What led to NSEL Crisis? How could it have been prevented?

“There is nothing called a Risk-free return if someone claims that he is giving more than bank fixed deposits.” Nithin Kamath, Founder and CEO, Zerodha. Mr. Kamath rightly pointed out the grave reality of the business world that people more than often fail to realize. One of the grave situations, where people miserably failed to realize the underlying storm was the NSEL Crisis. It all started when National Spot exchange (NSEL) started defaulting on its payments. The scam affected 15000 investors costing more than 5600 crores.

Exploring the underlying causes of the NSEL scam, we revisit the basics of what NSEL offered and what policies of NSEL ultimately led to its downfall. NSEL was basically an electronic market for exchange of commodities. It started in 2008 with Financial Technologies Limited as the promoter. It also included NAFED as a promoter by providing them a meager 100 share but in turn misusing their name as the major investor for NSEL.

When we contemplate on what led to the NSEL crisis, we come across some of the following given facts. NSEL was only allowed forward contracts in a maximum of T+11 format. Instead NSEL offered contracts for settlements which were due for T+2 or T+25 days. Such contracts were illegal. Due to lack of regulation of NSEL, illegal contracts in T+25 form were freely made for settlements without physical exchange of commodities. This offered longer delivery days making trading speculative.
  • Even though a few warnings were issues by the Department of Consumer Affairs, the warnings were recklessly ignored.
  • Additionally, it was found that more than 24 borrowers were given funds by the NSEL, without any underlying commodity being deposited by the borrowers. It was later discovered, that trades were made under the names of non-existent warehouses and the balance sheets listed commodities stored in quantities more than the required capacity of the listed warehouse. This should have come under the attention of the auditors, but it was comfortably ignored which led to delay in discovering the scam.
  • After issuing fair warnings, and receiving no significant response from NSEL, the government got into action and suspended all new contracts. This led to the loss of trading interest on all contracts except e-series products. The e-series contracts continued trading on the exchange.

Ultimately, the exchange started defaulting on its payments and could not payout. The scam was exposed on 31st July, 2013.

NSEL violated the conditions of ‘no short sale’, ‘no stock verification mechanism’ and ‘conducting trade beyond 11 days’. There was a lack of risk management. All these factors combined together led to the Scam. Ignorance by the government authorities led the losses to accumulate to almost Rs.5600 crores.

This scam could have been easily avoided if a few necessary steps were taken by the investors and the government authorities. The investors should have looked for clarity of how the system works. The lack of knowledge proved to be dangerous for them. They should have found out how NSEL is providing such easy money (such investments should be analyzed carefully and should raise a doubt whenever faced). They should have been informed about what are the risks involved on the counterparty. If they would have been informed well, they would have been saved from losing such high amount of money. Investors should have made sure to test the new exchange carefully before investing huge amounts. Secondly, spot exchange should have been properly regulated either by FMC or SEBI. Absence of non-regulatory body, resulted in a lack of regulation of accounts and further delay in the matters. Such a situation could have been easily avoided if a proper regulatory authority was present. The government also showed carelessness even after facing so many warning signs. They underestimated the gravity of the problem, and failed to follow up with the warnings they issued. The clumsy handling of such a matter led to an increase in losses. Also, if regular audits were conducted properly, the scam wouldn’t have aggravated to such a condition. However, the auditors did their job recklessly and did not cross-check the entries in the books, leading to the scam. This could have been avoided by proper regulation from the government side and from auditors side.

The government is now said to be working on the new regulations which are being specifically designed to govern the spot exchanges. They will help avoid such loopholes in the systems. NSEL is now, not allowed to launch any new contract. Also, SEBI has sought details regarding the regulations. Such steps will help prevent similar scams in future.