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Who is " Fit and Proper " to Run an Exchange? Regulatory Response to
Payment Default by National Spot Exchange Ltd (NSEL) of India

Working Paper · March 2016

DOI: 10.13140/RG.2.1.5121.4482

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 Who is “Fit and Proper” to Run an Exchange?

Regulatory Response to Payment Default by National Spot Exchange Ltd (NSEL) of

India.

Exchanges are the focal points of capital market in any country. Regulatory bodies

supervising capital marketsformulate rules and regulations for safeguarding traders’ interests.

These regulations normally relate to net worth requirement for brokers/dealers, open position

limits for traders and different types of margins on traded contracts. Regulatory bodies also

formulate policies for maintaining settlement guarantee fund (SGF henceforth). SGF acts as a

self-insurance mechanism and minimizes credit risk associated with counterparty default.

As self-regulating organizations (SROshenceforth), exchanges also formulate rules for

auditing books of accounts of brokers/dealers, rules related to listing and delisting of

securities and rules pertaining to settlement prices and daily mark-to-market margin etc.

Though there have beensporadic reportsof insider trading, market price

manipulations,circular trading leading to pricing rigging andcorporate governance

failuresatmany exchanges all over the world, there have been no reports of any

exchangefailing to fulfil payment obligations for the trades executed in its platform.

Failure of an exchange tosettle tradesbecame a reality, when National Spot Exchange Limited

(NSEL henceforth) of India, a commodity spot exchange, defaulted in paying INR 56000

million to thousands of investors during July 2013 leading to suspension of all trading

activities at NSEL.

The probe initiated byGovernment of India (GoIhenceforth)unearthed large scale violations

in almost all spheres of NSEL operations. In an unprecedentedmove, in December 2013, the

1
commodity market regulator of India, Forward Market Commission (FMC henceforth)

indicted fourentities associated with NSEL as “not fit and proper persons” to be associated

with anyexchange in India. These four entities are Financial Technology India Limited (FTIL

henceforth), the promoting company of NSEL, and three members of board of directors of

NSEL.

This case study focuses on the regulatory response to the payment default by NSEL which

shook the fledgling Indian commodities market. This case study also highlights the pitfalls of

under-regulation of Indian commodity market and critically examines the role of NSEL

management team as well as board of directors in the payment default. The case study

chronicles the major events surrounding the payment default crisis and the major initiatives

taken by the regulator to limit the impact of NSEL default on other exchanges in India.

The rest of the case study is organized as follows. Section 1.1 discusses the research findings

on the roles played by regulators vis-à-vis exchanges as SROs in maintaining market

integrity. Section 1.2briefly introduces the Indian commodity spot and derivatives market.

Section 1.3 discusses the data and methodology followed by the researchers to present the

case. Section 1.4introduces NSEL and its activities. Section 1.5highlights the NSEL

operation since its inception to the suspension of all trading activities on 31 July 2013.

Section 1.6 chronicles important events during August 2013 to December 2013 when FMC

declared FTILand three board members of NSEL as “not fit and proper persons”. Section

1.7discusses why FMC only penalizedfew of the board members and not the other members.

Section 1.8lists the major shortcomings of NSEL operations which FMC considered for

declaring these four entities as “not fit and proper persons”. Section 1.9concludes the case

study.

2
1.1: Literature review

The literature on the capabilities of by regulators vis-à-vis exchanges to prevent market

failures is scarcely reported. In one of the earliest studies, Jennings(1964) highlighted the

power asserted by the Securities Exchanges Commission (SEC) of USA to correct certain

abuses in stock exchanges’ practices as follows:

“congressional encouragement or pressure has apparently impelled the Commission

to assert its reserve powers in order to correct certain abuses that have persisted,

particularly in stock exchange practices. These moves on the part of the Commission have

been met so far by the stiff resistance of the officials of the NYSE and the American Stock

Exchange (Amex). The "Big Board" and the SEC have just gone through an eye-ball to eye-

ball confrontation over the Commission's proposal to ban or greatly restrict floor trading.

This showdown struggle over floor trading was heralded as the "biggest fight between the

Big Board and the Commission since New Deal days”…. This new-found firmness on the part

of the Commission, which has been construedin some quarters as an "attack on Wall Street”,

makes a reappraisal of therelative roles of the industry and the Commission in the self-

regulatory system particularly timely.”.

Pirrong (1995) analyzed self-regulation mechanism of 10 commodity exchanges inUSA. His

study covered time periods prior to the enactment of Grain Futures Act (GFA) of 1922, the

Commodity Exchange Act (CEA) of 1936, and the Commodity Futures Trading Commission

Act (CFTCA) of 1974 and reported that exchanges took inefficient measures to curb price

manipulation and were grossly inadequate in limiting monopoly practices. Pirronganalyzed

historical events to determine the correctness of various arguments put forwarded by many

influential persons associated with commodity market before the enactment of above

mentioned acts. Pirrong’s report mentioned that these influential persons also argued that

3
commodityexchanges can internalize costs and benefits of trading better than regulatory

bodies. Hence, exchanges can intervene at lower costs and take better precautions against

manipulations compared to regulators. Demarzoet al (2004) study found that stock exchanges

as SROs choose a relatively lax enforcement policy to govern brokers than what the

customers would like them to do. They also reported that the threat of government

enforcement by regulators leads to strict vigilance of agents by SROs. However, they also

reported that enforcement by SROs is just enough to pre-empt any government enforcement.

In contrast to above mentioned research studies, Lazzarinniand Mello(2001) reported that

BM&F, the commodity futures exchange of Brazil has been effective in regulating the

derivatives market in Brazil as compared to regulatory agencies. They found that regulatory

agencies are susceptible to governmentdiscretion and tend to pursue interest of the

government and not necessarily formulate policies to reduce market failures.

The failure of International Tin Council (ITC) and its impact on London Metal Exchange

(LME) hasalso raised many questions regarding the capability of exchanges to self-regulate.

It should be noted that on 24 October 1985, ITC announced its inability to pay the

counterparties for the trades it conducted at LME. Prest (1986) and AndersonandGilbert

(1988)reported the impact of failure of ITC’s buffer stock program which brought LME to

the brink of closure. Both these studies highlighted the fact that LME did not have a clearing

house till 1985and this exacerbated the counterparty risks. In response to this crisis, with the

enactment of Financial Services Actin 1986, Security Investment Board (SIB)of UK was

formed. SIB forced LME to start an independent clearing house and failing which LME

license would be withdrawn.

