After an investigation process that dragged on for years, the Securities and Exchange Board of India (Sebi) on Tuesday released a comprehensive set of orders on the National Stock Exchange (NSE) co-location controversy. The regulator said there was no evidence of fraud committed by the NSE, but the exchange did not exercise adequate due diligence while selecting its trading architecture, thereby creating an environment in which information dissemination was asymmetric. The exchange has also been indicted for “bad governance”, and criticised for its inconsistent “dark fibre” policy. The punishment has been severe: The exchange has been debarred from accessing the capital market for six months and asked to pay over Rs 1,000 crore in investor education. The regulator has also punished multiple individuals, who are current or former NSE
executives, including two former managing directors. Sebi has also debarred Delhi-based OPG Securities
from accessing the capital markets for five years, denied it the right to enrol new clients, and fined it Rs 15.57 crore for securing unfair access to the NSE’s systems. The regulator has further directed the NSE
to overhaul its algorithmic trading systems and co-location processes and to subject these to regular systemic audits. Several service providers and advisers to the NSE
have been indicted, and debarred from working in market-related areas. (One of these advisors, Ajay Shah, is a columnist with Business Standard.
This is, by far, the most stringent order issued by Sebi. Indeed, the case was so complex and multi-dimensional that the regulator issued five separate sets of orders, covering different aspects of the case. It has determined that the tick-by-tick co-location system deployed by the NSE allowed discriminatory access to several brokers. It has also determined large conflicts of interest with advisers who were given access to confidential data, which allowed them to develop algorithmic trading software that could be used for personal gains. The regulator has directed the NSE to start legal proceedings against these advisers. The orders will not affect the daily functioning of the NSE, which will be a relief to the ordinary investor. In any case, the exchange is under a new regime now. But it is possible that there will be legal challenges.
Policy issues arising from the increasing use of algorithmic trading systems and from the use of co-location processes are highly complex. Similar problems have arisen elsewhere as financial exchanges have deployed new technology. Co-location (setting up trading terminals in the same physical space as the exchanges’ servers), along with the use of dark fibre (dedicated cable lines transmitting only exchange data), gives users a significant advantage in data-access, especially in an era where AI-based algorithmic trading systems can exploit milli-seconds. While traders will pay more for such services, it also creates an asymmetric information environment. Regulators and exchanges have to work out a robust policy to oversee this and prevent abuse. There are increasing volumes of algorithmic trading on India’s financial exchanges. These orders demonstrate the regulator has developed a grasp of the technology and policy issues and it is willing to crack the whip to ensure an equitable environment. However, Sebi will have to evolve to stay abreast of changes in technology to cope with inevitable future changes.