THE GIST of Editorial for UPSC Exams : 03 MAY 2019 (Cracking the NSE colocation controversy (The Hindu)

Cracking the NSE colocation controversy (The Hindu)

Mains Paper 1 : Economy
Prelims level : NSE colocation controversy
Mains level : Highlights of the NSE colocation controversy

Context

• The NSE colocation controversy has been the subject of speculation, conspiracy theories and even a defamation suit against a media house (Moneylife) which doggedly pursued the issue.
• SEBI has now sought to bring closure after investigating it for four long years. \
• Its five voluminous orders this week clear the air on the colocation controversy.

What SEBI found

• Wrong protocol: NSE used a certain protocol (TCP IP) to disseminate order book data to the trading members on its colocation facility. But the TCP-IP protocol sends out data sequentially, bestowing an unfair advantage on members who are ahead in the queue. The allocation of ports and servers to trading members, crucial to their position in the queue, was decided at whim by NSE’s lower-level employees. The NSE woke up to this flaw in 2015 and switched to a fairer Multicast system. \
• But SEBI’s investigations found that the lack of proper policies on the allocation of ports and servers before 2015 left NSE’s colocation platform open to manipulation. It didn’t find any proof of trading members with preferential access making undue gains from their trades though.
• Wrong server: Some trading members, including OPG Securities, were able to switch their connections to NSE’s backup servers (which were less crowded) to gain quicker data access. After issuing perfunctory warnings on this misuse of backup servers, NSE did not take any penal action against them. When taxed with why it didn’t disconnect them, NSE officials told investigators that they didn’t do so as it would have caused ‘disruption of business and large financial losses’ to the members. SEBI found that OPG Securities did make unlawful gains of ₹15.57 crore through this route.
• Unauthorised dark fibre: Two brokers Way2Wealth Brokers and GKN Securities hired Sampark to lay dark fibre connectivity to the NSE’s colocation facilities for faster trade execution. Sampark did not have the required DoT license to offer such services.
• NSE officials scotched similar requests from for other brokers and allowed dark fibre access to continue, even after it was evident that the connections were unauthorised. Here, SEBI has taken a stern view. It has hauled up the brokers for engaging an unauthorised network provider in their ‘greed and exuberance’ to achieve high speeds and reprimanded NSE for ‘maladministration and mis-governance’ of its entire colocation facility.
• Doubtful data sharing: An NSE official entered into data sharing arrangements with related parties (Infotech Financial Services, Ajay Shah and others) to help design products for the exchange. But the agreement was prone to conflicts of interest and allowed misuse of data for commercial purposes, violating SEBI’s PUFTP regulations.

What’s the punishment?

• SEBI has acquitted NSE and its officials of charges of fraud and manipulation, because it could unearth no evidence of NSE employees deliberately colluding with or earning kickbacks from the brokers.
• Submissions by the 16 senior NSE employees named in SEBI’s original show-cause notices reveal a lot of buck-passing on the issue.
• SEBI has therefore come down hard on NSE for not complying with the Securities Contracts Regulation Act, which says that one of the cardinal duties of a stock exchange is to provide ‘equal, unrestricted, transparent and fair’ access to all persons trading on it. It has rapped NSE’s top bosses for neglecting their fiduciary duties.
• For the negligence, SEBI has asked NSE to ‘disgorge’ a ₹624 crore plus penal interest — effectively all the profits made from colocation between FY11 and FY14 and barred it from an IPO for six months. Ravi Narain and Chitra Ramkrishna have been asked to disgorge 25 per cent of their salaries drawn during the period and barred from market institutions for five years.
• OPG Securities, Way2Wealth and GKN Securities will need to disgorge their unlawful gains and are barred from dealing in securities for specified periods. Ajay Shah and others have been barred from associating with market entities for two years.

Regulatory red flags

• SEBI’s final orders on the colocation case may seem like an anti-climax to those who were expecting a multi-billion rupee scam, or a sordid trail of kickbacks. What it has exposed instead, is many acts of omission and commission by the exchange that left its doors wide open for market players to game the entire system.
• However, to dismiss the NSE colocation case as trivial, just because it hasn’t thrown up eight-figure monetary losses for anyone, would be quite short-sighted. The case raises four big regulatory red flags.
• The policymakers in India have always thought of stock exchanges as self-regulatory organisations, expecting them to crack the whip on market players stepping out of line. But the NSE saga reveals that in practise, exchange officials may often be on chummy terms with trading members.
• In both the dark fibre and backup server cases, NSE employees clearly bent over backwards to accommodate the needs of their clients so that their trading was not interrupted on any count. There’s a clear conflict here, between the exchange employees’ official role as regulators, and their real-life roles as business facilitators for their employer.
• With the advent of money-spinning ideas such as colocation racks that give affluent trading members privileged access to trading infrastructure, the profit maximisation goals of stock exchanges are today in direct conflict with notions of equitable access for all and fair play. NSE raked in as much as ₹811 crore from colocation charges alone between FY11 and FY14.
• The wedge between profit motives and the regulatory obligations of exchanges is only likely to widen with more exchanges turning listed entities. Indian policymakers and SEBI therefore need to put in place tighter regulatory oversight, similar to that for other market participants.
• Indian policymaking has all along assumed that squeaky clean governance at stock exchanges can be ensured through ‘fit and proper’ criteria for promoters and caps on promoter shareholding.
• But the NSE case clearly tells us that professional managers of a widely held company can be as prone to hubris and negligence, as family promoters.
• There’s also plenty of scope for collusion, manipulation of systems and corruption at every level of the exchange hierarchy below the top management. Ensuring good governance requires clear fixing of responsibilities for every individual employee’s role and strong deterrent action against individuals found crossing the red line.

Way forward

• A final takeaway from this case is that, when it comes to market crimes, prevention is far better than cure.
• Though SEBI has passed sizeable disgorgement orders against the wrong-doers, it is quite unlikely that the money can be returned to the real losers of the colocation scam the counter-parties to the dodgy trades put through by the favoured brokers or the market rivals edged out by them.
• It is also a disturbing thought that none of these serious flaws in exchange processes would have come to light, but for the efforts of one Mr Ken Fong. India’s market institutions, like its companies, need a robust internal whistle-blower mechanism.

Prelims Questions:

Q.1) Standard Time Meridian of India passes through which of the following states?
1. Uttar Pradesh
2. Madhya Pradesh
3. Chhattisgarh
4. Telangana

Select the correct answer using the code given below.
(a) 1, 2 and 3 only
(b) 2 and 4 only
(c) 1 and 3 only
(d) 1, 2, 3 and 4

Answer: A

Mains Questions:
Q.1) SEBI’s probe may not have revealed a multi-billion rupee scam, but it has exposed serious flaws in exchange processes. Explain.