Bernanke (1990) analyzed the role of Federal Reserve Bank (FRB) in averting a full blown

crisis soon after the stock market crash on 19October 1987 in USA. He reported that on

4
20October 1987, the FRB undertook a twopronged strategy that consisted of reversing FRB’s

tight monetary stance andFRB persuading ten largest banks in New York to increase their

lending to securities firmswho were unable to pay their margin. Bernankeopined that direct

intervention by Mr. Alan Greenspan, the then FRB chairman also had a considerable impact

on alleviating the fear of default. He cited the following statementissued by FRB on 20

October 1987which gave much needed assurance to the market: “The Federal Reserve

consistent with its responsibilities as the nation’s central bank, affirmed today its readiness

to serve as a source of liquidity to support the financial and economic system”.

Few research studies have focused on the role of regulation in shaping secondary capital

markets in developing countries. Research findings by Stigler (1964) and Black (2001)

indicate the importance of government regulation in bringing order tonewly formed stock

markets. Zang (2006) also suggested that government regulation should move beyond the

role of merely providing and maintaining legal and regulatory structure, and should transform

the old market institutions to become the creator and custodian of new and efficient financial

markets.

Except the findings of Lazzarinni and Mello(2001), analysis of other research papers

discussed above indicates the importance of regulatorsin bringing order to

markets,specifically during turbulent times.

1.2: Data and methodology

This case study has been developed from data and reports collected from various secondary

sources. Payment default by NSEL was widely reported in media and financial newspapers in

India with each giving their own analysis and interpretations.Since the payment default came

into public knowledge, almost every day some new aspects of the case were reported in

financial newspapers and websites. Facts and figures used in this study have been carefully

5
collected from authentic sources such as reports published by FMC, press releases available

at websites of FMC1, Ministry of Consumer Affairs, Food & Public Distribution and NSEL

as well asannual reports of FTIL and NSEL. It has turned out to bea daunting task to choose

only major events and report those facts and figures so that the important dimensions of the

case are brought into focus.

1.3 Introduction to Indian commodity spot and derivatives market

Commodity derivatives trading in India is nearly 100 year old. During 1940’s, India had

about 300 commodity exchanges offering futures contracts on commodities. Upto 1952, these

exchanges were operating as standalone units with each having its own trading guidelines.

There was no market regulator and no uniformity in trading practices. In 1952,

GoIformulated the Forward Contracts (Regulation) Act, 1952(FCR Act 1952) and set up

FMC to act as the regulator. Due to various reasons, GoI enforced a blanket ban on

commodity derivatives trading in 1966. Subsequently GoI formulated many committees to

start commodity derivatives trading. Based on recommendations ofseveral expert

committees, in the year 2000,GoIgave permission to restart commodity derivatives trading.

In 2002-03, three national level demutualizedmulticommodity exchangescame into existence,

namely National Multi-Commodity Exchange of India Ltd. (NMCE), National Commodity

and Derivatives Exchange Ltd. (NCDEX) and Multi Commodity Exchange of India Ltd

(MCX). Later during 2009 to 2012, three other commodity derivatives exchanges namely

Indian Commodity Exchange (ICX), Ace Commodity Exchange (ACE) and Universal

commodity Exchange (UCE)startedin India.All these six exchanges offer futures contracts on

agricultural products, base and precious metals and energy commodities. GoI is yet to allow

trading of option contracts in Indian commodity derivatives exchanges.

1
Press releases issued by FMC are available at
http://www.fmc.gov.in/index3.aspx?langid=2&subsublinkid=329&sslid=739

6
In India, spot trading of commodities is predominantly undertaken at “mandis”. “Mandi” is

Hindi word for wholesale physical market place where buyers and sellers including

middlemen congregate at a common place to trade. These mandis fall under the state

government’s jurisdiction. Each state governmentframesits own rules and levies its own

taxes. Hence at a given point of time, the spot price for a given commodity in each of these

mandis varies widely. As there is no quality standardization across mandis, the spot price

prevailing in these mandis are also not comparable. Without a standard spot price, pricing

derivative contracts on these commodities becomes difficult. These mandis are also

controlled by middlemen and they often form cartels. Hence price discovery in these markets

often tend to be faulty and opaque. To overcome difficulties associated with multiple spot

prices for a given commodity and poor price discovery in mandis, GoI permitted many

commodity exchanges to start electronic spot exchanges in 2005.NSEL came into existence

in 2007 to provide an online trading platform for spot trading of commodities. NCDEX also

started its own electronic spot exchange NSPOT in 2006. By 2013, NSEL had around 90% of

marketshare in the electronic spot trading in India.

It is to be noted here that NSEL and NSPOT are electronic spot commodity exchanges while

MCX, NCDEX, NMCE, ICEX, ACE and UCE offer futures contracts on commodities. All

commodity futures exchanges were regulated by FMC while all spot exchanges were

regulated by Ministry of Consumer Affairs, Food and Public Distribution(MCA-

FPDhenceforth)till February 2012.

1.4 NSEL: A brief introduction

NSEL was set up as a national level, institutionalized, electronic, spot trading platform for

commodities. From 2007 onwards NSEL started offering standardizedspot contracts. Around

33 commodities were trading at NSEL platform with trading terminals distributed across

7
India to bring buyers and sellers from all over India to its platform. As NSEL’s mandate was

to offer spot trading of commodities, GoI decided that NSEL would be governed by MCA-

FPDunlike commodity derivatives exchanges which are governed by FMC.

Insert Figure 1 here

Figure 1 shows the ownership structure of NSEL along with other group companies.NSEL

waspromoted by FTIL.FTIL is a listed company and is listed at Bombay Stock Exchange

(BSE) and National Stock Exchange (NSE). It provides business solutions to all types entities

associated with an exchange ecosystem such as stock and commodity exchanges, brokerage

firms, clearing houses and warehouses. FTIL also had equity ownership in many foreign

exchanges2such as Global Board of Trade (GBOT), Singapore Mercantile Exchange (SMX),

Bourse Africa, Baharin Financial Exchange (BFX) and Dubai Gold & Commodity Exchange

(DGCX).

