The Rs 5,500-crore scam no one wants to deal with

What exactly happened in the NSEL scam? How did Rs 5,500 crore disappear? And why is there still no sign of an investigation?

An innocuous-looking notification from the Forward Markets Commission (FMC) came in on July 12, 2013. And in the offices of the National Spot Exchange Limited (NSEL), a commodities exchange promoted by the Jignesh Shah-led Financial Technologies (FinTech), things began to change.

The notification restricted NSEL from making fresh contracts available as they were likely in contravention of the Forwards Contracts Regulation Act. NSEL first changed its contract duration to comply, and then when it found customers leaving in droves, threw up its arms and shut down the exchange.

More than Rs 5,500 crore was due, and over the next few days it became evident that there was neither the money nor the underlying ‘spot’ goods to settle trades by over 15,000 investors. Since then, the story has unravelled, slowly.

The scale of this default dwarfs the last big exchange crisis, the Rs 600 crore settlement problem at the Calcutta Stock Exchange in 2001.

What is a Spot Exchange?

Commodity spot trading is about buying and selling a commodity, paying cash for and receiving your goods on the ‘spot’. Which signifies that the buyer and seller agree on a price and ‘deliver’ their side of the contract immediately.

NSEL was a spot exchange designed to help this activity, with the added feature of being electronic (so buyers and sellers can be in different locations) and anonymous (the buyer and seller don’t know who the other side is).

The important feature of any such exchange is that the exchange has to stand guarantee to either party that it will ensure the contract is settled. If the buyer can’t bring in the money for any reason, the exchange should then sell the goods to someone else and recover the money (and make up the difference). And a similar exercise if the seller defaults.

Now, when the seller and buyer are far away from each other, how does the exchange guarantee delivery? The idea is that the seller must come to an exchange-designated warehouse and give his goods, which are then tested and verified for quality and weight. He then gets a warehouse receipt (WR) that is used for electronic trading. When he sells on the exchange, the warehouse receipt is transferred to the buyer; this receipt entitles the buyer to take the goods out of the warehouse, or if he chooses, to retain the goods there (to sell them later) by paying the warehouse rental charges.

There are rules governing commodity trading, which is regulated firmly by the Forward Market Commission (FMC). Under the Forward Contracts Regulation Act, any contract that is called “spot” must be settled within 11 days – that is, both delivery of goods and transfer of money must happen within 11 days (called “T+11”). The 11 days give the buyer and seller time to complete the contract. Thus, this would then not become a “forward” contract.

Spot contracts, by their nature, were deemed to be out of FMC regulation by a small notification in 2007 by the Department of Consumer Affairs. This exemption was given specifically for one-day duration contracts – or, technically those contracts that complete both delivery of goods and transfer of money within two days, called “T+2”.

What NSEL Really Did

Instead of just making T+2 contracts, the spot exchange designed multiple contracts. Some of them were T+2 settled, making them ‘spot’ in nature. Others were the same product but settled after 25 to 35 days, called T+25, or T+36 contracts. This was illegal – such contracts are forward contracts and NSEL was not authorized to execute these, but it did. And no one stopped it.

And the concept got worse. NSEL sold what seemed to be ‘arbitrage’. You could ‘buy’ the T+2 contract and ‘sell’ the T+25 contract and the difference in prices gave you nearly 15 percent per year, annualized. Effectively, you would be the owner of half a ton of sugar or castor seeds or such commodities, for a period of about a month, which would get sold when you ‘exited’.

The exchange practically removed all constraints from investors during this period – the goods would lie in the same warehouse and be sold from there, and the price difference included a 15 percent net return after storage charges, VAT, etc.

This arbitrage was almost ‘guaranteed’. NSEL as an exchange stood guarantee, or so investors thought.

Brokers peddled this product to their customers for over two years. The number of customers ballooned to over 15,000, each of whom put in at least Rs 2 lakh to get their ‘superior’ returns.

What Was the Problem?

Who was on the other side? That’s the question that no one seems to be asking.

Was the arbitrage genuine? It appears not. The contracts were always sold in pairs. Brokers have reported that no one was allowed by the exchange to just take one side of any contract – you always had to have a ‘buy’ on the near contract and a ‘sell’ on the far side.

A quick look at the Kadi contract for castor seeds, sold in pairs of T+3 and T+36, shows identical volumes and interest for both contracts in January 2013, and that’s the case with every commodity that had a near and far contract. This is hardly possible in a real market, so it points to the fact that these contracts were always executed in pairs.

The Ponzi Scheme

It turns out now that those on the other side were just 24 members of the exchange, called Planters or Processors or Borrowers. These members owned plants that processed commodities – or, at least, they said they did. For instance, NK Proteins owned a plant to process castor seeds in Kadi, Gujarat. The contract – the Kadi Castor Seeds contract – was settled at an NSEL warehouse located inside the Kadi plant of NK Proteins.

Processors like NK Proteins (and there were 23 other such members) were on the other side of the trade. They would sell at T+2 and buy back at T+23, offering huge returns.

