Home / Opinion / Online-views /  Did Sebi just ask NSE to investigate itself?

The Securities and Exchange Board of India (Sebi) has asked the National Stock Exchange (NSE) to appoint a third-party auditor to examine allegations that some trading firms had unfair access to its market data and trading systems. “Sebi has asked the board of NSE to get all the concerns expressed by its expert committee examined and take necessary action within three months and give a report," NSE chairman Ashok Chawla said in an interview with The Economic Times.

For perspective, Sebi’s expert committee had earlier found evidence that some trading firms had unfair access to NSE’s data and systems. So far, NSE has vehemently denied this, both in its interactions with the regulator and with the media.

It seems odd, to say the least, for Sebi to now ask the exchange itself to commission a third-party audit and then send an action-taken report to the regulator. According to an expert on market microstructure who did not want to be identified, the appointment of a third-party auditor that reports to the exchange serves no purpose. As pointed out in this column earlier, such an audit makes sense only if the auditor/consultant reports directly to Sebi and when the exchange has to compulsorily implement each of the consultant’s recommendations.

Sebi must insist on this, if the audit has to make any difference. It may be argued that Sebi has written to the board of the exchange, which can be expected to act independently as its objectives are not fully aligned with that of the management. But even if one were to assume that NSE’s board is completely independent of its management, the fact remains that the board cannot and will not assume the role of a market regulator. Sebi is best placed to oversee this audit.

In fact, the regulator can dust the chronicles of Forward Markets Commission (FMC) and take a leaf out of the former commodity market regulator’s books. In December 2013, a few months after the National Spot Exchange Ltd (NSEL) scam had erupted, FMC ordered Multi Commodity Exchange of India (MCX) to appoint a forensic auditor to scrutinize, among other things, related-party transactions. Back then, NSEL and MCX were both part of the Financial Technologies group of companies. The auditor, PricewaterhouseCoopers, submitted its report directly to FMC, besides sending it to MCX, and the regulator was closely involved in the audit process, even outlining the terms of reference for the investigation.

Of course, some of Sebi’s actions suggest it is acting tough against the country’s largest exchange. Mint reported last week that the exchange is also required to deposit the revenues earned from its co-location facilities in an escrow account till the auditor files its report. It remains to be seen where Sebi is headed with this, but these are clearly more than minor irritants for NSE. Revenues earned from co-location services may not be all that significant, especially in comparison with transaction fees, but the move is further evidence of the regulator’s unease with trading that emanates from co-located facilities. In fact, in its recent discussion paper on algorithmic trading, Sebi had talked of curbing the advantages of firms that have co-located facilities at the exchange. Any such move can hit volumes to a great degree.

But even otherwise, the commissioning of a third-party audit is hardly a great advertisement at a time when NSE prepares for its initial public offering. Investors are hoping for a rich 30 times one-year forward earnings multiple, valuing the exchange at Rs45,000 crore. But any regulatory action at this point either against the exchange or against algorithmic trading can act as a spoiler. Along with the fact that a few high-profile investors had cried hoarse about poor corporate governance at the exchange last year (when it had seemed to resist listing), some investors may well apply governance and regulatory risk-related discounts when they value NSE shares.

Sebi, meanwhile, must step up to the task and strengthen its capabilities in market surveillance and investigation in the sphere of algorithmic trading. This column has argued for a long time now that the regulator’s surveillance tools should be on par with the sophisticated trading tools that are being used in the marketplace. The allegations of unfair access at NSE just bring this issue to the fore again. It has been about 20 months since the NSE whistle-blower wrote to the regulator about one trading member gaining preferential access to the exchange’s systems by colluding with some exchange officials, and we’re yet to see closure of the case. The regulator must now take charge of the third party audit to ensure this does not drag endlessly.

Read Mobis Philipose’s earlier columns at livemint.com/inthemoney

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