As on March 31 2013, FTIL ownership structure was as follows: Mr. Jignesh Shah had

18.08%,La Fin Financial Services Pvt. Ltd. owned 26.76% and public shareholding stood at

54.37% of FTIL.

As on March 31 2013, FTIL had 99.99% of ownership in NSEL. Besides NSEL, FTIL

wasalso the promoter of MCX and was holding 26% of MCX. As mentioned earlier, MCX is

a commodity derivative exchange in India. MCX is also listed company and is listed at BSE

and NSE of India. FTIL also had majority ownership of Indian Bullion Market

Association(IBMA henceforth) as NSEL owned 60.88%ofIBMA. IBMA was a trading cum

dealing member with both spot and commodity derivative exchanges in India.
2
Annual report 2011 -2012 of FTIL lists many exchanges and clearing houses incorporated in foreign
countries as its subsidiaries. Some of these exchanges/clearing houses and FTIL ownership
percentage given within bracket as follows: Bourse Africa Limited (99.98% , Botswana), Bahrain
Financial Exchange (100%, Kingdom of Bahrain) , Singapore Mercantile Exchange (100%,
Singapore) , Singapore Mercantile Exchange Clearing Corporation ( 100%, Singapore), ICX platform
Ltd.(90%, south Africa) etc. The complete list available at
http://www.ftindia.com/investors/pdf/FTIL_AR_2011-12.pdf

8
To formalize NSEL operation, on 5 June 2007, MCA-FPDissued a landmark policy guideline

through a gazette notification(Annexure A). The important features of the notification are

follows:

 NSEL cannot offer short sell contracts i.e, a trader cannot sell any good without

owing the goods.

 Though NSEL is a spot exchange, it can offer T+1 contracts. A spot contract needs to

be settled on day T. That is, buyersneed to pay money and sellers need to deliver

goods on the trading day itself. As this would be too restrictive, GoI allowed NSEL to

offer 1-day forward contracts through T+1 contracts. This was done so that sellerscan

deliver the underlying commodityon T+1 day.

It is very noteworthy here that the gazette notification was vague in identifying the

regulator for NSEL. As can be seen in Annexure A, the gazette mentioned that “All

information relating to the trade as and when asked for shall be provided to the central

government or its designated agency” without explicitly naming the designated agency.

With this notification, NSEL started its operation in 2007 and only offered T+1 spot

contracts. However in due course of time, it permitted short sell contracts in clear

contravention to MCA-FPD gazette notification. In a short sellcontract, sellers can place sell

orders without owning physical goods thus making these contracts speculative. Though

NSEL was mandated to facilitate spot trading of commodities leading to actual delivery, short

sale contracts allowed traders who did not physically own a given commodity, to trade in

that commodity.In due course of time, NSEL also started offering another type of contract,

popularly known as paired trades (discussed in detail in next section) which were also not

sanctioned by MCA-FPD.

9
Riding on short sell and paired trades, NSEL trading volume grew rapidly during 2007 to

2012. It is worthwhile to mention here that NSEL continued its operation from 2007 till 2012

unsupervised by any regulatory body, even though on paper it reported to MCA-FPD. During

this period, many questions were raised at various forums regarding NSEL’s unauthorized

and speculative trading activities.MCA-FPD took cognizance of views expressed by people

privy to NSEL operation. MCA-FPDissued another gazette notification on 6February

2012and appointed FMCas the designated agency3.With this gazette notification, FMC

became the regulator of electronic spot exchangesand NSEL came under FMC’s regulatory

purview. However this notification came after five years of NSEL’s operations.

1.5NSEL operation during 2007 to July 2013

NSEL started offering standardized T+1 contracts for spot trading from 2007 onwards. It also

provided regular and reverse auction facilities to buyers and sellers for commodities not part

of standardized contracts. Initially in all standardized spot contracts, sell orders were backed

by warehouse receipts. As the trading volume werelow, NSELstarted allowing members short

sell contracts where a trader could give a sell order not backed by warehouse receipts. This

wasin clear violation to point (i) mentioned in the gazette notification dated5 January 2007 as

given in Annexure A.

To increase trading volume even further, in November 2009, NSEL started offering a new

type of contracts,namely paired tradecontracts. In a paired trade, a trader simultaneously

takes a short term buy contract alongwith a long term sell contract. For example, NSEL

“T+2 T+25” paired contract allowed a trader to take a buy position in T+2 contract and

simultaneously take a sell position in T+25 contract. Both T+2 and T+25 contracts were

3
The Gazette of India, Directorate of Printing, Government of India available at
http://www.egazette.nic.in/EnhancedSearch.aspx.The notification mentions that “in the said
notification, in condition (iv), for the words “in designated agency” the words “ Forward Market
Commission Mumbai shall be submitted. Amendments to the Notification No. S.O. 906(E),dated 5th
June, 2007, Ministry of Consumer Affairs, Food and Public Distribution.

10
taken by the same counterparties but in reverse order. For example, in the T+2 contract, a

trader “A” agrees to buy goods worth INR 1000 fromtrader “B” on day T. On T+2 day,

Bdelivers warehouse receipt and A pays INR1000 to B. On day T, both Aand B also agree to

take reverse position at INR 1014 to be effected on T+25 day. On T+25 day, Bpays INR1014

toA and A returns the warehouse receipt to B. In this case the paired contract ensured that A

is earning INR 14 for every INR1000 it invests for 25 days – a risk free return of 20.15%.

Besides “T+2 T+25” contracts, NSEL also offered “T+2 T+36” contracts. Effectively, these

paired trades functioned like a financingcontract and offered assured returns of 15-20% to

categoryA traders. In fact, trading members of NSEL started promoting these contracts as

assured return contracts which attracted many investors (mostly retail investors) into the spot

commodity trading market.

These paired contracts also violated the mandate given to NSEL as per the 5 June 2007

gazette notification. Being a spot exchange, NSEL was empowered to only offer

T+1contracts and not forward contracts for longer maturity such as T+2, T+25 or T+36

contracts.

As these contracts were offered by NSEL, it gave legitimacy to these transactions. Category

Atraders perceived that in case category B traders defaulton T+25 day, they have two lines of

defense. Firstly, being exchange traded contracts, all trades were guaranteed by NSEL

through SGFwhich wouldtake care of any counterparty default. Secondly these trades

werealso backed by warehouse receipts. In case of default, the exchange can sell goods

backed by the warehouse receipts and pay them their dues.

