Author: Annshika Bakshi, a student at Indian Institute of Management (IIM-Rohtak)

The National Stock Exchange (NSE) stands as one of India’s prominent stock exchanges, established in response to a significant scandal within the Bombay Stock Exchange (BSE). The regulators perceived a potent broker nexus within the BSE and established the NSE to dilute their influence and broaden investor choices.

Ironically, the NSE, meant to offer a remedy, has become embroiled in a substantial scandal. The Securities and Exchange Bureau of India (SEBI), responsible for overseeing Indian stock markets, has found the National Stock Exchange culpable in a co-location fraud. This involves potential market manipulation orchestrated by brokers and technology firms.

In layman’s language, co-location refers to a space where traders gain access to stock prices slightly ahead of the majority, thanks to a highly computerized system. Many algorithmic traders rent these spaces to engage in market trading. These spaces are located right next to the servers of the stock exchange, allowing traders to minimize the time delay in receiving market information. By being physically closer to the stock exchange servers, traders gain an advantage in reducing latency. Brokers and investors predominantly utilize these co-location areas for proprietary trading. Moreover, brokers invested extra funds in installing dark fibre lines, which transmit data faster than standard lines. Dark fibre lines are dedicated lines that, due to the absence of competing traffic, increase the speed of data transmission by a fraction of a second.

While it might appear insignificant, the situation holds considerable significance. This is due to the fact that numerous brokers employed algorithmic trading software, eliminating the need for manual trade placements. Even though they received information just fractions of seconds ahead of others, they effectively utilized technology to swiftly execute advantageous trades based on this information advantage. Through the combination of co-location and algorithmic trading, brokers were reaping profits amounting to millions of rupees daily. Some critics argue that the concept of co-location might not be legally permissible in India. However, such legality is not explicitly clear as the law can be subject to multiple interpretations.

In any scam, there are usually undisclosed figures involved, and the NSE co-location scam is no exception. In this instance, Ravi Narain and Chitra Ramakrishna, who were the CEOs of NSE at that time, were prominent figures implicated in the fraudulent activity. Due to their proximity to the exchange server area, these traders gained early access to stock information, buy/sell orders, and other crucial details. Brokerages operate nationwide, particularly in metropolitan cities like Mumbai, Delhi, Kolkata, Bangalore, and others. Each brokerage serves its clients, who access the market at various times to place their orders. While early price information might not significantly impact retail investors, it substantially benefits large-scale traders who invest substantial amounts in the market.

Tick-By-Tick, commonly referred to as TBT, represents a type of data feed where information is not uniformly disseminated to all parties. Consequently, due to the co-location facility, significant algorithmic and high-frequency traders gained access to information ahead of the broader market. In TBT, data distribution occurs based on individual logins to the system, whereas in a broadcast format, data is uniformly distributed to all recipients.

Omnesys, responsible for NSE’s technology, had the National Stock Exchange as an investor until 2013. Delhi’s OPG Securities displayed astuteness by recruiting a former Omnesys employee to gain deeper insights into the exchange’s system. Additionally, the firm sought assistance from Chitra Ramakrishna, who appointed Subramanian.

The scam surfaced when a whistleblower reported co-location issues to SEBI authorities in 2015. OPG Securities identified a TCP/IP protocol loophole within the TBT system’s data distribution method, enabling them to access information before others, with assistance from certain NSE officials. This unveiled the fraudulent activities occurring behind the scenes. When Moneylife exposed the scam, NSE’s management strongly reacted, taking stringent actions against media authorities and initiating a defamation case of 100 crore against Moneylife. The situation escalated as the matter proceeded to the High Court. Nevertheless, the Bombay High Court concluded the case by dismissing it, thereby rejecting all allegations made by the NSE. Furthermore, as a consequence of their perceived high-handed response to Moneylife’s media report, the NSE was required to pay a penalty fee of approximately 50 lakhs.

When the common people got to know about the scam, SEBI, the nation’s top security regulatory body, conducted an extensive investigation in collaboration with the Technical Advisory Committee. The investigation ultimately disclosed evidence suggesting improper assistance from within the NSE. The revelation indicated that it was highly improbable for any broker to gain access to confidential secondary server data of such a prestigious exchange for two years, spanning from 10th December 2012 to 30th May 2014, without internal authorization.

After this scam came into the light, SEBI, in 2016 directed the NSE to perform comprehensive legal investigations through a forensic audit. This audit aimed to scrutinize all transactions and deposits originating from the NSE’s co-location facility area. Deloitte was entrusted with the responsibility of conducting the forensic audits across the exchange’s system.

SEBI took action against the scam by directing OPG Securities in 2019 to reimburse the illicit profits gained during that period. According to reports, the profits amounted to 25 crores, and SEBI imposed an additional 12% penalty on the earnings from 7th April 2014 onwards. Upon revelation, Narain and Ramakrishna had to relinquish 25% of their earned salaries during the specified period.

In 2020, SEBI issued an order in the NSE co-location case, concerning allegations of unjust access to the NSE’s trading systems by specific traders known as “co-location” clients. SEBI’s investigation concluded that the NSE’s systems and procedures were unjust, lacked transparency, and were discriminatory. This was found to be in violation of the provisions outlined in the SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, and the SEBI (PFUTP) Regulations, 2003.

SEBI, in its ruling, imposed a substantial fine of Rs. 625 crores on the NSE due to its failure in ensuring equitable access to its trading systems. Additionally, the regulatory body prohibited the exchange from introducing any new products or services for a duration of six months. SEBI mandated the NSE to conduct a forensic audit of its systems and processes. Furthermore, the NSE was instructed to implement adequate systems and procedures to guarantee fair access to its trading systems. Moreover, SEBI imposed a fine of Rs. 1 crore on the former Managing Director and Chief Executive Officer of NSE, Chitra Ramkrishna. Additionally, three former executive directors of the exchange—Ravi Narain, R. Srinivasan, and C. B. Bhave—were individually fined Rs. 25 lakhs each. This penalty was a consequence of their failure in ensuring equitable access to the trading systems.

SEBI’s decision to delay the National Stock Exchange’s initial public offering by a minimum of six months deals a significant blow to the exchange. The NSE was on a promising path to raise over 10,000 crores by offering shares to the public. The timing was particularly advantageous, considering the markets were at their peak valuation, potentially allowing the stock exchange to secure a substantial premium. However, owing to the scandal, achieving this now appears doubtful.

The current scenario, coupled with global trends of central banks increasing interest rates, may impact the NSE’s prospects. The delay could diminish the exchange’s ability to attain as high a valuation as initially anticipated, altering the potential financial outcome.

SEBI’s ruling also included penalties, with SUN Trading facing a fine of Rs. 5 crores. Additionally, three individuals—Rajendra Gupta, Ashok Kumar Jain, and R. Venkattesh—were individually fined Rs. 25 Lakhs each for their involvement in obtaining unjust access to NSE systems. Furthermore, SEBI’s directive mandated the NSE to disgorge an amount of Rs. 62.50 crores, which represented the net profit earned by the exchange as a result of the mentioned violation. This disgorgement sum was required to be deposited with SEBI within 45 days from the order’s date.

The SAT overturned the decision, highlighting that the WTM (Whole Time Member) had cleared NSE of the accusation of breaching SEBI regulations. Justices Tarun Agarwala (Presiding Officer) and MT Joshi (Judicial Member) of the bench issued this ruling on January 23:

“In the instant case, the lack of due diligence is not on account of any violation of any provisions of the Act or the Regulations or circulars but is on account of human failure to comply with the circulars completely in letter and spirit…

…WTM has exonerated NSE of the charge of violation of the PFTUP Regulations holding that no fraud was committed by NSE or its employees. We, therefore, find that the activity of NSE was not in contravention of any provisions of the SEBI Act or the Regulations or circulars made therein and it is only a case of non-adherence of a circular to some extent.”

The Appellate Tribunal, however, directed the NSE to deposit a sum amounting to ₹100 crores in the IPEF as a deterrent and as a penalty for lack of due diligence which resulted in -“a lapse which is not expected from a first-level regulator”.

Interestingly, there’s a lack of definitive data regarding the profits amassed by traders exploiting the preferential access to the co-location facility. Estimates of the scam’s magnitude vary widely, with some reports citing it at around 50,000 crores, while others claim it to be a 75,000 crores scandal. According to the whistleblower’s report, confidential data was allegedly sent abroad, including to Singapore. Despite the passage of several years since the scam’s discovery, officials have yet to disclose precise figures regarding the involvement of both domestic and foreign entities who misused NSE employee assistance. While SEBI imposed fines in crores and lakhs on prominent management figures implicated in the scandal, many have criticized this action as insufficient compared to the substantial unfair profits realized in reality. This discrepancy has sparked criticism regarding the adequacy of the measures taken against those involved in the scandal.

Following the scandal, there has been a shift towards using the MTBT data feed. The security loophole exploited by manipulators was rectified in April 2014, when the exchange transitioned to Multicast TBT as its order execution protocol at the co-location facility. Subsequently, the problem has been eradicated. Unlike TBT, MTBT doesn’t operate on a “first come, first serve” data distribution model. Instead, MTBT ensures an equitable distribution of share data, regardless of when a user logs in. This change reduces the likelihood of a similar scam emerging in the future, as the system is designed to provide fair and equal access to share data for all users.

Whenever a scam happens, people lose trust in the market. SEBI tried its best to address these challenges by implementing stringent regulations aimed at restoring trust and effectively regulating both the system and exchanges. However, considering the overall situation, there are lingering concerns regarding the management and security practices at the country’s most prominent stock exchange. Over the past four years, SEBI has been actively addressing these shortcomings by implementing various regulatory changes. The outcome remains uncertain, as it remains to be seen whether the order will be contested in the Supreme Court or if the issue will be resolved with SEBI’s lessons learned.



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