NSE Co-Location Scam by Sanjeedeep Mishra

 

NSE Co-Location Scam

Report by- Sanjeedeep Mishra

Introduction

The case dates back to 2015 when a whistleblower filed a complaint with the Securities and Exchange Board of India (Sebi) alleging irregularities concerning NSE's co-location facilities. According to the complaint, a few traders in alliance with some NSE officials breached the co-location guidelines. It was alleged that the stock exchange indulged in practices of granting preferential market access to select brokers that resulted in market manipulation and artificial information asymmetry. At that time, the NSE was using the tick-by-tick (TBT) server protocol to disseminate data to its members. This market architecture was prone to market violations, according to investigation findings by the Technical Advisory Committee (TAC) of Sebi and Deloitte India. A whistleblower wrote to the market regulator alleging that some brokers, engaged in algorithmic trading, could log into the NSE systems with hardware specifications allowing them split-second faster access to the data feed of the exchange. It also said that the NSE had allowed non-empanelled Internet Service Providers (ISP) to lay fibre cables on its premises for a select set of traders who were reaping huge amounts of profits. The NSE has been facing accusations and monetary implications for several years after the scam was exposed. The NSE co-location case is under investigation by the Sebi, Central Bureau of Investigation (CBI) and Income-tax Department (I-T dept). The authorities concerned are probing the involvement of NSE's former and current brokerages and executives.

Why was NSE formed ?

Till 1992, the Bombay Stock Exchange (BSE) set up in 1875 as The Native Share and Stock Brokers Association was the undisputed stock trading centre of the country. But the BSE was just what it had been originally named, a closed club of powerful brokers who between them controlled trading in the country. Despite being Asia’s oldest exchange, it had failed to grow the equity culture in the country. The other 18 regional exchanges in the country played a minor role with BSE accounting for 70 percent of all trading. Harshad Mehta, a registered and well-known broker, manipulated the Bombay Stock Exchange (BSE) along with his partners by taking advantage of loopholes in the banking system. Involving a fraud of around Rs 4,000 crore, the ‘Securities Scam’, as it came to be known, is still one of the biggest frauds perpetrated on the Indian stock market to date.

By the early 1990s, the limitations of the giant of Dalal Street were self-evident and the need for a modern exchange that would break its hegemony was acutely felt. Consequently, in 1992, the NSE was set up, based on the recommendations of the Pherwani Committee Report on New Financial Instruments which was chaired by the former head of the Unit Trust of India, Manohar J. Pherwani. A second national exchange was a revolutionary idea for the times. The now famous Nifty 50 Index came into being in 1995. As a fully automated dematerialized, electronic exchange giving simultaneous access to investors across the country it was path breaking and went on to unleash a new class of retail investors, keen on higher returns on their savings than they got from traditional instruments like the post office savings schemes and bank deposits.

Initially, to avoid conflict with the powerful BSE, the NSE was expected to restrict listing only to medium-sized companies and also focus largely on debentures and bonds rather than shares. Since these instruments were largely ignored by the BSE and the other regional exchanges, it was felt that the NSE would complement their working rather than emerge as a rival.

Chitra Ramakrishnan

Ramkrishna was appointed as Joint MD NSE in 2009 and remained in the position till March 31, 2013. She got elevated as MD and CEO on April 1, 2013. Her tenure at NSE ended in December 2016.

According to reports, many whistleblower emails were sent to the Securities and Exchange Board of India (SEBI) in 2015 and 2016 regarding alleged abuse of the exchange’s co-location facility to make gains by getting early access to the stock market under Ramakrishna. Allegations included preferential access granted to certain brokers by officials of NSE and undue gains made out of it, during the tenure of Ramkrishna. It further stated that during Subramanian’s tenure at NSE, CEO Chitra Ramkrishna would give undue favours to him including frequent increase in his remunerations, that too, without the approval of the HR Department.

