Coming hard on top stock exchange NSE for its conduct with regard to 'freak' 920-point crash in benchmark index Nifty, regulator Sebi today censured the bourse and ordered an independent comprehensive review of its processes and systems to ensure overall market stability.
In a strong-worded order, Sebi also asked National Stock Exchange (NSE) to be "careful and cautious in its dealings in the securities market and comply with all the legal requirements that govern its functions as a stock exchange".
Capital markets regulator Sebi also said that "the system followed by NSE is not robust" and the incident, which took place nearly two years ago on October 5, 2012, shows that "wrong action on the part of one individual could result in bringing the entire system to a halt".
In the order, Sebi's Whole Time Member Prashant Saran said: "NSE is directed to carry out a comprehensive review, by an Independent Expert of the processes followed, checks in place, systems employed by NSE, not only in respect of the situation specific to this case but also for maintaining stability of markets in general."
The consultant would need to "suggest a more robust securities trading system" and submit its report to NSE within a period of three months from the date of this order.
On receipt of the report of the consultant, NSE has been asked, within a period of three months thereafter, to submit a report to Sebi along with its 'Plan of Action'.
The case relates to a sudden 920-point of 16 per cent plunge in the NSE's benchmark index Nifty, which is widely followed by investors in India and abroad, on October 5, 2012, despite the systems requiring circuit breakers - first at 10 per cent and further at 15 per cent movements within a day requiring halt in market trading.
The 10 per cent index circuit breaker for that time was 570 points, while the 15 per cent level for the circuit breaker was 860 points.
In its 40-page order, Sebi said its investigation found various lapses on the part of NSE including that of "not sending 'halt' trigger to its matching engines at the instance of breach of 10 per cent circuit breaker" on that day.
Further, the exchange did not halt trading exactly at 10 per cent and 15 per cent circuit breaker limits and did not cut short the market halt duration, the order said.
The regulator said that NSE did not halt trading in its equity derivatives segment when the circuit breaker was triggered in the cash market apart from not "co-ordinating with other stock exchanges regarding the market halt".
Citing these lapses, Sebi said the exchange failed to adhere to the regulator's norms and also failed to "effectively ensured that its stock brokers have necessary risk control systems and did not have a system at its end (as orders pass through its platform to be executed as trades) to manage risk in the event of failure of stock broker's risk management system."
"This had impacted market integrity and orderly trading on October 05, 2012. In view of the above, NSE has not in spirit adhered to the requirements of the SEBI Circular... ," the order said.
This is probably among the strongest Sebi actions against a stock exchange, although regulator also censured another bourse BSE recently with regard to some lapses during an Offer For Sale by the government in shares of state-run NMDC.
Noting that stock exchanges have a major role to play in the capital markets ecosystem, Sebi said they are entrusted with a responsibility that the stock markets run efficiently with least possible risk and interruptions.
While acknowledging that NSE is taking certain steps to prevent such occurrences, Saran, however, emphasised that "the need is to take a holistic, comprehensive review and create robust systems".
During the probe, NSE submitted before Sebi that it has implemented certain measures even before the occurrence of the referred incident and also implemented certain measures immediately after the incident in consultation with the regulator.
"Due to interdependencies of the markets and requirement of unified approach to ensure consistency across markets, some measures could not have been implemented on a standalone basis and as these measures needed market wide implementation, NSE has given its suggestions/recommendations to Sebi and I note that the same are under discussion with Sebi," Saran said in his order.
Following the steep plunge of 920 points on October 5, 2012, it was alleged that NSE failed to put in place a proper and an effective circuit breaker system.
After carrying out a special purpose inspection of NSE and submissions made by the bourse, Sebi had issued a show cause notice on April 18, 2013.
NSE has already undertaken a number of new risk management measures in the last two years, to try and ensure that a similar incident does not happen again.
These include limit on a single order size, price band for cash market stocks on which derivatives are available, allowing futures and options contracts only in a reference price range and executable range, mandatory risk reduction mode, among others.
