NSEL Fiasco – What Went Wrong?

Author: Bharat Goswami, NMIMS Mumbai

On 1st August, an army of brokers thronged the NSEL office in Mumbai, demanding commodity bourse pay up. The exchange could not meet its payout commitment after it suspended trading on several contracts that were disapproved by the Govt. Trading positions worth Rs. 5,500cr are pending on NSEL i.e. National Spot Exchange Limited, which have halted trading for fortnight.

Let’s see how NSEL managed to get into this mess

In simple terms NSEL mechanism was used by farmers/any party to take loans keeping items such as castor seeds, cotton, etc as security as these items are considered safe and loan amount used to be around 60-70 % of the market value of those items. Consider a situation where a farmer wants a loan, enters into an agreement with a trader who is an intermediary between investor and farmer. In consideration of the loan the farmer deposits his seeds (or any registered item) on T day at the warehouse and receives the loan on (T+3) day. Now, the farmer has to pay back this amount on (T+36) day (mostly) and can take back his security. In practice, the farmers used to involve in a rollover transaction where in they did not used to pay back the whole amount on T+36 day but only give some payment (mostly interest with the principal due to be paid on a later date) to the exchange which was then passed on to the investor. So, in a way it became a regular source of income for investors. Traders used to lure their clients by promising them 13-15% fixed return through such transactions.       

                                                                      Source:NSEL

But a few days ago, the Govt. issued a directive to  NSEL to cancel these forward contracts as they should not be more than 11 days. So, NSEL cancelled those long term contracts and issued 11 day contracts. So, ideally, after  the 11th day investors should have received their payments but the farmers did not have the money as they had got into a habit of paying interest after 38 days. Also, hearing the news of issue of new contracts most of the investors did not want rollovers and wanted their entire money back. But farmers were not ready to pay back the entire sum and there was liquidity crunch at the exchange. This resulted in payout demand exceeding the money that they used to get from investors via rollover transactions. This led to a cash crunch and NSEL had to suspend its working for 15 days. Although the NSEL management  has said that it has enough warehouse commodities or cash to cover the counter party risk the market does not believe so and it led to stock of its promoter company Financial technologies plummeting by 65% and 40% respectively in last 2 days.

Where does NSEL stand post this fiasco?                                                 NSEL MD and CEO, Anjani Sinha has told the media that they have physical stock of goods at their warehouses which were kept as a security from the borrower which is estimated to have a worth of around Rs. 6200cr. He also claimed that NSEL has Settlement Guarantee Fund which is set up mainly to insure timely payment to seller members on execution of trade. The Components of Settlement Guarantee Fund (popularly known as SGF) comprises of initial and additional contribution by members. Initial contribution refers to member providing a minimum security deposit. Additional contribution refers to providing additional securities mostly to open an account or in case if transaction is greater than 1cr. SGF is maintained in form of either cash, fixed deposit receipts or bank guarantees. But the reality is that NSEL which had SGF of Rs 800 cr has now been reduced to Rs. 60 Cr post settling the liabilities for month of March. Now to settle liabilities of Rs 5500 Cr against cushion of Rs 60 Cr will be a herculean task for the bourse

What is the possible way out of this mess?                                                       On 5^th August, NSEL officials met 21 entities (borrowers) and 2 options were considered. Under the first option, 8 members who have outstanding payments of Rs. 2,181cr agreed to pay the dues as per due date or even earlier (i.e. last date being 29^th July since the longest contract of (T+36) days was issued). 13 members who have outstanding dues of Rs. 3,107cr agreed to pay 5% of the total dues every week. And there are 3 other borrowers with outstanding dues of 311cr with whom negotiations are still going on. It was decided that borrowers who cannot meet the normal payment schedule have agreed to pay 16% interest. NSEL said it would take 5 months to settle the total amount. Under the second option, NSEL said that it is in possession of postdated cheques (PDCs) from various processors aggregating to Rs 4,900cr and thus proposed to use these PDCs for settlement. However, since it is thought that a settlement backed by PDCs may not be as smooth as under Option 1, market participants are not willing to accept this option.So, it has been decided that option 1 will be used to settle the pending obligations. So, Rs. 2,181cr i.e. 39% of the money will be paid to the investors by the end of the 1st week of September. And the rest about 5% per week till 20 weeks. Interest of 16% will be charged after the due date. To prevent itself from such a situation in future, NSEL has said that it will resume operations only after commodity regulator FMC (Forward Markets Commission) issues guidelines for the spot exchanges.