It is also worthwhile to mention here that in the NSEL payment default, number of category

A traders who lost INR 56000mnstood at 13000 compared to 25 companies belonging to

11
category B traders.For uniformity, these 13000 category Atraders are addressed as

“investors” and 25 category B traders as “defaulters” for the rest of this case study.

Both short sale contracts and paired contracts increased the trading volume at NSEL

significantly. Figure 2 shows the monthly trading turnover at NSEL during October 2008to

July 2013.

Insert Figure 2 here

After an initial period of low turnover, the trading turnover peaked to INR 454, 860mnduring

March 2012. In fact, paired trades grew significantly YoY. Table A shows that paired trades

accounted for about 99% of the total trading volume of NSEL during April 2013 to July

2013.

Insert Table A here

As mentioned earlier, on 6 February 2012, MCA-FPDissued a gazette notification and named

FMC as the “designated agency” to regulate NSEL. Based on this notification, FMC asked

NSEL to furnish trading data. This impacted NSEL trading volumeas can be seen from

Figure 2. After reaching a peak trading volume in March 2012, total trading volume declined

sharply in the month of April 2012. In fact, during April 2012, total trading volume fell by

45% compared to March 2012 traded volume. However, subsequently trading continued

unabatedly at NSEL.

Based on the analysis of trading data furnished by NSEL to FMC,in April 2012 FMC wrote

to MCA-FPD to initiate a probe against NSEL for violating the conditions (i) and (ii) of 5

June 2007 gazette notification. It is important to note here that even thoughFMC was made

the regulator of spot market throughFebruary 2012 gazette notification, FMC did not have

much power to take action against NSEL. In May 2012, MCA-FPDsought clarification from

NSEL. During June 2012, responding to the clarifications sought by MCA-FPD, NSEL letter

12
toMCA-FPD indicated that “NSEL does not insist on ownership of goods before allowing a

member to sell contracts4”.

It is interesting to note here that, MCA-FPD did not do take any actionuntil July 2013 even

after it received clarifications from NSEL affirming that it offers contracts not mandated by

the gazette notification. After a gap of 13 months, on 12 July 2013, MCA-FPDdirected NSEL

not to issue any fresh contract and settle all outstanding T+25 and T+36 contracts by 31July

2013.

On 31 July 2013, NSEL suspended all trading activities and announced that it has merged all

outstanding contracts. It also announced that settlements of all contracts would be deferred

till 25 August 2013and NSEL would make all payments by the deferred date. This

announcement created a panic in the market as manyinvestors feared that they would not be

able to recover their dues eventhough they have warehouse receipts as collateral. By this time

unconfirmed reports of warehouse receipts being fake ones started circulating fuelling

furtherpanic. On 31July 2013,media reports started pouring in regarding the payment crisis at

NSEL and this event became a national sensation.

4
Source: FMC notice on “Fit & Proper Notice” Dated 17th November 2013 available at
http://www.fmc.gov.in/WriteReadData/links/Order%20dated%2017-12-
2013%20in%20case%20of%20Fit%20and%20Proper%20Status-185672116.pdf

13
1.6: Sequence of majorevents after mayhem on 31July 2013

Like a multi starrer Bollywood movie, this case has many characters, turns and twists,

allegations and counter allegations, misappropriation of funds, related party transactions,

bribe, forensic audit, etc. The enormity of this payment default can be judged from the fact

that for months after the event, not a single day went by when financial newspapers did not

report some new dimension of the case.This section chronicles some of the majoreventsafter

the suspension of trading at NSEL on 31 July 2013.

1August 2013: To alleviate the panic that gripped the market, on 1 August

2013,Mr.AnjaniSinha (the then MD & CEO of NSEL) announced to media thatNSEL’s SGF

has INR 8500mn and investors need not worry abouttheir dues from NSEL.

4August 2013:Mr.Sinha in a press release5announced that NSEL is in possession of

INR49000mn of post-dated cheques (PDC henceforth) from defaulters, hence investors need

not worry.The press releasementioned that “while PDCs are a commitment, the payout

process may not roll out smoothly in a month’s time” effectively indicating that NSEL would

not be able to use these PDCs to pay investors. But no reasons were provided to explain the

inability. Interestingly he also announced that SGFonly had INR 620mn and not INR

8500mn as announced on 1 August 2013. The announcement also contained the list of

defaulters and the amount they owe to investors. He also informed about the outcome of

negotiation NSEL presumed to haveundertaken with these defaulters during last 4 days to

recover the dues. The defaulter list and the outcome of the NSEL negotiation with 24

defaulters are as follows:

5
NSEL Press Release “Proposed Settlement Cycle” dated 4 August 2013 available at
http://www.nationalspotexchange.com/NSELUploads/PressReleases/2013/August/English/48/NSEL_
Press_Release_-_08042013.pdf

14
  Eight defaultershad total dues of INR 21810mn and they were willing to pay by

scheduled due date (25August 2013) or even earlier. Interestingly Mr. Sinhadid not

name these defaulterspresumably because these companies agreed to pay their dues in

time.

 Thirteen defaulting companieshadtotal dues of INR 31070mn. Mr. Sinha named these

thirteen companies and mentioned that these companies have agreed to pay 5% of

their total dues every week. Names of thesedefaulting companies are given in Table

B1.

 Three defaulting companies had total dues of INR 3110mn. Mr. Sinha named these

three companies and mentioned that NSEL had startednegotiatingwiththese

companiesas these three companieswere not agreeing to pay their dues. Names of

these three defaulting companies are given in Table B2.

Insert Table B1 & Table B2here

Mr.Sinha also announced that defaulting companies listed in Table B1 have agreed to pay

their dues in an orderly manner and came out with detailed plan in which NSEL would

receive moneyfrom defaultersevery week for 30 weeksand NSEL in turn would pay to the

investors on every subsequent Tuesday for 30 weeks.