After the SEBI received complaints on Subramanian’s elevation, it initiated a probe into it. “…..the investigation that in pursuance to the criminal conspiracy the compensation of petitioner was arbitrarily enhanced without any reasonable basis at frequent intervals by gross abuse of official position by co-accused Chitra Ramkrishna. The frequent enhancements to compensation of petitioner were illegally and arbitrarily approved by co-accused Chitra Ramkrishna without taking any inputs from the HR department,” the CBI said.

“During the period 2010-15 (i.e. when the co-accused Chitra Ramkrishna was managing the affairs of NSE), OPG Securities Pvt. Ltd. had connected to the secondary POP server on 670 trading days in the Futures & Options segment,” the document submitted before the high court read.

Ramakrishna and Subramanian resigned from the NSE in 2016 and the board let her resign without highlighting her “grave financial irregularities”. According to Republic sources, the NSE system was rigged by placing a computer close to the NSE server. This offered the brokers a 10:1 speed advantage over their competitors. The information was disbursed in a sequential manner. This meant that the broker who connected to the server had valuable information before his rivals.

The Yogi Connection

Ramakrishna in her statements before SEBI dated April 14, 2018, said that she met Siddha Purusha, ‘Yogi’, Paramhansa, 20 years ago on the banks of Ganges, and has been taking his guidance on personal and professional matters, since then. She also disclosed that she corresponded with Yogi via email, with his email id as 'rigyajursama@outlook.com.’ Notably, in most of the conversations between Ramakrishna and Yogi, Subramaniam was also marked in the email.

Regarding whether discussion with an outsider as the chief of NSE Ramakrishna said, “As an MD and CEO, before I am able to come to a perspective of my view only, the guidance is sought. It is only to enable me in my role to have a primary view.”

“As we know, senior leaders often seek informal counsel from coaches, mentors or other seniors in this industry which are all purely informal in nature. In a similar strain I felt that his guidance would help me perform my role better. Being spiritual in nature there would never be a question of any confidentiality or integrity issues being compromised for the organization,” she added.    

Meanwhile, according to media reports, an audit by Ernst and Young LLP (EY)--which was asked by SEBI and commissioned by NSE-- has claimed that it is none other than Anand Subramaniam.

 

Subramaniam’s Entry

In her statements, Ramakrishna said that apart from financial decisions, she also sought guidance regarding the appointments and promotions of some of the officials of NSE from the 'Yogi.' According to SEBI, Subramaniam was appointed as a chief strategic advisor in the NSE by Ramakrishna with several procedural lapses wherein she neither consulted the HR department regarding Subramaniam’s appointment nor conducted a discussion with NSE Board. Subramaniam’s appointment in NSE was solely Ramakrishna’s decision. His primary role in NSE was that of a consultant working four days a week. Subramaniam, who had previously worked at Balmer and Lawrie drawing a salary of Rs 15 lakh, had no prior knowledge of capital markets. However, in 2013, when he was hired by NSE, he was offered a salary of Rs 1.68 crore. Over the years, he went on to become powerful in the exchange, with his salary shooting up to Rs 4 crore in 2016.

What actions are taken against NSE, Ramakrishna, and Subramaniam so far?

SEBI has imposed a penalty of Rs 3 crore on Ramakrishnan. Narain, Subramaniam and Ramakrishna have been barred from participating in the markets for the next three years. NSE, Narain and Subramaniam have been imposed a penalty of Rs 2 crore each. NSE is barred from launching any new product for the next six months.

Heart of the problem

In August 2009, NSE introduced the co-location facility, which allowed brokers to place their servers in the data centre of NSE. Of course, there was a charge for this service, and only the big brokers can afford it. The benefit of colocation is that it allows faster access to the price feed (buy/sell quotes) distributed by the stock exchange. That is because the broker’s server sits right next to the stock exchange’s server and so the data has to only travel a very short distance from the exchange server to the broker’s server. This was a big advantage to those trading members engaging in high frequency trading strategies.

