NSEL crisis: spotlight on conflict of interest

The ongoing National Spot Exchange Ltd (NSEL) payment crisis has highlighted the need for better regulation of commodities exchanges and increased transparency in corporate governance.

The NSEL is run by Financial Technologies (India) Ltd (FTIL), which also promotes the MCX commodities exchange and the MCX-SX stock exchange. All three are facing scrutiny from regulators.

In August, the NSEL suddenly suspended trading and halted the settlement of outstanding contracts worth over Rs 5,500 crore ($869.84 million).

Media reports indicated that this might have been triggered by the NSEL overstating the inventories of commodities traded on its exchange based on electronic warehouse receipts, which are issued by a group company.

National regulators, including the Forward Markets Commission (FMC) that oversees the commodities markets, quickly turned their attention to these allegations. They are investigating claims that the NSEL violated the mandatory 11-day settlement period by allowing trades to be settled up to one month after they were made.

The former managing director of NSEL has reportedly confessed that the defaults started small but eventually reached such proportions that the Economic Times compared it to riding a tiger, reminiscent of the Satyam accounting fraud.

These events have drawn attention to the soft-touch regulation that has been the norm in the commodities markets so far.

But even as the FMC attempts to manage the crisis, it is hampered by its limited powers and means, underscoring the need for more resources to be diverted to the regulation of the commodities markets.

Apart from its adverse impact on FTIL’s share value, triggered by investors’ fears of a cash crunch, the NSEL crisis has spread to other group entities. The MCX-SX is no stranger to close regulatory scrutiny, as the SEBI initially challenged its establishment. Although it was eventually given conditional approval, the SEBI imposed additional conditions last week while renewing its approval for an additional year. The close ties between the MCX-SX and NSEL are probably what attracted SEBI’s attention – the two entities share promoters and board members.

The SEBI has decided that the best way of preventing the NSEL crisis from spreading to equity markets is to wrest some operational control away from the common board members. Failure to meet the SEBI’s conditions may lead to the derecognition of the MCX-SX.

MCX, the other FTIL-promoted commodities exchange, is also being investigated by the FMC, which is questioning whether NSEL promoters and board members are “fit and proper” to remain stakeholders.

Satyam Revisited?

The FMC must determine whether the MCX and NSEL are sufficiently interconnected to justify stripping existing MCX board members of their positions. In doing so, it might take into account around Rs 25,000 crore ($3.95 billion) worth of trading positions taken by a group entity on MCX.

Simultaneously, brokers operating on the NSEL are crying foul; notwithstanding the fact that they often missold commodity futures. Questions are doing the rounds as to whether the brokers are themselves the defaulters.

The matter has now reached the Economic Offences Wing, and the connections between the defaulters and the management is likely to be investigated.

The Satyam case, and now the NSEL, demonstrates that human nature does not change – it will manifest itself in different forms.

While the ramifications of the NSEL crisis and discussions about possible responses to it will continue to make the front page, the scale of the crisis is not unmanageable, in spite of the possibility of some of the corporate entities and management personnel being indicted.

The government should see the crisis as an opportunity to remedy the structural deficiencies that allowed the crisis to occur.

(Ameet Hariani is managing partner at Mumbai-based law firm Hariani & Co. He is a columnist for Reuters)