NSE’s Systems Prone To Manipulation, Says Deloitte 

Forensic audit reveals NSE’s system prone to manipulation.

Employees stand at in front of an electronic board that indicates the latest stock figures at the the National Stock Exchange (NSE) in Mumbai, India (Photographer: Dhiraj Singh/Bloomberg)
Employees stand at in front of an electronic board that indicates the latest stock figures at the the National Stock Exchange (NSE) in Mumbai, India (Photographer: Dhiraj Singh/Bloomberg)

An external audit conducted by Deloitte India has found that the National Stock Exchange of India Ltd.’s systems are prone to manipulation. The exchange disclosed this information in its draft red herring prospectus filed with market regulator, Securities and Exchange Board of India, for its maiden public offer.

NSE plans to raise around Rs 10,000 crore by selling 22.5 percent of its paid-up equity capital, valuing the exchange at around Rs 45,000 crore.

Forensic Audit

According to the DRHP, Deloitte in its report submitted on December 23 found that:

  • A few stock brokers appeared to be able to connect to specific servers significantly faster than others. The system architecture was so designed that it disseminated data in a sequential manner, whereby the stock brokers connecting first were the first ones to get the information.
  • Preferential treatment may have been given to a few stock brokers. Faster data was provided to brokers connected to less crowded servers, thereby giving them an advantage over others.
  • Some particular stock brokers were consistently the first or second people to connect to a fall-back secondary server between December 10, 2012 and May 30, 2014. This couldn’t have been possible without the prior knowledge of the employees identified in the report.
  • The lack of a randomiser provided undue advantage to certain brokers connected to the secondary server.
  • NSE did not have specific policies and procedures to regulate the laying of optic fibre cables at its co-location facility, by non-internet service providers.
  • The report stops short of commenting on whether there was collusion or connivance by certain exchange officials.
  • There was lack of documented policies and protocols with respect to functioning of the tick-by-tick (TBT) system or its system architecture.
  • Additional TBT servers were found to be lacking a restoration process, even after the exchange confirmed the completion of the entire data restoration exercise. Officials interviewed by Deloitte were unaware of these servers.

The Deloitte audit also observed the absence of protocols related to data retention, emails and other information for certain former employees of NSE.

Freeze On Co-Location Revenues

NSE disclosed in the DRHP that revenue from co-location services for the financial year 2015-16 stood at Rs 554 crore, constituting 29.7 percent of revenue from operations. For the first half of financial year 2016-17, the exchange earned Rs 303 crore, which was 29.3 percent of the total revenue from operations. Market regulator SEBI had directed NSE to transfer revenue earned from the co-location to a separate escrow account.

“Accordingly, in addition to the rack charges and connectivity charges, an amount of Rs 145.52 crore, representing the transaction charges on trade orders placed through our co-location facility for the months of September 2016, October 2016 and November 2016 has been transferred to the separate bank account. We intend to deposit the rack charges, connectivity charges and transaction charges to the separate bank account, for each month going forward until SEBI directs us otherwise,” said NSE in its DRHP filings. 

Why SEBI Stepped In

The market regulator had received complaints against NSE’s co-location facility and service, including allegations that the exchange provided unfair access to certain stock brokers in early 2015. Subsequently, in December 2015, SEBI tasked a technical committee headed by Ashok Jhunjhunwala, professor at Indian Institute of Technology, Chennai, to investigate these alleged irregularities.

The committee, which submitted its report in March 2016, concluded that NSE’s systems were vulnerable to manipulation and abuse, violated norms of fair access and compromised market fairness and integrity as certain stock brokers gained materially from the feed provided to them. NSE disputed these observations in its response to SEBI.

SEBI in its ‘Observation Letter’ dated September 9, 2016, reiterated the observations made by the Jhunjhunwala committee. The regulator advised the exchange board to initiate an independent examination including a forensic examination by an external agency. It also passed an interim observation, pending investigation, to place all the revenue generated from co-location facility in a separate bank account.

The market regulator issued another letter on November 28 stating that the exchange had failed to comply with certain observations, including transferring the entire revenue generated from the co-location trading and facility into a separate bank account. The NSE board met on November 29 to comply with SEBI’s observation and deposited Rs 145.52 crore into a separate account. NSE intends to deposit the revenue earned each month from this segment into the escrow account, the exchange said in its filing on Wednesday.

Four days after SEBI issued its second letter to NSE, the exchange’s Managing Director and Chief Executive Officer, Chitra Ramkrishna resigned.