Home / Specials / Mint Asia /  The cracks in NSEL

Chairman and managing director Motilal Oswal is now one of the fiercest critics of Shah and his group of companies, which includes two listed firms, Financial Technologies (India) Ltd (FTIL) and Multi Commodity Exchange of India Ltd (MCX). FTIL owns 99.99% of NSEL. Oswal’s firm and some other large brokers are even advising clients to be careful while doing business on the group’s larger commodity futures exchange, MCX. The level of distrust among the broking and trading community is so high that some have approached MCX’s much smaller rival, National Commodity and Derivatives Exchange (NCDEX), to launch contracts that are similar to the former’s specifications so that they can move business out of MCX.

The NSEL crisis has gone much further than causing a mere credibility crisis for Jignesh Shah. There has already been significant collateral damage, and things are likely to get worse. Four independent directors on the FTIL board have quit. Six directors on the MCX board have submitted resignations.In a worst-case scenario, regulators may take away the group’s right to run any exchange business in the country. Besides, Shah may have to sell personal assets to make good the losses of NSEL customers. NSEL has thus far paid back 292 crore to investors, of which 177 crore has come as a loan from FTIL.

Before it suspended trading on 6 August, NSEL was India’s largest commodity spot exchange. But it permitted some low net-worth clients extremely large exposures, and failed to ensure that the warehouse receipts being traded on its platform were genuine. While there is no official estimate, the government and investors have concluded that the actual stock in the exchange’s designated warehouses is just a fraction of the value of warehouse receipts that were traded.

Key stakeholders allege that the NSEL crisis isn’t merely a case of poor risk management, but involved fraud. “Based on all the information coming out on NSEL now, it is evident the exchange management and its promoters were misleading us from day one," Oswal says. “They misled us by showing auditor statements regarding the stocks. Their intention has clearly been fraudulent, and demonstrates that the organization was not built on any moral values or principles."

Ramesh Abhishek, chairman, Forward Markets Commission (FMC), the regulator for commodity futures exchanges, says, “The NSEL crisis has now entered criminal domain—it’s clear that stocks are either not there or are a fraction of stated levels. This means there has been suspected forgery, cheating and money laundering. We had, therefore, requested the government for a multi-agency probe."

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Interview | NSEL was operating outside regulatory purview: Ramesh Abhishek

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FMC was asked by the government to supervise NSEL’s settlement process in early August.

Ever since, the regulator has found that the exchange and its directors were making inconsistent and false statements (see box), and suspected that the group is not making the best efforts to ensure settlement. On 20 August, FMC threatened Shah and other NSEL directors, in an official letter, that it would declare them as not “fit and proper" to run any recognized commodity futures exchange if they do not take complete responsibility for the settlement of outstanding trades at NSEL. To make things clear, it spelt out that this meant that Shah and the other NSEL directors would not be permitted to be a director or own any part of MCX. FTIL, in which Shah is the largest shareholder, currently owns a 26% stake in MCX.

“We are serious about our letter, which stated NSEL’s promoters’ and directors’ ‘fit and proper’ status is at serious risk," Abhishek says. “Having said that, given the seriousness of the matter, as well as the fact that the group has exchanges regulated by other agencies, we will take a collective view on the matter."

FTIL didn’t respond to emails sent on 26 August. But in a press conference on 28 August, Shah said, “Neither me nor Financial Technologies has done anything unethical or improper. Both me and the company are ready to undergo any scrutiny or anything which is required to be done."

There is widespread criticism from trading firms and investors that scrutiny by the Indian government has been lax and that action against NSEL and its directors has been delayed. While the crisis erupted on 31 July, it was only on 27 August that finance minister P. Chidambaram announced the appointment of two committees to probe the NSEL crisis.

“One working group formed by the government is headed by the director of enforcement, and has representatives of the income tax department, revenue intelligence, Reserve Bank of India, Sebi (Securities and Exchange Board of India) and FMC," Abhishek says. “This shows the seriousness with which the government is looking into the matter."

Government action was delayed because FMC bought the exchange’s initial version of the problem—that it was merely facing a liquidity crisis. NSEL assured FMC it had adequate stock of commodities in its warehouses, adding that its members needed time to make payments.

About two weeks later, it became clear that most members had no intention to pay and that there was barely any stock in the warehouses. After FMC realized this, it wrote to its overseer, the ministry of consumer affairs, suggesting, among other things, that the finance ministry be requested to get involved in the probe to trace the money trail. The inter-ministerial communication appears to have added to the delay. Even so, the criticism of the government is understandable—after all, since the regulator suspected fraud, four weeks provide ample time for those involved to cover their steps.