An algorithm or an algo is a computer program that automatically executes conditional orders on the stock exchange based on pre-set parameters. At a very simple level, a slice order (Order Slicing is an additional feature on the web trading platform that gives an edge to the Active Traders to divide the Large Quantity Order into multiple orders which is known as Child Orders. Order Slicing is important because if its not done than One single large quantity order can have direct implication on market liquidity and price discovery in very next moment.) will help you spread the buying or selling of a stock through the day to overcome the volatility in the price. At a more complex level there are options algorithms that can execute based on conditional undervaluation and overvaluation of options or arbitrage positions that can be executed automatically based on the spread defined.

Globally, markets operate substantially on algorithm driven trading. It makes the market broader and the large institutions act as automatic market makers. This improves the market quality. From a broker’s perspective or from a trader’s perspective, the algo can be set in such a way as to get the best possible price. Secondly, since algos are executed automatically and with great speed, there is tightening of spreads in buy and sell orders. That substantially reduces the risk for traders as the basis risk is largely reduced for buyers and the sellers. Lastly, algo trading also proffers the advantage of improving the liquidity in the market. An algo keeps throwing orders in the market and then withdrawing it. The bottom-line is that this aggressive interplay of orders helps improve the liquidity in the market and facilitates the execution of transactions seamlessly.

To begin with, co-location is a facilitator of high frequency trades. That means you get price feeds a split nanosecond quicker than the rest of the market gets. For that, the broker is required to put up a co-location server at the exchange which will give them that fractional advantage. Co-location of servers on the exchange actually facilitates high frequency trades (HFT). This HFT, in turn, facilitates execution of complex trading programs through algorithms. It is only with co-location and HFT that algo trading actually begins to add value to traders.

Three months after introducing the colocation facility, NSE started offering tick-by-tick market data. Again this was available for a fee. Each tick constituted a packet of information like a buy/sell order, order cancellation, order modification, or a trade that has happened. The data was exhaustive and only those brokers with sophisticated IT systems could take advantage of it.

Initially, this data feed was distributed through a tech architecture called Transmission Control Protocol/IP. In TCP/IP, the information would be delivered one-by-one, unlike a broadcast, where everyone got the information at the same time. Also, the data was distributed sequentially in the sequence in which trading members logged in to the NSE server. So the first one to connect to the server with the least load would receive data faster than others. One broker in particular, OPG Securities is alleged to have gamed the system because it was said to be aware of the workings of the NSE’s IT department.

TBT

The 'Tick-By-Tick' (TBT) data feed provided information on every change in the order book but this information was allegedly delivered one by one, unlike a broadcast where everyone gets the price information at the same time if they were at the same distance from the server. Rather, the TBT data feed was disseminated sequentially in the sequence the brokers connected or logged in to the server. This allegedly created a benefit to the first one to connect to the lowest-load server in terms of receiving the data faster than others. It was also alleged that some brokers got to access back-up servers as the load on those servers was low while a few not only logged in first on select high-tech servers but also tried to crowd out others by occupying the second and third positions on those servers. Over the years, Sebi has put in place stricter regulations to close the loopholes and to address concerns relating to algo trading and co-location facilities, including by making TBT feed free of cost to all trading members and asking exchanges to provide 'managed co-location service' through eligible vendors for ensuring low-cost services to all interested brokers. It has also been alleged that some brokers colluded with NSE's employees and outsourced staff to obtain information regarding load and starting of servers, including backup servers. This enabled 'first-to-connect' brokers to get data ahead of others for three years between 2011 and 2014.

Dark Fiber

Also, the brokers had spent additional money and laid down dark fibre lines. Dark fibre lines transmit information faster than other lines. This is because of the fact that these are dedicated lines where the absence of any other traffic increases the speed of data transmission by a fraction of a second.

Since, many of these brokers were using algorithmic trading software, if they were receiving information mere fractions of seconds earlier than the others, they were able to leverage technology and quickly place favourable bets based on the information advantage that they had. Using the combination of co-location and algorithmic trading, brokers were making in millions of rupees every day and dark fiber augmented the profit making.

