Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

NSEL crisis exposes regulatory gaps

The regulatory role of exchanges must be dealt by an independent entity

The liquidity crisis at the National Spot Exchange Ltd (NSEL) raises troubling questions on commodity trading, the troublesome aspects of Indian finance and on the credibility of NSEL’s promoter, Financial Technologies India Ltd (FTIL).

The list of omissions and commissions is a long one and starts with the exemption the consumer affairs ministry granted to the bourse from the Forward Contracts (Regulation) Act (FCRA) when NSEL launched one-day forward contracts. The exemption from FCRA placed NSEL outside the jurisdiction of the commodity markets regulator, the Forward Markets Commission (FMC). This led to laxity in supervising the stocks of members. In many cases, contract settlements were delayed for more than a month, allowing the bourse to attract growing trading volumes from members who found in it an attractive financing option. After the government put an end to trading of long-dated contracts last month, it immediately triggered a payment crisis that is yet to be resolved.

In its latest directive on Wednesday, FMC has asked the bourse to liquidate stocks to settle the unmet claims of investors promptly. While this is a step in the right direction, this might not end the crisis. Several members seem to lack either the stocks or the assets to clear their dues. A Mint analysis of the balance sheets of the 24 members who owe NSEL money showed they lack the financial assets to cover their dues.

If the members indeed lack the wherewithal to pay up, the axe must fall both on the defaulters and the bourse, since it is the exchange’s responsibility to check the adequacy of stocks. Even if charges of fraud are proved to be false, the episode has irreparably dented the image of the FTIL group, the promoters of NSEL. The Jignesh Shah-led group had several run-ins with regulatory agencies over the past few years. The capital markets watchdog, the Securities and Exchange Board of India (Sebi) had said in a 2010 order that FTIL was not “fit and proper" to run a stock exchange. After an adverse court ruling against the Sebi order last year, the FTIL-promoted MCX-SX stock exchange finally received conditional approval to launch an equities trading platform. The recent turn of events has once again cast a dark shadow on the credibility of the group that runs India’s largest commodity bourse, MCX, and dominates the market for retail trading platforms in the country.

At the root of the crisis lies the government’s incoherent regulatory approach towards trading of commodities in general and agricultural commodities in particular. Oversight in commodity futures is weak because we do not have an autonomous regulator, and the existing regulator essentially functions in the manner of an under-staffed department of the Union government. A Bill to grant FMC autonomy has been hanging fire for several years now. Agri-commodity trading is on even thinner ice since it is subject to sudden bans and their reversals. This discourages serious investors from participating, affecting liquidity and price-discovery. While the government has taken some measures to promote spot markets (NSEL is a beneficiary of such moves), numerous other restrictions on agricultural trade has meant that the limited reform has benefited only a small class of traders rather than farmer-entrepreneurs, the intended beneficiaries of such reforms.

In the absence of adequate regulations governing trades at NSEL, implicit trust of brokers among themselves and on the promoters of the bourse paved the way for the exchange to flourish, with growing participation from individual investors who were promised “assured returns" by some brokers. The role of informal ties has been a key driver of Indian credit and financial markets for the most part of our history, in the absence of credible institutional mechanisms to enforce contracts. The growth of the “badla" trades and the cartelization of BSE till the 1990s are two prominent examples where informal networks triumphed over formal contracts.

With the launch of the National Stock Exchange (NSE) and the setting up of Sebi levelling the playing field considerably, Indian finance has travelled a fair distance. Yet, as the latest crisis shows, we are still in transition and yet to evolve into an open order club where formal rules and laws outweigh informal networks. In such an environment, the exchange as a regulator provides a service that is almost akin to a public good, as former Reserve Bank of India (RBI) governor Bimal Jalan emphasized in his report on market infrastructure institutions.

Jalan may have erred on the side of caution while dealing with the issue of conflict of interest between the regulatory and commercial roles of an exchange but the caution he displayed was not unwarranted. Competition among exchanges is desirable but we can avoid a regulatory race to the bottom in a competitive exchange landscape only if the regulatory role of exchanges is taken over by a completely independent entity.

Is the government’s regulatory approach incoherent in nature? Tell us at views@livemint.com

Close