13August 2013: To ensure that NSEL refunds the money it collects from defaulters who

had agreed to pay, FMC met with NSEL officials. NSEL prepared schedule weekly

collection fromdefaulters to be deposited into an escrow accountto be operated by FMC so

thatproceeds from this account would be used to pay to investors. The schedulehad 20 weekly

installments of INR1740.72mn each, 10 weekly payments of INR 860.02mn each and

interestingly a balloon payment of INR12190mn against which no specific date of refund was

given. NSEL announced that the defaulters will pay INR 1219omn by selling commodities,

15
fixed assets and land but did not gave deadline by which date these amount were to be

refunded to investors. FMC also directed NSEL to submit the details of PDC that were

supposedly given by defaulters.

20August 2013: NSEL could not makefull payment of the first installment of the 20 weekly

installment payments even though it had mentioned that defaulters have agreed to pay as well

as it has in its possession PDC worth INR 49000mn . Realizing that NSEL is furnishing false

information and deliberating trying to mislead, FMC issued a notice6 to NSEL’s board of

directors to take complete responsibility for settling all outstanding dues. FMC also asked

NSEL to submit the stock verification report of NSEL warehouses. FMC appointed SGS, (a

unit of Swiss based firm SGS),a collateral management firm to do stock verification at NSEL

warehouses. FMC also appointed Grant Thorton to do forensic audit of NSEL

accounts.Interestingly on the same day,NSEL board of directors removed Mr.Anjani Sinha

along with five other top level executives7.

27August 2013: A high profile committee headed by economic affairs secretaryof GoI,

Mr.Arvind Mayaram, was given charge of probing NSEL payment default. The committee

had representation from Economic Offense Wing (EOW)of Mumbai police, Directorate of

Revenue Intelligence, Securities and Exchange Board of India (SEBI), Reserve Bank of India

(RBI), Forward Markets Commission (FMC), Serious Fraud Investigation Office (SFIO) and

MCA-FPD.

6
Available at
http://www.fmc.gov.in/show_file.aspx?linkid=Letter%20dated%2020082013%20to%20Board%20of
%20Directors%20of%20NSEL-501977106.pdf

7
Disciplinary action initiated by NSEL Board on Management Team
http://www.nationalspotexchange.com//NSELUploads/PressReleases/2013/August/English/55/PR_20
_Aug_2013.pdf

16
11September 2013: Mr.Anjani Sinha filed a 13-page affidavit8 in a Mumbai court where he

absolved NSEL board of directors9and named some of his NSEL colleagues to be responsible

for payment default. It is important to note here that Mr. Sinha and some of these executives

were removed from NSEL on 20August 2013. The salient points of the affidavit are as

follows:

 Mr. Sinha mentioned that“I along with the senior management team of NSEL, which

includes Mr.Amit Mukherjee (Assistant Vice President, Business Development),

Mr.Jai Bahukhandi (Assistant Vice President, Warehousing), Mr.Shashidharan

Kotian (CFO),Mr. S B Mohanti(Assistant Vice President, Delivery), Mr.Santosh

Mansingh (Assistant Vice President, Clearing and Settlement) of NSEL are

responsible for the current problem faced by NSEL. None of the board members are

responsible for this”.

 In this affidavit Mr.Sinha elaborated the lapses by different members

 Lapses by defaulters

o “Misrepresentation of facts pertaining to declaration of stock position”.

o “Issuance of sale invoice without having goods in stock”.

o “Issuance of false documents relating to physical possession of goods”.

o “Entering into sale transactions without having stock of goods”.

o “Defrauding money by enjoying the sale proceeds without effecting

deliveries.”

o “Diversion of funds availed through fictitious sale of transactions to buy real

estate and other properties”.

8
Available at http://capitalmind.in/2013/09/from-the-nsel-desk-anjani-sinhas-affidavit/
9
Interestingly complete detail of affidavit started circulating in media shortly after 11 September 2013.
It is widely believed that some of the board members of NSEL made this affidavit available to
journalists so that they can absolve themselves from the payment default.

17
 o “Making false statement about stock position in presence of FMC official”.

 Lapses by business development team headed by Mr.AmitMukherji

o “Introducing buyers with bad credentials into NSEL system”.

o “Not informing the management about the possible diversion of funds by

defaulters”.

o “Not informing management about non-availability of stock or pledge of stock

with other lenders and simply allowing them to siphon off funds”.

 Lapses on part of warehousing team, headed by Mr. Jai Bahukhandi

o “The violation done by the warehousing team is the most severe. The weakest

link in the entire episode is the warehouse management. Before launch of

every contract, Mr.JaiB ahukhandi used to visit the location, verify stocks,

depute warehouse supervisor and security guard and then give confirmation

about launch of the contract. Based on his report, trading commenced in every

contract. But subsequently thewarehousing team of NSEL did not have any

control on the stock.”

o “Not having adequate control on physical stocks and also making false

statement”.

 Lapses by himself.

o “Not having proper systems and controls to monitor physical stock vis a vis

exposure taken by traders”.

o “Not informing NSEL about increasing exposure and risks of widespread

default, which was a breach of trust of other Board members”.

o “Relying upon the statements made by Mr. Jai Bahukhandi about stock

statements and statement made by Mr.Amit Mukherji about buyers’

credentials without having cross verification”.

18
 o “Submitting wrong stock statement to the NSEL board on 30th July 2013, and

subsequently to FMC, based on the reports given by the warehousing

department”.

o “by 2011-12, the scenario was such that if we did not allow roll over, buyers

would have defaulted with huge amount. On the other hand, if we allow him to

roll over his position, his exposure keeps on increasing 20-25% every year

due to impact of roll over cost and exchange fee. The judgment error on our

part that due to fear of widespread default, we allowed the market to function

rather than stopping it boldly in past”.

 17September 2013:The collateral management company SGS submitted its interim

audit progress report regarding the stock available atwarehousesowned or approvedby

NSEL.SGS reported thatit could conduct audit at 17 warehouses as the owners of

other 30 warehouses10 did not permit SGS to conduct audit.

 20September 2013: Mr.Arvind Mayaram Committee (set up on 27 August 2013)

submitted its report to GoI. The committee questioned the role of NSEL auditor

“Mukesh P Shah & Co” and mentioned that action needed to be initiated against the

NSEL auditor for “failure to furnish true and fair view of the state of affairs at NSEL

in its balance sheet for the financial year ended March 31, 2013”.

