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Explained: Chanakya, LIX, dark fibre; the lesser known aspects of NSE colocation scam

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Explained: Chanakya, LIX, dark fibre; the lesser known aspects of NSE colocation scam

It is widely known that a handful of brokers profited hugely by exploiting the loopholes in NSE’s colocation facility and getting access to the exchange’s stock price feeds ahead of the rest of the market. Colocation means a broker being allowed to place his IT servers right next to NSE’s servers, for a fee. This is legitimate and allows brokers faster access to the price feeds as soon as they are broadcast by the NSE’s trading engine to all members. But some brokers were able to subvert rules and get access to the price feed ahead of the rest of the market on a regular basis.

Being able to get the price feed first is like watching a cricket match live and then placing bets with others viewing a delayed telecast of the same match. To know how the colocation facility was gamed by some brokers, read a detailed explainer here.
We now look at some of the lesser-known aspects of the colocation controversy, though these too helped some brokers get an unfair advantage.
The Liquidity Index angle
Before NSE introduced the colocation facility, a firm by the name of Infotech Financial Services obtained trading data from NSE, ostensibly for computing of Liquidity Index.
What was unusual about it?
One, the data was confidential and sensitive. Two, Infotech was awarded the project despite NSE’s subsidiary IISL being a specialist firm in index activities.
Ajay Shah, a board member of NSE subsidiary National Securities Clearing Corporation Limited (NSCCL), and also part of other NSE committees, was instrumental in Infotech being awarded the project.
Three, Sunita Thomas, one of Infotech’s directors, was Shah’s sister-in-law. Besides, Sunita Thomas was also the wife the Suprabhat Lala, who was heading the Trading Operations departments at NSE.
Was this data misused?
For sure. An excerpt from Shah’s e-mail to his sister-in-law bears this out. “You have to swear everyone to silence on the fact that the data that we are getting out NSE for LIX (Liquidity Index) is being used for algorithmic work. It would be a severe problem if this fact comes to light since NSE has not given anyone else this data.
Why was this data important?
More the historic price and volume data available, better the algorithmic trading strategies that can be developed. Think of it this way. Somebody who has data on minute to minute changes in temperature, humidity of a particular region for the last 100 years, will be able to come up with a superior weather forecasting model than somebody who has data only on the daily changes in temperature and humidity.
How did Infotech Financial Services use the data?
According to the SEBI report, Infotech used the data sourced from NSE for developing algorithmic trading software, which it then sold to clients. One of its products was named Chanakya, which Infotech offered to its clients on a profit-sharing agreement.
What did the SEBI order say?
It said that Ajay Shah, Infotech, its directors and Suprabhat Lala had colluded to make money by fraudulently using data that was obtained by them from NSE to develop the algo trading software. “The algorithmic trading software so developed from LIX data was meant to be sold to the traders/brokers in the market to induce them to trade in securities with better trading results, on the strength of capability of such algo trading software prepared out of such exclusive data not ordinarily available to other market participants.
What action did SEBI take?
Ajay Shah and Suprabhat Lala were barred from associating with any SEBI registered entity for two years. Infotech was directed not to offer any services to SEBI-registered entities for two years. However, all the parties appealed the order and the Securities Appellate Tribunal is yet to pass the final verdict in the matter.
What is the dark fibre controversy about?
Brokers who used NSE’s colocation facility were initially not allowed to access price feeds from the BSE’s servers for running algorithmic trading strategies. Some brokers violated this rule.
Why did NSE forbid brokers from accessing BSE price feed for algo trading?
Algo trading strategies that compared prices from two exchanges would execute buy/sell orders on the exchange offering the best price at that point. This would result in many orders being executed on the BSE as well, resulting in more business for that exchange.
How did some brokers bypass this rule?
They got a telecom services vendor not authorised by the NSE to lay a fibre optic cable connecting their co-location servers at both BSE and NSE. This meant they could simultaneously access price feeds from both exchanges.
Was the NSE aware of this?
Yes. The SEBI order said that some brokers were allowed to connect to colocation servers at both exchanges. The exchange officials did not inspect the premises of these brokers to check if the optic fibre line terminated at their office, as was required under the NSE rule.
But others who applied to the NSE for a similar arrangement were denied permission. So, those with access to both price feeds were at an advantage because they would always get the best prices, as compared to other brokers who had access to the price feed of only the NSE.
There was another aspect as well.
Even within the colocation facility, some brokers were allowed to connect much closer to the NSE’s trading servers. Think of it as some residents of a housing society being allowed to park their cars inside the building compound, while other residents have to park outside the main gate.
This again was done with the help of the telecom service provider who was not authorised by the exchange. When other brokers asked for similar arrangements, they were denied permission.
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