Unfolding of the Scam

According to officials’ statements, the scam came to light when a whistleblower complained about the co-location issues to the SEBI authorities in 2015. After that, the complete scenario of fraud happening behind the screen was disclosed to the general public. When Moneylife revealed the scam, the management of NSE took a severe step toward the media authorities and even filed a 100 crore defamation case against Moneylife. Things got worse when the matter progressed to the High Court eventually. However, the Bombay High Court finally made a verdict by dismissing the case and thus dismissing all the allegations made by the NSE. In addition, NSE had to pay a penalty fee of around 50 lakhs for the charge of taking arrogant action for the media report of Moneylife.

Technical Advisory Committee of SEBI

The allegations of the whistleblower was probed by the Technical Advisory Committee of SEBI and by Deloitte India, which was appointed by the NSE board. The TAC concluded that NSE’s TBT architecture was prone to market abuse thereby compromising market fairness and integrity, in that it provided quicker order dissemination to those who managed to login early. OPG tried to exploit this architecture by not only logging in 1st on select servers but it even tried to crowd out others by occupying 2nd, and 3rd positions on those servers. The reported also said that it was likely that OPG and some other brokers were given preferential access to back up servers of the NSE TBT system.

The Deloitte report too said that NSE’s TBT architecture the system was prone to manipulation, and that sequential distribution of price information reached brokers logged on to less crowded servers, faster than it reached somebody on a crowded server.

Also, when a complaint was first made to NSE, its management dismissed it and didn't initiate any steps to check the possibility of any collusion with the staff of the exchange. NSE's board was asked by the panel to initiate an independent examination, including a forensic probe by an external agency. The exchange was also directed to place its co-location revenues, including from any fiber connectivity from broker's co-location facility to their offices, in an escrow account. There were indications that certain brokers were moved to specific servers while the same was denied to others. There were also instances where some co-location members were allowed access to multiple TBT servers by redistribution of their IPs which was not in line with the sequential method. Further, e-mails reviewed during probes suggested that certain brokers may have got advice from someone within the exchange that there was an advantage in receiving market feeds on early logins to the TBT servers. The forensic audit also observed the absence of protocols related to data retention, e-mail and other information for some former top officials of NSE.

Over the years, Sebi has passed several orders, including against NSE and its then top executives as also against some brokers in the co-location matter for breach of capital market regulations. The ongoing probes are focussing on illicit gains made in the process and whether a 'money-making machine' was at play in hands of a coterie of people.

The advantage of connecting to least crowded servers would have been nullified if the NSE had a load balancer system in place. There was a prescribed limit of 30 connections for each port of the server from which the NSE disseminated price data to trading members. However, this limit was not followed and the number of connections on one port often exceeded 30. This put members who were on more crowded ports at a disadvantage. NSE’s colocation support and project support management teams were aware of the load on each server.

 

A load balancer would have distributed network/traffic load across a number of servers based on specific algorithms like least connections, least response time and ensured equitable load distribution across trading members.

NSE could have even nullified the advantage by introducing a randomizer. A randomizer, as the name suggests, would randomly pick a connection to begin dissemination of data rather than starting with first connection each time. But the NSE did not implement the system on the servers disseminating Tick by Tick data. This gave an advantage to brokers who logged in first.

Also, When a broker’s application for colocation facility was approved, the activation e-mail gave details of the secondary server as well, in addition to those of the primary server. Also, the secondary server was active at all times. There was no system whereby the secondary server would start only when the primary server failed. Since there was no documented policy on connecting to the secondary server, and since trading members had the details, they could log in to the secondary server anytime. Also, NSE did not have a monitoring mechanism to check if the brokers connecting to the secondary sever had a valid reason for doing so. Since the secondary server was to be accessed only when the primary server was not working, few brokers connected to the secondary server. As a result, the load on that server was low, and the few members connected to the secondary server would receive the price feed faster than members connected to the primary server.