This isn’t the first instance where the government has been found wanting on the NSEL issue. Oswal says, “The government also has to take some blame since it gave the exchange a special exemption from regulatory oversight. Besides, it had received a report from FMC almost a year-and-a-half ago, but it slept on it."

Prakash Javadekar of India’s main opposition party, the Bharatiya Janata Party (BJP), alleged in the upper House of Parliament in August that NSEL had close links with a minister in the central government.

Experts say the root of the crisis lies in the special exemption NSEL got from regulatory oversight.

Various conflicts of interests have now come to light (see box), which could have been easily avoided with regulatory oversight. “This episode makes it amply evident that when it comes to the exchange business, one can’t rely on a self-discipline mechanism. There is no incentive for a private enterprise to adequately invest in risk management," says a securities market expert, who did not want to be identified.

Allegations of political interference have been made against the group before. K.M. Abraham, a former Sebi board member, wrote to Prime Minister Manmohan Singh in 2011 that there was pressure from the then minister of finance, Pranab Mukherjee (now India’s President), to explore a compromise in Sebi’s position on MCX Stock Exchange’s application for trading equities.

His letter said Sebi chairman U.K. Sinha had made similar requests to buy peace with the finance ministry.

Abraham had rejected MCX’s application in 2010, saying that the applicants were not fit and proper because, among other things, “they had not adhered to fair and reasonable standards of honesty that should be expected of a recognized stock exchange".

The finance ministry, then, had made its own complaint against Abraham to the Prime Minister’s Office (PMO), saying he “committed serious misconduct and exhibited conduct unbecoming of a member of the service" and making three specific charges.

The PMO later rejected each of these charges and absolved Abraham, although it’s not clear what action it took on Abraham’s charges.

The FT group and MCX-SX took legal recourse and received a favourable judgement from the Bombay high court. Sebi initially challenged this in the Supreme Court, but later arrived at a compromise with the exchange.

This was long after Abraham finished his tenure at Sebi. Sinha, who approved the exchange’s equity trading licence in July 2012, will now be forced to look at the “fit and proper" status of the group afresh, owing to the FMC’s observations on the crisis.

Meanwhile, Jignesh Shah, 46, has been attempting to distance himself and FTIL from the crisis. NSEL’s chief executive officer, Anjani Sinha, said in a statement on 14 August that his management team and he were solely and directly responsible for all operations, including screening of parties, warehouse management, risk management and other related company matters. Trading firms and investors quickly reacted, saying this was a ploy to make Sinha the scapegoat and absolve Shah of his responsibilities.

Shah, on his part, told FMC on 13 August that he had concerns about the quantity and quality of the stock in NSEL’s warehouses. In other words, he was only beginning to get a feel of NSEL’s real problems. But the regulator noted that Shah himself had said only a month prior, on 10 July, that NSEL offered the highest level of safety for participants as it had over 100% stock as collateral (managed by an independent collateral manager), 10-20% as margin money and was backed by 100% of post-dated cheques from participants.

FMC’s letter, signed by deputy director Chalapati Rao, concluded, “This reflects the complicity and/or the incompetence of NSEL’s board members to govern an exchange."

“It’s unlikely that Jignesh Shah didn’t know much of what’s happening at NSEL and that he was misled completely by the exchange’s management team—especially given the way the FT group is structured and runs," Hirander Misra, co-founder and chief executive officer of London-based Global Markets Exchange Group, says. “Former exchange officials from the group have said that practically every budget proposal has to be signed by him."

Oswal says, “How is it even possible that such large transactions happened without the knowledge of the NSEL board and its holding company, FTIL?"

After a long hiatus, Shah appeared before the media on 28 August and said, “We are also victims; it’s very important that investors, brokers and the exchange work together."

In private meetings with investors and brokers, Shah had already suggested that they work together as a group in recovering dues from defaulting members.

In response, FMC’s Abhishek says, “If you call yourself an exchange, then you should do adequate risk management and ensure settlement. NSEL can’t get away from the responsibility of standing guarantor against counter-party risk by telling investors and trading members ‘We’ll go together after the defaulting firms.’"

This provides market participants a rather disconcerting glimpse into how Shah views the role of modern day exchanges and clearing houses. In an early August press conference, Shah even said it was incorrect to say NSEL had an obligation of 5,500 crore. “The exchange is a platform… the pay-in obligation is of the planters (defaulting members)," he said.

The head of a large domestic trading firm says, “It is the exchange’s role to ensure adequate stock as collateral and collect adequate margins. Besides, it should not have encouraged the seemingly unending roll-over of positions."

News of Shah’s woes have reached overseas markets and regulators such as the Monetary Authority of Singapore, which regulates his group’s Singapore Mercantile Exchange (SMX). Some overseas market participants say they are not very surprised by the current problems faced by FTIL.

