By Irwin Speizer
Across the Hudson River from Manhattan, among the warehouses, distribution centers and low-rise office buildings that have collected in Secaucus, N.J., sits an unassuming example of modern suburban office design. Beyond the front door is an unwelcoming foyer with no reception desk, no tenant list, no indication that you are in a major East Coast financial data center run by Equinix, a global data center operator located in Foster City, Calif. The only doors that lead beyond the entryway are locked.
Security in the form of badges and electronic handprint checkpoints will get you through the foyer to a security guard window, where proper clearance will get you past a second door into a small holding area. The door closes behind you. A security guard checks to make sure no one unauthorized has slipped in with you. Then the last door opens, allowing you, finally, into the world of co-location, a key link in today’s financial system.
You are in a windowless, cold and dimly lit interior space, broken up by row upon row of metal cages, each one populated with tall racks of computer gear—mostly servers silently at work for some distant bank, securities exchange or hedge fund. A handful of tech specialists are scattered about this vast space stringing cables or working on computer servers.
What happens in these data centers is at once mundane and mysterious. But the concept of co-location is not hard to understand: It simply occurs when companies place some of their computer servers in centralized communal data centers operated by third parties.
It’s also increasingly of interest to federal regulators who are examining how technology affects markets and their participants. A Securities and Exchange Commission review of the fairness of high-frequency trading operations has now broadened to include technology used by those traders as well as by others, including the use of co-locations as a way to gain a trading edge.
What interests the SEC at the moment is the technique of co-locating trading servers next to the exchanges where the trading is done, a move that can shave a few microseconds off turnaround time. That is enough time for high-frequency firms to churn out profits through high volume.
Funds that make use of co-location to conduct high-frequency trading say the answer is clear: The process is nothing more sinister than a free market at work. “Anybody who wants to can go and do it,” says Michael Graves, president and chief executive of Tesseract Capital, a New York firm that runs a high-frequency statistical arbitrage strategy and uses co-location to boost speed. “If someone is not using it, it is because they don’t need it.”
But co-location is a much broader application than what serves high-frequency traders. Hedge funds with no real need for the speed demanded by high-frequency traders are increasingly using co-location to meet their basic technology needs. And the two uses are becoming increasingly entwined, sometimes blurring the distinction between types of users, sometimes not.
Gravitas Technology, a financial technology services company in New York, sells co-location space on racks it maintains in the Secaucus site and has experienced a boom in business. Gravitas had a half dozen cabinets and a handful of hedge fund clients at its co-location operation there a year ago; today it has 30 cabinets and about 45 hedge fund clients and expects to expand to 50 cabinets to meet demand.
“Our co-location business has skyrocketed over the past year,” says Jayesh Punater, CEO of Gravitas. While the proximity to certain exchange servers is clearly a motivation for hedge funds moving in, Punater says, a host of other reasons are also fueling the surge.
Co-location can be a cost-effective way of meeting technology and operational needs without building an on-site data center. Emerging hedge funds can rent server space from a company like Gravitas, which maintains its own servers at the co-location site.
Co-location sites also can help funds meet the heightened demands for sufficient and consistent power, a recurring concern for funds in office buildings in Manhattan and throughout the country. Co-location sites come equipped with extra power and generators capable of running long after a power outage or other emergency. As the Equinix site shows, they also can provide plenty of security. And the sites can serve as backup data centers for disaster recovery.
Punater says that the recent financial crisis has caused hedge funds and other financial firms to postpone capital expenses such as computer upgrades. As the markets improve and funds start rethinking their technology needs, he expects more to consider co-location as an option. Kevin McPartland, a senior analyst at Tabb Group, says funds will likely focus more on co-location as they consider whether to build or expand their data operations at their offices or move servers to remote sites.
“Getting equipment out of the closet in an office and moving it into a data center is common now, and I think it will become more so,” McPartland says. “The data center providers have gotten more efficient at helping people migrate and manage their infrastructure. And because there is more competition, pricing has become more transparent.”
Add to those considerations the ongoing push for trading speed led by the high-frequency trading crowd and the lure of co-location becomes harder for hedge funds to resist, even though only a fraction of hedge funds are thought to actively engage in high-speed trading.
Andrew Lo, a professor of finance and director of the Laboratory for Financial Engineering at MIT, who also is chief investment officer of Cambridge, Mass.-based quant hedge fund Alpha Simplex, says his fund has servers at a co-location site in Billerica, Mass.
Alpha Simplex doesn’t need to co-locate near one of the exchanges in the New York area, Lo says, because its trading programs do not need to execute so quickly. Losing a few microseconds by being farther from the exchange, an effect known as latency, is not that important. “What we care about is connectivity and business continuity,” Lo says. “We are not that concerned about latency. But other issues are quite important. Our investors want to know that if we have a snowstorm, we can still operate.”
Yet even some firms that don’t see themselves requiring the speed of high-frequency trading can feel pressure to try to keep up with the general push for faster trading, and that can influence a co-location decision. Funds that don’t perceive the need to be among the fastest traders also don’t want to be among the slowest.
Quantitative Investment Management, a Charlottesville, Va.-based quant fund that trades thousands of futures contracts a day, figures it doesn’t need so much speed that it has to co-locate its trading servers beside exchanges, which can charge a premium over other co-location sites. But the firm is still considering co-location sites for its future needs. The initial reason is to improve the firm’s access to basic operational needs such as sufficient power and security, and for disaster recovery.
But the firm also is looking at sites around the globe near exchanges where it trades futures contracts. The reason: to reduce trade turnaround time. QIM isn’t looking to locate beside an exchange for maximum speed. But it is concerned that having its trading servers located thousands of miles from the exchange might leave it far enough behind those trading locally that the firm could be ceding a slight advantage to others—or at least the perception that it has ceded that advantage. QIM’s interest is in trading at a speed that local traders can expect in, say, Asia.
“It is not that we want to get some fanatically low level of latency,” says George Coles, head of algorithmic trading at QIM. “It is just to make sure we do not have some ridiculously high level of latency.”
Still, Coles says that the fact that latency even enters into the equation for QIM says something about the direction that co-location used to boost trading speed is headed. “If people like us contemplate it, it means it is something that can be done pretty efficiently,” Coles says. “We are an example of it becoming mainstream.”
To meet growing demand, hosting companies like Equinix are adding co-location space around the country and the world. New opportunities to get close to the New York Stock Exchange will be available once NYSE Euronext, the exchange’s parent company, completes its 400,000-square-foot data center now under construction in Mahwah, N.J.
For the SEC, the question is whether any of the recent activity in co-location requires additional oversight or regulation. There is no doubt that a firm that co-locates next to an exchange can gain a tiny edge in transaction speed. But whether any of that constitutes an unfair advantage over others whose trading servers are located farther away is a more difficult issue.
If the SEC does decide to examine co-location for high-frequency trading, it is unclear exactly what sort of action it might take as a result. In addition, the rise of co-location clusters around exchanges raises new issues about the vulnerability of financial networks.
But many hedge funds and service providers are counting on co-location not only surviving any review from Washington but ultimately expanding, particularly if co-location pricing becomes more competitive. Indeed, the type of co-location used by high-frequency firms might even become the standard rather than the exception.
