NSEL: Anatomy of a trade gone sour

Investors were lured by hefty returns at a time with markets were volatile
slew of resignations
Food Bill may be taken up in Parliament today
Stocks fudged and under-reported by NSEL defaulters: I-T
NSEL crisis: Defaulters barred from trading in stock markets
Furore in state assembly over chit fund scam
5%Trader Only Make Profit
95% Traders Lose Money Know How you can be in 5% ?www.niftymillionaire.com
7 Days Intraday Tips Free
Get 100% accurate NSE Intraday Tips Maximumreturn of investmentwww.intradaylevels.com
Ads by Google
Like many small investors, P Dharnidharka, 54, invested in thecommodity trades on the National
Spot Exchange Ltd. Dharnidharka was promised hefty returns by his broker at a time
when stock market was volatile and fixed deposit returns were not very attractive.

It looked too good to be true. Thousands of investors like Dharnidharka were lured into trading
what looked like exotic derivative contracts on the National Spot Exchange Ltd (NSEL) that
promised an assured return of anywhere between 15 and 18% per annum. Every trade would
result in earnings of 1-2% in a month or so - guaranteed.

Dharnidharka was delighted at the prospect of earningbusiness income from trading in
commodities. No trade could go wrong. Investors and brokers flocked in droves to a well-crafted
commodities-trading strategy that was simple to execute and immensely profitable. In the end, it
turned out too good to be true.

Nobody asked crucial questions. How can commodities traded on an exchange always turn a
profit for investors? How did the trade work? Who were the commodity traders? Where were the
warehouses? Nobody knew that one day the music will stop. And it did.
Looking back, when the NSEL commenced operations in October 2008, it started as an exchange
to facilitate commodity producers to find buyers for their products. Spot exchanges normally
offer T+2 or T+3 delivery. Any buy or sell transaction should be settled within a few days. If you
purchased on the exchange, you paid your dues in two or three days and took delivery the next
day of whatever you had bought whether castorseed or wool.
But as that didnt bring volumes to the exchange and trading was relatively thin, sometime in
2010, according to market reports, Jignesh Shah introduced forward contracts that could be
executed over 30-45 days. In other words, the settlement cycle was given another dimension.
Now there were two settlement cycles for the same castor seed: a three-day cycle and a, say,
thirty day-one.
As trades between two contracts go, arbitrageurs enter only when there is a huge difference in
what they buy and sell. But there was a crucial difference in the NSEL's price-discovery
mechanism. The 45-day forward contract, for instance, of all commodities was always higher
than a three-day forward contract. Says Shankar Raman, Head - Investment Products & Advisory
Services, Centrum Wealth Management: The prices were so funny that all the time there was a
15-18% forward gap. There will always be a carrying cost, but a fixed 15-18% is unheard off.
Commodity prices should fluctuate and they were not fluctuating. On the NSEL they were
"fixed". If the spot or three-day contract was x, the thirty-day contract was one or 2% plus x
depending on the commodity. One simply bought the three-day forward contract and sold the
thirty-day contract. You paid for the two-day contract. You waited for the 30-day contract to end
that you sold at a higher price. And pocketed the difference.
That changed the fortunes of the NSEL and volumes perked up. Average monthly trading
volumes shot up from Rs 1000 crore to Rs 28,000 crore till May 2013. Financial Technologies
derived 57% of its profits from NSEL. The higher the trading turnover, the higher the revenues
an exchange makes.
In a normal exchange, price-discovery is a continuous process. Forward contracts can go way
above a spot price or way below. Short-term contracts can trade at a premium to long-term
contracts, and vice versa. But at NSEL the longer-term contracts were always at a premium.
Always. Says Shankar: If you look at equity markets, there are periods when there will be huge
arbitrage in buying on spot and selling in futures.

Who made money and how
The Exchange
Revenues through charging a transaction cost as a percentage of turnover.
The more the turnover, the higher the earning.
The Broker
Brokerage fees of 2-3% on the gross amount invested. A typical AUM of Rs
100 crore nets the broker Rs 1-3 crore per annum.
The Investor
Earned 1-1.5% a month buy short-term contracts at lower price and selling
long-dated contracts at higher price. Pocketed the difference.
The Trader
Bought long-dated contracts at higher price and sold short-date contracts at a
lower price and a paid a net difference of 1-1.5%. In the process received
easy funding at a very low cost.

There are times when reverse arbitrage works and times when arbitrage is minimal. It all depends
on the market mood. NSEL did not seem to have a mood at all.
On NSEL, it didnt seem like anonymous trades were happening between anonymous investors.
But as profits were always assured, trading took off. Close to Rs 6000 crore was invested, and Rs
28,000 crore was traded in May 2013. Trading volumes even surged to Rs 40,000 crore in some
months. More investors started getting in till as late as a few months ago. This golden
opportunity spread through word of mouth among top investors and brokers and spawned coffee-
time conversations.
Brokers and high net worth individuals started to see more business, and more opportunities.
Dozens of investor presentations by brokers started flying around thick and fast. All brokerage
presentations were essentially saying the same thing. They touted the benefits of exotic
commodity trading, about the safety of the exchange, about stocks in warehouses, about the rag-
to-riches story of NSEL promoter Jignesh Shah, and about how to trade and make easy profit.

