NSE co-location scam

The NSE co-location scam relates to the market manipulation at the leading stock exchange of India -- National Stock Exchange of India (NSE). Allegedly select players got market price information ahead of the rest of the market, thus enabling them to front run the rest of the market^[1][2], and possibly breaching the NSE’s purpose of demutualisation exchange governance and its robust transparency based mechanism.^[3] The alleged connivance of insiders by rigging NSE’s algo-trading and co-location servers ensured substantial profits to a set of brokers.^[4][5][6] This multi dollar widespread market fraud came to the notice when markets regulator, Securities and Exchange Board of India (SEBI) received the first anonymous complaint through a whistle blower’s letter in January 2015.^[7][8] The whistle blower alleged that the trading members were able to do so by colluding with some exchange officials. The overall default amount through NSE’s high-frequency trading (HFT) is around 50,000 crores.^[9][10]

NSE co-location case is under the investigation of Central Bureau of Investigation (CBI), the Securities and Exchange Board of India (SEBI) and The Income-tax department (I-T department) are probing the involvement of NSE & SEBI officials, NSE’s former and current executives and brokerages.^[11][12][13]

Background

In January 2010, NSE started offering co-location facility to members. Members could place their servers in the Exchange premise in return for a fee, allowing them faster access to the buy and sell orders being disseminated by the exchange’s trading engine.^[14] The term ‘Co-location’ means ‘a setup wherein the broker’s computer is located in the same area as the stock exchange’s server. This gives a 10:1 (typically) speed advantage for the broker.^[15][16] In addition, HFT or algorithmic trading refers to the use of electronic systems, which can potentially execute thousands of orders on the stock exchange in less than a second. Also, retail investors monitoring prices on regular screens are subject to a delay as compared to a tick-by-tick data broadcast. The disadvantage is that they receive delayed prices unlike in the real market, kind of like watching a delayed cricket match.^[17] Strangely, SEBI did not put out a discussion paper to collect market feedback, as is usually the norm, before giving permission to proceed.^[18] The whole thing was kept so low that there are no public records about HFT that has been executed on NSE.^[19] It is just in NSE’s 2009-10 annual report statement, it was mentioned, “In keeping with global trends, the exchange has provided members a co-location facility for low latency high frequency trading. The Co-location data center is an international standard, state of the art, highly robust, resilient and secure infrastructure.”^[20]

The whistle blower’s letter that was addressed to SEBI and copied to the leading financial magazine -- Moneylife clearly stated that when the co-location was started by NSE it took some time for the more enterprising to figure out what was happening in the system. By the end of the year, smart people had all figured out the way to game the system lay in being the first one to connect to the server and preferably the server, which was fastest.^[21] Thus, the whole co-location case was initiated when certain members associated with HFT allegedly teamed up and worked in coalition for about four years, i.e. 2010- 2014 overriding rules and regulations set in place by SEBI, the market regulator.^[22][23] Access to co-location facilities & HFT trading gave the select brokers differential advantage such as display of market data, viewing order book prior to order execution.^[24]

Resignations at NSE

The Economic Times first reported that on 22 May 2017, SEBI issued show cause notices to the exchange as well as 14 individuals, including former managing directors Chitra Ramakrishna and Ravi Narain.^[25][26] Notices have been sent to Ravi Narain, vice-chairman of NSE, who was serving as chief executive officer (CEO) and managing director (MD) at the exchange during the period when the alleged violations took place. Other officials include Ravi Varanasi, who was the chief of NSE’s business development vertical and was heading the surveillance department of the exchange during this period, and Suprabhat Lala, chief of regulation and head of the trading division during 2010-13. Among other officials who received show cause notices were former technology heads — Ravi Apte, and Umesh Jain, and former chief operating officer Subramanian Anand. NSE vice-chairman Ravi Narain had put in his papers on June 2, 2017, amid regulators intensifying their probe into the alleged lapses in high frequency trading.^[27] This was NSE’s second high-profile resignation after Chitra Ramakrishna, MD and CEO, had resigned from the exchange in December 2016. It was out in media reports that Chitra’s resignation was the fallout of two governance related issues at NSE. First reason was the loss of confidence in the NSE top management due to colocation controversy and second was the controversy surrounding a high-ranking official at NSE, Anand Subramanian, who was re-designated on 1 April 2015 as Group Operating Officer and Advisor to MD. This appointment happened as per communication from the NSE, MD & CEO's office bypassing all norms of the HR department.^[28] Complaints regarding this appointment and Subramanian’s high salary reached the board prompting it to examine the appointment process, which led to Subramanian’s exit from the exchange in October 2016.^[29]Both Mr. Narain and Ms. Ramakrishna were part of the NSE’s founding team, having joined the bourse in 1994. ^[30]

