My Take on the NSEL Crisis

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August 19, 2013

Ok, please repeat after me. There is no such thing as a risk-free return. Even if you park your cash under the safety of your mattress, you’re still losing purchasing power as inflation erodes the value of your cash. Anytime someone offers you guaranteed risk free returns, please turn and walk the other way. If it’s your broker you should start running. If you’ve been following the news lately, you’ll know that the National Spot Exchange (NSEL), a subsidiary of Financial Technologies (NSE: FINANTECH) suspended all trading in forward contracts on July 31, 2013. The Forward Market Commission (FMC), India’s commodity derivatives regulator, requested that NSEL shut down all trading in forward contracts when it found out that NSEL was offering forward contracts for delivery over a period of 25-36 days. Under current regulations spot forward contracts must have a delivery period less than 11 days. Additionally, all spot exchanges must ensure that all outstanding positions will result in physical delivery and not allow any short selling.

The NSEL received approval to operate in June, 2007. According to this article from The Hindu Business Line, the exchange struggled to find market participants until it began offering a paired T+2/T+25 product. This product essentially allowed a “lender” to buy a commodity on a T+2 settlement basis and then simultaneously sell the same commodity for a T+25 settlement at a higher price. The person entering the opposite side of the transaction, otherwise known as the “borrower” sold his/her commodity on a T+2 basis received funds upfront and then paid back the funding on a T+25 basis. According to various presentations made by brokerage companies a “lender” could earn up to 11-15% annualized returns doing this type of transaction. Naturally, my first question is who would be stupid enough to take the other side of this trade and pay 11-15% for financing. However, Deepak Shenoy, who has done an excellent job in covering the whole scandal, makes an excellent point about how current financing rates in certain sectors are almost equivalent to the rates being offering through the T+2/T+25 paired trading scheme.

The problem with the whole scheme occurred when the FMC shut down all future contracts on the NSEL. This resulted in “lenders” pulling back funds and left “borrowers” on the hook to pay back the funds without rolling over new contracts. However, the “lender” does technically own warehouse receipts for a commodity that he originally bought on a T+2 basis. Theoretically, he should be able to sell this commodity and recoup some of his money. The only problem is that no one really knows whether the actual commodities exist and if they do, what prices a distressed seller would receive.

Additionally, it’s looking increasingly unlikely that NSEL has the physical inventory to make good on its payments. In my view, the stock of parent company Financial Technologies is not investable. As an investor you can’t make an accurate determination of the liabilities from both a financial and regulatory perspective that the company is facing. As a result, any investment in FT is simply speculation and not an investment. However, there might still be one way to play the crisis. MCX, which is India’s largest and only listed commodity exchange has been a victim of collateral damage. Financial Technologies, is the single largest shareholder with a 26% stake in MCX. Although there have been no accusations of wrongdoing targeted at MCX, investors are concerned about the potential exposure from related party transactions and the fallout from the NSEL scandal impacting trading volumes.

I’ll start with focusing on the business before dealing with potential liabilities relating to NSEL. There are currently six electronic multi-commodity exchanges recognized by the government of India: MCX, NCDEX, NMCE, ICEX, ACE and UCX. The national exchanges accounted for 99.7% of the turnover of commodity futures contracts trading in India during FY13. If you’re trading commodity derivatives in India, you’re using one of the main national exchanges. Based on company data, MCX maintained a market share of 86% and 87.3% in terms of total value traded in the Indian commodity futures markets. MCX is by far the dominant player in commodity exchanges in India. NCDEX was a distant second in terms of market share with 9.4% for FY13. In general, I want to find companies that have a sustainable competitive advantage. It’s clear that MCX benefits from a “network effect”. As more buyers and sellers utilize the MCX, the alternative exchanges become less attractive in terms of pricing and liquidity. The question that you need to ask yourself is whether investors will move to another exchange because they no longer trust management or counterparty risk following the NSEL scandal. I’m still doing some additional research and will provide an update in a separate post, but I still think MCX is worth researching at current levels. It will be interesting to see how the situation unfolds and whether NSEL will be able to stick to its most recently revised payment schedule. As a value investor, sometimes crises can also mean opportunity.  

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