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All You Need to Know About the NSE Colocation Scam

Editor, TRANSFIN.
May 28, 2021 6:42 AM 4 min read
Editorial

The Securities Appellate Tribunal (SAT) on Monday allowed the National Stock Exchange (NSE) to access ₹6,085cr ($822m) of its revenue, a sum which till then was locked in an escrow account as one of the punitive actions by SEBI as a consequence of the NSE colocation scam, which broke in 2015.

As per Moneylife, the publication which broke the scam in 2015:

The order is an embarrassing indictment of the market regulator, which has been conducting a meandering investigation and issued multiple orders over the past six years that are nothing more than a slap on the wrist of the Exchange.

But first things first.  

The NSE Colocation What?!

Between 2011 and 2014, a handful of brokers managed to secure preferential access to NSE’s trading servers. This gave them an undue advantage over other traders, enabling them to clock huge gains to the tune of ₹50,000cr ($6.87bn) in gross violation of the rules in place.

To understand how exactly we came here, let’s break things down and begin from the beginning...

 

What is a Colocation Facility?

This essentially allows brokers to place their servers in a stock exchange’s data centre provided they pay for the same. The NSE introduced a colocation facility in 2009 (incidentally, without securing SEBI’s approval).

Why would a broker want to pay to keep their server beside the bourse's data centre? Because this gives them quicker access to the price feed (buy/sell quotes) issued by the NSE. Quicker, that is, vis-a-vis a broker whose server is not located in the same colocation facility.

This advantage can be just a few milliseconds, but in the world of high-frequency trading, such an advantage could mean the difference between clocking crores in profits or missing the trade altogether.

Is providing premature access to critical market information to those who can afford it unfair? Yes. But this is not exactly illegal - stock exchanges around the world have such facilities.

 

What Was the Tick-By-Tick System?

Besides the colocation facility, the NSE also began offering tick-by-tick market data. A "tick" is essentially a packet of info regarding buy/sell orders, cancelled or modified orders, or trades that have taken place. This data was exhaustive and instructive - brokers who had timely access to it (and who could afford sophisticated IT systems to analyse it) could game the system to reap huge rewards.

Now, this data was distributed by something called Transmission Control Protocol/IP (TCP/IP). This is a tech architecture where data is disseminated one-by-one instead of en masse as a broadcast. The data was distributed sequentially in the order of which traders logged in first on the NSE server. Translation: Brokers whose computers suffered the least time lag and the least load could receive market data before others.

The combination of a colocation advantage and the tick-by-tick system gave some brokers a lucrative split-second advantage over the rest of the market. This, needless to say, was unfair and illegal.

FYI: The colocation scam benefited three brokers in particular - OPG Securities, GKN Securities and Way2Wealth Securities.

 

How and When Did the Scam Break?

In 2015, a whistleblower wrote to SEBI exposing this unfair access issue. They also alleged that there was a nexus between NSE officials, brokers and the company in charge of the tech apparatus, with a profit-sharing arrangement in place. Since then, the scam has been probed by a motley of institutions including SEBI, CBI, the IT Department and the Madras High Court.

Fun Fact: Ironically, the NSE was created because of a broker nexus scam at the Bombay Stock Exchange (remember Harshad Mehta and Scam 1992?). Regulators wanted to dilute the BSE's power, and ergo the NSE was born.

 

What Did SEBI Find?

The market regulator formed an expert committee to investigate these allegations in 2016. Three years later, this committee reported that (1) the TCP/IP infrastructure was indeed prone to misuse. And that (2) some brokers got preferential access in that they were able to log in to several servers through several IPs assigned to them. This enabled the same brokers to log in more than once, crowding out others by occupying multiple positions on these servers.

However, in a development in February 2021, SEBI said that there was no evidence "leading to the culpability of any specific employee of NSE [or] the collusion or connivance from the side of NSE with any specific trading member". Essentially, the regulator ruled out fraud and said officials were guilty of not exercising the requisite due diligence, but not of collusion to make illegal gains.

 

What Did SEBI Do?

  • A penalty of over ₹1,100cr ($151.2m) was imposed on the stock exchange.
  • The bourse's former MD and Vice-Chairman (Chitra Ramakrishna and Ravi Narain respectively) were each fined ₹25L ($34,362). Both were also ordered to disgorge 25% of their salaries and barred from the market for five years.
  • NSE was barred from introducing any new derivatives contracts for six months. 
  • The aforementioned three brokers were banned from the market for five years, fined and asked to disgorge their illegal gains and interest on the same.
  • Several people identified as having facilitated the brokers have also been penalised and/or banned. This includes former Finance Ministry official Ajay Shah.

 

What Have the Repercussions Been?

The multi-year investigation has derailed NSE’s ₹10,000cr ($1.37bn) IPO dreams (it filed its DRHP way back in 2016).

Some reforms have been implemented to ensure there’s no sequel to the colocation saga. The tick-by-tick system, for instance, was replaced by a multicast one, which gave all brokers simultaneous access to the price feed regardless of when they logged in.

However, the biggest consequence has been on the NSE’s image - the veil of impartiality has eroded. Regardless of the regulator exonerating the exchange from complicity, the shadow of collusion will continue to hang over the bourse for some time.

FIN.
 

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