* Transaction tax, scam at National Spot Exchange deters trade
* Government fails to push through reforms needed to expand markets
* ICEX to cease operations within months
By Rajendra Jadhav and Siddesh Mayenkar
MUMBAI, Feb 7 (Reuters) - The Indian Commodity Exchange (ICEX) is set to fold due to plummetting trading volume as a result of the government's failure to liberalise and investors retreat from futures markets after a major financial scandal at another exchange last year.
It will be the first to go, in what has become an overcrowded segment since India first allowed futures trading in commodities in 2003.
Launched a little over four years ago, ICEX grew to become India's fourth largest commodity exchange and its demise would be symptomatic of a wider malaise.
Confidence in India's commodity markets suffered a massive blow last July, when the National Spot Exchange Ltd (NSEL)abruptly suspended trading in most of its contracts.
Subsequent investigations revealed a 55-billion-rupee ($880 million) fraud, as the exchange defaulted on obligations to market participants.
While there has been no official notification that ICEX will shut, the exchange has no tradeable contracts after April 18.
ICEX has already ceased trading natural gas and iron ore, while all contracts for other commodities like soybean, rapeseed and silver will expire in two months.
Though ICEX did not respond to telephone calls and emails seeking comment, a member of the board of directors told Reuters that operations will be suspended in the next few months.
"It ran out of money and anchor investors are not interested in putting in more," the director said on condition of anonymity.
ICEX's investors include state-run trading firm MMTC Ltd , India's biggest importer of gold, and a unit of Reliance Capital, who both hold 26 percent.
Indiabulls Financial Services Ltd, one of India's leading non-banking financial companies, has a 14 percent holding, while Indian Potash has 10 percent.
They are not the only ones regretting their investment in commodity exchanges, as trading volumes collapsed across the board over the past year.
With two months of the financial year remaining it looks like the combined transactions of all Indian exchanges will be around half the 170.46 trillion Indian rupees ($2.73 trillion) that they notched in 2012/13.
"Foreign investors are not happy," said an official with a leading exchange, who declined to be identified. "If they see returns are not coming anytime soon, they may sell stakes."
TRANSACTION TAX, GOLD CURBS
The retreat has already begun at India's biggest commodity exchange, Multi Commodity Exchange (MCX). MCX is one of several exchanges created and operated by Financial Technologies (India) Ltd. NSEL was a stablemate.
In the last four months, foreign investors have cut their holdings in MCX from nearly 37 percent to around 25 percent.
NYSE Euronext was the biggest seller since September, disposing of a 4.73 percent stake. Swiss Finance Corporation and Government of Singapore Investment Corporation both cut their holdings by 1.24 percent apiece.
The Mauritius unit of Bank of America Merrill Lynch sold the last 2.79 percent of its stake in January, but the buyer was a fellow foreign investor -- the Mauritius unit of private equity manager Blackstone Group LP.
Foot-dragging over crucial reforms by the government exacerbated investor fatigue.
A bill was introduced to parliament in 2006 that would open the gate for banks, mutual funds and international players to participate in India's futures market. It is still sat there.
With a change of government expected after an election due in May, the fate of the Forward Contract (Regulation) Amendment Bill is very uncertain.
The government has dealt other blows to these markets.
Last year, it introduced a commodity transaction tax (CTT), applicable to non-agricultural and some agricultural commodities. The tax has driven away market players like jobbers and hedgers.
And as the rupee plunged last summer, the government slapped curbs on gold imports, hurting exchanges like MCX, who counted gold futures as their biggest single market.
"The commodity markets are witnessing some challenging times," said Samir Shah, managing director of the National Commodity and Derivatives Exchange (NCDEX), the country's second-biggest exchange by turnover. "In addition to the impact of CTT, the series of events that unfolded in the NSEL case shook investors' confidence."