Feature: Colocation - A Game Worth the Candle? Issue 04 January 2007 Automated Trader Magazine
Exchanges, networks and service providers are turning to the laws of physics in the race to reduce latency and win customers. But do colocation and proximity trading really offer substantial benefits worthy of the investment, or is it mainly a triu.

The market's need for speed is genuine. In today's market milliseconds really do matter, although they matter more for some than others. What is more debatable is the best way to achieve a latency rate of milliseconds.

Colocation and proximity trading have become the latest area of interest for those firms seeking ultra-low latency. By way of definition it is commonly accepted that proximity trading refers to sites located as close to the venue as possible while colocation refers to the more recent practice of actually being located within the firewalls of the exchange itself.

For colocation services of this kind to flourish, the exchanges have had to get involved and look for partners to develop these services. Fortunately, the increasing pressure that they face from regulations such as MiFID and RegNMS in the US, plus a demand from the market for lower transaction fees has forced them to compete on price and product. Many have targeted the low latency market as a possible source of new revenue streams.

The London Stock Exchange is currently in talks with a number of brokers to have their algorithmic trading engines inside the exchange's firewalls. The New York Stock Exchange has colocation services offered within its data centres operated by SIAC Sector. Most recently, in the commodities and futures market the Chicago Mercantile Exchange has opened up its doors and through a venture with colocation provider Equinix is set to launch the Lnet Service in the first quarter of 2007 for users of the Equinix Chicago Internet Business Exchange centre.

"It is the first offering by a major commodities and futures exchange allowing a direct connection to its matching engine," claims Dan Walker, vice president, sales for the Western and Central regions of the US at Equinix. "The idea is to eliminate the middle man and remove any unnecessary latencies and network hops. The goal is to get the network latency as close to zero milliseconds as possible without residing in the engine itself."

Walker expects a great take up of these services, most likely from the sellside prop shops and high frequency hedge funds. Dmitry Bourtov, manager of the Solaris Market Neutral hedge fund uses colocation selectively for proprietary trading purposes. "The advantage is that it significantly cuts our messaging time so we are able to make our decisions on whether to buy or sell a lot quicker."

Bourtov sees developments such as the CME and Equinix Lnet service, where he can plug directly into the exchange's router, as a "big step forward" on the basis that the closer you are to the exchange's network then obviously the lower the latency. However, he also warns that there is more to consider and there is room for improvement.

"Sometimes it is not just the speed that is important with colocation, it is also about the reliability and how often the system goes down," he says. There is also the issue that latency can be lost elsewhere in the process chain. Because of the inefficiencies of the service providers involved, it reduces all the customers to the same latency so that even when you have a two millisecond connection to the execution venue you are not getting any gain. "This issue needs to be addressed on a vendor-by-vendor basis because it is extremely important," he says.

Elsewhere on the sell-side there are also concerns about whether there are significant gains to be made from investment in colocation services. Richard Balarkas, head of Advanced Execution Services at Credit Suisse accepts that speed is very important to the statistical arbitrage traders and ultra-high frequency hedge funds, but he also believes that the money being made in these markets from speed has been reducing.

"Five years ago a hedge fund may have been able to say that each 50 milliseconds shaved off latency equated to $X,000 of revenue," he says. "But the process has been finessed so much that it is getting harder to measure whether those changes in latency are really producing markedly better performance."

For Frederic Ponzo, managing director of financial technology consultant NET2S, the differences in distance and speed for a West End based hedge fund trading on the LSE being offered the chance to place its servers underneath the chair of the exchange's chief executive are so slight they are bordering on lunacy. "Light travels at 200km/sec in glass or optic fiber, therefore you are gaining 1 millisecond every 200km, so locating 10km nearer will save you 50 microseconds."

Milliseconds do matter, he says. For fixed income they matter in the order of 150-200 milliseconds. In equities it is a little lower and for arbitrage activity or small-cap funds it is still a case of 50-100 milliseconds and shaving 50 microseconds, or 0.1%, is not going to make any difference.

There is also a logical finale to the development of services for clients who have velocity as their modus operandi and where the way to beat your competitor is to get as close to the execution venue as possible, says Kevin Bourne, global head of execution at HSBC.