The Commodity Conundrum

About 2 months back someone asked me to invest in a new commodity product that was guaranteed to return 12-16% a year, I cut them off before they gave me more details and said “no thank you”. I told them I would not touch commodities with a 10 foot pole after being burned by the commodity markets in 2006…December 7, 2006 to be exact. I remember that day vividly because I woke up feeling like a million bucks because it was the day I was getting my marriage registered at the Bombay Courts. I grabbed the newspaper and immediately felt like someone punched me in the gut. The FMC (Forward Markets Commission) had announced they were banning hedge funds in the commodity markets.

The FMC is the regulatory authority for commodities like SEBI (Securities and Exchange Board of India) is for equities. I use the term “regulatory” very loosely, to say the commodity markets are politically controlled would be an understatement. In India the largest industry in terms of revenue and people employed is agriculture, which brings a whole host of political people trying to “help” the farmer.

In mid 2006, the Minister of Agriculture was getting intense heat from the rest of the government for the rise in essential commodity prices which saw onion prices go through the roof. The Minister of Agriculture is none other then political heavy-weight Sharad Pawar. The Minister of Agriculture decided to act via the FMC and ban all hedge funds from trading on the National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX). The FMC was more concerned about NCDEX since that is where many of the Indian agro commodities trade. Our fund and about 10 others were out of business overnight – December 7, 2006. We had dealt with the FMC for many months prior and it was clear they were not calling the shots, they were being told what to do. In the crossfire the hedge funds were collateral damage.

Enough about my sob story, back to this new commodity product being pushed by many of the big brokerage houses. The product was traded on the National Spot Exchange Limited (NSEL) which was backed by Jignesh Shah of Financial Technologies. At MProfit we were increasingly getting requests to create an import template for these contracts so people could track their investments in our software. When people showed us the contract notes where the buy and sell prices had already been established, that should have been a red flag. However, like everyone else we figured it was legitimate because it had the stellar reputation of the Financial Technology group behind it. Not to mention the equity markets were dead so people must have moved to this new exchange to trade the markets…wrong.

When the NSEL issue came to light I had a chat with the head of a large commodity broker who had some exposure to the product, rather his clients has exposure to the product. He was very adamant that it was the government’s fault (not true) and that clients would get their full money back (pretty sure that ain’t happening). The minute I heard that the NSEL might not have the money to cover all the investors I knew right away the goods were probably never there, either fictitious warehouse receipts or sub-standard commodities were being warehoused.

I’ve heard from several people that some of the brokers were unofficially pushing it as a commodity PMS (Portfolio Management Service) which is ILLEGAL in India. Equity PMS products are legal since they come under the purview of SEBI, whereas the FMC banned PMS products in commodities on December 7, 2006 (yes, that date is etched in my forehead!). And just recently, someone forwarded me a product presentation slide deck for a commodity PMS being offered by Forefront (click for preso). It mentions the fund is registered under SEBI’s Alternative Investment Funds (AIF) rules, but commodities fall under the FMC lens. So who has jurisdiction over this fund if things get out of control? Everything looks great on paper until the shit hits the fan.

This type of jurisdictional conundrum is what caused the NSEL to spiral out of control. No one had regulation over the spot markets which is what the NSEL was all about – hence their name National Spot Exchange Limited.