The commodities regulator and the banking regulators need synergies with related stakeholders rather than other trading platforms

Reserve Bank of India (RBI) governor Dr Raghuram Rajan has expressed apprehension about having a Unified Financial Agency (UFA), as recommended by the Financial Sector Legislative Reforms Commission (FSLRC). Especially, Dr Rajan is not happy with the idea of merging organised financial trading activities like bond-currency controlled by RBI and commodity futures regulated by Forward Markets Commission (FMC) as he feels there is no synergy between these. However, the FSLRC is not the only one who appears to have failed to assess the commodities market. Till date the government is not sure about commodities trading and who and how it should be regulated or controlled, as highlighted by the National Spot Exchange Ltd (NSEL) payment crisis. But more about it later.

Comparing trading of commodities and bonds and the role played by incumbent regulators FMC and RBI, respectively, Dr Rajan said, the FSLRC also seems to be inconsistent in its emphasis on synergies and regulatory uniformity. "For instance," he said, "in forward trading where a real commodity is delivered, regulatory oversight over the real markets for the commodity where price is discovered, as well as over warehouses where the commodity is delivered, may be important sources of regulatory synergy. Should the FMC be subsumed under the Unified Financial Agency or would it be better off having stronger links to the ministries overseeing the real commodities? I think the answer needs more investigation."

"Similarly, is the regulation of bond trading, more synergistic with the regulation of other debt products such as bank loans and with the operation of monetary policy (which requires bond trading) than with other forms of trading? Once again, I am not sure we have a compelling answer in the FSLRC report. My personal view is that moving the regulation of bond trading at this time would severely hamper the development of the government bond market, including the process of making bonds more liquid across the spectrum, a process which the RBI is engaged in," Dr Rajan said.

Coming back to NSEL, which, although blamed for the payment crisis, has brought forward the regulatory vacuum, especially in the context of how a spot exchange needs to be run.  There was no clarity on who should regulate spot exchanges. It was not under the control of Forward Markets Commission (FMC) as spot contracts are different from forward contracts. Also, since it is not a contract on financial assets, Securities and Exchange Board of India (SEBI) or Reserve Bank of India (RBI) could have regulated it. NSEL knew this better than anybody and exploited the vacuum to float contracts, which created opportunities for transactions in commodities.

Then one day when Ministry of Consumer Affairs (MCA) came out of slumber, it felt the need to regulate the exchange. Why was the regulation of NSEL never taken seriously? How can an exchange be allowed to trade critical asset like commodities without proper regulation? This is a classic case of regulatory vacuum. Or is it that it was known to the government and was being overlooked?  

NSEL must be hauled up for wrongdoing, if any, but nobody seems to realise that the buck, in this case, should stop right at the top—with the Ministry which allowed a commodity spot exchange to be set up with just a government notification.

The  Ministry of Consumer Affairs, with no experience of regulating a market (or consumer issues for that matter), triggered chaos with an order that virtually shut down an exchange overnight. This, after it sat on concerns about NSEL’s ready-forward trades (conducted openly and transparently by the bourse), for more than a year. When NSEL suspended all contracts other than e-series, and decided to merge settlements, it triggered a panic, which ultimately turned into a Rs5,600 crore payment crisis.

The question again is why there was no attempt to create a framework or infrastructure to regulate commodities exchanges. Why were spot exchanges not under the regulation of FMC, which regulates commodity trading? Why a half-baked system without proper oversight and regulatory inspections was allowed to operate under the sleepy disinterest of the Ministry of Consumer Affairs?

NSEL's mission statement reads, “To develop a pan-India, institutionalized, electronic, transparent Common Indian Market offering compulsory delivery-based spot contracts in various agricultural and non-agricultural commodities with a reduced cost of intermediation by improving marketing efficiency and, thereby improving producers’ price realization coupled with reduction in consumer paid price”.

However, nobody was interested in knowing or investigating how the spot exchange became a place for speculation for investors and commodity holders. People with no direct interest in commodities started speculating in commodities. There are reports which suggest that the spot exchange became a place where 10% plus returns were guaranteed. While commodity holders deposited commodities in the warehouse to sell commodity, investors bought it and sold a longer settlement period. For example, if the depositor of the commodity sold it on T+2 basis and was bought by an investor, the investor further sold it for T+25 basis. This resulted in the creation of a repurchase contract, which is also known as repo contract. This was the beginning of speculative activity. Most of the transactions were driven by speculation and the opportunity to make short term and quick money.

Earlier, while speaking with Moneylife about the T+2 and T+25 contracts, the top management of NSEL had said, “In T+2 contracts, farmers, producers and traders sell commodities for delivery on T+2 days and they get payment on T+2 days. The actual users, processors and exporters, buy commodities in T+25 contracts, make payment on T+25th day and get delivery. An investor buys the commodity in T+2 contract and sells the same in T+25 contract. As a result, trading volume for T+2 and T+25 is identical. All such trades are backed by physical delivery of goods and warehouse receipts (WRs).”

However, as it has come to light, NSEL sacked its chief executive Anjani Sinha accusing him of having hushed up the fact that WRs were not backed by physical stock of commodities. The forward contracts of NSEL should have been backed up by the goods in the warehouses but nobody seemed to verify whether the goods actually existed or not. In addition, there was no mechanism or third party verification of stocks that NSEL claimed to have in its warehouses. The WRs were used in similar manner to bank receipts used by Harshad Mehta during the 1992 scam. (http://www.moneylife.in/article/nsels-warehousing-receipts-similar-to-bankers-receipts-of-harshad-mehta-scam/34239.html)

Debashis Basu and Sucheta Dalal in the book 'The Scam', had written about how the quality of regulation failed to keep pace with the volumes -most glaringly in stock markets- and the absence of penalties and disclosures of transactions. The same holds true for the commodities market this time around.

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 Ministry and the mischief by the NSEL.

The NSEL crisis is a great learning for regulators, investors as well as exchanges. There is an immediate need to regulate exchanges on a comprehensive basis. In addition, the government needs to ensure that blatant speculative activities are not allowed through exchange platforms especially in case of commodities.

Will the Narendra Modi-led government take the lead in order to have proper regulations in place in an over regulated environment? Will RBI governor Dr Rajan's strong views and comments on FSLRC report sound the bell for the government? Only time will tell.

As Moneylife pointed out, the recommendation of creating UFA looks revolutionary on paper, but is neither practical nor of any use. From the consumers’ perspective, the track record of these regulators is a huge disappointment. In fact, there is hardly an example about an investor or saver receiving satisfactory redressal of his grievances from these regulators.

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