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A Ponzi on the Spot Exchange

Given the technologies available now, it was believed that exchanges were commonly less prone to mispricing, price manipulation and other fraudulent practices

The Global Financial Crisis (GFC) of 2008 was an event, while the Great Recession (2008 - till now) was the aftermath. That is the relationship between a point and a line; if we try and make it even finer, we can say that the GFC started with an epicentre, the 'Lehman moment'. Poor Mr Lehman must be turning in his grave, scarcely able to believe that his name adorns one of the blackest moments in the world's economic history, all because he set up an Investment Bank. But that Investment Bank went on to do things he had no idea about, and stood at the epicentre of a crisis that he could not have imagined.

The subsequent Great Recession threw up all kinds of other fault lines, which created a different set of fissures, subsequently called the Euro Crisis/ Greek Crisis, and the (still-to-be-named) Japanese crisis.....and maybe the Indian (Currency) Crisis.

Of the many new thoughts that took hold after the GFC, one was that the Banking 'innovation' that preceded it was highly flawed and should have been regulated better. A sub-thought that came out of that is that private transactions that take place between a bank and its customers, or with other banks/ investors, or with miscellaneous other counter-parties, and really a 'common market'. These Over-the-Counter (OTC) products or transactions are more transparent, better amenable to regulation and more monitor-able, if they are converted into standardised instruments, which are traded on an exchange. Given the technologies available now, it was believed that exchanges were commonly less prone to mispricing, price manipulation, cornering and other fraudulent practices that are so much a part of the OTC markets. This is mostly true, and India, which is so far behind on most other reforms, did better in this area. The equity markets have been a beacon of good behaviour for the last 20 years, after the Harshad Mehta Scam, which robbed the banks through fraudulent OTC transactions.

After this, there has generally been good progress, even if it was always punctuated by some scam or the other. Forex markets started to develop after an episode of mis-selling derivatives by foreign and private banks to SMEs, causing them huge losses. What looked like hedging structures turned out to be gambling of the worst sort, with SMEs unable to figure out the fine print. It created a lot of litigation and mostly, the corporates paid. Some of them never came back. Alps Industries was found to have as much debt in these derivative-caused liabilities, as in the rest of its business.

The RBI turned extremely negative in its regulatory stance, towards the OTC Forex market. A series of circulars made it progressively difficult to trade frequently in the OTC market. This was turned into a kind of 'spot market' by disallowing the rolling and cancellation of forward contracts in the forex markets. Another 'cornering' of forward exposures by some top corporate in 2011, led to a crisis of confidence in the rupee, even as the cash/spot market stayed surplus. This prompted the RBI to accelerate the development of the currency futures market.

Periodic episodes of bad behaviour by market participants has led to the opening of the exchange-traded markets, in equities, bonds, currencies and now commodities. Barring real estate, there are now exchanges that trade almost everything that you use in your daily life: cotton, crude oil, electricity, metals, agri-produce, money instruments.....these are not just 'financial' markets any more, they are like your local mandi in many cases. They might look complicated at first, but they are giving us fragmentation of economic power and transparency in price discovery, two very important 'soft services' in a world of increasing economic complexity.

The National Spot Exchange should be seen in this context. It was like the local mandi had come to your doorstep......except that it brought the village moneylender as part of its dowry. The transactions in question were 'repo' transactions, sold for years as 'risk-free' transactions, because of a perception created after the cleaning up of the equity markets, that exchange-traded transactions have no counter-party risk and that settlement is fully guaranteed.

As the CFO of a mid-cap company, I used to get these deals offered to me through the broking community. It looked like a 'free lunch', you could invest your savings at almost twice the bank rate, get scrips of paper that looked secure, with the underlying assurance that the counter-party risk management of a registered exchange and its Settlement Guarantee Fund were available as standby to ensure that your savings were safe.

There are about 25 'borrowers', i.e., people who have sold commodities in the first leg of a 'repo' transaction. They have to deliver inventory, which has been paid for by the 13,000 buyers. When this repo is unwound, the commodity is bought back and the money returned with an underlying interest, called 'carry'. This annualised carry was running at 14-18 per cent in various commodities, on which these repo transactions were being done.

It seems that this inventory is lying in the exchange warehouses, or with third parties. We have to see the quality of this inventory, and whether it really is what it was supposed to be. One of the big grey areas is the quality of inventory, especially in agri-produce; even the top commodity exchanges struggle with standardisation issues in physical inventory. It is very likely that claims about inventory (quality, saleability, valuation, etc) will turn out to be grossly overstated, and that is where the hole will surface. The lenders will either get unsaleable inventory, or it will be of substandard quality, and of course, it cannot be exchanged for cash, except at a steep loss. It is always difficult to judge the size of the hole, but the amount outstanding is Rs 5,500 crore.

As pointed out above, the exchanges are supposed to be a quantum improvement over the banking/ OTC markets. This kind of repo business replaces 'commodity financing' by the Banks, which itself was peppered with huge frauds: remember Rajinder Sethia's duping of Bank of Baroda, where he facetiously claimed that the sugar cargo he was carrying just sank and 'dissolved' in the ocean. He even claimed Insurance on the scam.

I am not suggesting that the two incidents are even remotely similar. There is no evidence yet to prove that NSEL will not honour its obligations by selling its inventory. My regret is for what this episode will do to the credibility of the exchanges. While the banking system stands discredited for taking an excess of risk, the exchange system works on systemic risk management; individual players may misbehave, but subject to caveat emptor, the only risk you are taking on the exchanges is market risk, i.e. price risk. You were insulated from counter-party risk, and certainly, fraud and misrepresentation. The NSEL episode will derail an otherwise progressive trend, i.e. towards the conversion of all OTC transactions into exchange-traded transactions. I used to dream that one day, banks would be mere 'bundlers' of debt, which would be bid for, at a debt exchange. So a company would only go to a bank as a credit intermediary, which would do the credit appraisal as a service to the actual lender. There would be 'portfolio creators', like Mutual Funds, who would put together 'pools of debt' which would then be marketed to the savers. The real role of banks would be as 'credit enhancers', who use their capital to guarantee the repayment of capital, their real function. The debt markets would do the rest.

We seem to be very far away from such a destination. If it now turns out that the platform itself loses credibility, it will be a very big setback for progress. The 'NSEL moment' will be remembered as a point in time when India took a step back.....