Market regulator Securities and Exchange Board of India (SEBI) has issued show cause notices to 14 senior officials, from National Stock Exchange (NSE) in the algorithm (algo) or high frequency trading (HFT) case. Those who have been issued notices include, NSE's former Managing Director & chief executive (CEO) and present Vice Chairman Ravi Narain, former MD & CEO Chitra Ramakrishna, Ravi Varanasi, present chief of business development, Suprabhat Lala, present chief of regulation, Ravi Apte and Umesh Jain, both former chief technology officer and Subramanian Anand, former chief operating officer at the Exchange.
Media reports say SEBI had sent notices to some officials in the technology and business divisions of NSE to get their reactions on the co-location (Colo) misuse allegations. "Till March 2013, Ravi Narain, one of the founder-members, was the CEO of the exchange. Narain, who stepped down a year before his term ended, continued to be a director on the NSE board. He was succeeded by Chitra Ramkrishna during whose term NSE switched over to a technology that was far less prone to manipulation. She resigned abruptly as CEO in December 2016, almost 15 months before the end of her term," says a report from the Economic Times.
But here are a few facts that need revisiting now that SEBI has issued notices and it is learn that the Finance Ministry is also pushing for a detailed investigation.
NSE was quietly allowed to start algo trading in January 2010, without following the usual procedure of putting out a discussion paper and issuing guidelines. A protest from the BSE was also dismissed. Any investigation into the misuse of algo ought to go back to how and when it was started, why were there no proper clearances, who in the SEBI permitted it - and if there was no official permission, why did the market regulator fail to act on it for two year until 2012 when it woke up. Before that in November 2011, SEBI in its status paper on secondary market issues had admitted that no specific guidelines on algo trading and co-location were prescribed.
Algo trading is subject to SEBI regulations issued in March 2012 and May 2013. These regulations include a list of minimum order level checks to be performed on algorithmic orders, a consolidated audit trail and framework for penalising cases of high order-to-trade ratios. However, NSE started algo or HFT in 2010 itself. While there is no record available in public domain about NSE starting HFT, there is a mention in the Exchange's own annual report for FY2009-10 about this. It states, "In line with exchanges across the globe, NSE has provided its members a colocation facility for their DMA and ALGO Trading. The co-location setup is a state of the art, highly robust, resilient and secure infrastructure." (NSE Annual Report 2009-10 page 23)
Moneylife had raised these issues in its response to the defamation case filed against us by the NSE. We had said:
“We discovered from our sources, that SEBI had received a specific complaint from a market participant highlighting concerns with regard to co-location facility. The complaint sought discontinuation of co-location because, it said, “FIIs had the unfair advantage of faster and better execution and timing the order as compared to normal retail investors. Following this, on 1st July 2011, Pawandeep, Manager from the Policy Division of SEBI’s market regulation department wrote to stock exchanges asking their comments.
In November 2011, Agenda item No 16 at SEBI’s board meeting mentions “status paper on ongoing issues in secondary market”. Sub-item No.7 was on “Development of Algorithmic Trading and its Supporting Infrastructure”. There was no information on whether this was indeed discussed in the next three board meetings (3rd January, 28th January, 24th March 2012) before the guidelines were issued on 30th March 2012.
SEBI’s website has never put out a paper for public comments and the report of the Technical Advisory Committee on the guidelines and framework for Algo trading is also not available in the public domain. We have asked the regulator for the same, but have received no response.
We discovered that the first set of guidelines were issued only in March 2012, while NSE had started offering HFT or Algo trading in January 2010.
This again corroborated the whistleblower’s contention of a ‘patchwork solution’. Given this background, it is strange for the NSE to argue that a set of guidelines ensure that it runs a flawless system.”
NSE however claimed in court documents that SEBI had permitted algo trading as far back as April 2008. In fact, SEBI set up a Technical Advisory Committee (TAC) to advice it on technical matters only in April 2010 and a Secondary Market Advisory Committee was formed in July 2009. It further claims that the Reserve Bank of India was also aware that SEBI had cleared algo trading in 2008 and that the BOTH national exchanges were offering colocation facilities since 2010 as is apparently evidenced by the RBI's Financial Stability Report of 2010. All this only suggests that the investigation should probably go back to how and why SEBI permitted algo trading to be started without following its own practice of preparing a discussion paper, seeking public comment and framing rules before permitting HFT which allows a class of big investors with deep pockets to get a distinct advantage in terms of orders and price.
SEBI also had the knowledge that algo trading was taking place on certain exchanges. In its 30 March 2012 circular, SEBI had said, "For stock brokers that are currently executing orders through algos, a period of three months is provided to the stock exchanges within which the approval process shall be completed and minimum risk controls shall be established, if not already done."
The misuse of Colo or algo trading came to light when on 19 June 2015, Moneylife published
a whistleblower's letter on manipulation and collusion with select players in algo trading and use of co-located (Colo) servers at NSE. Moneylife had duly contacted NSE for its response before writing the article. On that occasion too, the NSE had refused to respond despite three attempts by Moneylife to elicit its views. After Moneylife published the articles on HFT, NSE filed a Rs100 crore defamation suit against Moneylife with prayers to remove the articles and stop Moneylife from writing further on the issue. A single Judge in Bombay High Court dismissed this. The judge also asked NSE to pay to Ms Dalal, Debashis Basu, Editor & Publisher of Moneylife Rs1.5 lakh each as cost and Rs47 lakh to two trusts, Tata Memorial Hospital and the Masina Hospital for free treatment of the poor. The Exchange has filed an appeal against that order.
Last year, in a written reply in the Lok Sabha
, Arjun Meghwal, the Minister of State for Finance, says, "The architecture of NSE with respect to dissemination of tick-by-tick through transmission control protocol (TCP) or internet protocol (IP) was prone to manipulation or market abuse. And this system has been discontinued by NSE from 3 December 2016".
"Preferential access was given to stock broker(s), wherein it was possible for stock broker to log into multiple dissemination servers through multiple internet protocols assigned to him. It was also possible for a single member to have multiple logins to a single dissemination serve through multiple IPs assigned to it. It was observed that stock broker(s) had multiple advantages by logging in first or even second and third," the Minister said quoting the SEBI report.
Even NSE, quoting an independent agency, in its draft red herring prospectus (DRHP) filing had admitted misuse of its HFT and Colo by certain brokers. The DRHP filing stated, "The Independent Agency's analysis indicated that one particular stockbroker almost consistently connected first to the fall back or secondary server during the period from 10 December 2012 to 30 May 2014 and was very often also the second stock broker to connect during this period. The Independent Agency observed that the particular stock broker's continuous access to the fall back or secondary server during the period from 10 December 2012 to 30 May 2014 may not have been possible without the knowledge of certain employees identified in the report, who did not take any action despite consistent connections to the fall back servers against protocol..."
According to a report from Economic Times, it is perceived that once the shadow of Colo scandal is behind, NSE can also pursue its listing plan, which has been hanging fire for months. "The show-cause notices from SEBI followed scrutiny - including a forensic review by Deloitte Touche Tohmatsu - of co-location facility that NSE provides to member brokers. While the report does not point out culpability of senior exchange officials, it makes a mention of an oral statement by a former midlevel officer who told the Deloitte's forensic team that 'oral instructions for server allocations and other changes' were often received from 'seniors'.
"While a show-cause to an individual relates to the culpability of the official in question, a show-cause to a regulated organisation like an exchange requires a response from the board of directors and exposes the organisation to possible penal action. The NSE management and the officials in question are taking legal advice to prepare their response for the market regulator," the newspaper report says.