 21September 2013: Mukesh P Shah &Co informed NSEL that the accounts of

FY2012-13 of NSEL and IBMA could not be relied upon. The following lines were

prominently displayed in the NSEL website: “In view of request made by statutory

auditors as per standard on Auditing SA-560, no reliance may be kept on audited

financial statements for FY 2012-13 for NSEL and IBMA”

10
At a later point of time, SGS reported that many of these 30 warehouses existed only in paper.

19
 4October 2014: FMC issued“fit and proper” show-cause-notice to four entities

associated with NSEL. These four entities are FTIL, the parent company and the

largest shareholder of NSEL as well as three board members of NSEL namely

Mr.Jignesh Shah, Mr. Joseph Massey and Mr. Shreekant Javelgekar. Table C lists

board members of NSEL as on 31 July 2013 and their subsequent association with

NSEL.

Insert Table C Here

The criteria for a person deemed to be “a fit and proper person” is given in Annexure

B. FMC gave two weeks’ timefor receiving responses from these four parties

explaining theirviews.

 17October 2014: Mr.Anjani Sinha was arrested and taken to police custody. The

probe team started an enquiry under the Prevention of Money Laundering Act

suspecting large-scale money laundering by Mr. Sinha. The probing team found a

new dimension involving Ms.Shalini Sinha, wife of Mr.Anjani Sinha. Ms.Shalini

Sinha was the owner and Managing Director of SNPDesigns. On behalf of

SNPDesigns, IBMA was trading at NSEL platform and no margin money was ever

taken from SNPDesigns for trading at NSEL platform.

 18 October 2014: In a surprising turn of events, Mr.Anjani Sinha filed a fresh

affidavit in which he mentioned that“The affidavit I filed on 14August 2013 was

under duress and was forced to do so by NSEL Board”. He also mentioned that all

trades were authorized by the board of directors and he and other employees

20
 mentioned in his earlier affidavit dated 11September 2013 shouldnot be held

entirelyresponsible for the INR 56000mn default.

 6November 2014: Grant Thornton (appointed on 20August 2013) submitted its

forensic audit report to FMC. The report detailed many violations by the NSEL.

Some of these are as follows:

o NSEL used the SGF margin money to repay bank loans as some traders had

taken loan from these banks to trade at NSEL. In fact, NSEL had provided

guarantee to these banks on behalf some of the defaulters i.e., if these

defaulters do not repay the loans, NSEL stood as guarantor.

o NSEL had no system of maintaining records of margin money paidby traders.

o Many warehouses existed only on paper.

o Many defaulters existed on paper. NSEL did not follow the basic principle of

Know-Your-Customer norms before allowing traders to trade in its platform.

 17 December 2014: FMC ruled that11 FTIL and the three board members are “not

fitand proper persons12” to run any commodity exchange business in India.

As the probe progressed, the investigative agencies arrested Mr. Amit Mukeerjee and

Mr.Jai Bahukhandi , the two persons named by Mr. Anjani Sinha in the 11September

2013 affidavit. Subsequent probe by investigating agencies led to arrest of Mr. Jignesh

Shah and Mr. ShreekantJavelgakar. As on July 2014, FMC and other law enforcement

Source: FMC notice on “Fit & Proper Notice” Dated 17 November 2013 available at
11

http://www.fmc.gov.in/WriteReadData/links/Order%20dated%2017-12-
2013%20in%20case%20of%20Fit%20and%20Proper%20Status-185672116.pdf

As part of the “Guidelines for constitution of the Board of Directors, Nomination of

12

Independent Directors and appointment of Chief Executives at the Nationwide Multi

Commodity Exchanges.” issued by FMC on 12 August 2013. Source: http://www.fmc.gov.in

21
 agencies are actively pursuing defaulters and have put many defaulters (listed in Table B1

and B2) behind bars. The 13000 investors havealso created a NSEL Investors Forum

(NIF)13 and collectively mounting pressure on FMC to speed up the attachment of

property of defaulters and sell or auction these to recover their dues. In the meantime,

NSEL has appointed a new MD and also has reconstituted the board with four new board

members. Jointly working with FMC and other law enforcement agencies, NSEL has

started making part payments (Table D) to these 13000 investors from the proceeds

collected from defaulters.

Insert Table D Here

1.6:NSEL board and FMC

Table C lists the details of board of directors of NSEL as on 31July 2013. Except Mr.

AnjaniSinha who was removed from the NSEL board on 20 August 2013, other six members

resigned from the board at different points of time after the payment default. However, out of

these sixmembers, FMC brought three individuals to its “fit and proper” investigationambit

and exonerated others. This section briefly analyses the reasons for doing so.

Data given in Table C indicates that Mr.Jignesh Shah and Mr. Joseph Massey werealso board

members of MCX. Mr.Shreekant Javelgekar was the MD &CEO of MCX as well as board

member of NSEL and IBMA. As mentioned earlier, MCX is the leading commodity

derivatives exchanges in India and a group company of FTIL.FMC chose these three persons

to ring-fence MCX operations as these three persons were also the board members of MCX.

FMC observed that “general reputation and character, record of fairness, honesty and

integrity of these three persons have been eroded substantially” and hence they should not be

associated with any other commodity exchange in India. Similarly for penalizing FTIL, FMC

13
These investors have a created a social media account for the forum as NIF NEL Investors Forum
available at https://www.facebook.com/nseldefault

22
reported that FTIL being the 99.99% owner of NSEL is responsible for the failure of NSEL.

FMC also reasoned thatbeing the major shareholder of MCX, FTIL cannot be entrusted with

the responsibility of governing MCX. The FMC report dated 17 December 201314stated the

following details:

“Keeping in view the foregoing observations and the facts which reveal misconduct,

lack of integrity and unfair practices on the part of FTIL in planning, directing and

controlling the activities of its subsidiary company, NSEL, we conclude that FTIL, as the

anchor investor in the Multi-Commodity Exchange Ltd.(MCX), does not carry a good

reputation and character, record of fairness, integrity or honesty to continue to be a

shareholder of the aforesaid regulated exchange”.

1.8Major shortcomings of NSEL operation and the role of NSEL Board

Soon after the payment default became public,NSEL board members pleaded innocence and

tried to put all blame on the exchange officials. This section highlights the major

shortcomings ofNSEL operations which could not have escaped attention of NSELboard

members.