As investors started to pour in money, brokers began to finance some high net worth individuals
against these trades. The NSEL trade was an arrangement that brokers should have been familiar
with. It was a financing scheme and there was an arbitrage much like the badla system, says
Motilal Oswal, chairman and managing director, Motilal Oswal Securities. The age-old badla
system was banned in back in 2000, after futures trading was introduced. Trading in forward
contracts on the NSE is exactly the same. Back then, investors funded those who didnt have
shares to sell, and pocketed a difference called badla. Because of the badla-system any short-
sale could be carried on in perpetuity as all the borrower had to was a transaction cost.
<

A typical broker sales pitch
Commodity Duration Lot Size Days (Approx) Investment Yield*
Castor Seed T+3 & T+36 300 bags 52 Rs 10 lakh 16%
Castor Oil T+5 & T+30 10 MT 38 days Rs 10 lakh 15%
Paddy T+2 & T+25 300 bags 35 days Rs 3-4 lakh 14%
Steel T+2 & T+25 10 MT 35 days Rs 5-6 lakh 14%
The same thing happened on the NSEL. Investors started rolling over positions and pocketing a
difference of 1-1.5 percent every month. Brokerages skimmed about 1 to 3% of the gross
investment per annum, and furnished the net difference -- of about 12-15% per annum -- to
investors.
One crucial difference that everybody overlooked was that these contracts should have been
guaranteed by goods in the warehouses. Nobody seemed to verify whether the goods actually
existed or not. Brokers started giving out contract notes to hundreds of investors backed against
just one warehouse receipt (you cant split a receipt). The warehouse receipt acted as title to the
stock. The broker was taking a risk on the warehouse receipt.
Nobody verified the warehouse receipt or whether goods were actually at the warehouse. Some
warehouse receipts are said to be authentic as some genuine producers wanted to finance their
working capital till their goods were sold. But as nobody verified the warehouse receipts more
commodity traders started producing warehouse receipts against which they received easy
funding. Some may have used this money for financing their business, but the rest is anybody's
guess.
Borrowers paid around 12-18% per annum as they were selling-long dated contracts and buying
higher priced spot contracts. They rolled-over their positions as nobody asked for collateral or
their investments back. As they repeated the cycle, in the end, the whole thing ballooned into a
huge un-checked financing scheme for commodity traders.

Structure of the trade
For investor
Buy a lower priced T+2 contract
Sell a higher priced T+35 contract
For trader
Sell a lower priced T+2 contract
Buy a higher priced T+35 contract
Contract
T+2
Money moves from investor to trader
Stock moves from trader to investor

T+35
Money moves from trader to investor
Stock moves from investor to trader

Since February last year the Forward Markets Commission (FMC) started monitoring what was
happening. The NSEL was not regulated as a commodities exchange under the FMC as it
obtained a waiver from the Consumer Affairs Ministry from the Forward Contracts Regulation
Act.

Then came the blow. Forward trades were banned by the Forward Markets Commission in NSEL
as the exchange was not authorised to do so.

As investors could not trade in these long-dated contracts on the NSEL ever again, the arbitrage
game that everybody played closed down overnight.

And now this.

The Fallout

Ever since, the FMC sent a letter to NSEL to stop carry forward trades in July, the exchange and
its promoters were in a denial. Queries from media on the lack of stocks and probable default
were met with strong denials. Even before the July 31st statement by NSEL to stop the forward
trades, the markets was abuzz that NSEL was heading for trouble and some traders will not be
able to meet their commitments.

Investors and their brokers are especially bitter about the way NSEL and its promoters Jignesh
Shah informed everyone that all commitments will be met by the exchange and the traders.

Around July 12th, Anjani Sinha went to Motilal Oswals office to convince them that everything
is fine and all payments will be made in time. Many other times were shown including auditors
certificates that there are enough stocks in the go downs. They kept on misleading all brokers
that they have enough stocks, margins and trade guarantee money. During the presentation
before Secretary, Department of Consumer Affairs on 10th July, 2013 and during the meeting
with FMC, Jignesh Shah, Director, NSEL and promoter of Financial Technology had said that
NSEL offers highest level of safety for the participants as the model assured that 100% stock as
collateral (managed by independent collateral manager), 10-20% as margin money and backed
by 100% of post dated cheques from participants. But we soon realized later that this was just to
hoodwink us and to perpetrate a fraud on investors. Their chairman's son in law is lent 700
crore, said Oswal.

Oswal and other brokers, investors are now staring at a huge default of Rs 5,500 crore from
NSEL with more than 15,000 investors now waiting for their money to come back. Small
investor body say it will be difficult for NSEL to raise so much of funds and the only way to get
money is to sell assets of NSEL and its promoters. This is a crisis of confidence.
No one trusts Shah or his words. They want to see the cash on table, says Kirit Somaiya, BJP
National Seceretay and President of small investor lobby body Investors Grievances Forum.
We have already sought a probe by police, enforcement directorate and have appealed to the
Bombay High Court to take over the assets of NSEL, FT and its promoters.

The Indian government which took some half-hearted measures
in the beginning swung into action when the matter reached the
courts and the Parliament.
The income tax department surveyed all the 24 defaulters who
owe Rs 5,500 crore to the investors. But investors like
Dharnidharka says its a case of too little, too late.

I now just want to get back my money and go back to Rajasthan. All my retirement savings are
now stuck with NSEL. I will never look for easy money in markets again, says Dharnidharka.