The story that began on 19 June 2015, when Moneylife published a whistleblower’s letter on manipulation and collusion with select players in algorithm (algo) trading and use of co-located (Colo) servers at the National Stock Exchange (NSE), seems headed to a conclusion.
On 9th September, the Securities and Exchange Board of India (SEBI) wrote to NSE’s new chairman, Ashok Chawla, asking the NSE to “immediately initiate an independent examination (including forensic investigation by an external agency) of all the concerns highlighted by the SEBI expert committee in its report alleging lack of process that allowed this to happen and collusion if any and fix accountability for the aforesaid breaches covering NSE and stock brokers, vendors and outsourced entities involved in the issue.”
Apart from a forensic investigation, the most significant punitive aspect of SEBI’s directive is that all revenue accruing from its co-location facilities, including from fibre connectivity between brokers’ co-location facilities and their offices, must be paid into an escrow account. The NSE has been asked to get all concerns expressed by the committee addressed, and take necessary action, within three months.
There are several interesting queries that arise out of the regulatory action finally going public. Remember, the NSE had filed a Rs100-crore defamation suit against Moneylife and this writer for publishing the whistleblower’s letter. Its attempt to gag Moneylife was dismissed by the order of Justice Gautam Patel of the Bombay High Court which also imposed costs of Rs50 lakh on the Exchange. The NSE had appealed the order and a division bench issued a stay on the payment of costs; the matter is in a limbo ever since.
Almost immediately after the stay, the report of SEBI’s technical advisory committee became available to the media and it confirmed all the whistleblower’s allegations. But the NSE, which had always denied wrongdoing, continued to aggressively defend itself and, according to one media report, had even rubbished and challenged the findings of SEBI’s expert committee.
Some former regulators wonder at the absence of a formal show-cause notice to the NSE in such a serious matter. They are also intrigued by the fact that the NSE has been asked to investigate its own actions and act on the possible collusion of its officials with those who obtained unfair access to the system. How feasible is that, in a closed, secretive, unlisted entity? However, my sources, directly connected to the action, are emphatic that SEBI has already concluded that there was wrongdoing and the NSE has only to ‘identify the persons responsible and act’. Even this action was possible after overcoming stiff and powerful resistance, we are told.
While SEBI has asked the NSE to deposit the revenue accruing from co-location into an escrow account, market sources are unclear how this would be calculated. SEBI has not disclosed its action through a clear press release. An exchange, typically, earns over 60% of its revenue from listing fees and transaction charges. In the NSE’s case, its income is now in the region of Rs2,000 crore. However, co-location fees are unlikely to be over Rs20 crore. On the other hand, if SEBI asks for transaction charges accruing from co-located servers to be included, then the amount going into the escrow account will be nearly Rs1,000 crore.
This is bound to have an impact on its Rs45,000 crore valuation and affect the interest of existing shareholders until the investigation is completed. My sources insist that co-location fees and transaction charges will have to be deposited into an escrow account. Since the NSE is working on an initial public offering (IPO) and has already appointed four investment bankers, there will either be a pressure to complete the investigation and clean-up before the issue, or it would mean a delay in the listing. Interestingly, three of the four lead managers—Citibank, Kotak Bank and Morgan Stanley, have a stake in the NSE and, hence, a direct interest in the valuation and pricing of the IPO.
It may be recalled that SEBI’s technical advisory committee (TAC) had appointed a committee comprising experts from IIT Mumbai to investigate three letters from a whistleblower, of which the last was sent to the regulator by me, while the first two letters were addressed to SEBI and copied to me.
In April 2016, a Bloomberg report said that the NSE planned to challenge SEBI’s findings and insisted that there was no wrongdoing at all. The report also quoted anonymous sources connected with the NSE on its stand that the committee had, “simply repeated allegations made by an unidentified whistle-blower without doing a thorough investigation.” This time, however, the NSE has not reacted to SEBI’s directive.
Media reports quote the NSE chairman Mr Chawla as merely confirming the receipt of the letter with no mention of whether the bourse planned to challenge the order before the appellate tribunal. An email from Moneylife to the NSE on its reaction was not answered at the time of writing this column.
While a forensic investigation into wrongdoing, and possible collusion at the NSE, is a good first step, the bigger issues is: What happens to the beneficiaries of NSE’s faulty system that could be manipulated to provide preferential access to certain brokers, or worse, those who obtained a ‘dark fibre’ link to give themselves faster access and bigger profits?
It may be recalled that the first whistleblower’s letter specifically mentioned OPG Securities as a beneficiary. This was confirmed by the SEBI-appointed expert committee. The third letter from the whistleblower of 3 October 2015, signed by Ken Fong, made a more alarming charge. It said that AlphaGrep, a Singapore-based HFT (high frequency trading) trader (connected to Ways2Wealth, which is, in turn, a part of the Café Coffee Day group) had access to a ‘near dark fibre’ link through a company called Sampark Infotainment which allowed it faster access and a big increase in market share.
But, he alleged, since Sampark Infotainment did not qualify to be an ISP, there was a ‘post facto’ attempt to legitimise an illegal activity by “brokering an agreement between Sampark and Reliance Infocomm.” All the players mentioned above have issued denials to the media. However, SEBI’s technical advisory had said, “With regard to the issue of dark fibre, the committee was of the view that, in violation of its own policy on allowing only ISPs, NSE allowed non-ISPs like Sampark (Infotainment), to lay fibre in its premises for various members.”
Will there be a separate investigation into these beneficiary entities? Or will it be part of the NSE’s inquiry in the next three months? Nobody knows. Strangely enough, the regulator has not bothered to make a full disclosure of its action, even though the NSE has a near-monopoly over trading in India and is among the top five exchanges in the world. Surely, investors have a right to understand what the bourse on which they trade, which is also a first-line regulator, has been pulled up for.
The fact that SEBI’s action against the NSE has repeatedly taken the form of media leaks also indicates that the market regulator, which mandates, regulates and supervises disclosure and transparency by listed companies and market intermediaries, is rather fuzzy about the logic and need for disclosure.
Someone needs to tell the regulator that transparent action and full disclosure, no matter how powerful the parties involved, is essential for building investor confidence in regulation and supervision. Selected leaks only lead to needless speculation and mis-reporting. This pussyfooting over action and investigation also confuses SEBI employees, who are already agitated at being made the scapegoat of decisions taken by the top brass.
However, asking NSE to "arrange" a forensic audit is like asking a thief to investigate himself.
However, asking NSE to "arrange" a forensic audit is like asking a thief to investigate himself.