In June 2015, Moneylife published the first letter from an anonymous whistleblower on manipulation at the National Stock Exchange (NSE). The letter, and two subsequent ones, triggered a chain of events: a Rs100-crore defamation suit against us by the NSE; a detailed investigation by the market regulator’s technical advisory committee (TAC) which confirmed the whistleblower’s charges; regulatory action to impound part of NSE’s revenues and investigation to fix responsibility; sweeping changes in NSE’s top management and, finally, NSE’s admission of wrongdoing in its draft red herring prospectus.
On 14 February 2017, the whistleblower sent a detailed fourth letter addressed to Securities and Exchange Board of India (SEBI); a copy was mailed to me. The closely typed, 13-page letter, with technical details and names, identifies loopholes in NSE’s systems architecture that remain unplugged even after the wide-ranging SEBI investigation. More worryingly, it shows how a few large traders, with high-frequency trades (HFTs), are ripping off huge profits by exploiting currency derivatives (especially contracts for the USD-INR pair) and commodity markets which the whistleblower says continue to operate in a ‘regulatory vacuum’.
With a new chairman at SEBI, a new managing director at the NSE, and the government fully apprised about issues of manipulation in NSE, we will wait to see if there is any action on this report. Meanwhile, here are the key issues raised this time by the whistleblower.
Currency Trading Manipulation
A big new disclosure is about the manipulation of currency derivatives which are also regulated by the Reserve Bank of India (RBI). He says, “for most contracts traded in India, the price discovery tends to be in India, during Indian working hours, except for currency pairs such as USD-INR. In case of currency pairs, especially in emerging market currencies, the price discovery happens in global financial capitals such as London, Singapore and Hong Kong. The USD-INR pair is traded on the Reuters trading platform. The interbank spot fx market is by far the largest platform where spot currency is traded. Since its sheer size is much larger than the futures market, the spot market is often the place where price discovery occurs. Banks also price NDF (non-deliverable forwards) on any currency including USD-INR using the spot price as the starting point for generating their quotes.”
The whistleblower alleges that a couple of global HFT firms (a specific global firm with Indian operations is named along with a previously named firm which is being investigated) access price/data feeds which are prohibited for non-bank participants for Indian trades. This gives them a huge two-second information advantage, allowing them to operate on miniscule price changes, that are exploited through large trading volumes which are, sometimes, as high as 30%-40% of the entire USD-INR futures volume, on any given day. The letter informs regulators about how his allegation can be verified by checking the open positions of that firm and low inventories.
He says, one foreign firm alone has made profits of anywhere between Rs200 million to Rs300 million (2013-14) in the very first year that it began to use such prohibited data feeds in India. This global firm has faced allegations and investigation in overseas markets as well. The whistleblower wonders why surveillance systems of both, RBI and SEBI, are never able to capture what is being done by this global firm and another one which is already under investigation.
Old Problems at NSE Remain with Small Changes
Following the SEBI investigation, the average order response time at NSE’s co-location has gone down from the order of around two milliseconds to approximately 150x00 microseconds, depending on various factors. But, he says, the “advantage of speed is not only in absolute terms but always in relative terms.” So, he says, a select few traders still get to calculate real-time latency across multiple gateways and then route all orders via the fastest gateway. The whistleblower alleges that NSE continues to drag its feet about introducing basic transparency measures such as allowing PTP (point to point connectivity) at the co-location. He says, without PTP, it is almost impossible for SEBI to catch preferential access to a select few and it means that the “Exchange can pretty much do whatever it likes so long as it is not blatant enough to be observed.” The motive, according to him, is to support their profit objectives “without looking at the market-wide consequences.” Does this mean that, apart from individual collusion, there is an institutional issue as well? SEBI will need to investigate. The letter has a long and technical narrative on what can be done to fix the problem.
There are also issues of disclosure by exchanges and adherence to SEBI’s rules. For instance, he says, NSE does not publish “latency encountered at co-location,” despite a clear SEBI circular. While the BSE (Bombay Stock Exchange) publishes these numbers real-time, NSE publishes average latency across the quarter! “In an era of micro seconds, what usefulness is provided by publishing quarterly average latency to the market is beyond comprehension. It is unfortunately a reflection of the lip service to the spirit of compliance which exchanges do even to SEBI directives,” he says.
Market Abuse through Spoofing/Flashing Orders
The whistleblower details how a few firms are working around the rules that were framed to prevent order spoofing (creating the illusion of demand/price by placing a large number of orders and modifying or cancelling them rapidly to confuse other traders by whipping up a froth of artificial trading volumes). Without going into technical details in the letter, the whistleblower makes a pertinent point when he says, “It is strange that the exchanges are not able to notice this (manipulation through spoofing or cancelling orders) as a discernable pattern in their tick data and haul up firms which are trying to act in this manner. Either they simply do not care or they wish to permit the same and not raise red flags on purpose.”
He says that there is time-stamped data available for an auditor to “check which firms are engaged in this practice and then match their trade pattern in the scrips where they flash orders.” He accuses both the national exchanges of granting favourable access to some, or creating impediments for others, including grant of connectivity. One feels confident that SEBI’s TAC will want to investigate these revelations.
Commodity Exchanges and Regulation
According to the letter, the commodity exchanges have the least regulatory oversight and need urgent attention. He comes back to the ‘dark fibre’ issue (flagged off in his second letter), which seems to have been ignored in the corrective action so far. This issue concerns large telecom carriers which are the billing companies for providing connectivity to algo traders. Although NLD (national long distance) licence-holders are required to have complete ownership of the telecom equipment, in practice, actual networks are owned by unlicensed vendors and the carrier only acts as a billing agent. These vendors raise invoices in the name of ‘link optimisation’ for installing devices and dark fibre paths to ‘speed up’ links to the exchange. It should be easy for SEBI to verify which firms have been paying money to unlicensed vendors for services, says the whistleblower.
Interestingly, he says, telecom firms with NLD licences that are disallowed by NSE because they do not have certain equipment (and their vendors providing ‘speed links’) are operating on commodity exchanges and have a big market share. There are firms providing dark fibre links to commodity exchanges quite openly, for inter-exchange connectivity. Shockingly, he says, some firms provide different speeds of connectivity based on what they are paid. All this becomes a matter of serious concern as SEBI is set to permit options trading in the commodities exchanges.
I have shared the whistleblower’s letter with former SEBI chairman UK Sinha and several SEBI officials, top bureaucrats in the finance ministry, the RBI governor and some key officials at the NSE. NSE wrote to say that the “matter is under consideration” and it has been advised to “restrict any outside communication, in respect of matters disclosed in the DRHP (draft red herring prospectus),” hence, it is “unable to provide any response at this point of time.” We will watch how SEBI and the government deal with this information.