 NSEL offered paired trade contracts and short sellcontracts which were not permitted

by the regulatory body. Though FMC raised objectionsto these contracts as early as

April 2012, NSEL continued to offer these contracts. In fact, in April 2012, fifteen

months before the crisis, NSEL informedMCA-FPD that, “NSEL does not insist on

ownership of goods before allowing a member to sell contracts”. So the board

members knew that trading takes place at NSEL platform and sell orders are allowed

to be executed although these were not backed by warehouse receipts.

Source: FMC notice on “Fit & Proper Notice” Dated 17th November 2013 available at
14

http://www.fmc.gov.in/WriteReadData/links/Order%20dated%2017-12-
2013%20in%20case%20of%20Fit%20and%20Proper%20Status-185672116.pdf
23
 NSEL warehouses issued fake warehouse receipts. Not only were warehouse receipts

fake, but also in many cases,thesewarehouses existed only in paper. Such gross

violation of basic trading guidelines could not have happened without the knowledge

of the board members.

 NSEL did not maintain enough SGF to protect traders from counterparty default thus

clearly violatingone of the basicexchange guidelines.

 Annual report FY 2012-13 of NSEL indicated that as on March 2013, NSEL had INR

8.466 mn in SGF. But at different points of time after the payment default, NSEL

official press releases indicated SGF figures ranging from INR 8500mn to INR

620mn. The NSEL board was actively involved in damage control measures when

the payment default became public. Why did the board members allowed the official

press release to contain wrong and highly inflated figure? Why they did not verify the

source of SGF increase from INR 8.466mn to INR 8500mn within 4 months i.e,

during 31st March 2013 to 31stJuly 2013. This indicates that board members allowed

the press release witherroneous information probably to mislead FMC and the 13000

investors.

 On 4 August 2013,NSEL announced that it hasPDC worth INR 49000mn from

defaulters. This information was also misleading as NSELdefaulted in depositing first

scheduled weekly payout scheduled on 13August 2013. If NSEL had INR 49000mn

PDC at its disposal, why it could not deposit the first installment of INR 1727.4mn

?In fact, only 20 days before the default became public, on 19July 2013, Mr. Jignesh

Shah gave a presentation to FMC and MCA-FPDofficial where he made a strong case

for NSEL and declared that all trading on NSEL platform is backed by 100%

commodities, 10-20% of margin money as well as 100% PDCsthus making NSEL

trading activities completely risk-free.

24
 NSEL allowed members to trade even after they defaulted on margin payment. Based

on the forensic audit report by Grant Thorton, FMC cited that Lotus Refinery, a

trading member at NESLdefaulted on 198 occasions during April 2012 toJuly 2013.

But itcontinued to trade as NSEL granted exemption to the company from depositing

margin money. During 2009 to 2014, NSEL granted 1800 margin limit exemptions to

many trading members including198 exemptions to Lotus Refinery. FMC argued that

such gross violation of exchange norms could not be possible without the knowledge

ofthe board members.

 NSEL gave trading membership to companies without following the mandatory

Know-your-Customer (KYC) documentation for identity proof, address proof,

shareholding pattern, memorandum of association etc.

 NSEL did not have any system to limit a member’s exposure based on theirnetworth

and credit score.

 The affidavit given by Mr. Anjani Sinha on 11September 2013 clearly showed that

NSEL faltered in many areas of its operation. This could not have gone unnoticed by

the NSEL board year after year.

 NSEL allowed IBMA (another group company) to trade at NSEL platform in clear

violation of related party transaction guidelines. IBMA was registered as a trading

member with NSEL though NSEL owned 60.88% of IBMA shares. NSEL and IMBA

had also some common board members.Obviously NSEL board members knew it

clearly that NSEL is violating related-party-transaction guidelines by allowing IBMA

to trade in its platform.

 Many of the warehouses associated with NSEL existed only in paper. NSEL did not

carry out any due diligence to check whether these warehouses existed or not. Some

of the genuine ones had their own IT systemsbut these were not integrated to NSEL

25
 IT system. An integrated IT systemcould have made it possible for NSEL officials to

know the status of commodities available in these warehouses. FTIL being

atechnology company specializing in offering technological backbone to many

leading exchanges in the world, did not deliberately integrate these warehouses to

facilitate these wrong doings and this could not have been undertaken without the

knowledge of the board members.

 NSEL board of directors did not constitute different committees as per the rules and

by-laws of the NSEL. The board was responsible for formulatingtrading committee,

clearing house committee, commodity specific committee etc. FMC found that NSEL

board did not constitute nine out tenmandatory committees required for running an

exchange.

1.9: Conclusion

NSEL started as a spot exchange and provided online platform to bring buyers and sellers of

commodities from all over India. Since its inception till March 2012, it was regulated by

Ministry of Consumer Affairs. In February 2012, when FMC was appointed as the regulator

of NSEL, it started questioning the nature of contracts traded at NSEL.

On 31July 2013, payment default became public knowledge when NSEL suspendedall

trading activities. Media reports started pouring in regarding the imminent payment default

by NSEL. It became a national sensation with TV channels beaming pictures of investors

flocking to NSEL offices to recover their dues. Within few days, the enormity of the problem

came into fore -- NSEL payment default stood at a staggering figure of INR56000mn. The

number of traders who lost money stood at 13000 compared to only 26 defaulters.

FMC as the regulator of commodity market roped in other investigating agencies and

initiated multipronged investigations and reported that rut at NSELrandeeper andfar more

26
serious than initially perceived. Though NSEL board members tried to put all blame on the

exchange officials,FMC not only took exchange officials and defaulters to task by putting

some of them behind bars, in a rare move, FMC indicted four NSEL board members as “not

fit and proper persons” to be associated with any commodity exchanges in India.As a result,

FTIL was directed to reduce it ownership in other commodity exchanges such as MCX and

Indian Energy Exchange (IEX). As the case is being written, FMC and other regulatory

bodies as well as law enforcement agencies are trying to recoverdues from defaulters to pay

to these 13000 traders.

The analysis of this case also clearly indicates that NSEL failure as a self-regulatory

organization even though its board members had vast experience in running many exchanges

in India as well as outside India.

