While market regulator Securities and Exchange Board of India (SEBI) has shot off show-cause notices to 20 entities on the now infamous market manipulation in co-location servers of the National Stock Exchange (NSE), any fair investigation into the misuse of algo trading or co-location services ought to start in 2010.
The fact is the NSE quietly started tick-by-tick (TBT) high frequency or algo trading (HFT) and co-location services in January 2010. For such an important market development, SEBI normally puts out a discussion paper, consults its Technical Advisory Committee (TAC) and then issues guidelines after due consultation with various stakeholders.
(This page is now modified by the NSE)
However, in this case, no such steps were taken. Why? The managing director of the NSE at that time was Ravi Narain and the chairman of SEBI was CB Bhave.
While there is no record available in the public domain about the NSE starting TBT services, there is a mention in the NSE’s own annual report for FY09-10. It states, “In line with exchanges across the globe, the 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." (The NSE Annual Report 2009-10 page 23).
After the NSE launched its TBT in co-location, BSE protested. It sent a note emphasising the need for a fair regulatory framework. SEBI ignored this note. Why? BSE's top officials, who were then in charge of the Exchange, say that they were disappointed, but not surprised. “Anything that came from the NSE was approved or approved post-facto,” they say.
How did a bunch of officials from the stodgy, government-owned Industrial Development Bank of India (IDBI), come to acquire such enormous powers and a grip over the market regulator?
Unfortunately, such extensive powers of the NSE were not matched by its technological skills, in a business where technology is all-important.
According to the whistleblower, who exposed the malpractices and market manipulation in the NSE's co-location servers, “When the NSE started TBT in 2010, all independent software vendors (ISVs) wrote programs using the NSE's API (application program interface, which defines the protocol as per which information will flow from the exchange). Logically, all people should be on equal footing. The issues started since this was essentially a patchwork solution put together by the NSE, it had several internal inconsistencies. The system had to cater to a significant load, which it was not architected for.” SEBI remained unaware of this flaw, which was the source of market manipulation.
SEBI Buried Complaints
SEBI got a chance to find what was going in the NSE co-location servers in July 2011, when it received a complaint about undue advantage given to foreign institutional investors (FIIs) from the co-location facility. The complaint sought discontinuation of co-location because, saying, “FIIs had the unfair advantage of faster and better execution and timing the order compared to normal retail investors.”
Following this, on 1 July 2011, Pawandeep, manager from policy division of SEBI’s market regulation department, wrote to stock exchanges asking their comments.
SEBI asked BSE for its response. It is not clear whether SEBI asked the NSE and what the reply was. In any case, as is clear now, SEBI was acting in a manner that furthered the NSE’s interests.
In July 2011, BSE replied and complained about the NSE’s anti-competitive practices. The NSE’s flawed co-location facility continues as before. In November 2011, the Agenda item No16 in SEBI’s board meeting was “status paper on ongoing issues in secondary market.” It admits that no specific guidelines on algo trading or co-location have been prescribed. Sub-item No.7 was on “Development of Algorithmic Trading and its Supporting Infrastructure”.
There is no information on whether this was, indeed, discussed in the next three board meetings on 3rd January, 28th January and 24th March 2012. Finally, in March 2012, SEBI stirred itself and issued guidelines on algo trading.
At the time, SEBI had the knowledge that algo trading taking place on certain exchanges was irregular. 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.”
A fair investigation into the NSE’s algo scam would not be limited to allegations of recent unfair practices in the NSE’s co-location servers but should extend to 2010 and include why were there no proper clearances, who in the SEBI permitted it, and if the NSE did not have official permission to start algo trading, why did the market regulator fail to act on it for two years until it issued the guidelines in 2012? But this would involve SEBI taking a close, hard look at its own officials by themselves.
The misuse TBT services 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-location servers at the NSE. The NSE had filed a Rs100 crore defamation suit against us with prayers to remove the articles and stop Moneylife
from writing further on the issue. A single Judge in Bombay High Court dismissed this frivolous suit, ordering the NSE to pay to a fine of Rs50 lakh mainly to two Mumbai hospitals.