The NSE Co-Location Fraud

The National Stock Exchange (NSE) is one of the two leading stock exchanges in India. Ironically, the National Stock Exchange was created as a result of a huge scam which happened in the Bombay Stock Exchange (BSE). The regulators were of the opinion that the broker nexus in the BSE was too strong. Hence, in order to reduce their power and give investors more options, the NSE was created.

However, ironically, NSE has now found itself in the middle of a massive scandal. Securities and Exchange Bureau of India (SEBI) which regulates Indian stock markets has found the National Stock exchange guilty in the co-location fraud.

In this article, we will have a closer look at what the co-location scandal is. We will also understand how stockbrokers used technology as well as their personal connections in order to gain a competitive edge over their peers.

What was the Fraud?

The NSE co-location scam included possible market manipulation by brokers and technology companies.

• Co-Location: In 2009, the National Stock Exchange started offering co-location services to some brokers in exchange for a fee. Co-location services meant that the National Stock Exchange would allow some brokers to keep their servers within the premises of the National Stock Exchange. By co-locating the servers, these brokers would receive price information a few seconds before the other market participants. 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.

  This might not seem like a big deal, but it is. This is because many of these brokers were using algorithmic trading software. Hence, they were not placing trades manually. This meant that even 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. This continued for a couple of years before a whistleblower wrote a letter to SEBI and this scandal became known to the external world. Many critics have also alleged that the concept of co-location is not legal in India. However, this cannot be clearly inference as the law can be interpreted in more than one ways.

• Profit Sharing: The whistleblower has alleged collusion between the NSE officials, the brokers as well as the technology company. Investigators have not been able to find any clear evidence. However, the payment arrangement between the brokers and the software company is extremely unusual. It is a known fact that stock trading is an extremely speculative activity. This is the reason why software companies which make products related to stock trading give out licenses in exchange for a fixed fee. They are more interested in making a fixed amount of money rather than taking on the vagaries of the market. However, in this particular case, the software provider was so confident of the results, that they licensed the software on a profit-sharing basis.

What were the Repercussions?

Ever since the scam broke out, the NSE has been facing litigation for several years. Now since it has been convicted it faces several monetary implications. However, most importantly its image as an unbiased stock exchange has been tarnished.

• Fines and Penalties: The National Stock Exchange was found guilty of lapses. As a result, it has been asked to return over 630 crores which the bourse had earned from co-location. The bourse has been asked to pay this money to Investor Protection and Education fund along with 12% interest. Hence, the NSE will have to pay out more than 1000 crores in fines and penalties.

  Along with the course, SEBI has also punished the higher-ups at NSE for what it deems to be negligence. SEBI has asked many top-ranking officials in the National Stock Exchange to return about 25% of their compensation for the past several years. This move has been done to ensure that top-ranking individuals at stock exchanges are individually made responsible for the actions undertaken by their bourses.

• Delayed IPO: One of the biggest blow to the NSE is that SEBI has delayed NSE’s initial public offer by at least six months. The National Stock Exchange was well on track to raise more than 10,000 crores via selling shares to the common public. The fact that the markets are now at their peak valuation would also have helped the stock exchange obtain a significant premium. However, thanks to the scandal that may now not be possible. Since central banks all over the world are raising interest rates, this could mean that the NSE may not be able to obtain as high a valuation as it would have hoped for.

Hence, one of India’s largest stock exchanges has been found guilty of enabling insider trading. Although the issue has been detected and also penalized, it still raises questions on the entire trading infrastructure in India.