After ‘colo’ order, what next for NSE?

The NSE co-location issue, which has been dominating headlines over the last four years, is finally nearing closure with SEBI delivering the much-awaited orders against the NSE and others.

It is interesting to note that despite the detailed investigations by various technical committees, the regulator has not been able to prove that the exchange has committed any fraud or had mala fide intentions. The order states that the exchange did not exercise the requisite due diligence while putting in place the architecture in its co-location facility. The same created a trading environment which was unfair, resulting in violation of Regulation 41(2) of SECC Regulations, 2012.

The regulator has however ensured that the punishment is on a scale that sends the message to all market infrastructure institutions to put their house in order. SEBI has also passed punitive orders against the people who led the NSE when the scam took place, OPG Securities (the perpetrator of the scam), Ajay Shah, and a host of others in an attempt to address all the issues, directly or indirectly, related to the scam.

Whether these orders would bring a rather sordid chapter in Indian capital markets to a close, only time will tell. But what are the implications for the NSE?

The colo issue

Before we look at how the NSE will be able to cope with this order, here’s a brief recap for those who joined late. Prior to 2014, the NSE’s co-location facilities (some trading members place their servers in these colo facilities, which are right next to the exchange server, so that their algo trades can be executed faster) disseminated data through the Tick-By-Tick system where order book data was delivered sequentially. Member who logged in first, through a server with lesser traffic could get the data before others, thus enabling faster execution of the algo transactions.

The SEBI order says that OPG Securities, a brokerage, discovered this route to game the system with the help of an insider. OPG made certain arrangements with NSE’s data centre staff — Jagdish Joshi — who would tell him the time when the servers would start. OPG used NSE staff members to access the least crowded servers and also indulged in front-running in collaboration with NSE employees.

Besides this unfair access issue, SEBI passed orders on two other complaints — one regarding laying dark fibre connectivity by Way2Wealth Brokers and misuse of relationship with NSE by Ajay Shah and others.

What lies ahead?

With SEBI stating that no fraud has been committed, the credibility of the exchange is no longer under a cloud. Also decks are now cleared for NSE’s Initial Public Offer; though after six months.

While the quantum of the disgorgement is large,the NSE’s finances are not likely to be unduly hit. The SEBI has directed that the NSE disgorge the entire profit made from the transaction and connectivity charges from the co-location facilities for the period between FY11 and FY14 along with an interest of 12 per cent for the subsequent period.

The profit for the period works out to ₹624.88 crore while the interest calculated on a cumulative basis from FY15 to FY19 amounts to ₹358 crore. The disgorgement in the dark fibre order adds a further ₹95-crore penalty on the NSE. The total sum of ₹1,077 crore is not small for the exchange as the net profit on a consolidated basis for FY18 was ₹1,461 crore. But the exchange had been directed by SEBI to set aside all revenues from co-location facility in a separate bank account. Such transfers amounted to ₹1,197 crore towards the end of March 2018 and would have swelled further since then.

The exchange actually stands to gain with this closure as it can now use the surplus amount set aside in the escrow account to augment its cash flow.

Further, with turnover from co-location contributing 26, 34 and 44 per cent of equity cash, equity derivative and currency derivative turnover respectively, the NSE would be glad to be free to use the future revenue from this facility.

Asking the exchange to pay interest on the disgorged amount is, however, a trifle overdone as the delay in passing the order was mainly on account of SEBI’s prolonged investigations.

Challenges posed by tech

The most important fact that emerges from this episode is that adoption of technology is going to pose unique challenges in supervision as well as regulation in future. The manner in which SEBI conducted its investigation, relying on one expert committee after another, highlights the difficulties in understanding the intricacies in speedily developing technology. Both the regulator as well as the exchanges need to improve the skill levels of their senior staff to tackle these changes.

The co-location facility in the exchange commenced its operations in 2010 and the unfair access by OPG Securities took place between 2012 and 2014. To give the exchange and it’s then chiefs their due, it is possible that certain unscrupulous employees managed to get away with exploiting gaps in the rule-book, that was still in the formative stage then. It needs to be noted that the NSE switched to Multicast TBT system by 2014, due to which sequential dissemination of data came to an end and OPG could no more gain an advantage.

The regulator is also not entirely without blame in this episode since it has allowed exchanges to facilitate DMA (direct market access), algo trading and co-location facilities without too much deliberation and planning. It was only in 2013 that SEBI put out a discussion paper on co-location facilities.

The entire investigation and its fallout could have been avoided had the NSE acted on whistle-blower Ken Fong’s first complaint in 2015 instead of remaining in denial. The NSE should have conducted an internal investigation then, punished the staff found colluding with trading members and passed orders against OPG Securities. Avoiding hubris, being more open to criticism and taking corrective actions, should be the watchwords in future.

The exchange also needs to create a wall between its operational staff and trading members. It’s clear that everyone in the market is out to make money and will use every trick in the book to do so.

Communiqué needs to be sent to every staff on the dos and don’ts while communicating with external sources, especially trading members. Conducting system audits regularly, as advised by SEBI and review of all third party agreements should also be on the check-list.

Finally, let’s not forget that the NSE, with over 80 per cent share in the cash market and 100 per cent in the equity derivatives, has done well so far to keep the Indian capital market in step with the best globally. This issue should serve as a wake-up call to spring-clean its internal processes and move ahead.

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