John J. Lothian, a Chicago-based commodity trading adviser and a member of the US Commodity Futures Trading Commission’s technical advisory committee, says, “Some friends of ours, who are industry vendors, had very bad experiences with the FT Group, which did not pay the entire contracted amount to our friends despite the work being completed. We had written a commentary about the lack of respect by the FT Group for contracts and how that was likely to be their demise. As a result, we are not really surprised with the NSEL crisis."

Patrick L. Young, a Europe-based expert on exchanges and market structure, says, “What I term “Shahdenfreude"—a feeling of shameful joy at the downfall of FTIL/MCX/NSEL founder Jignesh Shah—has infused global markets. There is a spirit of antipathy towards the plight of Shah, sometimes verging on the positively vitriolic. Over the years, a number of people feel Shah has played somewhat fast and loose in various dealings and, consequently, there is little sympathy for his current plight, regardless of the many notable achievements of his business empire." Schadenfreude is German for pleasure derived from the misfortunes of others.

Shah has carefully nurtured his public image and that of his group. He told Business Standard newspaper in a previous interview that he favoured the Mercedes-Benz car because he believed it projected the “right image" and insisted that all his senior executives get suits made with the finest fabric from Gabbana, a clothier popular with the business community.

He made no secret of his ambition. In an interview with Business Standard in 2005, Shah said: “We will create billion-dollar stories out of million-dollar ones. We are players in a high-speed, high-stakes game, we can’t stop now."

Shah is well known in the global exchange industry, thanks in part to the success of MCX and owing to the large number of overseas exchanges FTIL has invested in. The group boasts of nine exchanges in India, West Asia, Singapore and Africa, making it the owner of one of the largest networks of exchanges. Clearly, he was a man in a hurry. FTIL had humble beginnings, starting in 1995 as a small technology products firm. But it quickly picked up steam and soon had a majority share in trading technology in the domestic market. Shah started his career as an employee of BSE Ltd, but always wanted to run large exchanges. His break came when the group won a licence to launch a commodity futures exchange. MCX attracted volumes largely because of the latent demand for commodity trading. Besides, the shrewd design of its contracts helped, as they were similar to the most popular commodity contracts traded in the US. A large part of trading on the exchange occurs in the late evening session, which coincides with the US market timings, enabling traders to engage in arbitrage. MCX’s success attracted large investors as well, which helped the group’s cash flow. Later, when exchange stocks were in great demand globally, the group launched a number of overseas exchanges.

“The FT group is known to be very aggressive in its dealings, and until the NSEL episode, this approach seemed to work well in its Indian operations. But it hasn’t had the same success abroad," Misra of Global Markets Exchange Group says.

Among its overseas ventures, Shah’s group has tasted success only with Dubai Gold and Commodities Exchange (DGCX), whose volumes have more than doubled in each of the past two years.

But its role here has been largely limited to that of a financial investor.

The exchange’s operations have been managed by Dubai Multi Commodities Centre since 2007, said a person at the exchange on condition of anonymity. DGCX even replaced FTIL’s trading platform last year. In short, FTIL can’t take much credit for DGCX’s success, although its stake in the exchange will fetch it much more value than its other overseas ventures.

FT tried a big-bang launch for its Singapore Mercantile Exchange (SMX), initially even managing to hire Leo Melamed, former chairman of the Chicago Mercantile Exchange (CME), as chairman of its advisory committee. But Melamed resigned within a month owing to controversy about a conflict of interest with CME, where he was still a director. SMX hasn’t really taken off, and has witnessed a string of exits by senior personnel. Its volumes in July were a fraction of those recorded by DGCX.

On 3 August, SMX issued a press release saying it was business as usual and that NSEL’s problems wouldn’t affect its operations. But market participants beg to differ. Lothian says, “Trading firms had reservations earlier and the NSEL crisis only makes things worse."

A moot question here is if liquidity will shift from MCX, since there are no worthy alternatives in the non-agricultural commodities space. On 26 August, NCDEX, encouraged by traders’ requests, launched new gold and steel contracts, which together account for half of MCX’s turnover. It even cut transaction charges sharply. Misra, who was chief operating officer at pan-European multilateral trading facility Chi-X Europe when it successfully captured share from incumbents such as London Stock Exchange and Deutsche Borse, says, “Many trading firms would be reluctant to be associated with the group’s exchange ventures after this (the NSEL crisis). While today there may not be any decent alternative to MCX, over time, that can change."

