NSEL: Brokers and trading clients

The Brokers sold the contracts to their trading clients as a structured product in violation of two NSEL circulars dated February 7, 2012 and August 2012 which prohibited promise/guarantee of assured returns by any member, and that is how the popularity of the contracts increased. The volumes in these types of contracts increased only during 2012-13. During 2012-13, the equity markets were not doing well and many brokers and their trading clients started participating in the T+2 and T+25 contracts with a view to make trading profits.
• All the brokers and their trading clients who traded on NSEL are experts and knowledgeable and
participated in the contracts after duly assessing the risks. All the trading clients made financial gains
through trading commodities until July 2013 when the market was halted due to government directions.
• The contracts on NSEL were traded by large listed brokerage houses. These brokers have large legal
and compliance teams and are operating in equity and commodity futures markets as well. These
brokers have participated in NSEL only after exercising due diligence. Brokers pushed client investment in a particular NSEL contract due to higher yield they could get for the clients and higher brokerage they could charge from their clients. Many brokers sold this product as a part of portfolio management and also made loans available where client's paid only 10-20 percent and the balance money was deployed as loan taken by the client from the brokers, which earned the brokers additional return on money lent. The clients got lured due to fixed cost of borrowing and a higher returns against the commodities trading.
• Further, several brokers acted as C&F agents for their trading clients and visited (50 times over a 36
month period) warehouses (of the defaulting members) storing the commodities under intimation of
NSEL for stock verification and never complained or brought to the notice of NSEL about missing or
shortfall in commodities. Further their audit firms have also certified inventories and reported the
same in the annexures to the balance sheets of the respective broking firms.
• The police found that in some instances the broking houses used their clients' accounts, without their (clients') information and consent for doing purchases. The brokers altered the rules for their personal benefit.
• Essentially, a distinct aspect came to the EOW's notice during their investigation, which was also
mentioned in their charge sheet - that a big broking firm assured its trading clients about the security
of their invested money, besides the existence of stocks in the warehouses.
• The defaulting members are operating entities and were having huge bank limits as well. Prima facie it was impossible to detect that irregularities were being committed as the warehouse inspections by market players did not raise any alarms. It appears that many of these defaulters have repaid the banks out of the funds received from trading at NSEL. The defaulting members are willful defaulters.
• Further, these defaulting sellers issued VAT invoices in the name of the trading clients as late as until June 30, 2013.
• Throughout the vilification campaign against the Financial Technologies Group, the impression that
was created was that of innocent trading clients were duped by NSEL and thus needed to be helped
with great urgency. It took more than a year till Hon'ble Justice, in it's Order given on August 22, 2014 in the Criminal Bail Application No. 1263 of 2014, observed as under.

NSEL: The role of employees

The NSEL business was spearheaded and conducted by the MD & CEO, who enjoyed complete autonomy and functional freedom. The role of the top management of NSEL and officials entrusted with different functions and responsibilities is under investigation for any possible lapses and deviances from established practices of risk management and due diligence. While NSEL has now revamped the entire management team, it will comply with any actions required to be taken in case if any involvement of the staff in any action leading to the crisis is established.

Missing stocks at NSEL

Throughout, the FMC maintained that the crisis emerged out of a warehousing problem. In reality, the FMC was provided periodic (fortnightly) information on the stock of commodities held in the
warehouses by the executive management of NSEL. The MD & CEO had repeatedly assured that stock position was comfortable. Even after the crisis, the MD & CEO made public statements that the stocks in the warehouses were more than the value of the settlement. Trading members of NSEL belonging to the public sector have conducted separate inspection of the warehouses, on select basis, through CAG approved auditors and found no shortages or lapse in the warehouses. Additionally, brokers also have visited warehouses nearly 50 times over a 36 month period to confirm stock positions and raised no concern. NSEL statutory and internal audit reports, periodically brought out, also found no deviance or deficiency in this regard. When all these measures have never raised any red flag over the stocks in the warehouses, blaming the NSEL Board and FTIL for missing stocks and attributing motives is plain unjust and unfair. Thus, the action being initiated against the non-executive members of the NSEL Board, FTIL and the promoters of FTIL are not justifiable in this context.
In a meeting FMC held with all the players on August 4, 2013, it was assured by the brokers and The
Defaulters that the money and stocks relating to trades remained adequate. The situation however
drastically changed thereafter. There could be a possibility that once the Government caused sudden
stoppage of business, some of the defaulting members with a view to protect their positions might
have migrated the stocks from the designated warehouses. This further accentuated the liquidity
position leading to default in the settlement. The possibility of banks cutting off their credit lines
without the stocks in place might also have induced them to shift the stocks out of the warehouses.
Such a scenario could be expected in any financial markets business and not just in NSEL. Sudden
stoppage of business will create panic in the market that will lead members to try to get away from
the responsibility and obligations, which happened in the case of NSEL also.

