Financial Technologies (FT) and Multi Commodity Exchange Ltd (MCX) lost over 75% and 70% of their market value respectively in short span of two weeks in light of severe governance failure being unearthed in one of its group companies, National Spot Exchange Limited (NSEL). While the magnitude of the NSEL debacle and its impact on FT future earnings is huge, MCX business remains relatively unaffected by this crisis, except the sentimental impact & fear emanating from the fact that FT and MCX have common promoters. The arguments that we have heard from investors and analysts against MCX range from cash being siphoned from MCX to brokers across the country boycotting the MCX platform due to trust deficit.

We completely acknowledge that materialization of either of the above two risks can sound the death knell for MCX, but our detailed analysis of the entire episode leads us to believe that there is no way the money is being siphoned out of MCX and very low probability that brokers will shun the MCX platform. It can be categorized as a High Return, Moderate Risk opportunity. Intermittent volatility in the stock will be high as the cycle of price fall, fear and further price fall continues until the audit on MCX is underway. General risk aversion will keep value investors away and regular investors will continue to rant the bad corporate governance theme. Meanwhile, a small exposure could expose you to the huge upside in case MCX is able to clear its name. The worst risk is that of regulatory action in trimming down the commodity futures market and thereby affecting the business in a huge manner. But again, the probability of it coming out is quite low.

We recommend investors to accumulate MCX between Rs 180 to Rs 260 with a view of 2 to 3 years. The only word of caution is not to over allocate into this stock.

The NSEL Debacle: Before building any view on MCX, it is important to understand the recent problems that cropped up in NSEL that triggered the massive price fall for FT and MCX. National Spot Exchange Limited (NSEL), unlike MCX and NCDEX, is a 'spot' exchange platform with contract periods of 1 to 65 days. Some important features of trades at NSEL are:
a. The buyer and seller both are aware about the identity of counter party
b. Counter party in both buy / sell transactions is same (the exchange; in this case NSEL)
c. In an ideal transaction at NSEL, investor enters into 2 transactions simultaneously with the Miller / Stockiest of commodities. 1) Spot transaction to buy commodity from Seller. 2) Forward transaction to sell the same commodity to Seller at later dates (T+7, T+21, T+35, T+65).
This clearly suggests that the primary reason for the selling party to use NSEL platform was to ensure short term funding by providing commodities as collateral. The only role of NSEL was to ensure collection of sufficient collateral from the seller before passing the investors money to the seller. This is where the exchange failed miserably.

And when the risks came out in the open, investors stopped rolling-over their positions. If the collateral would have been collected well, the settlement of any of these investors should not have been affected. Since the collateral was insufficient, the unwinding of positions did not take place in a rightful manner. There were many loopholes that suggested the potential problems with NSEL even before all was out in open. Some of the biggest risk management failures at NSEL were:

• Mark-to-Market Collection: MTM margins were not collected from the seller of the commodities i.e. Millers. NSEL only collected 10% margin from the seller party. For every Rs. 100 worth collateral given by seller, Rs. 90 was given to him and only Rs. 10 was retained by the exchange as a part of the Settlement Guarantee Fund (*see attached note). Obviously, the buyer (investor) paid the exchange Rs. 100. In an event of more than 10% fall in price of underlying commodities, there was a clear risk of default in paying back the money.
• Sellers Concentration: There were more than 10,000 investors funding only 23 parties. For example, around Rs. 800 crores were raised by a single party against the claimed 1.5 Lakh tons of castor seed stocks stored in Gujarat. Similar is the case in Wool, Sugar, HR Coils, and TMT Bars among others. Ideally there should have been exposure limits to a single party as set by many other stock exchange like including MCX and NCDEX. But NSEL retained its lose risk management in order to ensure that business grows.
• Warehouse Location Issues: Most of the warehouses that were approved by NSEL for the storage of collateral stocks belonged to the selling parties themselves. This was a clear conflict of interest and it is really surprising how this was allowed. This means that the selling party got the money on the goods sold but the corresponding material were still under their direct control as they were stored in the warehouses owned by them! This clearly indicates the NSEL didn’t have control on the collateral against which investors had lent money.
• Over-Leverage: Most of these 23 parties had first pledged the same stock with some bank and then re-leveraged it through the exchange platform. The due diligence was not properly done by the exchange before allowing these trades.
• Lack of Transparency: Investors never questioned about the quality and location of the commodity stored. They simply trusted the exchange, which never provide sufficient documents explaining the ownership/quality/quantity/location of those materials. The stock positions at each of the warehouses were not even audited by any external party.

The role of NSEL was smooth settlement of funds and collateral management. But it failed miserably there. It is also impossible to think that promoters were not aware about the situation at hand further raising doubts in investors mind about promoters personal interest in letting this happen.

Impact on Financial Technologies (FT): In FY13, FT earned a total profit of Rs270 crores, of which ~Rs170 crores coming from NSEL, its fully owned subsidiary. With NSEL on the verge of shut-down, all its earnings from this division will be gone. Fixed costs will take time to decline and there is an easy case for 70% earnings de-growth in FY14. With this kind of financial impact, it is not surprising to see FTs stock fall by almost 75% in no time. If we add the discount due to the corporate governance issues within NSEL to the financial impact, FTs stock price should fall much more than just the financial impact, though it cannot be quantified correctly.