The fact that the contracts were executed in pairs indicates a financing program. Something is placed as collateral to borrow money for a short period of time. This used to be commonly known as “badla financing” in the pre-2000 stock exchanges, where shares were collateral. (Badla is banned now; the financing has moved to the futures market.)

Let’s say I am a plant owner, and I can’t get a loan from a bank. I can effectively borrow from you at 15-18 percent – much cheaper than I can borrow from banks. And if I’m smart, I know that the goods I sell you will remain at a warehouse inside my premises, so why not cheat a little and tell you that yes, I’ve added more goods to your warehouse, and you, on the other end of the phone agree.

In this situation I can invent stock that doesn’t exist and borrow against it for 15 days; for the interest, I might pay some out, but immediately get it back in a new contract when I add even more imaginary stock. This was the Ponzi nature of the game.

Indeed, it turned out that some of these companies had poor balance sheets incapable of handling such large loans – loans of the size of Rs 900 crore. And the exchange did nothing.

Most ‘investors’ rolled over their contracts. That is, when the contract was unwound after T+35, they would enter a fresh round of T+2 (buy) and T+35 (Sell). Meaning, the interest received was also ploughed back into further purchases; a ‘borrower’, on the other hand, was pretending to pay interest, but was simply creating warehouse receipts for the interest and trading them on the exchange, while rolling over the contract forever.

The End of the Game

All this had to stop sometime, and the circular from FMC stopped it.

First, on 16th July the contracts were cut to T+10. But that would involve too many pair trades – from one a month to three a month, each of which had higher transaction costs.

Next, some investors smelt a rat and didn’t roll over their contracts.

The lack of a rollover shuttered the exchange. When the ‘borrowers’ were told that they had to pay back all the money, they simply could not (or didn’t want to). And it turns out they don’t seem to have the goods to back it up either.

On July 31, NSEL issued a circular saying all future contracts would be stopped. And because there was a settlement problem, they would have to delay payouts for a while.

Remember, some investors had bought goods on a T+2 contract, paying upfront. Now they expected that after their 25-35 days, the other contract would kick in and they would be paid back money at the higher rate on that contract. 

At this point, the exchange should have stood guarantee. That’s the role of an exchange. But because it didn’t get paid from the borrowers, it didn’t have the capacity to pay.

Lies, Deceit and an Incestuous Web

The exchange started to lie. The CEO, Anjani Sinha said on August 1st that they had a ‘Settlement Guarantee Fund’ of over Rs 800 crore plus they had all the stocks in the NSEL warehouses. In a few days they changed that position, stating they had only Rs 60 crore in cash and the rest of the ‘guarantee fund’ was in stock. All entities were supposed to put a tiny amount – up to 5 percent – as margin until trade completion. This, too, was unavailable for some reason.

And then, after telling everyone that they would get their money back, the NSEL management said they had to auction stock to get the money. Soon, even that avenue was gone as there wasn’t any stock.

Jignesh Shah, the founder of FinTech, which promoted the exchange, said in a press conference that they would have a high-powered committee, including an ex-SEBI chief, a senior police officer and the like, to ensure settlements happen. As it turns out, the committee was useless in actually enforcing the contracts.

NSEL next created a complex settlement program. After a few days, NSEL management offered a ‘settlement calendar’ stretching 30 weeks where people would be paid back Rs 174 crore per week for 20 weeks, Rs 86 crore a week after that, and a big balloon payment at the end.

NSEL couldn’t even make the first week’s payments properly – it paid up just half. In the second week, to fend off investor aggression, FinTech dipped into its resources and paid Rs 177 crore to those with less than Rs 10 lakh outstanding. There have been three payments till now – of Rs 92 crore, Rs 190 crore (including small investor payouts) and then, this week on Tuesday, 3rd September, Rs 15 crore. But in the settlement program, NSEL had promised to pay Rs 174 crore on each of these three Tuesdays.

In the middle of all of this, it turned out that many of NSEL’s 24 Processor members were related to each other. One of the biggest borrowers, NK Proteins, is owned by the son-in-law of NSEL’s chairman Shankarlal Guru. Then there was Indian Bullion Market Association, owned primarily by NSEL, which participated as a member, allowing parties in the bullion space to buy through them.
The whole thing began to stink.

N Sundaresha Subramanian of Business Standard visited many of the defaulting members and found strange results. There was a mall in the place where 2 lakh tons of sugar was supposed to have been stored, at the address of a NSEL borrower called Mangla Shree Properties. In Ludhiana, where ARK Imports was supposed to have 12,000 tons of raw wool, there was apparently nothing. One borrower had vacated its premises months back, while another refused to admit they owed anything.

NSEL’s investors involved clients from nearly every major broker in the country. Even the Sahara Group, which is under RBI and SEBI fire, was found to have invested more than Rs 200 crore. Some NSEL board members were close to political bigwigs like Union Agriculture Minister Sharad Pawar. CEO Anjani Sinha had earlier in his career overseen defaults in two exchanges in Magadh and Ahmedabad.