NSEL FACT SHEET

There is an impression created that NSEL has introduced the contracts that came into problem
with a view to make quick profits, which is not the case. A wide range of contracts were traded
at NSEL, including
(a) Farmers contracts,
(b) Auction Contracts,
(c) Forward Auction,
(d) Reverse Auction,
(e) e-Series contracts,
(f ) Traders contracts, and also physical procurement business and LC business. Traders used all these contracts as also paired some of these as an arbitrage strategy
to maximize returns.

BUSINESS
It is also wrong to say that the entire business of NSEL was built on the contracts that came into
problem. During the period 2008-13 NSEL turnover was to the tune of Rs 7,67,000 crore with
volume being more than 1000 crore lots. During this period, it has carried out pay-in and payout
of Rs 2,80,156 crore. It had 147 delivery locations and paid service tax to the tune of Rs 28
crore. It has nationwide spread of 800 members, with 46000 terminals in which 52 commodities
were traded of which 34 were agricultural commodities. It is wrong to say the whole business of
NSEL revolved around the defaulted contract. Out of total 702 contracts launched only 29
(around 4%) contracts were unsettled due to the member defaults.

BUSINESS INCOME AND NOT INVESTMENT
Trading clients were booking income earned from NSEL products as business income which was
being offset with losses. This itself demonstrates that they took it as a business activity involving
buying and selling.

ORDERLY SETTLEMENT OF e-SERIES CONTRACTS
The settlement of the e-Series contracts in gold, silver and other commodities, which involved
approximately 33000 investors, were being conducted in an orderly manner.

CAUTION TO TRADING CLIENTS
NSEL has been giving the brokers with whom it had privity of contract sufficient caution against
advertising fixed or guaranteed return on NSEL platform. Typical to any market, as the trading
clients were making good returns from pairing the contracts, brokers who marketed these
products were not enforcing this discipline and caution while making aggressive sales. Brokers
were even extending financing to their trading clients who were interested in trading of the
contracts through pairing.

PRIVITY OF THE CONTRACT
Privity of the contract is between the brokers who sold the product and their trading clients who
bought it. It is the brokers who marketed and sold the product and identified the trading clients.
The brokers are the ones who should have cautioned them on the risks associated with the
product, in which they failed. It is the brokers who chose the commodity counterparties while
entering into these contracts and who were expected to conduct due diligence.

EXPLANATIONS AND CLARIFICATIONS
NSEL has provided explanation and clarification immediately to the regulatory authorities and
the government on any issues raised by them on any aspect of the operations and business. The
last of such explanation was provided in August 2012. No order was issued following the
submission of the detailed explanation to the show cause notice. Instead a letter from the DCA
in July 2013 to stop issuing fresh contracts unleashed and accentuated the problem.

NSEL crisis: The then management

The then management of the NSEL, which had the privilege of full functional autonomy, was saying as
late as August 2013 that commodities existed in the warehouses. The management at that time was the
sole point of contact with FMC or DCA which had communications of various nature. The Board of the
NSEL, never had any direct contact with the FMC or the DCA as also the latter has never approached or
written to the Board on any concern that they might be having on the operations of the exchange. Even
the show cause notice issued to NSEL was addressed to the then Managing Director and CEO and the
Board was never informed of the same. Neither the DCA nor FMC nor the Broking firms nor the
management ever raised any red flag to the Board that could have alerted them to take any preventive
action.

NSEL crisis: Role of brokers

• Created structured product involving contract for buying and selling of commodities on NSEL platform
• Overlooked the exchange advice to inform risks involved in buying and selling of commodities to the clients
• Aggressive marketing and mis-selling in violation of Exchange's circulars
• Instances of funding clients
• As it was a business involving buying and selling of commodities principals of business income and
offsetting expenses were applied
• Have strong legal and compliance departments that made them aware of the nature of buying and
selling and risks involved
• Active as C&F agents for the Trading clients, they visited warehouses numerous times (nearly 50 times during a 36 month period) and yet not raised red flags any time
• Audit firms of broking firms showed inventories held in trading as annexures in the balance sheets of the respective firms.
• Instances of executing certain orders without client consent (approximately 3,00,000 client code
modifications)
• Did not once raise or bring to the notice of NSEL Board any irregularity
• Majority of the big brokers were C&F agents and verification of stocks on behalf of their clients was their responsibility

FTIL by itself has not committed any breach of governance standards or market abuses. It is a well-run company, with close to 60,000 public shareholders, an accomplished Board and a dynamic management, that has steered this company from being a start-up in early 2000s to one of the most respected and widely regarded technology solutions company that pioneered multi-asset-class trading segments, which stood the tests of competition from global majors such as IBM. Cost-effective and efficient technology solutions enabled Indian financial markets to expand the reach and access nationwide, benefiting millions, including financial institutions, intermediaries, investors and other stakeholders.
Since its inception, FTIL has not received any complaint from exchanges or intermediaries, which are its biggest clients and customers. Even competing institutions used to buy technology solutions from FTIL, which is a testimony for its integrity and business ethics. There was never any regulatory action of any sort though the exchange and ecosystem ventures of the Financial Technologies Group were operating in several regulatory jurisdictions in India and abroad.