Link between MCX, FT & NSEL: Although there are a lot of differences between MCX and NSEL, they have one very strong link common promoter. Financial Technologies (FT) holds a 100% stake in NSEL and a 26% stake in MCX. The entire management team of MCX is selected by the promoter themselves in both these companies. While it is only natural for an investor to be concerned about the common promoter link in NSEL and MCX, the biggest difference is that MCX (and NCDEX) are regulated by Forward Markets Commission (FMC) whereas NSEL was not a regulated by any agency. The risk management policies of MCX / NCDEX confer to the standards defined by FMC, which are stringent as well as prudent. Another point to be noted is that out of the Rs. 40,000 cr of daily volumes on MCX, less than 5% settlement happens in delivery mode. This in case of NSEL was almost 80% to 100%. Remaining transactions in MCX are either for hedging or of speculative purpose. As an illustration, the total outstanding delivery position in MCX as on 10th August 2013 is just under Rs450 crores (see table below). And the underlying stock is for real. The stock can be easily verified with the multiple centers warehouses where real lifting and depositing of goods keep happening.

Comparison of risk management

Strengths of MCX

1. Virtuous cycle of participants and liquidity: Ask its existing members one simple question, "Will you stop trading at MCX due to the NSEL fiasco?" The reply is a clear NO, the primary reasons being Liquidity, Liquidity, and Liquidity! Some people do argue that participants can easily shift to the NCDEX platform. While we don't dispute that this is impossible, it will take a long time to achieve penetration levels of MCX. Just to give you a glimpse about liquidity on NCDEX, silver contracts in NCDEX has zero volume and no quote available to trade. Similar is the case in Gold. And NCDEX crude volume is almost 90% lower than that in MCX. Members of MCX who are aware about this issue will be cautious and may scale down their volumes till the time the overall perception of MCX has improved. But will the stop overnight? Unlikely, as it's their bread and butter.

2. Commodities stock at MCX warehouses real: There are multiple warehouses where the commodities are deposited in MCX. Addresses of all warehouses are available on the exchange website. All the commodities have a certain expiry date by which these commodities have to be lifted (except for Gold / Silver). There are insurance agencies that have insured these materials. Testing agencies have done sampling and given a report on the quality of materials. MCX traders have continuously lifted the stocks from warehouses for real to their satisfaction. There is little to suggest that collateral value is lower than what the exchange claims.

3. Risk Management Systems:

• Settlement Guarantee Fund: Ideally, SGF should include a fund that never decreases except in case of a default by one of its member brokers. It does not include the margins that are paid by the member brokers as was the case with NSEL. That is precisely the case with BSE, NSE, NCDEX and MCX. The amount of SGF with NCDEX is in lower single-digit crores for MCX and NCDEX both. However, the case of a default does not arise even in the worst cases as they keep collecting M2M margins and there are exposure limits on each parties.
• Daily M2M Collection: Mark to Market collection and payment is done to / from all the members on a daily basis. This minimizes the risk of defaults only to those events where the price movements are extremely sharp. This is the nature of business at all exchanges. The defaults, if at all, cannot be more than a certain amount due to the exposure limits set on individually members, individual clients and individual commodities.
• Insurance per member: MCX Investor relations also confirmed about taking insurance against the defaults of upto Rs 5 crores per member.
   

4. Debt free company, low promoter holding: MCX has a very strong balance sheet with almost Rs. 800crores as cash. Some of its shareholder banks are also the banker to MCX and the chance of misreporting the cash position looks relatively low. Jignesh Shah through Financial Technologies Ltd, holds only 26% stake in MCX. Another 47% holding is held by institutional investors.

5. Regulated by FMC: The exchange is regulated by FMC and therefore has been much better in terms of governance levels.

6. Major Volumes are trading based and not delivery based: More than 95% of the volumes in MCX are for hedging or speculation and not delivery based. Maximum turnover is based out of non-agri commodities like Gold, Silver, Crude and Copper. This does not require it to have large godowns in distant locations as is required for exchanges primarily of agri-commodities.

7. Zero Liability of MCX in NSEL: In a press release by MCX, it is clearly stated that there is no financial liability that can arise for MCX in the NSEL fiasco. The only common link is the common promoter. In fact according to us there is a strong case that the promoters of Financial Technologies might have to resign from the board of MCX and Forward Market Commission (FMC) will instill a new board. This however is our personal opinion and the real outcome could be significantly different.

8. Attractive risk-reward: Given its cash position at Rs. 800cr, the core business of MCX is being valued at Rs. 300cr based on the current market capitalization of Rs. 1100cr. Considering that its core business generated earnings to the tune of ~Rs200cr in FY13, it is available at trailing earnings multiple of 3x. The market is currently factoring a 60-80% decline in its core income. The bigger call one has to take is whether MCX will survive the crisis faced by NSEL, the subsidiary of its promoter. Our analysis indicates that survival won't be under threat.

Risks:

1. Intermittent volatility in MCX stock price could be high. It is anyone’s guess as to the timeline and the manner in which the crisis and its solution would shape up. Till such time, fear will prevail over value and you may end up losing another 20-25% in no time. We would recommend our investors to take a plunge only if they can handle such volatility and believe that MCX may survive the current phase.
2. There is a high likelihood that the promoters and the board can be charged with the criminal penalties and it can affect the market sentiments even further. The biggest risk is if the FT management is intentionally involved in the risky practices of NSEL for personal gains. We believe this will only accelerate the change in management, which will be a great relief for the investors of MCX.
3. The biggest risk comes in the form of disruptive regulation in terms of downsizing the operations of MCX. At this stage we do not think that there is any scope for this. However, before investing in the company one needs to have a thought about a minute possibility of this.
    

*Note on Settlement Guarantee Fund: NSEL always mentioned about its Settlement Guarantee Fund being Rs. 800 crores. However, one fine day they declared that it has dwindled to Rs. 65 crores. As NSEL was an un-regulated exchange, they abused the meaning of Settlement Guarantee fund. According to NSEL, SGF consisted of the 5-15% margin collected from the seller party (Borrower). Basically SGF consisted of Initial Margin. This means that SGF in NSEL was a floating fund that went up/down depending upon the total outstanding at NSEL. That was absurd.

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