High-frequency misadventure

It took almost five years for the market regulator, the Securities and Exchange Board of India (Sebi), to bring a conclusion the in infamous co-location case of National Stock Exchange (NSE), with the final judgement passed on April 30, 2019, in voluminous five series orders.

Interestingly, after multiple years of investigations and a number of forensic audits, the regulator could not find NSE guilty of any fraudulent activities or unfair trade practices, though a penalty of around Rs 1,100 crore, including interests for five years, has been imposed on the exchange.

In Sebi's own words, “In the absence of any evidence leading to the culpability of any specific employee of NSE or the collusion or connivance from the side of NSE with any specific with any specific trading member (TM), I'm compelled to rule against the possibility of existence of a 'fraud'.”

However, in the same order, Sebi's whole-time member G Mahalingam states, “...Even though sufficient evidence is not available before me to conclude that the Noticee No.1, NSE has committed a fraudulent and unfair trade practice as contemplated under the Sebi (PFUTP) Regulations, I find that it is established beyond doubt that NSE has not exercised the requisite due diligence while putting in place TBT architecture.” The regulator has, hence, directed NSE to disgorge Rs 624.89 crore, along with interest at the rate of 12% per annum from April 01, 2014 onwards. The exchange has also been barred from accessing the capital markets for six months.

What is the impact?

Some market experts feel Sebi's order is contradictory in nature. According to a market expert, the regulator could not find sufficient evidence against Sebi, yet it has imposed a heavy penalty on the exchange, along with the disgorgement of partial salaries of two of its former MDs and CEOs – Ravi Narain and Chitra Ramakrishna.

“The whole issue got dragged for too long. Apart from a little delay in the public issue, no other significant impact is expected on the exchange's business due to this,” says this person, on condition of anonymity.

NSE, which was set up in 1992 to break the growing monopoly of Bombay Stock Exchange, has its initial public issue lined up for a long time. Now, it will get delayed by a further six months.

Recently, in a telephonic conversation with DNA Money, NSE's current MD & CEO Vikram Limaye has said, “We are not allowed to access the public market for six months, after that we can go ahead with it. The IPO cannot happen for six months, which is okay since any IPO preparation will take that much of time.”

However, the delay is unlikely to dampen investors' sentiments, feel experts.

According to legal and financial consulting services firm Corporate Professionals Group founder Pavan Kumar Vijay, the issue at hand is about poor surveillance on NSE's part.

“No doubt the exchange's credibility has been affected. There will be now a difference in perception, but it may not affect the IPO. The issue is more about ethical practices than legal, and investors understand that,” he says.

Echoing Vijay, New York-based corporate investigations and risk consulting firm Kroll's MD and head of South Asia Tarun Bhatia says that though the judgment was pronounced on April 30, the matter has been going on over last 4-5 years.

“To that extent, it is not a new matter but more a conclusion to it. The final order confirms some of the risks and fears around it, but does not come as a surprise for market participants,” he points out, adding that the order is unlikely to have any direct impact on the investors' sentiments as the issue has spread out over a span of 4-5 years.

What is the matter all about?

It relates to market manipulation at the NSE, where the exchange officials did not exercise due diligence while using a certain protocol that sends out data sequentially, and allowed a set of brokers unfair access on its co-location servers set up at the exchange site, which could speed up the algorithmic trading. This created a trading environment in which the information dissemination was asymmetric, which helped the set of brokers to make substantial profits. The issue was brought into notice after a whistle-blower first complained to the regulator in 2015, which was first reported and pursued by media house Moneylife, despite a defamation suit was filed by the NSE.

Traders such as OPG Securities were able to switch their connections to NSE's backup server for quicker data access. Two other brokers – GKN Securities and Way2Wealth hired Sampark Infotainment, which did not have the required DoT licence, to lay dark fibre connectivity to the co-location facilities for executing faster trade.

Meanwhile, NSE officials entered into data sharing arrangements with related parties, like academicians Ajay Shah, his wife Susan Thomas, sister-in-law Sunita Thomas of Infotech Financial Services and her husband Suprabhat Lala, assistant vice president of trading operations of NSE at that time, giving rise to a conflict of interest.

What are the orders?

In a series of five separate orders in the algo-trading case, apart from the penalty levied on the exchange along with its debarment from tapping the capital market for six months, the former MDs Narain and Ramakrishna were prosecuted, ordered to disgorge 25% of their salaries for the specific period, and barred them from associating with any market intermediary or market infrastructure institution (MII) for five years.