Sebi, however, said the issue needs "needs an in-depth analysis as how the systems could be made more robust so that mistakes on the part of one or two persons does not bring the entire system to a halt.
"Towards this end, it becomes necessary that NSE undertakes a comprehensive review of its systems and processes generally and more particularly in the light of this subject matter," the order said.
"The Stock Exchanges have a major role as it is through their systems the trades are executed. Stock Exchanges are entrusted with a responsibility that the stock markets run efficiently with least possible risk and interruptions. Therefore, it is necessary that Stock Exchanges have systems which are robust enough to withstand individual failures," Sebi said.
Sebi further said that "a stock exchange, being a first level regulator, is expected to visualise possible problems and take pro-active steps.
"NSE should not have rested with contentment by telling its stock brokers that they should ensure compliance with the stipulations in this regard. If only NSE had in place a proper system/process to ensure the same, the incident that happened on October 5, 2012 would not have happened."
With regard to the exchange's contention that the problem was caused by non-compliance by one member and there was no systemic issue, Sebi said that however "such erroneous orders of huge value emanating from a few stock brokers, if let unchecked, as happened in this case, does pose systemic risks".
On that date, Nifty breached 10 per cent lower limit at 09:50:58 am, but by the time the market halted at 09:51:04 am, the index had already fallen by 920 points after breaching the 15 per cent level circuit breaker also.
It was therefore alleged that NSE failed to put in place a proper and an effective circuit breaker system and thus failed implement the necessary requirements, when it failed to halt the trading when the market fell by 10 per cent and allowed the index to fall further by 920 points (16 per cent) which resulted in the breach of market integrity and financial loss to investors.
The same day, Nifty issued a press release, saying that market-wide index circuit breaker system was triggered due to execution of 59 erroneous orders placed by one of its members, namely, Emkay Global Finance Services Limited, on behalf of an institutional client, for an amount of Rs 650 crore.
However, it was alleged in the Show-Cause Notice by Sebi, that NSE failed to ensure adequate Order/Trade Limit Controls and Risk management at its end and placed the onus entirely on the stock broker, Emkay Global.
The notice further alleged that no check was put in place by NSE in the cash market segment to validate orders in terms of permissible quantity/values at its end as the same would have ensured that even in case of a failure of risk management at the end of stock broker, order level checks at the stock exchange would have prevented such error.
As part of efforts to identify actions required to prevent such incidents, NSE later informed Sebi that it formed a cross functional internal team comprising of representatives from various segments including technology, risk, trade and regulation.
Besides, the exchange had engaged the services of an international exchange technology expert David Tsoi to study the index-based market-wide circuit breaker mechanism implemented by major stock exchanges worldwide.
The counter party members to the trades of Emkay Global were Inventure Growth and Securities, Prakash K Shah Shares and Securities Pvt Ltd, Labdhi Finance Corp, and Focus Shares and Securities Pvt Ltd.
"It was observed that trades of aforesaid counterparty brokers (whose margins were lesser than the required levels) had constituted 59.81 per cent of total value of the trades of Emkay Global
"... In view of the above, it was alleged that NSE had failed to ensure that aforesaid brokers had system based control facility on the trading limits of the clients and exposures taken by the clients, and failed to monitor risk management, as mandated by Sebi," the order said.
In August, Securities Appellate Tribunal had upheld NSE's decision to refuse Emkay Global Financial Services plea for annulment of erroneous trades executed in October 2012.
At the same time, the tribuanl had asked NSE to review trades executed by Emkay with two brokers - Inventure Growth and Securities and Prakash K Shah Shares and securities.
Emkay had approached SAT after the National Stock Exchange (NSE) refused to accept its request for annulment of the erroneous trades.
In a final ruling dated August 26, SAT upheld NSE's contention that norms related to trades on exchange should be inviolable "to ensure sanctity of dealings on the exchange".
"If trades are executed due to negligence or breach of duty they cannot be considered material mistake and therefore not qualify for annulment," SAT had said.
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