Belling this cat will not be an easy task.

Where are the Regulators?

The FMC was supposed to control regulation of all forward contracts. Although NSEL had received an exemption, it was only for the T+2 contracts and definitely not the T+35 contracts. The new FMC Chief, Ramesh Abhishek followed this up since 2012, but what about those before him?

The Department of Consumer Affairs was the de facto regulator when no one else was. It had been made aware of the situation over a year ago and should have taken action, and it didn’t.

Even after the scam was unearthed, and the scale of the borrowing discovered, regulators remain tight-lipped about action. SEBI has barred some of the 24 ‘borrowers’ from trading on the stock exchange, and FMC has ring-fenced MCX (a commodities futures exchange which shares the same promoter, FinTech, with NSEL) from helping the beleaguered NSEL with its cash. However, any other actions have yet to come through.

Where is the RBI? Banks have lent to operations that involve stocks in warehouses. In fact, some photos of NSEL warehouses explicitly state that goods are pledged to certain banks. Are these goods there? Has the RBI asked banks to initiate a probe? Not yet.

If FinTech is the promoter of NSEL, and NSEL has seen a huge default, the obvious next step is to declare that FinTech is not ‘fit and proper’ to run any other exchange, including MCX. This has not yet happened.

Given this is a huge fraud, it remains astounding that agencies like the CBI, the Economic Offenses Wing or others have not been brought in to investigate. The failure of regulation could be because there are too many agencies involved.

Were Brokers to Blame?

Brokers might have known something was wrong. After all, you don’t get an exchange everyday where you have to coordinate between a buy and a sell on the phone.

Many, though, fell prey to the machinations themselves.

They promised investors a return of, say, 12 percent, and then took that money to NSEL and decided to make the 3 percent extra that NSEL promised.

Now, when NSEL has defaulted, brokers want to put the blame on the exchange – but just like the exchange, they promised the money, which they have to pay. SEBI must act and ensure these brokers pay.

Also, brokers are expected to be fiduciary agents of their customers – should they have exercised more caution before recommending such an investment?

Where is the Money?

The short answer is: we don’t know.

The Enforcement Directorate and a Mumbai Police Special Investigations Team (SIT) are trying to find the money. It’s gone abroad through hawala, says the SIT. Others claim it has gone to fund real estate, where there is no swift liquidity. Yet others claim the money was used to prop up FinTech and MCX shares in the stock market – so when those stocks fall, the amount of money that can be recovered reduces. It is also believed the money was siphoned for political interests or for personal gains of the personalities involved.

Jignesh Shah, the ambitious promoter of FinTech, started out as an engineer on the BOLT system for the Bombay Stock Exchange in 1989. After learning the ropes, he set up FinTech in 1995 and established a presence in brokerage back-office and terminal software across India. Then he set up MCX and a slew of other exchanges in India and abroad.

Shah won a battle against SEBI in 2012 about a circumvention of regulation in their new MCX-SX stock exchange. He had aggressively taken away market share from other exchanges. He had sued people who wrote against him and kept media as a friend with a big advertising budget. NSEL’s exemption from the Department of Consumer Affairs was attributed to Shah’s influence. But it is now apparent that everything is not clean in the FinTech empire.

It would be a surprise if someone with Shah’s business sense let all this happen without knowing where the money has gone.

What Happens to MCX and FinTech?

FinTech, at Rs 111 per share, is down over 70 percent from its 31st July price of Rs 540. It derived a large portion of its profits from NSEL – the trades resulted in outsized earnings through exchange fees. But the sudden lack of profit is not its only problem. If it is declared unfit to run exchanges – and it has about nine of them – that would destroy the enterprise. Apart from this, there are potential fraud charges if more dirt is discovered.

MCX is a well-regulated commodities futures exchange. The volumes in it haven’t come down quite as much as one would suppose. Its share price fell 60 percent after NSEL’s shutdown announcement on July 31 but has now recovered to a mere 40 percent fall. The expectation is that regardless of what happens to its promoter FinTech, MCX will be sold – and there are willing buyers.

The Future?

The NSEL crisis shows the investment community one thing: we do not have adequate regulation or enforcement. That if there is a crisis, the ‘agreement’ will not be sacrosanct; it will be secondary to the interests of the parties who have better political and business connections.

This default will trigger other issues, and in a country already branded as crony capitalist, the lack of will to enforce laws and put people in jail for fraud will hamper future investment. Decisive action is required, but the window for action is fast shrinking. There is a political fallout to this crisis, but the details on that are sketchy at best.

The problem really is: we have lost trust. The entire financial system is based on trust – for example, if everyone tried to withdraw his or her bank deposits at once, we’d have to shut everything down. Every attempt to undermine this trust must be dealt with heavily.

NSEL’s ‘getting away’ will leave us all with a deficit worse than a fiscal or current account one: the Deficit of Trust.

Deepak Shenoy is a founder at Capital Mind (, a financial data, commentary and analytics site and lives in Bangalore with his family. You can reach him at and follow him at


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