What is the co-location scam?

In order to understand the co-location scam, it is necessary to understand what co-location facilities are. There are dedicated spaces in the exchange building, right next to the exchange servers, where high-frequency and algo traders can place their systems or programs.

With the co-location facilities being extremely close to stock exchange servers, traders here have an advantage over other traders due to the improvement in latency (time taken for order execution). But the co-location is mainly used only by institutional investors and brokers for their proprietary trader. Retail investors have negligible presence here.

The scam in NSE’s co-location facility took place almost a decade ago. It was alleged that one of the trading members, OPG Securities, was provided unfair access between 2012 and 2014 that enabled him to log in first to the secondary server and get the data before others in the co-location facility. This preferential access allowed the algo trades of this member to be ahead of others in the order execution.

How did it happen?

SEBI’s investigation through a Technical Advisory Committee revealed that the broker was aided by certain employees of NSE. Otherwise, it would have been difficult for this particular stock broker to consistently connect first to the secondary server of NSE between December 10, 2012 and May 30, 2014.

Very often he was also the second to connect. While many of NSE’s employees were named in the SEBI order of 2019, for colluding with OPG Securities, nine of them were given a clean chit by SEBI in 2020.

How was the scam unearthed?

The scam came to light due to a whistleblower’s complaint to SEBI in 2015, in which the entire modus operandi of the people gaming the system was laid out. When Moneylife exposed the scam, the NSE management adopted a high-handed attitude, slapping a ₹100 crore defamation suit against Moneylife.

The matter moved to Bombay High Court, which came down hard on NSE and dismissed its suit. Further, NSE was told to pay ₹50 lakh as penalty for its arrogant attitude in responding to the media.

What is the extent of loss or default due to the scam?

The point to note is that there is no way of proving any loss to any investors or traders due to this scam. The SEBI order of 2019 directed OPG Securities and its directors to disgorge unfair gains of ₹15.7 core with interest of 12 per cent from April 7, 2014. That is the extent of notional loss, if any, suffered by other privileged trading members in the co-location facilities.

What happened next, how did SEBI’s investigations proceed?

In 2016, SEBI asked NSE to carry out a forensic audit of its systems and deposit the entire revenue from its co-location facilities in to an escrow account. Deloitte was tasked with the job of conducting a forensic audit of NSE’s systems.

In 2019, SEBI passed its order on the issue, asking NSE to pay ₹625 crore with an interest of 12 per cent and also barred NSE from raising money from stock market for six months.

Ravi Narain and Chitra Ramakrishna, who were at the helm of the affairs during the issue were asked to disgorge 25 per cent of their salary drawn during a specified period and penal order were also passed against others seen to be gaming the system.

In a recent order given on February 10, 2021, penalty of ₹1 crore has been imposed on NSE, and ₹25 lakh each on Ravi Narain and Chitra Ramakrishna.

What are the implications for investors and traders?

Retail investors and traders do not participate on co-location facilities and hence are not impacted in any way by the scam. NSE has changed its order execution protocol in the co-location facility to Multicast TBT from April 2014, thus plugging the loophole that allowed some to game the system.

But the entire episode raises questions about the governance and system lapses at the country’s premiere exchange. SEBI has been bringing about a series of regulatory changes to address these lapses over the last four years.