The unfolding crisis at the National Spot Exchange (NSEL) throws up many questions about the regulation of commodity exchanges, definition of spot contracts and many other issues.

But the most intriguing one is: Why did high networth investors, who are otherwise free to bet on everything from real estate in Dubai to US-listed shares, choose to punt on more humble paddy and castorseed?

Further, if they were only playing the commodity futures game on the NSEL, what stopped them from trading gold, silver or metal futures on the regular futures exchanges?

The answer seems to lie in the very absence of regulation in this particular ‘spot’ exchange, which allowed so many unusual practices to flourish.

Indeed, the kind of deals being facilitated on the NSEL platform couldn’t have been replicated by any regulated exchange.

Here is why.

First and foremost was the fact that intermediaries were reportedly offering ‘guaranteed’ returns of 12-14 per cent per annum to clients from trading on the exchange.

Now, those trading derivatives know that they always offer a thrilling ride and, at times, bumper profits. But not even the savviest punter can ‘guarantee’ returns from them.

So how did the ‘guarantee’ on NSEL operate? Reports have it that trades on this exchange involved two parties — stockists (or processors of agri-commodities) and investors, with the former entering into ‘informal’ buyback arrangements with the latter.

The first leg of such trades consisted of the stockist selling a commodity (or warehouse receipt representing it) to the investor for an upfront payment within two days.

If this was a stock exchange, the trade would be concluded then and there. But on the NSEL, every sell trade was informally ‘paired’ with a buy trade to take place 25-35 days hence. The agreement was that the investor would sell back the commodity to the original stockist and receive payment from him for it. This ‘price’ would include the promised 12-14 per cent (annual) return.

The above arrangement, the argument goes, was win-win. The commodity processor or stockist, who found it difficult to access credit through formal channels, was now effectively getting funding at 12-14 per cent per annum ‘interest’ for 25-35 days by pledging his stock. And the investor got a high ‘fixed’ return impossible to get from any formal financial instrument.

Inflated prices?

So what’s wrong here?

Well, two things.

In any ordinary exchange — that too, for spot transactions — there is no question of a buyer and a seller agreeing on a ‘fixed’ price and then ‘routing’ it through the bourse. The very idea of an exchange is that many buyers and sellers come together and offer their wares for sale. Prices are discovered and deals concluded, when the bid and ask price match.

In the NSEL trades, even if prices in the first leg were market-discovered, by all accounts, they weren’t in the second leg. For if they indeed were, how could any trader expect a ‘fixed’ return of 12-14 per cent?

If every trade was put through at a ‘fixed’ mark-up, it is obvious then that prices quoted for commodities at the exchange would over time have become artificially inflated. They would have moved way out of sync with normal market prices.

In an ordinary platform, such anomalies would be an invitation to traders to immediately get into the act. If they believed a commodity was over-priced, they would sell it until it aligned with market prices.

But what seems to have prevented it in this case was the fact that the commodities being traded on NSEL were paddy, raw wool, castorseed and others, for which there are no commonly accepted benchmarks for determining prices.

That links up with the second problem of trades at the exchange. If there was no common market benchmark for these commodities, what price would the underlying stocks fetch in an auction? Is it really possible to put a number to their ‘market value’ at this juncture?

Whether this is what transpired at the NSEL is not yet clear. But this episode does far more than expose the lacunae in regulation of commodity markets.

It exposes the lacunae in market structure for agri-commodities itself.

After all, the prospect of spot-plus-forward contracts, paired trades or fixed returns wouldn’t have arisen if India had a formal, transparent and organised market where farmers and producers transparently do deals with investors.

If this episode proves anything, it is that we do need a thriving spot market in agri-commodities with transparent benchmark prices, before we move on to futures or forward trades on such products.

While policymakers come up with their new set of regulations for spot exchanges, they must make sure they don’t throw the baby out with the bathwater.

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