I’ve been getting a few questions about NSEL and its operations. Here’s my quick take.
Aren’t NSEL’s contracts fair anyhow? So what if people wanted to finance using them?
Firstly,
if you set up a financing scheme then the system has to be regulated in
terms of assessment of NPAs, provisioning and margining. You would
actually need very strong margin management, customer wise position
limits, capital adequacy checks of the exchange, etc. So yes, it’s ok to
run it as a finance scheme, but you should just finance, not do this
drama.
What it has done is push agri products into
warehouses while people play with the money used to finance them;
effectively keeping those products out of the hands of people who will
consume them.
Thirdly, they got approval for one
day forwards. What they created T+25 and used some technical language to
call that a one-day forward, that was in my opinion a violation of
rules.
But what if there was a genuine arbitrage?
People
will tell you that farmers wanted to sell today at price X. Mills (who
use the stock) wanted to buy 25 days or so later, but at a higher price.
Who is stupid enough to do this consistently? Are all our mills running
on serious JIT inventory management techniques that they are willing to
pay 15% (pa) higher to get stuff late? Isn’t village land ludicrously
cheap enough to be able to store the darn thing for nearly free even if
it is so?
But the genuineness of the arbitrage
fails when you look at any contract of the near and far terms. You will
find that nearly at all times, the open interest in any near-far
contract is EXACTLY the same.
Take a look at the
Castor-Seed contract for Kadi delivery – there is a 3 day contract, and a
36day contract. If there was genuine end-user demand for these
contracts, then you might find at least a few open contracts at the 3
day level that will be higher or lower than the contracts at the 36 day
level. Answer: No. Looking at EVERY SINGLE DAY in 2013, not a single day
did you find a difference in the open interest between the two
contracts. There are volume differences but that could be due to
intraday trading (no longer allowed). Here’s a sample from Jan 2013:
This doesn’t bode well.
Were the contracts designed for such financing? Did the exchange know?
I give you exhibit #1: The Jeera (Cumin seed) contract specification, which says:
Storage Charges are waived off for those members and their constituents, who sale Jeera on JEERUNJH25 out of the delivery receivable against the purchase position of JEERAUNJH2 contracts.So if you specifically make it cheaper to do the round trip trade rather than take delivery…well, it’s difficult to say the exchange was not aware.
But isn’t it all backed by collateral? What’s the problem then?
Here’s
the operation: a “lender” buys a 2 day contract and simultaneously
sells a 25 day contract. The ‘borrower’ gets money after two days, and
will have to return it in 25 days and take his goods back.
So
what happens if there’s a default in the 25 day contract? Answer: they
have 2% margin from the buyer of the second leg (the “borrower”). And
then they have the goods.
But in a system wide
crisis, they can’t easily sell the goods, because the market prices will
fall especially when players know someone’s going to dump a large
amount on the market.
This is if you believe the
goods are actually at the warehouses, and haven’t been spoilt after
years of this moving back-and-forth thing.
What’s next? Will I get my money back? Does that mean FT is a good investment?
I
believe most investors will be paid back, at least partially. The sad
thing is that FT hasn’t immediately dipped into their settlement
guarantee fund, but it’s a little doubtful how that fund is composed –
if it includes broker deposits then that part can only be used to
guarantee against defaults from that broker’s clients.
But
there definitely is some stock, and over the next few months they might
be able to repay most of the money. They will need to liquidate stock
slowly to ensure the market doesn’t collapse. But in some situations
where they are a large part of the (remaining) market, prices will fall
anyhow.
As they recover money they will pay back and it’s even possible that investors get paid off in full, eventually.
But
FT’s reputation looks increasingly weak. Unless they pull off a huge
turnaround like paying back everyone immediately and taking the hit
themselves (by borrowing or getting a large agri-based investor). Short
of that, their future revenue growth – claimed to come largely from
exchanges, in India and abroad – is going to be stunted because no one
will want to deal with an entity that delays settlement.
There
is a big political angle to this as well. If agri-good prices tank,
farmers will hurt when they bring their produce to the market. It’s even
possible a government agency or FCI helps. Remember, this is what the
US Fed did with banks who had “dodgy” assets – gave them time to unwind,
and even bought some of those assets to help banks tide over. But the
question I leave unanswered is: Is NSEL too big to fail?
