Dummies guide to what Mr X who controlled an Exchange would do to make windfall gains

There’s a speculation that there was a group of high and mighty who controlled NSE from outside. Let’s call this group collectively as Mr X

There’s also a line being pushed that Mr X made windfall gains through colocation and HFT. This piece attempts to throw some light on various possibilities.

Over the last few years that I have been writing this blog, I have come to realise that operating in colocation requires significant technology and spend. This is not just in servers, rack space, message rates etc. but also personnel with deep understanding of maths, engineering and technology. It needs high end Intellectual Property in the form of proprietary algorithms to make high rate of returns. Colocation and HFT space is infact the hardest to manipulate because the players in colocation aren’t just the most technologically and mathematically advanced players in India but some of the players from across the globe are already in Indian markets. Most of them have been around for 10+ years in Indian markets.

As a matter of fact, I can’t think of a way in which members by sheer virtue of speed alone can make sure-shot profit. Not just this, it is even harder to imagine how this can be manipulated to create illegal profits. Having said that, Algorithms can be manipulative and even HFTs have been known to create havoc in the stock market. But these are NOT due to nano-second differentials in market data speeds within the colocation. The best thing about colocation trading is that, everything is available in form of data. A detailed look at data is necessary for investigators to get the complete picture of this controversy. So far, exhaustive investigations by India’s four premier Investigation agencies and Regulator also seem to suggest that the profit earned in colocation is not even a fraction of the scale which is being talked about in the media. But some “wise men” have been challenging collective wisdom and competence of these agencies. On the other hand, as I had written in my earlier blog, there is confidential exchange data which if obtained can be used to rake in big money. In this blog, I will try to put together a few examples of such illegal profits.

Disclaimer 1: These views are just expressed as possibilities which could have been, rather than something which happened in reality. I have no knowledge of any event remotely resembling what I describe below.

Disclaimer 2: This is not an exhaustive list of what can be manipulated. These are just few ideas which come to my mind knowing the exchange ecosystem. I am sure there could be many more ways in which markets can be manipulated if insider data was known.

Disclaimer 3: As earlier, some people are bound to say that this blog is an attempt to deflect investigations into on-going colocation controversy. I’m sure that investigators have extremely competent teams with their own mind. Huge data is available at their disposal. Investigations will surely proceed on findings based on data & facts, and not on perceptions being created without giving any facts.

Example 1 : Front-running & Insider Trading

Data Needed : Client wise trades and positions in a particular stock

If a certain stock is seeing interest by promoters, institutional investors and/or large HNI clients, price of the stock can be predicted in the short term. If one comes to know that a large institutional investor is getting into the stock, the price in the near term is sure to go up. The person privy to this information before others can materially gain by placing a buy order and see his profits go up as the price of the stock goes up.

Assuming that the person is privy to the information that insider is selling the stock. In this scenario, the person privy to this information knows that the price is going to go down. All he needs to do is to sell the stock, may be in derivatives market, before public gets the relevant disclosure. His profits are going to be certain and huge.

Regulators have put in place several mechanisms to ensure that such information which can move stock prices is disseminated to the wider public at the earliest practical time, so that possibility of abuse of privileged knowledge of the information is reduced. Insider trading and Front running is specifically prohibited and information pertaining to trading by insiders is required to be disclosed to the stock exchanges so that the wider public has access to all such price sensitive information at the earliest.

Price sensitive trading related information includes trading by company promoters, Directors and key management personnel as well as large shareholders. Information of trades by such persons affects stock prices and is typically required to be disclosed by these persons within 2 days of the trade. However if someone has access to information about these trade prior to disclosure on the stock exchange then such a person can take unfair advantage of this information and make windfall gains.

Example 2 : Unfair profiteering

Data Needed : Client wise position and margin in a particular stock in derivatives segment of Large Investors

If price moves in an adverse fashion, margin of the client starts to increase, at some point of time he has to unwind his position. For example, a client believes that price of INFOSYS will go down and he has taken a short position in the derivatives segment. At this time, a manipulator will start to build a long position in the stock and cause the stock price to move up. This would cause this client to accumulate notional loss called MTM. This starts to deplete client’s margin and as soon as his loss becomes close to his margin, he has to unwind his position in a significant loss. This can only be done when the manipulator knows the exact margin, financials and position of the client. With this information, he can take the client close to his margin call and make him unwind his position in loss and with gains for himself.

Example 3 : Price manipulation

Data Needed : Prior information about stocks going into derivatives and/or stocks changing in the wide use Index (NIFTY / BANKNIFTY / SENSEX).

If a person was privy to which stocks are coming into derivatives and also which stocks are getting in/out of the major index. Just this information before it is made public can be used to make significant money. A large number of funds and ETFs have considerable position to match the INDEX. As soon as the information is made public, the price of the stock getting into the INDEX rises significantly and the price of the stock getting out the INDEX falls. When such a specific demand is created, this presents an opportunity for front running and taking advantage of inevitable price moves.

Stock exchange is a storehouse of all such sensitive information. Any person who has such access to top management of an exchange that he can obtain such privileged information ahead of public dissemination of information or seek access to information which would never be available to the rest of the public can potentially stand to make windfall gains. Access to such information could give much larger gains as compared to what can be generated through the small size gains which are sought after through HFT and co location. The range of return on capital deployed from HFT and colocation is typically between 15% to 45% per year depending upon the strategy deployed. Why would anyone take the trouble of deploying capital and carrying out high frequency trading if they could make humongous gains , maybe 100 times this range, merely based on privileged information access and a few well timed trades.

Also, Mr. X would control Surveillance actions by the exchange and manage internal investigations into trading to benefit his friends in the industry.

Mr X, if he or they existed, was not a fool, unlike…..