The market regulator is putting the onus of corrective action on National Stock Exchange of India Ltd (NSE) after a forensic audit found that NSE’s algorithmic trading platform and co-location facility were “prone to manipulation" and allowed “potential preferential access" to some brokers.

The Securities and Exchange Board of India (Sebi) will ask the exchange to strengthen its trading systems, fix responsibility for lapses found by the audit, suspend employees who were at fault and examine members who may have profited illegally or unfairly, four people familiar with the matter said.

The independent audit report, whose findings were revealed by NSE in its share sale prospectus last month, observed that for certain periods, a few stockbrokers who co-locate their servers on the premises of the exchange appeared to be the first to connect to specific servers. NSE’s systems architecture meant that the first person to connect also accessed the data first, the report said.

That translates into an unfair advantage in algorithmic or high-frequency trading, in which traders use electronic systems that execute thousands of orders in less than a second.

Considering that some of the findings against the exchange are grave, Sebi may also prescribe measures to tackle governance lapses, said the four people cited above, including officials from the regulator and the exchange.

“The revenues arising out of co-location since September 2016 that are currently deposited in an escrow account will remain frozen till that time (the Sebi investigation reaches a conclusion)," said one of the four, all of whom spoke on condition of anonymity.

“Sebi’s audit highlighted that some members made profits during the said period and when NSE changed its systems, the profits went down sharply. We had an option of either shutting down the prone-to-manipulation systems or segregating the funds; we took the second option," said a second person.

The corrective action may delay NSE’s share sale. The exchange’s board said that it plans to go public via an offer for sale at the start of the April-June quarter after it resolves the allegations of “unfair access" to its algorithmic trading platform.

An email sent to NSE seeking comment on whether it had received any communication from Sebi after the submission of the findings of the report went unanswered. An email sent to Sebi on Friday, seeking comment, also elicited no reply.

“Sebi had already asked the NSE board to get an independent investigation conducted and take corrective action and fix responsibility. The forensic audit has reached the same conclusion that the Sebi committee did in April," said a third person.

“The regulator will take corrective measures. They should look at the role of the errant employee(s). Also quantify the illegitimate gains made by the members who gained unfair advantage," the third person added.

Allegations of unfair access for some brokers at NSE first came to light when a whistleblower who went by the pseudonym Ken Fong wrote to Sebi, alleging that the bourse’s systems were being misused. Sebi referred these complaints to its technical advisory committee for investigation. NSE had initially denied these allegations.

Mint reported on 5 April that the Sebi committee concluded that NSE violated norms of fair access and allowed some brokers to benefit.

Following these observations, Sebi directed NSE to commission a forensic audit of its systems and deposit all the revenues generated out of co-location facility in an escrow account.

According to NSE’s share-sale prospectus, NSE’s revenues from the co-location facility for the six months ended 30 September 2016 was Rs302 crore, or 29.3% of revenue from its operations.

Revenues generated out of co-location since September 2016 were to be deposited separately in an escrow account. NSE has listed it as one of the risk factors in its share sale documents and is waiting for a direction from the regulator on these revenues.

A person familiar with the thinking of NSE said that this was an issue of the past. “NSE’s systems were prone to manipulation till the time data was disseminated to one member at a time with microseconds of lag. However, since it has moved to the broadcast system of disseminating data the issue is resolved," he said, declining to be named.

“The concerned NSE employee who was interacting with the members who allegedly got unfair access has also left the organization. It is difficult to say now that whether it was dishonest conduct," he added.

“NSE has already started making changes such as the data retention policy and strengthening systems and process. As far as examination of the errant members is concerned, NSE has already done it once and found negligible gains, but the exchange will do it again," he said.

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