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Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

To spot a future problem

Indian retail investors should stay away from deals that sound too good to be true

When retail investors begin to jump onto an investment idea that is either complicated or offers very high returns or both, you know that the end is near. We never hear of investors rushing suddenly to the idea that large-cap funds are so cool. Or that the Public Provident Fund is the next best thing after toasted bread. Nope. But you get asked if it is a good idea to buy a contract on a commodity exchange to earn a sure 15% return — and by a person who otherwise has just fixed deposits (FDs) and real estate in his portfolio. This has happened so many times that it is almost a rule set in stone. So when some three months ago I began getting questions from readers and viewers about investing in 100% guaranteed products offering double the FD rates by brokers on the National Spot Exchange Ltd (NSEL), it was clear that the unravelling would begin soon.

A quick recap of what has caused NSEL and its promoter Financial Technologies (India) Ltd to make the headlines for all the wrong reasons. A monopoly in the spot exchange space, NSEL accounts for 99.99% (according to its website) of the so-called “spot" business and provides an online real-time market place for agri commodities and metals. We need to remember that political trade-offs and serious lobbying have not allowed the integration of securities and commodities regulators in India. Equities and their derivatives are regulated by the capital market regulator. Commodity futures are regulated by the Forward Markets Commission (FMC) and come under the jurisdiction of the consumer affairs ministry. The birth of the spot exchange happened in the regulatory dark spot with no centralised regulator overseeing its operations. Though agricultural spot markets are a state subject, it is unclear exactly why the FMC was prevented from regulating NSEL through a government of India gazette in June 2007. A department of consumer affairs notification specifically exempts NSEL from the reach of the FMC and the provisions of the Forward Contracts (Regulation) Act. These can be read here: http://fmc.gov.in//WriteReadData/links/gazette_notification_fcra-712771626.pdf. It may be worth an enquiry to see the file noting that led to this.

So the NSEL is born and allowed to operate in the spot market. It is specifically forbidden to offer forward contracts or to short-sell products. The fact that 25-50 day future contracts were being traded on the NSEL and that some structured products offered by brokers on the exchange were offering assured return of 15-18% a year to investors has been known for sometime. But the regulatory cracks that NSEL fell into and the market perception of political support kept the story going. The decision of the ministry of consumer affairs to order NSEL to stop launching new contracts in mid-July precipitated the problem, resulting in a payment crisis that is estimated to exceed 5,000 crore. A payment crisis in one exchange has the ability to cause contagion since brokers, companies and high net worth investors operate across the market. The FMC is now dealing with the situation and trying to get retail investors’ money stuck in the exchange out first.

The NSEL implosion has two lessons for us. One for Indian retail investors. And that is: stay away from deals that sound too good to be true. Stay with financial products you can understand. Remember that you will always catch the tail end of a scheme at a time it is about to burst. The second for Indian policy makers. A series of market events is pointing to the need for a unified markets regulator. The powers that be should look at this as an opportunity to push through the Indian Financial Code with its United Financial Agency as suggested by the B.N. Srikrishna committee and stop those that have figured out the dark corners of the regulatory landscape from creating businesses that tend to explode.

End Note: How should one spot a future stock or company explosion? Analyse the birth, maturity and death of an exploding company and you get certain common features. First, there is a meteoric rise of the promoter – a little-known person suddenly straddles a multi-billion-rupee empire. The face and name of the promoter and company is in a huge media and event splash. The company logo and promoter face becomes a fixture on page one ads of newspapers and in giant hoardings at industry events. The group will sponsor everything as long as the promoter gets to speak. Then the whispers of deep political connections, of concessions won and obstacles weeded out. Somewhere in the middle of all the buzz is a product offered to the market that gives super-normal returns, or returns that are in excess of what others in the same space offer. The Saradha Group explosion in West Bengal was just one case in point. Small money will do well to just stay away. Policy makers (at least those that are not on the payroll) will do well to ask questions.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, and Yale World Fellow 2011. She can be reached at expenseaccount@livemint.com.

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