Colocation

Colocation, in trading, is the placing of a market participant's computers in the same data center that houses an exchange's matching engine. The firm rents rack space, power and network connections from the exchange or its data center operator. Being physically next to the exchange removes almost all the travel time for market data coming in and orders going out.

Colocation is sold by most major exchanges as a commercial service. It is used chiefly by firms for which speed is a competitive factor: high-frequency trading firms, electronic market makers, and brokers that offer fast access to their clients. It is one of the main components of low latency trading infrastructure.

The exchange operates or leases a data center and sets aside halls for customers. A firm installs its own server hardware in a locked cabinet. A physical cable, called a cross connect, links the cabinet to the exchange's network inside the building. Over it the firm receives the exchange's direct data feeds and sends orders to the trading gateways.

Exchanges take care to treat colocated customers alike. A common practice is to give every cabinet a cable of the same length to the matching engine, so that a firm at the far end of the hall has no disadvantage against one beside the exchange's equipment. Services are sold from a published price list, with fees for cabinets, power, connections of different speeds and data feeds. In the United States, the New York Stock Exchange runs its markets from a data center in Mahwah, New Jersey, Nasdaq from Carteret, New Jersey, and CME Group from Aurora, Illinois.

A signal cannot travel faster than light, and in glass fiber it travels at roughly two thirds of the speed of light in a vacuum, about 200,000 kilometers per second. The one-way delay over a link is:

• $t$ is the travel time.
• $d$ is the length of the path.
• $v$ is the speed of the signal in the medium.

A firm whose servers sit 100 kilometers of fiber away from the exchange faces a delay of 100 ÷ 200,000 = 0.0005 seconds, or 500 microseconds, in each direction. A colocated firm with 50 meters of cable faces 0.05 ÷ 200,000 seconds, or a quarter of a microsecond. When two firms react to the same price change, the one that is 500 microseconds closer will reach the order book first every time. No software improvement at the distant site can recover that gap.

For a firm engaged in market making, speed is a form of protection. Its quotes rest in the order book and can be hit by faster traders the moment news arrives. The quicker it can cancel or reprice, the smaller its losses to better-informed orders and the tighter the spread it can afford to quote. For firms that pursue arbitrage between related instruments, being first to a mispriced quote decides who gets the trade.

Slower participants use colocation indirectly. Brokers place their order-routing systems in exchange data centers and give clients access through direct market access. Inside the cabinet, firms shave further time with specialized network cards and with the field-programmable gate array, a chip that processes data in hardware.

• Proximity hosting. A firm rents space in a third-party data center close to the exchange instead of inside it. See proximity hosting.
• Links between data centers. Firms trading the same product on venues in different places need the fastest route between them. Straight-line optical fiber routes and, faster still, a microwave network serve that purpose.
• Direct data feeds. Colocated firms take the exchange's full-depth feed, such as tick-by-tick data, in place of slower consolidated feeds.

Regulators accept colocation as a legitimate service on the condition that access is open and even-handed. In the European Union, the rules made under MiFID II require trading venues to offer colocation on a fair, transparent and non-discriminatory basis, with the same conditions for all users of the same service. In the United States, colocation is treated as a facility of the exchange, so its terms and fees are filed with the Securities and Exchange Commission.

The service has not been free of controversy. In India, the securities regulator SEBI issued orders in 2019 concerning unequal access to the National Stock Exchange's colocation data feeds in earlier years, a case that led to changes in how the exchange distributes data. More generally, critics argue that colocation creates a two-tier market in which those who can pay see prices first, and that the spending is an arms race with little benefit to investors. Defenders reply that the service is open to anyone on equal terms and that competition among fast market makers has narrowed spreads.

Colocation is costly. Beyond the rental fees, a firm needs hardware, direct feeds, engineers and a presence in every data center where it trades. The advantage is also relative: once most competitors are colocated, being there is a requirement and no longer an edge, and the contest moves to hardware and code. For strategies that hold positions for hours or days, the microseconds saved make no measurable difference, and ordinary hosted or cloud infrastructure is sufficient.