Lessons From The Crash

NSEL crisis shows you must be careful with financial products that promise high returns with little risk
Rahul Oberoi/Money Today        Print Edition: October 2013
Lessons From The Crash
PHOTO: Reuters

The National Spot Exchange (NSEL), promoted by the Financial Technologies group, recently came under the regulatory scanner after being hit by a payment crisis. What happened was something like this: A commodity spot exchange is neither allowed to offer forward contracts nor settle contracts beyond 11 days (T+11). However, the NSEL was doing both. The Department of Consumer Affairs, after a few warnings, sent a notice in July. This triggered panic among traders, many of who rushed to close their positions. The exchange, as a result, had to defer settlements.

Raghavendra Raju GV, manager, JRG Securities, explains. "In the second half of July, investments in these structured products are reduced by approximately 50%, which affects the NSEL's fund inflows. During this period, fund outflows remain high (almost double the inflows) considering the redemption requirements of earlier contracts. This mismatch has put the NSEL in a situation where it is not able to meet its fund requirements with the current inflow."

A spot exchange normally offer T+2 contracts. Thus, if you buy on the exchange, you have to pay within two days and take delivery.

ORIGIN OF CRISIS

The reason for the crisis was lack of risk management, say market experts.

Quote

There is nothing called a risk-free return if someone claims that he is giving more than bank fixed deposits.

NITHIN KAMATH

Founder and CEO, Zerodha

First, the exchange was unregulated. A spot exchange should not offer forward contracts but NSEL was offering T+2 and T+25 contracts and also T+2 and T+35 contracts. Within these forward contracts, an investor could lend money for 25-50 days for a receipt of commodities stocked in warehouses, and after the end of the contract (which was after 25-35 days) get a pre-agreed fixed return and return the receipts.

The exchange collected a margin of 10% apart from having the security of the underlying stock. Also, the exchange is expected to facilitate short sales, but it is believed that stockists were allowed to sell the commodity on a T+2 basis without actually depositing the commodity in the warehouse. Also, there were doubts about storage and quality of physical goods in the warehouse.

Vivek Gupta, director, research, CapitalVia Global Research, says, "The whole process turns out to be financial engineering where the NSEL was acting as a finance company, the investor was investing in commodities and processors were getting finance from investors, enticing them through higher riskfree returns mentioned on the website of the NSEL."

WHAT TO DO?


FOR E-SERIES INVESTORS

> Investors can continue to hold e-series units in the demat form or opt to convert them into physical metal


> The latter will involve paying conversion fee, octroi, value-added tax and depository charges

The NSEL has also suspended trading in e-series contracts till further notice after the Forward Markets Commission, or FMC, banned new commodity futures contracts due to alleged violation of norms. This has put investors with e-series units in a difficult position as they can't sell them on the exchange platform.

Yogesh Nagaonkar, vice president, institutional equities, Bonanza Portfolio, says, "Investors have two options. They can continue to hold e-series units in the demat form or opt to convert them into physical metal." E-series products allow people to invest in gold, silver and platinum in small denominations in the demat form.

"Those who want physical delivery can fill the surrender request form and submit it to their depository participant. However, you will have to incur conversion, octroi, value-added tax and depository charges when you take delivery," says Nagaonkar.

LESSONS LEARNT

The first lesson from the NSEL crisis is that if someone promises easy money, there must be something wrong somewhere. Investors must seek complete clarity when any product promises to give high returns for very long periods.

Dilip Bhat, joint managing director, Prabhudas Lilladher Group, says, "In case of the NSEL, there was always a doubt as to which regulator governs it, whether it was regulated at all, and whether the contracts were valid and enforceable. The press had often mentioned the gap that existed between the finance ministry, Sebi and FMC on this issue."

The other lesson is that while investing in an instrument that is offering such returns, the risk on the counterparty has to be evaluated. While the average investor may not understand the minute details, one thing that was under question in this particular crisis was the size of the Trade Guarantee Fund versus the volumes being reported.

Nithin Kamath, founder and CEO, Zerodha, says, "There is nothing called a risk-free return if someone claims that he is giving more than bank fixed deposits. Be extra careful when getting into a product like this. Lastly, investors should test any new exchange for integrity before investing huge amounts. It has been seen on many occasions that the government and other regulatory agencies straddle the fence and in the end the fraud entity gets an alibi and walks away free."

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