Following warnings by the NSE’s IT team, most brokers reverted to the primary server. But some like OPG Securities continued to connect to the secondary server despite warnings. The SEBI report observed that the NSE did not penalize the brokers who were repeatedly flouting NSE’s directive on connecting to the secondary server.

SEBI’s Conclusion

The regulator has ruled that the stock exchange has failed to ensure a level playing field for the trading members who had subscribed to NSE’s colocation services and were getting the tick-by-tick data. However, SEBI feels the exchange cannot be charged with fraud as there is no proof of collusion of employees with brokers, or proof of some brokers having been discriminated against, or some NSE officials or brokers having gained financially because of the lapses. Also, SEBI feels failure to have a randomizer or load balancer cannot be seen as a breach of the principle of fairness and equity. So NSE cannot be held guilty under the provisions of fraudulent and unfair trade practices. At the same time, the exchange did not exercise the requisite due diligence while putting in place the TBT architecture. Also, the exchange’s policy on retention of electronic records were weak. For the above failings, the exchange has been ordered to disgorge a part of the profits made from the tick by tick data dissemination between 2010-11 and 2013-14. That works out to Rs 625 crore along with an interest of 12 percent from April 2014.

Actions Against OPG

In response to the co-location scam, SEBI took action against OPG Securities in 2019, ordering them to return the ill-gotten profits they had made during that period. The profits were reported to be around 25 crore rupees, and SEBI also imposed an additional 12% penalty on the gains earned from April 7, 2014, onwards. When the co-location scam came to light in 2016, SEBI instructed the NSE to conduct a comprehensive forensic audit to investigate all transactions and deposits that occurred in the NSE's system from its co-location facility. Deloitte was tasked with carrying out these forensic audits for the exchange.

Scandals like the NSE co-location scam often involve various individuals operating behind the scenes. In this particular case, Ravi Narain and Chitra Ramakrishna were key figures implicated in the fraud. When their involvement was revealed, Narain and Ramakrishna were required to forfeit 25% of their salaries earned during the specified period.

The Securities Appellate Tribunal (SAT) has ruled against the Securities and Exchange Board of India (SEBI) in a case involving the National Stock Exchange (NSE) and the co-location issue. In this decision, SAT dismissed a SEBI order that imposed a penalty of Rs 1 crore on the NSE. This penalty was part of SEBI's larger investigation into the co-location case. Moreover, the appellate tribunal also overturned a Rs 25 lakh fine that had been levied on two former NSE chiefs, Ravi Narain and Chitra Ramkrishna. It's worth noting that this is the second instance in which SAT has overturned SEBI orders related to the co-location scam. In an earlier case in January 2023, SAT had already reversed SEBI's decision that had required the NSE to disgorge Rs 624 crore in illegal earnings and pay a Rs 100 crore penalty for due diligence violations.

 

Furthermore, in March, the Supreme Court of India directed SEBI to refund Rs 300 crore to the NSE. This sum had been deposited by the NSE under disgorgement orders. The Supreme Court also declined to stay the ruling of the Securities Appellate Tribunal (SAT), which had overturned SEBI's disgorgement judgment, and ordered the NSE to pay Rs 625 crore, plus interest. During the legal proceedings, the NSE argued that the prior ruling had already fulfilled the purpose of punishment, which is to act as a deterrent for future offenses. Given that the regulatory objective had already been addressed by the earlier order, the penalty should be set aside. The legal team of Ravi Narain, the former CEO of NSE, made similar arguments, stating that the present order was based on Stock Exchanges and Clearing Corporations Regulations that were not in effect at the time of the alleged violations. The tribunal had previously held that these regulations did not apply to the case.

On the contrary, SEBI contended that the penalty was imposed for distinct offenses and should not be invalidated in the current instance. Another similar appeal related to the co-location case is still ongoing before SAT. In this case, the NSE was fined Rs 90 crore by the markets regulator for providing preferential treatment to certain brokers through dark fiber connections.