Why the National Spot Exchange stopped trading

The National Spot Exchange Ltd (NSEL), owned by Jignesh Shah's Financial Technologies, has stopped trading in most contracts after an objection raised by the Department of Consumer Affairs. While this spells bad news for India's somewhat moribund commodities market, the situation has arisen following a complicated trading practice that came about due to confusion about which regulatory authority NSEL was governed by. The exchange took advantage of the confusion.
 
One of the products offered by the NSEL was essentially a repo (repurchase) of commodities, known as a funding product, say sources in the commodities market. It essentially brought together lenders and borrowers, who were not necessarily traders and purchasers. Normally, spot and futures exchanges are used by bulk growers and purchasers to fix prices and protect themselves from undue fluctuations.

However, options, an integral part of price hedging, have not been allowed in the commodities markets so far. This is why the overall trade becomes difficult to define from a regulatory perspective.

Spot trades are not regulated by the Forward Markets Commission (FMC). They come under the domain of the Agricultural Produce Market Committee (APMC) and Forward Contract Regulatory Act (FCRA) rules.

The APMC is a board set up by respective state governments. The forward trade leg does indeed come under the FMC, but it is settled as a spot trade immediately after the first trade in this particular transaction. This takes the overall trade outside the purview of a single regulator.

This product proved popular with borrowers who would not get credit otherwise because they were not creditworthy. Lenders were mostly high net worth individuals looking for a 12 to 18 per cent returns. In futures markets actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract, and contracts are settled by paying the difference without any physical delivery of goods , according the FMC rules.

Since only investors and borrowers are in the market, it doesn't necessarily remain pure commodity market play. The hybrid nature of the deal and the nature of the players makes it a funding product.

The selling or buying is done simultaneously, or one right after the other.

There are two legs to the transaction, one of which is carried out as a spot dealing , but the other is a forward contract, which is, for example, a 'T+31 day' contract (or 31 days from the date of the contract). The underlying commodity, the exchange has claimed in media reports, is held in its warehouses.

NSEL did the entire transaction on its electronic trading platform.

The lender sells the contracts and simultaneously buys a 30 day forward contract while pocketing the difference, said a commodities market source. This keeps the prices in both trades practically fixed.

The product was popular among broking houses, who didn't think there was any problem. "It does not violate any regulations," Chetan Barkhada, Head Commodities and Currency said in an interview with Business Today last month. The real issue, said Kishore Narne of Motilal Oswal, is one of regulation and investor education. Both said that the product was available to investors who would want returns from the market.

They did not respond to calls after today's developments. Anjani Sinha, MD and CEO, NSEL, did not respond either.

Commodity prices are physically related to demand and supply, which makes returns impossible to predict in a free market, and yet the product had up to Rs 5,500 crore in assets under management, according to sources.

Many investors had put in up to Rs 100 crore in this product. The fact that the funds involved in the product reached this level means it provided some returns in a commodities market that have traditionally been shallow. To make matters more complicated, any product that provides remotely consistent returns makes it an implied interest rate product, which cannot be sold by any entity not regulated by the RBI, sources said.

Now the Forward Markets Commission will, in conjunction with the new FCRA rules, might start regulating this market.

What remains to be seen is what the fate of investors in the product will be.