Background: In India, National Spot Exchange (NSEL) is a commodities exchange that is a joint venture between National Agricultural Cooperative Marketing Federation of India (NAFED) and Financial Technologies (India) Ltd. (FTIL). On October 15, 2008, a Wednesday, National Spot Exchange started offering live trading in various commodities. Before adding a variety of commodities, it started trading in pre-certified cotton bales for delivery to Mumbai and immediately imported gold and silver bars for delivery to Ahmedabad. The declared goal of National Spot Exchange is to create a common Indian market by establishing an advanced electronic spot market and offering innovative tools for commodity trading, delivery, and settlement. Due to a significant commodity scam, this exchange is now involved in controversy, and all trades have been put on hold.
SERVICES and FACILITIES IT OFFERED:
- Selling – NSEL provides an electronic trading and auction platform to sell commodities (Agri, bullion and Metals).
- Procurement – Bulk buyers can procure the Agri-commodities directly from farmers through electronic platform provided by the NSEL.
- Warehousing – NSEL provides warehousing facilities for various commodities and also facilitate to sell it through the electronic platform to the bulk buyers and millers situated across the country.
- Investment – NSEL provides investment instruments. E-series products launched by NSEL can be bought by the investors for accumulation in the Demat account, just like the shares in the equity market. Currently, E-Gold, E-Silver and E-Copper are available to investors.
Process
An innovative approach to commodities investment: NSEL’s E-Series Product Initiative National Spot Exchange has launched E-Series commodities products for the first time in India. Nowadays, regular investors can trade and make investments in commodities just like they can in stocks. This new market segment will operate similarly to the cash segment in stocks, but it will offer commodities in smaller denominations in demat form. As is customary in the stock market, the clearing and settlement pay-in and pay-out will be dependent on a settlement cycle. This instrument will provide ample opportunity to the masses as secured investment in their product basket of diversification. NSEL released its initial product released on March 17, 2010, on a Wednesday under the E-Series as E-Gold. To enable them to transfer the units to the corresponding client’s account, clients or retail investors who want to purchase E-GOLD units must open their beneficiary account with NSEL empanelled Depository Participants (DPs) and provide their client IDs and DP IDs to their respective members. FTIL advertised NSEL as a spot commodity exchange, and NAFED received 100 token shares to use under its brand and market the exchange as a “farmer’s market.” The Ministry of Consumer Affairs, led by Shri Sharad Pawar, granted NSEL a specific exemption from the Forward Contracts Regulation Act (FCRA) 1952 even before the company opened for business in 2007.
What went Wrong
The NSEL was established in order to improve price realization for farmers, increase price transparency, and provide a wide range of trading opportunities for traders and investors. NSEL was therefore brought in to create harmony with the current marketing systems and to keep pace with the markets. NSEL was an electronic platform that served as a bridge between three organizations. The parties financing the entire transaction were the investors, forward buyers, and commodity sellers. One-day forward contracts were permitted for spot exchanges, such as NSEL, as long as participants would refrain from short sales and outstanding positions at the end of the trading day would be delivered. However, the FMC discovered that the exchange permitted trading on its platform without checking to see if the seller had stocks, thereby permitting members to engage in short sales. 2. The Forward Contract Regulation Act, 1952 was broken by the contracts traded on the exchange for which the settlement period exceeded 11 days, according to the FMC’s investigations. These contracts were non-transferable specific delivery contracts. The fact that there were approximately Rs 5400 crore in outstanding payouts as of July 29 caused this issue to worsen. This resulted in an indefinite suspension of trading and the initiation of new contracts. To make matters worse, it was found that demutualization concept was found to violated altogether as NSEL was found to be an entity owned by the Financial Technologies promoted by Jignesh Shah. NSEL scam is found to loop in borrowers, sellers and investors in a puzzle altogether. It was found through investigations that investors and speculators used forward contracts to make money. The forward contracts in the beginning involved some set of commodity stockiest selling warehouse receipts to investors for immediate payment. These investors also entered into buyback arrangements by selling back the commodity to stockiest after 25-to-35-day periods ignoring the forward markets regulation act. Thus earning at least 12- 14 percentage return. Thus the deal helped stockiest receive immediate money and investors their returns. 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 actual problems arose when investors entered into arrangements without proof of underlying stock. The investors actually sold commodities without proof of underlying stock and entered into buyback arrangements. It is observed that the quantities of underlying commodities may be fictitious.
Internal Auditor insights.
Gaps in regulatory compliance may have been identified by internal auditors. They could have drawn attention to the oversight gaps in regulatory agencies like SEBI and emphasized the necessity of more stringent compliance controls to guarantee openness and conformity to trading standards. Verifying the existence and value of commodity stocks kept in warehouses would have fallen under the purview of internal auditors. Their concerns regarding differences in inventory records may have led to the discovery of the fraud’s central component—the false representation of commodity stocks. The efficacy of internal controls intended to stop and identify fraud is evaluated by internal auditors. They could have found gaps in the systems that regulate trade execution, settlement procedures, and trading activity supervision. It is possible that management would have strengthened internal controls to reduce the risk of fraud as a result of insights into control shortcomings.
Internal Auditor Observation
NSEL was found to have neglected to carry out adequate due diligence on the paired contracts it provided to investors by the internal auditor. They had observed a lack of information about the risks and underlying assets connected to these contracts. Inaccuracies or differences in the handling of commodity inventories stored in warehouses had been noticed by auditors. Additionally, they discovered cases of incomplete or incorrect records, indicating that investors may have been misleading about commodity stocks
Auditors discovered flaws in financial reporting methods, including the integrity and openness of financial statements. Observations of exaggerated income, underestimated obligations, and misrepresented assets may indicate false reporting. Auditors found flaws in internal control protocols designed to detect and stop fraud. They found weaknesses in the way duties were assigned, in the way access was restricted, and in the ways that fraud was kept under wraps. Additionally, they found shortcomings in the exchange’s monitoring of trading activity. They observed inadequate oversight of the settlement procedures, risk management systems, and transaction execution, which may have permitted fraud.
Learning
The case highlights how crucial it is for governmental and commercial institutions to have watchful regulatory mechanisms. In addition, these organizations urgently require corporate governance reform in order to prevent decisions from being made with the interests of the majority of shareholders in mind. The case also highlights how crucial it is to redefine the responsibilities of auditors in order to stop fraud in the future.
Conclusion
The primary reason for the emergence of such scams is a lack of regulation in commodities markets. The main causes of such scams are a lack of regulation on the part of our auditors, who come out clean in all such cases. Furthermore, it is clear that there are only four people on the board, two of whom are from FTIL, so it is fairly obvious that the majority of decisions will be made in the interests of FTIL, the promoter company, with very few chances that any of the directors will discuss the interests of the investors. This happened because there were extremely poor corporate governance mechanisms in place to keep in check the promoters of the exchange.
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Authors:
Umesh Vishwakarma | Director
Ritik Prajapati | Associate Consultant
Email: blogs@bilimoriamehta.com
Author Bio
Very nice narrative. SIr, I don’t understand why they are not releasing the bullion which has been hold by them. They may either give physical delivery or sell in the market and distribute the amount.
The small %age of investor who has nothing to do are stuck up. Further, to the best of my knowledge, the entire issue was on agri commodity side and not bullion segment.