Finance Ministry nudges regulators in Mumbai to probe NSE’s HFT scam
After five months of silence, multiple agencies have woken up to the possible dangers of large-scale market manipulation by large institutional traders who run high-frequency trading (HFT) programmes in India.
A whistleblower’s letter to the Securities and Exchange Board of India (SEBI) detailed how certain institutions registered for HFT, also known as algorithmic trading or algo trading (based on formulas that execute rapid and large volume trades), were allowed to profit illegally by the NSE’s (National Stock Exchange) insiders. The letter, written in January 2015, was addressed to SEBI’s deputy general manager BK Gupta; it was copied to me and sent by snail mail from Singapore.
For several months, I shared the letter with key market-players and investigators to find out more; but the NSE operates like a fortress and outsiders had no details. Nobody we spoke to was surprised to know that the system was manipulated and each one speculated about the likely beneficiaries; but no proof was forthcoming. The reason for this is best explained on the jacket of Michael Lewis’s book Flash Boys. It says: “Now, the world’s money is traded by computer code, inside black boxes in heavily guarded buildings. Even the experts entrusted with your money don’t know what is happening and those who do aren’t about to tell—because they are making a killing.”
It is a market where every microsecond that you gain in executing high-speed trading orders is worth several hundred crore rupees in profits. Large investment institutions pump money into expensive technology and servers get co-location advantage by installing them inside the Exchange’s premises. The whistleblower’s letter explains in detail how the NSE’s insiders allowed some chosen traders to benefit through faster connectivity, day after day. These high-frequency trades contributed to the huge froth of trading volumes on the Exchange. Since top management salaries at the NSE are linked to the turnover and profit generated by the Exchange, there may have been a reluctance to upset the applecart. The NSE is unique in having had the same senior management for the entire 20+ years of its existence.
We expected the whistleblower’s letter to trigger, at least, an investigation. After four months of silence, I sent a copy of the letter to the SEBI chairman as well as NSE’s chairman, Ravi Narain, and managing director, Chitra Ramakrishnan, seeking their comments. No response. After another text message to the NSE’s top brass, we published the letter on 19th June on our website. The letter can be accessed on http://tinyurl.com/pl46qfw
Action started only after that. We now have information from credible sources that the finance ministry has desired that, apart from SEBI, the Reserve Bank of India (RBI) also take a detailed look at the implications of continuing HFT without adequate safeguards. Government sources also tell us that “NSE’s management of HFT servers in the initial years until 2013 (which are the subject of the whistleblower’s letter) may need a detailed review by SEBI or an investigation agency.”
Soon, SEBI and RBI dutifully responded to the finance ministry’s direction. The Financial Stability Report (FSR) released in June suddenly identified algo trading as an area of concern. It said, “The increased complexities of algorithm coding and reduction in latency due to faster communication platforms needs focused monitoring, as they might pose risks in the form of increased possibilities of error trades and market manipulations.” It goes into some detail about the rise in algo trading in the cash market and speculates that certain instances of abnormal movement in Indians stocks are attributed to algo trades.
Immediately thereafter, the Business Standard and other papers reported that SEBI was considering steps to slow down the pace of trading through measures such as a minimum resting time for orders before execution and randomising the time priority of orders that an Exchange receives. This will effectively reduce the co-location advantage enjoyed by large trading firms.
The critical issue here is not whether some band-aid is applied by SEBI. It is whether our regulators have the will, and the expertise, to assess the systemic risks and even catch the manipulation, if it involves insiders. Until now, they have shown neither. HFT is, often, blamed for precipitous sell-offs in global markets. We need a clear assessment of the risks that India is exposed to. Then, there is the issue corruption. Clearly, people at the NSE and SEBI who permitted the manipulation of algo trades and attempted to bury the scandal cannot be in charge of this investigation. It has to be done by an independent agency.