Flashboys Colocation Explained
Colocation (also spelled co-location) is a commonly used phrase in Michael Lewis' book Flash Boys: A Wall Street Revolt. It can be difficult to understand what colocation is and why it matters to high frequency traders.
In the book, Lewis describes how high-frequency traders used colocation to gain a speed advantage over other traders and one another. The trader who colocated closest to the servers used by market exchanges had the highest speed advantage.
What Is Colocation
Colocation is simply sharing the costs of a data center between multiple organizations. A colocation provider offers a data center. The customers of that provider then rent individual space within the data center. No single company owns the whole data center.
This is in contrast to large companies such as Amazon or Google, who are big enough to own and operate their own exclusive data centers.
So a colocation facility is a data center that has different organizations using its space. Some of these organizations can connect to one another within the colocation data center.
What Is High Frequency Trading
High-frequency trading (HFT) is a way of using computers and speed to leverage markets. Stock markets can be used by high-frequency traders to make almost rick-free money. HFT is a multi-billion dollar industry.
High-frequency traders have computer programs that use speed to perform massive amounts of trades in a single day. These stock trades all produce a little bit of profit, but because there are so many of these trades, they end up making a ton of money. It's a very lucrative industry.
Because HFT depends on speed, the faster the HFT computer can connect and talk to the stock market, the better a HFT firm will do. For HFT to work, the trading firm must be able to complete an order on the stock market before other people are able to do so.
Why Colocation Matters
So why does colocation matter to HFT? HFT uses computers. So do stock markets. They both have extremely powerful computers which need to talk to one another. The more powerful a computer, the faster in can process data. However, the speed at which two computers communicate also depends on how close they are to one another.
So for HFT to work, the HFT computer must be able to communicate with the stock market's compute before anyone else can.
When data travels between different locations, it uses fiber optic and copper cables. These cables have a limited speed. A fiber optic cable, connecting two computers can send data about 1/3rd of the speed of light. This is a physical limitation. Light inside a fiber optic cable does not go faster than 1/3rd the speed of light.
So lets say there is a stock market computer in New York. Lets say there is a trading company in California and a trading company in New Jersey, and they both want to buy the same stock and the same time. Each trading company has the same powerful computer, and they both put in their order at the exact same time. The New Jersey company will always have their order go through successfully. This is because when everything else is equal, the distance between California and New York is going to create a lag (delay) in the time the California order gets to New York. The New Jersey order will get there first because both orders are going the same speed (1/3rd the speed of light) but the New Jersey order has much less distance to travel.
So HFT firms have taken this distance factor to the extreme. Now they do everything they can to have their trading computers in the same physical location as the stock market computers. The high-frequency traders are making sure that their equipment is colocated in the same facility as the stock markets.
Not only that, but in Flash Boys, Lewis describes how these HFTs pay an arm and a leg to be meters closer to the stock market computers than their competitors.
The reason why colocation matters to high-frequency is that leasing space in certain colocation facilities allows the computers of the HFTers to be closer to the stock market computers, allowing for faster communication between the two. When speed is making you millions of dollars in income, every meter distance matters.