Financial Tech fiasco: Commodity trading is all about price rigging

Already shaky market confidence got a bigger jolt yesterday as Financial Technologies-promoted National Spot Exchange suspended trading in most of its contracts and deferred payouts to its members, triggering fears of a default.

Shares of a few brokerages, who are members of NSEL, tumbled, along with Financial Technologies and MCX.

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Investors hammered the brokerages yesterday, as they feared a likely impact from NSEL’s liquidity issue. Most of them recovered towards the end of the day, after clarifications from the companies.

The reaction, or over reaction, at these counters is enough evidence for the fears that simmer in the market.

Even a whiff of a negative news is sending shivers down the investors’ spine, resulting in a panic.

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The government has swung into action. It has asked Forwards Markets Commission, which regulates commodity futures and not spot markets, to probe into NSEL’s trading suspension.

FMC’s chief told CNBC-TV18 today that it has sought financial details from the exchange and said the government has given enough powers for the probe.

What really happened

NSEL, a spot commodity exchange promoted by Financial Technologies, introduced products with characteristics that purportedly violated the norms governing such exchanges.

NSEL launched contracts with more than 11 days tenure, while spot exchanges are not allowed to offer such contracts. The exchange also reportedly allowed members to do short selling, which is not permitted on spot exchanges, where delivery of the commodity traded is mandatory.

Short selling is trading strategy where investors sell without owning an underlying asset.

The government did not approve of the product of NSEL. Interestingly, the exchange has been in discussions with the authorities for the last one year, according to reports.

A column by Mobis Philipose in the Mint said, citing a MoneyLife report, the exchange effectively allowed short sales by not verifying whether the seller of a commodity actually had the stocks with her.

Finally, the government on 12 July directed the exchange not to launch any more such contracts and also asked it to settle all existing contracts on the due date. On 31 July, NSEL stopped trading in all contracts, barring e-Series, and also deferred payments to members, triggering fears of a default. The fear has not receded yet despite the exchange’s the best of the efforts to allay it.

The reason for this is that nobody really knows why the exchange deferred payouts to members. According to reports, the payments would have amounted to a few hundred crores only. The general assumption is that a fall in trading volumes on the exchange could have triggered a liquidity crunch.

The fears of a payment default are looming large. Such an eventuality will definitely dent the market mood.

Weak FMC

At the heart of the unfolding developments is the shoddy regulation of the commodity markets.

The spot commodity exchange is not regulated by FMC or the Central government. It is a state subject.

But still it was the department of consumer affairs of the central government which acted on NSEL. According to the Mint column, in response to the government’s directive the exchange had cut the tenure of its contracts to below 11 days. But there is no clarity as to whether these are acceptable.

[caption id=“attachment_1005249” align=“alignleft” width=“380”]  Nobody has called it a scam yet. But it has the potential to snowball into one.[/caption]

The story of commodity futures trading is also no different. If as capital market regulator Sebi is bad, FMC is worse. However, the case of FMC is different. It doesn’t have powers to act. Amendment of Forwards Contracts (Regulation) Act, 1952, which will give more autonomy to FMC, is hanging fire for the last many years.

Because of all these reasons, trading in commodity futures is just a game of speculation in India. There is no serious hedging taking place, which is the objective of allowing futures. Price rigging is the order of the day.

A case in point is guar, one of the commodities that has a strong export market. Guar gum finds use in oil and gas exploration sector. It is also used as thickening agent food items.

In 2012, guar contracts had witnessed extreme price volatility despite the regulator increasing the margin amount several times. The regulator finally had to ban trading these contracts. It also took action against a few brokerages for violation.

For a vibrant commodities market, the government needs to take urgent steps to introduce the FCRA amendment bill, which will also increase the market depth.

As far as NSEL imbroglio is concerned, the events are still unfolding. According to a report in the Economic Times, the Sebi is looking into whether brokerages had diverted funds meant for equity investments into commodities trading. It is also looking into whether they launched portfolio management services (PMS) to trade in commodity markets.

“PMS schemes were using Spot Exchange products as underlying. Sebi needs to make PMS more transparent. PMS schemes hide behind jargon,” Mint Money editor Monika Halan tweeted today.

But it remains to be seen whether Sebi will really be able to get to the bottom.

At stake is Rs 5,000 crore of investor money in NSEL. The exchange has assured that it can liquidate the commodities it has in the warehouses and overcome the liquidity crisis. But what if things did not work out as it has planned?

Nobody has called it a scam yet. But it has the potential to snowball into one.