National Stock Exchange Co-Location Case

NATIONAL STOCK EXCHANGE CO-LOCATION CASE
What is co-location?
Co-location allow brokers to operate closer to their servers upon payment of additional fees.
It helps brokers secure advantage over others due to proximity to exchange servers as data
transmission takes less time. Orders reach exchange servers faster than those who have not
availed of the facility.
What is the scam?
A whistleblower in 2014-15 complained to the Securities and Exchange Board of India (Sebi)
saying some brokers in collusion with a few top NSE officials had abused the colocation
facility. NSE was then using the so-called tick-by-tick (TBT) server protocol to relay data to
members. The peculiar part about this protocol is how it delivers the information. Normal
data protocols send data to all users connected on the network at the same time. But TBT
transmits in the sequence of orders received. In other words, the user who gets the access to
the system first would receive data earlier than the rest. A select set of brokers in collusion
with NSE officials and Omnesys Technologies (the company that provided technology to
NSE) got the first access to the NSE’s servers giving them a head start.
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 software1. 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.
1
Algorithmic trading (also called automated trading, black-box trading, or algo-trading) uses a computer
program that follows a defined set of instructions (an algorithm) to place a trade. The trade, in theory, can
generate profits at a speed and frequency that is impossible for a human trader.
Findings of SEBI
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.2
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 manipulating the system: Some trading members, including OPG Securities,
were able to switch their connections to NSE’s backup or secondary servers (which were less
crowded) to gain quicker data access. Also, OPG Securities was able to able to figure out
which server was working better, what time the servers would be started, and would access
the least crowded servers. OPG Securities was alleged to have mapped multiple IPs to a
single server such that it would get the first two or even three connections to that server and
crowd out other members. After issuing obligatory 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(Department of Telecommunication)
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
2
Multicast is a communication tool where data feeds are delivered to destination computers simultaneously.
reprimanded NSE for ‘maladministration and mis-governance’ of its entire colocation
facility.
Could the NSE have negated the advantages some brokers had by connecting to least
crowded servers?
Yes. The advantage of connecting to least crowded servers would have been nullified if the
NSE had a load balancer system in place.
There was a prescribed limit of 30 connections for each port of the server from which the
NSE disseminated price data to trading members. However, this limit was not followed and
the number of connections on one port often exceeded 30. This put members who were on
more crowded ports at a disadvantage. A load balancer would have distributed
network/traffic load across a number of servers based on specific algorithms like least
connections, least response time and ensured equitable load distribution across trading
members.
The obvious question is that when the officials at NSE were aware of this flaw, why did
they not implement a load balancer?
The NSE’s stand was that deployment of a load balancer would have introduced an increase
in time lag because the additional hardware device would add an extra step through which the
data would need to flow.
Punishment given by SEBI
The regulator has ruled that the stock exchange has failed to ensure a level playing field for
the trading members who had subscribed to NSE’s colocation services and were getting the
tick-by-tick data.
However, SEBI feels the exchange cannot be charged with fraud as there is no proof of
collusion of employees with brokers, or proof of some brokers having been discriminated
against, or some NSE officials or brokers having gained financially because of the lapses.
Also, SEBI feels failure to have a randomizer or load balancer cannot be seen as a breach of
the principle of fairness and equity.
So NSE cannot be held guilty under the provisions of fraudulent and unfair trade practices.
At the same time, the exchange did not exercise the requisite due diligence while putting in
place the TBT architecture. Also, the exchange’s policy on retention of electronic records
were weak. For the above failings, the exchange has been ordered to disgorge a part of the
profits made from the tick by tick data dissemination between 2010-11 and 2013-14. That
works out to Rs 625 crore along with an interest of 12 percent from April 2014.
Also, NSE has been barred from accessing the securities market for six months.

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NATIONAL STOCK EXCHANGE CO-LOCATION CASE

What is the scam?

Unauthorised dark fibre: Two brokers — Way2Wealth Brokers and GKN Securities —

Punishment given by SEBI

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