Whether by accident or design, almost all of the group’s domestic exchange businesses have been hit by regulatory or government measures. MCX’s volumes have fallen by over 40% since July after the finance minister introduced a transaction tax on all non-agricultural commodities futures trading. MCX-SX’s currency derivatives segment was hit in July, when the central bank and Sebi instructed exchanges to cut position limits in the segment.

There are faint whispers that the group’s recent woes have to do with the change in political winds—Mukherjee left active politics to become the country’s president about a year ago and was replaced in the finance ministry by Chidambaram.

On the other hand, it can be argued that there has been a transaction tax for equities trading for years, and that the finance ministry was only correcting this anomaly. The clampdown on currency derivatives appears to be guided by the central bank’s concerns about the rupee’s sharp depreciation against the dollar. MCX-SX’s entry into the equities segment six months ago hasn’t exactly set Dalal Street on fire—volumes are a fraction of both National Stock Exchange and BSE Ltd, despite a scheme to incentivize liquidity providers.

In addition to all this, effective 2 September, FMC has doubled margin requirements for gold, crude oil, silver and natural gas contracts, which together account for about two-thirds of MCX’s volumes. With double the capital requirement, volumes are expected to fall sharply, for the second time in three months. FMC has also directed commodity futures exchanges to transfer an amount equivalent to 5% of its gross revenue in the past five years to the settlement guarantee fund. This will entail a large cash flow impact for MCX.

All of these problems together pose severe challenges to the group; but the NSEL crisis has put its survival at stake. If the government’s probe concludes there was complicity by the promoters and directors, Shah will get embroiled in legal battles, and risks losing his empire. But even if complicity is not proved, as FMC’s letter puts it, the directors’ competence to run an exchange will be questioned. This, again, will put Shah’s exchange ventures at risk, although FTIL’s technology business and other non-exchange related businesses may survive.

Misra says, “Firms should be careful to always stay on the right side of certain boundaries because, before you know it, you may be too far out and can’t escape regulatory scrutiny. In the end analysis, while there is a thrill of running ahead fast like a hare, it’s those who exercise discretion, like the tortoise, who often win the race."


— National Spot Exchange Ltd (NSEL) permitted trading of warehouse receipts on its platform. It has emerged that a number of warehouses are controlled by the very people who bought the warehouse receipts and owe the exchange funds. Now, many of these members are not paying, nor is there adequate stock to make good the exchange’s and investors’ losses.

— NSEL’s largest clearing member, Indian Bullion Market Association (IBMA), is majority owned by NSEL, which in turn is 99.99% owned by Financial Technologies (India) Ltd. IBMA also traded on another exchange promoted by the group, MCX (Multi Commodity Exchange).

— Shreekant Javalgekar, chief executive officer of MCX, served simultaneously on the boards of MCX, NSEL and IBMA. He resigned from the boards of NSEL and IBMA in August.

— The promoter of NSEL’s largest client, NK Proteins, which owes 970 crore, is related to Shankarlal Guru, chairman of the exchange. Guru resigned after the crisis erupted in August.

— NSEL’s auditor, Mukesh P. Shah and Co., is run by a relative of Jignesh Shah.

— The government official who signed off the special regulatory exemption for NSEL was later employed by MCX Stock Exchange (MCX-SX) in an advisory role. FTIL and MCX have a majority economic interest in MCX-SX through equity shares and warrants.


— Jignesh Shah tells FMC on 10 July that NSEL has 100% stock in warehouses against open positions of members. NSEL’s CEO Anjani Sinha reiterates this soon after the crisis becomes public on 1 August, stating the exchange has stock worth 6,200 crore. According to news reports, surveys by the income-tax department later showed there was little or no stock in the warehouses.

— Sinha states on 1 August that the exchange has a settlement guarantee fund of 850 crore, and later revises it downward to 65 crore and ultimately to only 5 crore.

— Shah tells FMC on 10 July that the exchange has collected 10-20% margins from members. According to exchange data released on 29 August, the difference between the gross outstanding of members who have pay-in obligations and the net outstanding amounts to 692 crore. The net obligation is after adjusting for margins, charges and pay-ins. NSEL has received pay-ins of 105 crore, which still leaves an amount of 587 crore as margins, the whereabouts of which are not known.

— NSEL said on 4 August that members will pay in 94.5% of their obligations, or 5,288 crore, in 20 weeks. It then said on 14 August members will pay 78% of obligations over a 30-week period, with the remaining amount expected to be recovered through a sale of members’ assets. It should have collected 524 crore by end-August; instead, members had paid only 110.75 crore until 31 August.

— A government initiated co-operative, Nafed, is projected as a co-promoter of NSEL, despite making only a token investment of 1,000. NSEL’s total share capital stands at 45 crore, with FT bringing in the balance.

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