Capital market regulator Sebi is trying to find a way to regulate large investors who place their trading servers within the exchange premises to gain a split second advantage - a practice that makes markets more vulnerable to flash crash. Better known as co-location, stock exchanges and other aparties appointed by them offer stock brokers the option to locate their trading-related equipment next to the exchange server.

Since only brokers with deep pockets can afford it, there is a widely shared perception that small intermediaries lose out to them on speed. Co-location also came under attack after the October 5 flash crash which some attributed to highspeed trading systems. Making a note of a growing market perception, Sebi, on Friday, released a discussion paper, proposing that exchanges should provide co-location in a "fair, transparent and equitable manner" to ensure a level playing field for all brokers.

Sebi said that exchanges should ensure that the size of the co-located space is sufficient to accommodate all stock brokers and data vendors that are desirous of availing the facility.

Besides, bourses should also avoid situation of monopolising of rack space by certain stock brokers. While Sebi is silent on whether exchanges should make the service more affordable, it said that brokers who are not co-located must have fair and equitable access to the stock exchange's trading systems. Besides, stock exchanges facilitating co-location should implement an "order handling architecture comprising two separate queues for co-located and non-colocated orders" so that orders are picked up from each queue alternatively.

"It is expected that such an architecture will provide orders generated from a nonco-located space a fair chance of execution and address concerns related to being crowded out by order placed from co-location," said the Sebi paper.

Market participants have been asked to give their views by May 31, 2013. Although technological advances improve liquidity and tighten spreads, there is also a growing perception that co-located market participants using high-frequency trading algorithms crowd out the orders of brokers who are not co-located. It's widely accepted that the factor of closeness to the stock exchange's matching engine provides co-located trading members with an advantage of being the first recipient of the market data and among the first to place orders.

Many think it has also contributed to the increased volatility. Globally, regulators have either prohibited exchanges from offering co-location or decided to regulate the facility. Recently, commodities market regulator FMC prohibited the co-location facility for members of the commodities derivatives exchanges. Sebi said a sizeable proportion of the total orders received by the bourses are now being generated by algorithms. In February 2013, NSE handled as much as 94% of its derivatives trades and 74% of cash trades from co-located brokers, said Sebi.