In the Harshad Mehta scam bankers were issuing fake bankers receipts or BRs, representing government securities. But while BRs were accepted on the basis of trust, NSEL created the illusion of a 'trade guarantee fund' which has mysteriously vanished
History never repeats itself, but it rhymes, said Mark Twain. Some 21 years after the Harshad Mehta scam shook the market, the same saga seems to have been repeated in the scam involving National Spot Exchange Ltd (NSEL). In 1992, the country woke up to the fact that Harshad Mehta, who was pumping up stocks to frenzied heights, was systematically taking advantage of a poorly regulated government securities market, which had no proper checks and balances. And he was not alone - a cabal of top bankers and brokers were found to have issued fake bankers receipts (BRs) which were supposed to represent gilt edged government securities and bonds. The truth spilled out only when the Reserve Bank of India (RBI) appointed a high-level multi-disciplinary committee to investigate. The story of NSEL is fast representing a similar situation. The exchange has sacked its chief executive Anjani Sinha, accusing him of having hushed up the fact that warehousing receipts (WRs) are not backed by physical stock of commodities. What is this other than the fake BR scenario of the Harshad Mehta scam? While cases related to the Harshad Mehta case continue to drag on in our courts, the government does not seem to have learnt any lessons about effective regulation and accountability.
According to a report from Business Standard, one crucial difference that everybody overlooked (in NSEL saga) was that these (forward) contracts should have been backed up by the goods in the warehouses. Nobody seemed to verify whether the goods actually existed or not. Brokers started giving out contract notes to hundreds of investors backed against just one warehouse receipt (you can't split a receipt). The warehouse receipt acted as title to the stock. The broker was taking a risk on the warehouse receipt, the report said.
"Nobody verified the warehouse receipt or whether goods were actually at the warehouse. Some warehouse receipts are said to be authentic as some genuine producers wanted to finance their working capital till their goods were sold. But as nobody verified the warehouse receipts more commodity traders started producing warehouse receipts against which they received easy funding. Some may have used this money for financing their business, but the rest is anybody's guess," the report added.
Now let's see, what were the loopholes exploited by Harshad Mehta and other brokers during the 1992 scam? According to 'The Scam', the book written by Debashis Basu and Sucheta Dalal, this is how the infrastructure of money markets and stock markets was creaking:
"The Public Debt Office (PDO) was supposed to record the transaction details of various government securities for each bank on the basis of subsidiary general ledger notes. The PDO did the recording manually in ancient ledgers, often falling behind by more than ten days. The subsidiary general ledger (SGLs) entered in the ledgers often carried no reference to transactions. For instance, if three SGLs of the Bank of America reached PDO on the same day and two bounced because of insufficient balance, it would be impossible to say which of the three had bounced. And most amazingly, in a system where the daily trade ran into hundreds of transactions, the banks were informed of the bounced SGLs by post.
Brokers and bankers quickly learnt to take advantage of PDO's sloppiness. They created delays and deliberately had the SGLs bounced to show an artificially higher balance and then traded on that. Bounced SGL intimation notes were made to disappear and their loss blamed on postal delays. SGL bouncing was a genuine problem too. Often, banks issued SGLs without realising that they had no balance in the PDO to support the sale. To counter this came another instrument: BRs. A selling bank would issue a BR instead of securities. The technique was especially useful in the case of buyback deals (ready forward) for short periods where there was no need to exchange physical securities. But it gave further room for manipulation.
Banks and other financial institutions would issue BRs without holding securities, or issue BRs against BRs. This way, the original BR of a weak bank was quickly exchanged for that of a more "respectable" bank. This technique was used by foreign banks to cover their tracks. They used Andhra Bank, Syndicate Bank, State Bank of Saurashtra and Canara Bank. Some banks like Metropolitan Co-operative Bank also got into the name-lending business, issuing BRs for free. Citibank even had the gall to issue bounced SGLs, which is akin to issuing a bounced and cancelled cheque. To meet his inexhaustible appetite for cash, Harshad pressed ahead with the ultimate subversion: securing straight credit from the National Housing Bank (NHB) against no transactions or securities and BRs.