The order states, “Having held the senior most management position in the NSE and being in charge of the affairs of the conduct of the stock exchange business, they cannot limit their roles to the non-technology issues of the exchange. The MD and CEO of a stock exchange cannot abdicate his/her responsibility by citing limited knowledge in certain spheres of the business activities.”

The regulator has also barred OPG Securities from accessing capital markets for five years, and fined Rs 15.57 crore, along with interest at 12% per annum from April 7, 2014, onwards, for gaining unfair access to NSE's system. Its directors Sanjay Gupta and Sangeeta Gupta are asked to stay away from the securities markets for five years.

Two other brokers – Way2Wealth and GKN are penalised Rs 15.34 crore and Rs 4.9 crore, along with interest of 12% per annum, respectively, and are barred from taking any new client for one year and undertaking any trade for two years. GKN Securities' partners Sonali Gupta, Om Prakash Gupta, Rahul Gupta, Way2Wealth's CEO MR Shashibhushan, along with directors CK Nithyanand, BG Srinath, and Sampark's CEO Prashanth D'Souza are also barred from holding any position with a market participant for two years.

Economist Ajay Shah has been barred from holding any management position or association with any exchange, clearing corporation and brokerage firms for two years, whereas Sunita Thomas and her firm Infotech Financial Services are barred from providing service to any Sebi-registered firm for two years. Suprabhat Lala, too, has been barred from holding any position at MII for two years.

NSE officials Ravi Varanasi, head of business development has been banned from holding positions or associating with entities in securities markets for three years, whereas Nagendra Kumar, head of membership department and Deviprasad Singh, head of collocation support, are barred from holding similar roles for a period of two years.

Why the delay?

Vijay believes that the decision took a long time because Sebi, as a regulator, wanted to be certain before passing the final order and did thorough study and research before coming to its conclusion against the largest MII.

“This is a watershed order in the regulatory history of the country. NSE is considered a self-regulator, hence a regulator passing an order against another regulator has to be very careful,” he says.

However, various investigations and forensic reports had in the past indicated non-cooperation and refusal to provide information by the exchange.

Bhatia feels that the regulator should have appointed an independent investigative firm or a forensic auditor, and could have asked the counter-party to adhere to all requirements, instead of asking NSE to appoint one independent investigator.

“Asking the organisation to appoint an investigator does not signal an independent process. We were told in the past of NSE's non-cooperation with Sebi in the matter which may have resulted in the delay,” Bhatia says.

According to him, the order was not timely, despite some actions were taken at the end.

“This took way too long. Going ahead, I would like to see faster resolution, as for an entity like an exchange, it takes a long time to build confidence. Even if you order a penalty of Rs 1,000 crore after such a delay, the confidence is already dented in the system,” he adds.

According to him, the penalty isn't a small amount, but it will not impact NSE's operations.

Limaye, too, has said that the exchange has put aside co-location vertical revenues in a separate account over the last 2-3 years. Hence, there is no problem from a cash perspective in case the exchange agrees to pay the penalty.

“This is more a message to the broader market that these things will be taken seriously. However, timing and speed are most critical during such cases, and 4-5 years' time lapse only brings down the impact significantly,” Bhatia further says.

The way forward

NSE and its officials are taking legal advice through separate counsels. Three officials have moved to the Special Appellate Tribunal (SAT), which has passed an interim stay on the orders passed by Sebi. The three brokerages, OPG, GKN and Way2Wealth were also granted interim relief, though they were asked to deposit 50% of their penalty amount as security by May 20. The next hearing is scheduled on July 22.

According to the market expert, quoted above, it would be better for NSE to pay up and move on, as challenging the decision will only drag the matter for a further 5-6 years, given such matters take a lot of time in India.

Bhatia feels that whenever such an order and penalty are imposed, one always needs to weigh the impact and implication of accepting the order and the penalty versus contesting it.

“If you accept, it means you agree that such a thing happened, you take it in your stride and move on. If you contest, it signals that you are not fully guilty for what you have been held accountable for, and fighting for your cause. But with that come a few uncertainties,” he adds.

According to him, such matters in India get dragged on for a long time and involve a lot of additional costs. Investors, on the other hand, would like to settle the matter, ensure such things do not happen again, and focus on strengthening the main business.

“Investors would want the exchange to take things at its stride and move on,” Bhatia says.

In fact, the foreign investors of NSE have asked the exchange not to contest Sebi's order and focus on the preparation of the public issue.

However, in view of Vijay of Corporate Professionals, NSE, as an institution, may be fighting Sebi's order and it would be interesting to see whether the ethical and governance isues would pass the test of legality.