receipt (you can’t split a receipt). The warehouse receipt acted as title to the The broker was taking a risk on the warehouse receipt.

Nobody verified the warehouse receipt or whether goods were actually at the warehouse. Some warehouse receipts are said to be authentic as some genuine producers wanted to finance their working capital till their goods were sold. But as nobody verified the warehouse receipts more commodity started producing warehouse receipts against which they received easy funding. Some may have used this money for financing their business, but the rest is anybody's guess.

Borrowers paid around 12-18% per annum as they were selling-long dated contracts and buying higher priced spot contracts. They rolled-over their positions as nobody asked for collateral or their investments back. As they repeated the cycle, in the end, the whole thing ballooned into a huge un-checked financing scheme for commodity

Structure of the trade
For investor
Buy a lower priced T+2 contract
Sell a higher priced T+35 contract
For trader
Sell a lower priced T+2 contract
Buy a higher priced T+35 contract
T+2 Money moves from investor to trader
moves from trader to investor
T+35 Money moves from trader to investor
Stock moves from investor to trader

Since February last year the Forward Commission (FMC) started monitoring what was happening. The NSEL was not regulated as a commodities exchange under the FMC as it obtained a waiver from the Consumer Affairs Ministry from the Forward Contracts Regulation Act.

Then came the blow. Forward trades were banned by the Forward Commission in NSEL as the exchange was not authorised to do so.

As investors could not trade in these long-dated contracts on the NSEL ever again, the arbitrage game that everybody played closed down overnight.

And now this.

The Fallout

Ever since, the FMC sent a letter to NSEL to stop carry forward trades in July, the exchange and its promoters were in a denial. Queries from media on the lack of stocks and probable default were met with strong denials. Even before the July 31st statement by NSEL to stop the forward trades, the was abuzz that NSEL was heading for trouble and some traders will not be able to meet their commitments.

Investors and their brokers are especially bitter about the way NSEL and its promoters Jignesh Shah informed everyone that all commitments will be met by the exchange and the traders.

Around July 12th, Anjani Sinha went to Motilal Oswal’s office to convince them that everything is fine and all payments will be made in time. Many other times were shown including auditor’s certificates that there are enough stocks in the go downs. They kept on misleading all brokers that they have enough stocks, margins and trade guarantee money. During the presentation before Secretary, Department of Consumer Affairs on 10th July, 2013 and during the meeting with FMC, Jignesh Shah, Director, NSEL and promoter of Financial Technology had said that NSEL offers highest level of safety for the participants as the model assured that 100% stock as collateral (managed by independent collateral manager), 10-20% as margin money and backed by 100% of post dated cheques from participants. “But we soon realized later that this was just to hoodwink us and to perpetrate a fraud on investors. Their chairman's son in law is lent 700 crore,” said Oswal.

Oswal and other brokers, investors are now staring at a huge default of Rs 5,500 crore from NSEL with more than 15,000 investors now waiting for their money to come back. Small investor body say it will be difficult for NSEL to raise so much of funds and the only way to get money is to sell assets of NSEL and its promoters. “This is a crisis of confidence.

No one trusts Shah or his words. They want to see the cash on table,” says Kirit Somaiya, BJP National Seceretay and President of small investor lobby body – Investors Grievances Forum. “We have already sought a probe by police, enforcement directorate and have appealed to the Bombay High Court to take over the assets of NSEL, FT and its promoters.”

The Indian government – which took some half-hearted measures in the beginning – swung into action when the matter reached the courts and the Parliament.

The income tax department surveyed all the 24 defaulters who owe Rs 5,500 crore to the investors. But investors like Dharnidharka says it’s a case of too little, too late.

“I now just want to get back my money and go back to Rajasthan. All my retirement savings are now stuck with NSEL. I will never look for easy money in markets again,” says Dharnidharka.

First Published: Mon, August 26 2013. 13:55 IST