Public sector companies, which raised money through bonds, took almost a year to allot them, since printing the bonds was not allowed until a mortgage was created. So, letters of allotment were traded as security. One public sector unit (PSU) had not printed bond certificates even four years after raising money. There was no method of credit rating the bond and prices depended on the traders' perception of the issuer. This could be highly biased. Even when bond certificates were available, trading volumes were so large that it was difficult to effect deliveries. Once a broker needed 240 signatures to transfer 680,000 bonds. Obviously bankers were reluctant to take deliveries and instead relied on their makeshift stock depository certificate - the BRs. The same story occurred in the equity markets. Share certificates belonging to SBI Caps were piled up in the corridors of State Bank of India (SBI).
The quality of regulation failed to keep pace with the volumes -most glaringly in stock markets. There were no penalties and little disclosures of transactions."
You can buy the book, The Scam, the only definitive account of the Harshad Mehta and the Ketan Parekh scam here
A similar regulatory vacuum was allowed to build up in the commodity markets. This was clearly deliberate, because it is not as if this was not noticed or written about. In 2004, Sucheta Dalal had this to say in the Indian Express about four new national commodities exchanges that were cleared to trade a slew of commodities futures India. "The four exchanges- National Multi Commodity Exchange of India Ltd, (NMCE), National Commodity & Derivatives Exchange (NCDEX), National Board of Trade (NBOT) and Multi Commodity Exchange (MCX) are involved in an intense struggle for supremacy by trying to build volumes and capturing niche markets in specific commodities. But badly regulated commodities trading can be a dangerous business, as was recognised by Prime Minister AB Vajpayee himself at the launch of NMCE when he said: "I would like the regulatory system for commodities exchanges to be strengthened to create confidence among all stakeholders". However, it did not happen.
Such regulation, she wrote, "…would logically entail a high level of automation, strict surveillance, dynamic regulation, investor protection, efficient clearing and settlement, preferably a trade guarantee mechanism plus warehousing facilities, logistics management, quality control and effective handling of warehousing receipts. Unfortunately, much of this has not happened. As is often the case, traders managed to persuade the government to allow trading to commence without ironing out many glitches and shortcomings.
The problem is lack of foresight in preparing for an automated national trading system before clearing several bourses to start operation. For instance, the Central Warehousing Corporation (CWC) would have a key role to play in the development of the commodities trading business and should ideally have played the same role as the National Share Depository Ltd. Instead, it has allowed itself to be roped in as a promoter of one of the national bourses, forcing other exchanges to search for potential in state warehousing companies to play the role.
The FMC should still rectify the situation by persuading and helping the CWC to exit its role as promoter of an individual exchange and instead take on the larger and more significant job of providing independent warehousing facilities to all the four national commodities exchanges. If the CWC is modernised and allowed to link up with state warehousing corporations, it would revitalise them and help create nationwide infrastructure for commodity trading."
Instead, a half-baked system without proper oversight and regulatory inspections was allowed to operate under the sleepy disinterest of the Ministry of Consumer Affairs (MConA). What is different this time is that those involved created an illusion of having all the bells and whistles of a modern exchange in place. There was automated trading, there was a trade-guarantee fund and there was apparent oversight by the commodities regulator. In fact, none of it is true. The government, which rushed off to empower the Securities & Exchange Board of India (SEBI) with draconian powers of search and seizure, has been sleeping over empowering the FMC. Thanks to political compulsions of a coalition government, the plan to bring the Forward Markets Commission (FMC) under SEBI was also dropped, that too after creating a third post of Whole Time Director at SEBI to take on the additional work pressure. It should be no surprise that the plan to merge FMC with SEBI was dropped under pressure from Sharad Pawar, Union Minister for Agriculture, who then held the portfolio of MConA as well.
What is shocking is that there is still no attempt to conduct a detailed investigation along the lines of the Janakiraman Committee of 1992 or any attempt to pin accountability for the failure to regulate by the MConA and the mischief by the NSEL. Instead, a government that is struggling to cope with an economic slowdown and sinking currency, seems determined to be in denial about what is going on at the NSEL.
Meanwhile, the NSEL Investors Forum has organised demonstrations outside the office of Jignesh Sha, the main promoter of the Spot Exchange. "NSEL has reportedly only Rs100.5 crore against commitment of over Rs350 crore, there are concerns that funds have been siphoned off. The matter appears to be another Harshad Mehta and Ketan Parekh scam combined. The government response to this scam is disheartening," the Forum said in a release.
Inside story of the National Stock Exchange’s amazing success, leading to hubris, regulatory capture and algo scam