Much ado about the NSE co-location issue

Imagine a large buzzing airport in a metro with thousands of commuters using the facility to travel everyday. Now, let’s say there is a special nook in the airport for the privileged class, where the uber rich make reservations on private jets. If some users of this privileged class made a hue and cry that the airport was giving preferential treatment to some by helping them take a private jet 5 minutes before the others, what is the reaction this is likely to elicit?

That is the situation in the ongoing skirmish involving the NSE and users of its co-location facilities. The co-location facilities are used by just a handful of traders with really deep pockets. These traders are perched next to the exchange server in order to get their orders through before everyone else. Now they are complaining that one of this privileged bunch managed to pip the others.

There have been allegations that ‘unfair access’ was provided to a certain member using the co-location facility between 2012 and 2014 that enabled him to log in first to the secondary server and get the data before everyone else. This made the member’s algo programmes better placed to execute trades.

It is true that the episode points towards lapses in controls and processes within the stock exchange. Employees colluding in the matter must be brought to book. The manner in which the management of the exchange handled the media when the whistle-blower first brought this to light was unsavoury and high-handed. But to say that the episode indicates that NSE is compromising the interests of all investors would be wrong. For the co-location facilities are used by the privileged class among traders. There has been no issue of favouritism or governance in the platforms where the 2.7 crore common investors trade and invest.

In fact, ‘unfair access’ was granted by the regulator, the Securities and Exchange Board of India, when it allowed co-location facilities to be set up on Indian exchanges. Those members who traded through the co-location facilities could execute orders well ahead of others in the queue, since their proximity to the exchange servers increased the speed of transaction.

In its recent board meeting, SEBI said that it is trying to resolve the concerns relating to systems and processes in consultation with its Technical Advisory Committee (TAC). A closer look at the lapse shows that the issue is being blown out of proportion. The report of the independent agency that inspected the charges indicated that one particular stockbroker almost consistently connected first to the secondary server between December 10, 2012, and May 30, 2014, and was very often also the second stockbroker to connect during this period. The report also indicated that the stockbroker could have been aided by certain employees identified in the report.

While there have been lapses in the past, they appear to have been rectified since. The independent agency’s report states that the exchange has adopted a different system from April 2014 (Multicast TBT system) due to which issues related to benefits from early connectivity and sequential dissemination of ticks could have been have been addressed. Either way, investors trading from non-colocation facilities would not be too concerned. Long-term investors do not really suffer if their order is executed a little slower since they play for much larger gains. The smaller traders are anyway far behind those trading from co-location facilities in general and would not really be worried about the advantage that one member had for a certain period.

It also needs to be kept in mind that the entire segment of stock market dealing with algos and co-location facilities is a nascent one. The regulator is still trying to understand these trades and framing apt rules for them. It was in 2008 that SEBI paved the way for ushering in algo trading by allowing trading members to give direct market access (DMA) to their institutional clients. Soon exchanges allowed colocation facilities, sometime in 2010, to help algos execute their trades faster. In short, DMA, algos and co-location facilities were allowed in Indian exchanges without too much deliberation and planning. It was only in 2013 that SEBI put out a discussion paper on co-location facilities. Last year the regulator began thinking about bringing parity between co-location and non-co-location trades by allowing minimum resting period between orders, having two separate queues for co-location and non-co-location orders, and randomisation of orders. Since these are early days, the regulator needs to focus on framing fool-proof rules first before trying to enforce them.