SEBI has done well to come down heavily on the NSE, which stood exposed on charges of unethical practices. This will go a long way in protecting the integrity of capital markets

The National Stock Exchange (NSE) was set up as a fully automated body by the Government during the early 1990s to checkmate the broker mafia-controlled Bombay Stock Exchange (BSE). It went on to become one of the largest stock exchanges in the world and in the process, decimated the BSE and all other Regional Stock Exchanges (RSEs). After 25 years of market leadership, NSE’s no-nonsense image has now taken a severe beating due to allegations by some brokers as also entities. Three years of investigations into the allegations that some brokers have gained unfair access to the systems of the country’s premier stock exchange reveal that the charge is indeed true. The Securities and Exchange Board of India (SEBI) has now passed an order against NSE. The penalties imposed are as follows:

• Disgorge an amount of Rs 624 crore (profit from its co-location operations) along with an interest of 12 per cent per annum to the SEBI’s Investor Protection and Education Fund (IPEF).
• NSE has been barred from accessing the securities market for six months. (Hence, the  Initial Public Offerings (IPO) of NSE can’t go through for next six months).
• Barred it from floating any new derivative products for six months.
• The regulator has ordered Ravi Narain and Chitra Ramkrishna — both former Managing Director and CEOs of NSE — to disgorge 25 per cent of their salary drawn when they were at the helm of the affairs at the exchange.
• Barred OPG securities, allegedly the prime beneficiary of the co-location matter and its directors from accessing the securities market for five years, while also directing the entities to disgorge Rs 25 crore.
• Ajay Shah of the Indira Gandhi Institute of Development Research has also been restrained from holding any position with a stock exchange or a listed company for two years.

“NSE has committed a fraudulent and unfair trade practice as contemplated under the SEBI (PFUTP) Regulations. It is established beyond doubt that NSE has not exercised the requisite due diligence while putting in place the Tick-by-Tick (TBT) architecture,” G Mahalingam, whole-time member of SEBI said in the order.

It is noteworthy that it was only last year that the Central Bureau of Investigation (CBI) had registered a case of undue access to NSE systems, against brokerage firm OPG Securities Pvt Ltd and its promoter, Sanjay Gupta, as well as Ajay Shah of the Indira Gandhi Institute of Development Research, who facilitated Gupta’s exploitation of NSE systems by developing a software called Chanakya. A case was also registered against unknown officials of SEBI and NSE for corruption.

The SEBI order and the CBI probe laid bare NSE’s claim of being a provider of a “transparent” and “unbiased trading platform” and brought to the fore the murky dealings of a coterie in the exchange. The CBI’s probe revealed that Ajay Shah collected NSE trade data in 2005-06 under the garb of doing research while he was employed with the Centre for Monitoring Indian Economy (CMIE). Ajay Shah, along with his wife, Susan Thomas, developed NIFTY 50 index, which is the most successful product of NSE. In an unprecedented gesture, the NSE had been giving Ajay Shah and Thomas a hefty annual royalty as a certain percentage of the income generated from Nifty trading. Suprabhat Lala, who was administration head at NSE, was married to Sunitha Thomas, who is sister of Susan Thomas. Sunitha Thomas and Ravi Varanasi, who was head of trading at NSE, had promoted the company that designed the algo (Chanakya) for OPG Securities. CBI also found that Sanjay Gupta, the promoter of OPG Security Pvt Ltd, had gained undue access to the server architecture of NSE with help of algo developed by Ajay Shah and may have shared part of the proceeds.

NSE got its algo systems audited by Deloitte two years back as was ordered by SEBI. Audit of NSE’s algorithmic trading practices found that the systems of the country’s premier stock exchange were prone to manipulation by brokers and, in fact, indicated that some brokers may have had unfair access to NSE’s servers. NSE had then forwarded this Deloitte report to SEBI, requesting the regulator to advise further directions in the matter.

The matter of unfair access started when a whistle-blower from Singapore wrote to SEBI and NSE during 2015, alleging that some brokers have gained unfair access to price and order book information, while trading on NSE’s algorithmic trading platform. It was then that the regulator decided to conduct a special inspection of NSE, after which it found preliminary evidence that as many as 12 brokers might have got unfair access to NSE servers. The allegations against NSE pertain to members who co-located their servers on the BKC premises of the NSE. This reduces the time it takes for an order to travel to the exchange, giving them a speed advantage over those who are at farther places.

Unfair access being referred to occurred by enabling certain brokers, who had their co-location servers in NSE premises, to get price information ahead of the rest of the market participants. To understand how this has happened, one has to first understand how the price information is disseminated by NSE. The NSE disseminates price information through two types of price feed streams — one is the broadcast stream or UDP stream (User Data-gram Protocol), which is used by NSE for its VSAT and leased line networks. This multi-broadcast (which everyone can view on TV) is limited to two mbps bandwidth due to NSE leased line network capacity. The second price feed stream is TBT, which actually reflects each and every new order price information coming into the exchange system. Due to the large size of the price information, TBT price stream was available only to co-location brokers of NSE. TBT price information was disseminated through TCP/IP (Transmission Control Protocol/Internet Protocol) mode. It’s like information is delivered to one by one instead of a broadcast. In a broadcast mode, everyone gets the price information at the same time. When NSE started TBT in 2010, one TBT server of NSE had to serve several connections of brokers. Since TBT price information was disseminated sequentially, it simply meant that the broker, who connected first to the NSE-TBT server, would get the price information ahead of others throughout the day.

Complications in TBT price stream only raised further as demand for co-location servers by members sky-rocketed and NSE put up multiple TBT servers. This meant that the traffic or load was not necessarily uniform across all TBT servers of the exchange. So, connecting first to the least-traffic TBT server of exchange has become crucial in the game. Smart brokers had figured out that the way to ace the system lay in being the fastest one to connect to the lowest load server. There were allegations that such smart brokers had colluded with co-location data centre staff of NSE and also took some officials on their payroll, developed in-house software and took algos assistance of Omnesys, a technology partner of NSE, to beat the system.

By front running through unfair access to price information, these few privileged co-location brokers earned hundreds of crores of rupees at the cost of other investors. While NSE started TBT price stream in 2010, its technical team somehow felt that they could not generate this stream as a broadcast or multicast. NSE eventually upgraded its technology and converted this TBT price stream to what is called multicast TBT stream sometime during 2014, to blunt the front-running. But in the intervening years, a few privileged front running brokers minted hundreds of crores of unfair profits and in the process, severely damaged NSE’s reputation. Allegations were also made that the NSE management tried to hush up  the matter instead of attacking the issue head-on when it first came to their notice. The TBT system was discontinued by NSE with effect from December of 2016, as per reports.

Due to unfair access to the exchange systems and unfair trade practices followed by some brokers, most small investors would have lost their hard earned money in margin trading and Futures&Options (F&O) trading. SEBI’s action will go a long way in protecting the integrity of capital markets in India.

(The writer is former Managing Director, Ahmedabad Stock Exchange Ltd)