After receiving show cause notices from SEBI, 12 out of 14 high profile current and former top executives of NSE including Ravi Narain and Chitra Ramakrishna filed an application with SEBI for settling co-location issue under consent mechanism in July 2017.^{[31] [32]}The consent process is an alternative dispute redressal mechanism, allows an alleged wrongdoer to settle a pending issue by accepting a penal action without admitting or denying the guilt.^[33] During this period, in July 2017, Vikram Limaye took charge as managing director (MD) and chief executive officer (CEO) of the NSE. He assured that he would approach SEBI for a settlement of the co-location issue and would find the underlying cause of this issue. ^[34]However, a consent application filed by the exchange was later returned in March 2018 after the CBI investigation gathered momentum. ^[35][36][37]

The Brokers-NSE Nexus

The brokers-NSE nexus came to the forefront with the co-location scandal. The broker entity to receive maximum benefit in the scandal was OPG Securities, which was provided multiple login IPs and allowed access from the secondary servers.^[38][39] Due to favourable access, OPG Securities and other entities benefited instead of other brokers and their clients.^[40][41] It has been revealed in the CBI investigation that 90% of the time OPG securities, in collusion with unknown officials of NSE, was first to access the NSE servers.^[42] SEBI’s TAC report also revealed that OPG securities was given access using the co-location facility during 2010-2014 that enabled it to log in to the NSE server before any other entity and therefore, received data before any other broker in the market.^[43] SEBI has alleged in its show-cause notice that the firm has earned close to ₹ 25 crore in profit owing to the aforementioned.^[44]

According to the whistle-blower, OPG Securities alone had traded worth over Rs. 6,000 crore on NSE using colocation. In addition, the “order book” of the exchange was exported to FIIs and FPIs, helping them make illegal gains in the stock market.^[45][46] While OPG Securities used the base technology, Omnesys Technologies provided the trading software. Whistle blower Ken Fong's letter points to Bangalore-based front-end technology provider Omnesys, a company that sold trading software to NSE's members and is said to have benefited, legitimately, from its ability to connect ahead of others to the exchange's servers. The whistle blower states Omnesys was so sure of the early bird strategy that it had profit sharing arrangements with clients.^[47] Omnesys gave the technology to NSE members on profit-sharing basis and NSE’s wholly owned subsidiary secured 26 per cent stake in Omnesys at a huge discount.^[48] This is to be noted that Chitra Ramakrishna, NSE's then deputy managing director, was sitting on the board of Omnesys technologies according to documents from the registrar of companies.^[49] As whistle blower mentioned in his first letter dated, 14th January 2015 - Omnesys was the market leader with its DMA product being highly popular on the institutional desk. It is important here to note that since NSE was the second largest shareholder of omnesys and worked closely with them for several years.^[50]

NSE vs. Moneylife Case

On 8 July 2015, Sucheta Dalal wrote an article on Moneylife’s portal alleging that certain NSE officials were leaking sensitive data related to HFT or co-location to a select set of market participants so that they could trade faster than their competitors.^[51] Her article was based on an alleged complaint made to SEBI in January by an official of a Singapore-based hedge fund. The whistle blower’s first letter came from Singapore that was addressed to BK Gupta, Deputy General Manager, SEBI, dated 14 January 2015, and the same was copied to Sucheta Dalal from Moneylife.^[52] The co-location scandal came under spotlight when NSE filed a defamation suit on 21s July 2015, claiming damages of Rs.100 crore in the Bombay High Court against Moneylife, to stop the publication and circulation of the article. However, the court dismissed the case and asked NSE to pay Rs.1.5 lakh each to journalists Debashis Basu and Sucheta Dalal. Besides this, the court imposed a penalty of Rs.47 lakh on NSE to be paid in the form of a donation to Masina Hospital and Tata Memorial Hospital in Mumbai. The court also ordered SEBI to investigate the charges levelled by the whistle-blower.^[53]

References