This is Why the CoLo Business is Lucrative for Exchanges

Even with a fall-off in trading volumes, offering colocation (CoLo) services to Wall Street banks, high frequency trading firms and market makers is still a top revenue generator for major stock exchanges operating their own data centers. Exchanges rent out space, cooling, and servers in their data centers to enable HFT shops, market makers, and brokers running algorithmic strategies to place their servers near their electronic matching engines.

“Colocation is important to trading,” said Richard Repetto, CFA, principal, Sandler O’Neill. “The more people you colocate, the more potential they have for people to do trading. It’s like a mall — the more stores that you have in the mall, the more you’re going to get overall sales,” says the analyst.

In Nasdaq OMX’s case, colocation service revenue, (e.g. monthly cabinet leases, power connection, and market connectivity), falls under a business known as “Access Services,” which also includes subscription revenue from risk management solutions for broker-dealers and their customers, and exchange membership and registration fees, assessed both monthly and annually.

Is it lucrative?

“It’s fair to say that overall revenue [from Access Services] doubled from $112 million in fiscal year 2008 to $239 million in fiscal year 2012,” according to Repetto speaking of Nasdaq OMX.

Nasdaq attracts people who want to colocate [near the matching engine] who want to pay for high- speed feeds, comments Bernard Donefer, a professor in the information systems department at Baruch College. “So how do [exchanges] make money? It’s an equation, explains Donefer, “One is transaction fees, two is market data, three is colocation for high speed trading. All of those things have to now be added together,” says Donefer.

This is why CoLo is so valuable to customers: If they colocate at an exchange like Nasdaq OMX, trading firms get access to all the U.S equity and options markets via a single hand-off, and they can cross-connect to other CoLo customers including major dark pools. They also get low latency – 60 microseconds round trip and access to all major raw market data feeds, notes the exchange’s site.

By offering CoLo, exchanges can sell other services such as connectivity, on demand, access to compute power, and access to low-latency services such as market data and risk management. This is all part of their diversification strategy on the part of exchanges seeking more stable revenues away from transaction fees.

According to Nasdaq OMX's earnings report for the second quarter of 2013, access and broker services revenues totaled $63 million in the second quarter of 2013, down $3 million from the second quarter of 2012. In its explanation of the results, Nasdaq OMX cited lower demand for connectivity and colocation in the second quarter of 2013, compared with Q2 of 2012. However, newer products such as microwave connectivity, a lightening fast connection between Nasdaq OMX’s data center in Cartaret, New Jersey and CME Group’s data center in Aurora, Ill. and FinQloud, a cloud-based offering for storing compliance data, are seeing increased demand.

Perhaps as sign of lighter demand, this summer, Nasdaq OMX has been offering a discount on CoLo. According to a price list on Nasdaq Trader’s site. Firms that order CoLo cabinets in the months of July and August and power up by November 2013 could be eligible for up to a 50 percent discount, pending approval by the SEC. The discount would last for two years for customers who meet the eligibility requirements. A low-density cabinet that usually costs $4,000, would rent for 50 percent less or $2,000 while SuperCab, the most high –end cabinet, which normally costs $13,000 per month, would be discounted by 38 percent to $8,000. But they must pay for fiber cross-connects, bandwidth, electricity, copper wiring, as examples of other changes.

While some market watchers and lawmakers view the CoLo service as giving high frequency firms an unfair speed advantage over ordinary investors, exchanges are required to provide equal access to everyone.

Tom McCabe, COO of single-stock futures exchangeOneChicago, says that exchanges have to charge a certain price for CoLo to accommodate everyone. “You see the marketplace wants colo facilities, so as you provide them, one way to do it with equal access to charge a price at a premium level, so it’s only worth it to those people who want it. “You are using a price to ration service,” explains. McCabe. “If I make a colo space and charge $100, I couldn’t make it big enough. “If I would charge a price of say $1,000 that equates demand with what I can support,” says McCabe., offering an arbitrary example.

An electronic exchange that doesn’t provide colo is in trouble, asserts McCabe.”If I have to provide it, my only way to do it on an equal basis is to charge a premium, because that will allow me to let anyone come,” says McCabe.

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Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio