The primary tenet of any well-functioning capital market is that exchanges provide fair, transparent, equitable and non-discriminatory access to all market participants. The largest stock exchange in India, National Stock Exchange of India, has been found violating this primary tenet.
On April 30th, SEBI passed five related orders that held the NSE, two of its former managing directors, a few employees, a few trading members and other market intermediaries guilty on various counts. SEBI has relied largely on violations of Prohibition of Fraudulent and Unfair Trade Practices (PFUTP) regulations to arrive at the conclusions in these orders.
The orders cover two important technical aspects. The first was preferential access of market data provided to a few brokers. Front running of orders leveraging technology was the essence of how one broker, OPG Securities, exploited this. It was found out that the NSE tick-by-tick (TBT) architecture was prone to market abuse where OPG Securities could login early, get early access to stock prices and undertake quicker order dissemination, thereby getting prices ahead of others in the market and taking advantage of the early market access. SEBI concluded that the NSE had not exercised the requisite due diligence while putting in place the TBT architecture. It was concluded that OPG indulged in front-running in collaboration with NSE employees.
The second technical aspect was the preferential treatment granted to certain stockbrokers, Way2Wealth and GKN Securities, by the NSE in accessing its co-location facility to install point-to-point (P2P) connectivity while refusing the request of other brokers. The NSE had used an unauthorised telecom service provider, Sampark, at the NSE co-location server facility in a manner that Sampark allowed the two brokers to gain undue advantage in terms of low latency and high bandwidth in data transmission as compared to other brokers.
SEBI has also held two past managing directors Ravi Narain and Chitra Ramkrishna guilty of dereliction of duty. SEBI has ruled that they cannot abdicate their responsibility by citing limited knowledge in certain spheres of the business activities and cannot limit their roles to the non-technology issues of the exchange. As CEOs they were responsible for even the technology issues of the exchange and found to be derelict of their duties.
In one of the orders SEBI also found that Ajay Shah, his wife Susan Thomas and sister-in-law Sunita Thomas misused market data obtained from the NSE for commercial gains. Additionally, SEBI also pointed to inherent conflicts of interest of Ajay Shah that the NSE ignored.
All the above issues were first brought to light by a whistle-blower in 2015. It is indeed surprising that the initial reaction of the NSE to the whistle-blower complaint was to be dismissive of the complaint and fight back at the complainant. This showed hubris on the part of senior management of the exchange. It also shows that there weren’t any risk management and control systems within the NSE to unearth technical issues of these nature.
Probably for the first time in Indian capital markets, a case of technology being used for unlawful gains has been unearthed. SEBI has taken over four years to arrive at these conclusions. Multiple committees and investigations on the various aspects were undertaken by Deloitte, E&Y, the Technical Advisory Committee with IIT Mumbai and ISB that were engaged either by the NSE or by SEBI.
SEBI has rightfully come hard on the exchange and its former managing directors. Apart from the monetary disgorgement, NSE is also prohibited from accessing the securities market directly or indirectly for six months which will further delay NSE’s IPO. The NSE also cannot introduce any new derivative product for six months. Though the absolute amount of the monetary disgorgement seems high, given the graveness of the matter, the loss of reputation for the NSE is enormous. The NSE would be well advised to disgorge the amount and continue to work towards maintaining its leadership position amongst Indian stock exchanges. Else, any loss of trust of investors in the NSE’s technical robustness could destroy the stock exchange.
SEBI has also directed the NSE to audit its systems at frequent intervals. Stock exchanges are technology powerhouses and the key executives of any stock exchange cannot feign ignorance of technical aspects. It will not be the last time that market participants exploit loopholes in technical infrastructure for monetary gains. However, senior managers must be serious about any complaints and ensure that there is thorough investigation.
In any other developed country, this issue would have attracted class action suits against the exchange. One can only guess the quantum of wealth lost by investors who traded in the same period when the above market abuses were occurring. SEBI has loudly sent out a message that the integrity of capital markets is sacrosanct for the development of the Indian economy and that cannot be compromised.
Views are personal.
The author is founder and managing director, InGovern Research Services.