NSE struggles with controversy over algo trading

Sebi letter written in Dec reveals exchange's management has failed to comply with earlier directive

Four days before National Stock Exchange (NSE) managing director Chitra Ramkrishna quit on December 2, the exchange received an important letter from the market regulator. It had some good news and some bad news.
 
The Securities and Exchange Board of India (Sebi) had extended the deadline to submit the forensic audit report of Deloitte on the alleged misuse of its co-location facility, which allows brokers to locate their servers close to the exchange’s server in order to reduce latency, and algorithmic trading facilities. But it was unhappy that the exchange’s management was not following its earlier directive in full.
 
In September, Sebi had asked NSE for the forensic audit, by an independent agency, and to deposit earnings from its co-location services in an escrow account, following a report by its Technical Advisory Committee.
 
Following this, Deloitte was appointed to do the audit, and the exchange deposited Rs 6.53 crore (the amount collected towards co-location charges in the nature of rack charges and connectivity charges) in the escrow account. But, Sebi was not convinced.
 
On November 28, Sebi made it clear it had asked for “the transfer of all revenues emanating from the co-location facility, including those generated from the trading activity.”
 
That meant a substantial portion of the bourse’s revenues would be unavailable for an indefinite period. For NSE, which was preparing for a much-awaited initial public offering, this was bad news.
 
The very next day, the NSE board decided to comply with Sebi’s letter. This was the last board meeting Ramkrishna would attend.
 
Thus, the bourse deposited Rs 145.52 crore in the escrow account. This represented the transaction charges on trade orders placed through its co-location facility for the months of September, October and November 2016.
 
That translates into roughly around Rs 600 crore in annual revenue. In FY 16, NSE’s revenue from operations on a standalone basis was about Rs 1,473 crore. In the last couple of years, the co-location facility has contributed 26 to 30 per cent of the bourse’s operating revenue at the consolidated level.
 
When asked if there was any relaxation from the regulator on the clampdown over co-location earnings and other related queries an NSE spokesperson said in an email: “We have submitted our DRHP (draft red herring prospectus). Thus (we) can hardly comment beyond what is written there. Also, we usually do not comment about our discussions with the regulator.”

NSE managing director Chitra Ramkrishna

 
A cause for concern
 
The uncertainty around this major revenue stream will be a key overhang as investors look at the richly-priced shares for investment, some fund managers feel. “There is not much on the table (for subscribers in the IPO),” says the honcho of a foreign fund, referring to the fact that the Hong Kong Stock Exchange has been trading at twice its average cash turnover value for several years now.
 
The co-location segment’s rapid growth in a short period of time has come as a double-edged sword for the exchange. While it brought in faster trades and sophisticated trading systems that boosted volumes, it has made what some fear a permanent dent in the image NSE so consciously built over years.
 
It took Sebi nearly a year to refer the allegations of a Singapore-based whistleblower to a professional team. The whistleblower first wrote to Sebi in January 2015. The letter, which alleged manipulation through preferential access gained by some brokers in 2011-2014 in collusion with co-location data centre staff, was initially forwarded to NSE which denied all allegations after referring the matter to its own technology committee.
 
When Money Life magazine wrote about this in June that year, the NSE management, then headed by Ramkrishna and advised by her deputy Anand Subramanian, decided to sue it for damages of Rs 100 crore. The move backfired as the Bombay High Court not only dismissed the plea but also slammed the exchange’s attitude towards public scrutiny.
 
The matter went to the parliamentary standing committee on finance and finance ministry.
 
In December 2015, Sebi assigned the task of comprehensive examination of complaints to a team headed by IIT Bombay professors and advised NSE to extend all cooperation to the team.
 
Three months later, this team said the exchange’s architecture “was prone to market abuse” and that “one of the members consistently logged in early and crowded out other members and gained materially,” essentially confirming what the whistleblower had alleged.
 
The expert team also added that the “company was not fully co-operative with the team in providing complete and / or timely responses,” NSE said in the DRHP. The Sebi-appointed team also found that NSE “was in violation of the internal policy by permitting entities that are not internet service provider to lay fibre optic cables at its colocation facility.”
 
No wrongdoing here
 
NSE management disputed this report. In letters in May and June 2016, the exchange argued that “trading members logging in early would not necessarily receive data ahead of other trading members or any material advantage”, and that it provided a level playing field to all trading members and consistent early login per-se would not amount to market abuse.
 
It contended that no limit had been placed on the number of IP connections available to any trading member and on this ground disputed the observation that one member was crowding out others. It also denied the findings about the violation of optical fibre policy and non-cooperation.
  
Some people close to the development say “manipulation” and “abuse” are strong words and do not accurately capture what happened. The exchange had chosen the particular technology to enable faster uptake by brokers. They argue that the total time lapse between the person who logged in first and the one who logged in last was just about 50 microseconds. Even this was addressed when the exchange moved to a new protocol in April 2014, months before the whistleblower complained.
 
Somewhere in May, the tide seemed to have turned against Ramkrishna and her lieutenants as several board members completed their tenures and new directors got inducted. Ashok Chawla took over as chairman and expressed his willingness to take the bourse to its IPO.
 
Meanwhile, in September, the regulator bypassed the management and wrote to the exchange’s board asking it to immediately initiate “an independent examination (including forensic examination by an external agency) of the concerns highlighted in the interim report, including the lack of processes and collusion, if any, and fix accountability for the breaches.”
 
Deloitte, which was appointed to do this forensic examination, submitted its report to Sebi on December 23. The report highlighted trends for certain periods where a few stock brokers appear to be the first to connect to specific servers more often than others. It also observed indications of potential preferential treatment to a few stock brokers.
 
It also found that one particular stock broker almost consistently connected first to the secondary server from December 10, 2012 to May 30, 2014. The whistleblower had named a Delhi-based broker as the one with connections with the data centre staff of the exchange.
 
 It also said this might not have been possible without the knowledge of certain employees. Though the report found various gaps, the lack of documented policies of data retention and certain differential behaviour made Deloitte state that “it is not in a position to comment on whether this would amount to collusion or connivance.”
 
The exchange disclosed in the DRHP that on December 19, it took the Deloitte report on record and decided to initiate a review of the Multicast TBT systems (this broadcasts data simultaneously to all users against the earlier system, which disseminated in the order of log in) including processes and procedures, job rotation, mandatory leave, and segregation of duties.
 
How will the controversy impact NSE? In an analysis of NSE’s IPO, R Balakrishnan, an independent analyst, wrote that it “may have had its share of controversies and corruption. At this point it is headless, with no CEO. However, the organisation seems to be robust enough to carry on business without a leader.”