Analysis of this case throws open some questions which are yet to be answered. NSEL

remained practically unsupervised from its inception till February 2012. Even though FMC

was appointed as regulator from February 2012 onwards, FMC was not empowered to take

any action against NSEL. On many occasions, FMC raised several questions regarding

NSEL’s operations, but no action was taken by MCA-FPD. Had MCA-FPD taken cognizance

to these alerts earlier, would this problem have taken such mammoth proportion? If a

government body is at fault, then who should be penalized?

Trades executed at NSEL did not require sellers to own commodities. Hence almost all trades

were speculative in nature and could have influenced spot price prevailing for those

commodities in the physical market. Did spot price discovered at NSEL contribute to

inflationary price trend in many commodities in India?

Why did these three experienced and seasoned individuals with so many years of experience

in running exchanges faltered in almost all areas of running another exchange? Is the concept

27
of “too-big-to-fail” equally applicable to individuals who thought that they can get away by

doing (or not doing) anything? Would three of them and the management team of NSEL

have behaved differently if they would have known that the MCA-FPD had the power and

intention to penalize?

References:

 Anderson R.W., Gilbert C. L.(1988). Commodity agreements and commodity markets:

Lessons from Tin, Economic Journal, 98,1–15
 Bernanke B.S.(1990). Clearing and Settlement during the Crash, The Review of Financial
Studies, 3(1) ,133-151
 Black B. (2001).The legal and institutional preconditions for strong securities markets,
University of California Law Angeles Law Review, 48,781-855.
 Commission’s order dated 17-12-2013 in the matter of Fit and Proper status of FTIL, Mr.
Jignesh Shah, Mr. Joseph Massey and Mr. ShreekantJavalgek available at
http://www.fmc.gov.in/WriteReadData/links/Order%20dated%2017-12-
2013%20in%20case%20of%20Fit%20and%20Proper%20Status-185672116.pdf last
accessed on 26th February 2014.
 Demarzo P.M, Fishman M.J, Hagerty K.M., (2004). Self-Regulation and Government
Oversight, The Review of Economic Studies, 72(3),687-706.
 Criteria for a person to be deemed to be “a fit & proper person” available at
http://www.fmc.gov.in last accessed on 20th February 2014.
 Forward Contracts Regulation Act, 1952, available at http://www.fmc.gov.in last
accessed on 20th February 2014.
 Jennings R.W.(1964). Self-Regulations in Securities Industry: The Role of the Securities
and Exchange Commission, Law & Contemporary Problems, 29(3), 663-690.
 Lazzarinni S.G. &de Mello P. C. (2001).Governmental versus self-regulation of
derivative markets: Examining the U.S. and Brazilian experience, Journal of Economics
and Business, 53, 185-207.
 NSEL Annual Reports and Financial Statements during FY 2005-06 till FY 2012-13
available at http://www.nationalspotexchange.com/abt_us.htm?id=11 last accessed on
21June 2013.
 Pirrong, S. C.(1995). The self-regulation of commodity exchanges: the case of market
manipulation, Journal of Law and Economics, 38,141–206
 Prest M.(1986).“The collapse of International Tin Council”, IDS Bulletin,17, 4, available
at http://onlinelibrary.wiley.com/doi/10.1111/j.1759-5436.1986...x/pdf last accessed on
20 August 2014.
 Stigler G.(1964).Public regulation of the securities market, Journal of Business, 38,117-
142.

28
 Weekly settlement Schedule by NSEL available at
http://www.nationalspotexchange.com/ last accessed on 27th February 2014.
 Zhang, X.2006. “Financial market governance in developing countries: Getting the
political underpinnings right”, Journal of Developing Societies, 22(2),169-196. DOI:
10.1177/0169796X06065801
 Forward Market Commission, India available at http://www.fmc.gov.in/
 Financial Technology India Ltd. available at http://www.ftindia.com
 National Spot Exchange Limited available at http://www.nationalspotexchange.com/
 NIF NSEL Investors Forum available at https://www.facebook.com/nseldefault
 Ministry of Consumer Affairs, Food & Public Administration, Government of India
available at http://fcamin.nic.in/
 Multi Commodity Exchange available at www.mcxindia.com

29
 Annexure A
MINISTRY OF CONSUMER AFFAIRS, FOOD & PUBLIC DISTRIBUTION 1
(Department of Consumer Affairs, Government of India)
NOTIFICATION
NEW DELHI: 5th June 2007
In exercise of the powers conferred by Section 27 of the Forward Contracts (Regulation) Act,
1952, the central government hereby exempts all forward contracts of one day duration for
the sale & purchase of commodities traded on the National Spot Exchange Ltd. From
operation of the provisions of the said Act subject to the following conditions, namely : --

(i) No short sell by members of the exchange shall be allowed.

(ii) All outstanding positions of the trade at the end of the day shall result in delivery.
(iii) The National Spot Exchange Ltd. shall organize spot trading subject to regulation
by the authorities regulating spot trade in the areas where such trading takes place.
(iv) All information or reruns relating to the trade as and when asked for shall be
provided to the central government or its designated agency.
(v) The central government reserves the right to impose additional conditions from
time to time as it may deem necessary and
(vi) In case of exigencies, the exemptions will be withdrawn without assigning any
reason in public interest

(signed by Paul Joseph,

Senior Economic Advisor)

30
 Annexure B

CRITERIA FOR A PERSON TO BE DEEMED TO BE “A FIT AND PROPER PERSON1”

Issued by Forward Market Commission (FMC), Government of India

For the purpose of these guidelines, a person shall be deemed to be a fit and proper person if:-

(i) such person has a general reputation and record of fairness and integrity, including but not
limited to:

(a) financial integrity;

(b) good reputation and character; and

(c) honesty

(ii) Such person has not incurred any of the following dis-qualifications :

(a) the person has been convicted by a Court for any offence involving moral
turpitude or any economic offence, or any offence against any laws;

(b) the person has been declared insolvent and has not been discharged;

(c) an order, restraining, prohibiting or debarring the person, from dealing in

commodities / securities or from accessing the market has been passed by any
regulatory authority.

(d) Any other order against the person which has a bearing on the commodities
market, has been passed by any regulatory authority.

(e) The person has been found to be of unsound mind by a Court of competent
jurisdiction and the finding is in force.

(f) The person is financially not sound; and

(g) The person is involved in any action of fraud or dishonesty.

31

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