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NSEL: Chronicle of a crisis foretold

By operating on the outer edges of the financial regulatory system the serial payment defaults were inevitable. The time has come to equate spot exchanges with stock exchanges and commodity futures ex

Rajnikant Patel 

Rajnikant Patel

Every day, there are new developments to follow in the National Spot Exchange Ltd (NSEL) crisis. Payment defaults are becoming a regular feature and the amount collected is never in sync with the schedule that is announced. How did matters come to this pass? Although the "how" is important and needs to be examined to find a solution to the chronic issue of settling outstanding payments, it is equally important not to lose sight of the regulatory and systemic issues. In finding answers to the settlement default and the protection of investor interest, a proactive and long-term solution to the present market structure must be formulated. There is no better time than the present to review the system and take immediate corrective steps.

There seems to be an erroneous perception in the marketplace that equates spot exchanges (spotexes) with stock exchanges (SEs) and commodity futures exchanges (comexes). A spotex is as different from an SE and comex as chalk from cheese. The latter two are licensed, regulated and supervised by their respective regulators - the Securities and Exchange Board of India, the Forward Markets Commission (FMC) and the ministry of consumer affairs. The former is a completely independent entity. A spotex has to obtain exemption under section 27 of the Forward Contract Regulation Act from the FMC if it wants to offer intra-day netted spot contracts. This exemption, if granted, gives FMC limited oversight on a spotex. Compare this to an SE or comex where everything, from the application for permission to act as an exchange to the equity capital structure, board composition, CEO appointment and so on, is governed by regulators.

Further, various regulations regarding operations such as trading, settlement, margining, surveillance, member inspections, audits and so on are all closely formulated or issued by the regulator. After the 2001 capital market scam, the processes of corporatisation and demutualisation were introduced to take care of conflict of interests between owners and the management and exchange administration. None of these checks and balances are applicable to a spotex. Hence, to believe blindly in the safety of the settlement process takes courage. When the financial exposure of a quasi-regulated entity runs to thousands of crores, regulatory oversight becomes inevitable.

By definition, a spotex deals in physical commodities since it is a spot-market intermediary. This presupposes the presence of a uniform, credible and financially sound regulated national market structure such as warehousing (WH), collateral management, transportation and quality control. The Warehousing Development & Regulatory Authority was established to take care of these issues but is yet to deliver. In 2011, a notification dealing with WHs and electronic/negotiable warehouse receipts (EWR/NWR) was drafted in consultation with industry. It also dealt with spotex regulations such as equity structure, board composition and a depository structure, WH registration and supervision and so on. But that notification never saw the light of day; it disappeared into the black hole of regulatory jurisdiction.

One of the major issues in the current crisis yet to be conclusively resolved is the availability and amount of stocks with the WH. This is the starting point of the spotex trading system. Had an accreditation and supervisory regulatory system been in place, it would have exposed the vulnerability and probably would have helped in the investigations.

A corollary to this is the settlement guarantee fund (SGF) and margining system. The base components of SGF are initial margin/deposits, mark-to-market and value-at-risk margins and accumulated interest, penalties and collaterals. Margins will get affected (mostly adversely) based on the manner of calculating open positions - whether it is on a gross basis or net. There is a possibility of a broker net-position being almost zero if the clients have offsetting positions. This, however, increases the default risk manifold and brings the client default to the broker and ultimately to the exchange level.

In short, complex structured products with inadequate or no underlying assets along with low-base capital, under-margining and an inadequate SGF make a perfect recipe for a default. Add regulatory gaps and we are looking at a systemic disaster.

So, what do we take home?

First, it is imperative to resolve the current crisis as quickly as possible to restore confidence in the system. That is easier said than done, of course, given the numerous challenges before the regulators that probably raise more questions than answers, but something has to be done before the issue gets out of hand.

Second, some possible systemic changes are needed along with operational measures to tackle the issue on hand.

A. Regulatory

  • Bring EWR/NWR into the definition of "Securities", to enable a national-level trading platform regulated by a national regulator. It may be possible to handle the constitutional allocation between states and the Centre by equating electronic warehousing receipts with capital market.

  • Implement WH regulations and make them mandatory for WHs if they are to be associated with spotexes and comexes. This will bring uniformity of quality, storage and accounting practices to enhance the accuracy and credibility of WH receipts.

  • Specify the equity capital requirement, board composition and governance structure of spotexes.

B. Risk management/operational
  • Create an integrated clearing and settlement system and centralised margining and capital adequacy norms
  • Tighten the integration of spotexes with comexes to prevent the mushrooming of spotexes without adequate financial capability. It will enable fungibility across the spot and futures markets, may facilitate implementation of the Goods and Services Tax, provide an audit trail for the government, and ensure better risk management and default management
  • Create infrastructure for WHs and network them to spotexes and comexes just like SEs. The technology to do this exists. This move will also attract WHs of sound financial health and increase the reliability of the entire system
One of the major handicaps for integrated/coordinated regulation has always been the issue of jurisdiction. Every authority wants to have independent and total control over its jurisdiction. Nothing new or wrong with that. Attempts to coordinate through coordination committees, whether high level or low level, have never worked. But surely, the time has come to overhaul the issue of jurisdiction in the interests of the national financial system?

The writer is former MD & CEO, BSE

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First Published: Wed, August 28 2013. 21:44 IST