Last week, the National Spot Exchange Ltd (NSEL) announced a repayment programme spread over 30 weeks. According to the NSEL website, not all defaulting parties have paid up. Moreover, a majority of those who have paid have done so only partially. As on August 19, NSEL managed to collect only Rs. 81.13 crore against the liability of Rs. 174.72 crore for the first payout due on on the next day.
As the NSEL saga unfolds, it is clear that there is much pain to be lived through. There is no surety on whether or not there are enough commodity stocks in warehouses (against which trades were done) and the cash available with the exchange is not enough to repay investors. The payment schedule released by NSEL seems far from sacred if the outrage by large brokers and investor forums is anything to go by.
But why didn't these brokers and even investors question the trade earlier? In spite of the fact that the counter-party risk for the transaction was guaranteed by the exchange, the trade itself should have raised question marks.
How did prices only move up? Prices of any assets and commodities fluctuate or move up and down, but in this case commodity prices were moving only upwards. According to Kiran Kumar Kavikondala, director, WealthRays Group, a wealth planning firm, "Investors were looking at their end payoff which may not reflect in the actual market price but no one was bothered as long as they made the promised 12-15% return."
How could the rise be so steep in a short period? The question is how did the price of one commodity rise 1-1.25% in every trade cycle in a matter of 25-30 days, regardless of what the underlying commodity was, who was selling it and the economic conditions (see graph).
Was it an investment/trading or a lending activity? The answers lie in the fact that the profit was not so much through the change in the price of the commodity, rather it was the interest which borrowers (commodity growers or suppliers or owners of warehouses) pay for the liquidity provided. This simply means that you aren't really investing/trading in a commodity; rather you are just lending money. Well you don't really need an exchange to do this and that is not the purpose of an exchange in any case.
Till the going was good, brokers relied on NSEL's assessment of all matters and now they are unwilling to trust the same set of people. While investing money you need to assess the viability of an asset, a business, the growth of an industry or the economy, but lending money to a third party without verifying credentials is simply not wise.
Lesson 1: Know the asset
The first lesson of investing (the transaction on NSEL had little to do with investing) is to understand what you are buying. "Derivatives in commodities is very speculative. You are taking a chance on something you have no control over and there is no economic value created," said Rajesh Saluja, chief executive officer, ASK Wealth Advisors Pvt. Ltd.
In this case, not only was there no economic value but the underlying asset was irrelevant; people did not bother to verify that the receiver of the funds was indeed a genuine trader of the commodity or just somebody looking for easy access to funding.
Lesson 2: Evaluate the risks
As the adage goes, there are no free lunches. A 12-14% annualised return in a matter of 30-35 days can't come risk-free. If you are getting a high return in a short period of time, it has to come with high risk. For getting a consistently high return in equity investments, too, you have to remain invested for at least 10 years. So evaluate the risks carefully if the return promise is much higher than ordinary.
"If you can't understand something, you should stay away from it," said Saluja. "For retail investors it was the lure of guaranteed or assured returns. It was the greed for fixed return which investors consider the least risky that drove them." Here the risk was not a market risk, rather a counter-party risk. As a lender, that should have been checked thoroughly if not personally.
"Any market is driven by greed and fear," said Kavikondala. "In this case many just bought because it was a simple mechanism and there was an exchange guarantee on counterparty." The lack of transparency, governance and compliance issues were always a red flag, he adds.
Lesson 3: Evaluate your broker
Lastly, not only should you evaluate your investment carefully, but also your broker. This is the person you are entrusting your money to. Should the broker not have ticked off the above two points before getting your funds put in it as well? According to Kavikondala, the exchange itself was promoting this product to the brokers.
Getting taken in by an easy money scheme without running the relevant checks, just because everybody is doing so is foolish.