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Hedge Funds Leveraging Colocation to Take on Larger Firms

In today's market, hedge funds are aggressively taking advantage of colocation services to take on larger investment firms and other high-frequency players. And as anyone in real estate knows, location matters.

Looking back on his 40-year career in crime, famed bank robber Willie Sutton reportedly gave this answer to the reporter who asked why he robbed banks: "That's where the money is."

While there is some dispute about the authenticity of this clear-eyed quote, it made sense in the 1950s, when Sutton was arrested. But if he were alive today, Sutton might be waving his Thompson machine gun in a new location: the Wall Street data center.

Once the dead-end warren for housing old emails, expired market data and other bits of corporate effluvia, today's financial data center is where the action is. Forget the exchanges -- these days you're more likely to find a listless remote shot of a lonely CNBC reporter on an exchange floor (if you can find an exchange floor) than the hustle and bustle of yesterday. Instead, the liquidity is in the data centers that hum several miles away from the once-fabled exchanges.

As the markets have become increasingly electronic, the liquidity previously found on the exchanges left the cities for data centers found in the suburbs and exurbs -- thanks to cheaper power and real estate and locales away from the crosshairs of terrorists. Today, buy-side firms are exploiting any method to get as close to the liquidity and the market makers as possible. This is where colocation services come in, and they are changing the way the buy side trades and reaches alpha.

The Data Center Is the New Exchange

In the past, investors had to hire brokers who worked inside the exchanges to make deals on their behalf. But in the past decade the financial markets became more electronic, and human traders and brokers largely were replaced by machines that execute trades in milliseconds. The future had arrived as financial services firms turned their trading strategies into black boxes and placed them next to the exchange matching engines. Instead of a buyer shouting bids into the ear of the seller in a trading pit, machines were programmed to do the bidding.

In today's fast moving, highly fragmented market, investors want to connect to multiple end points, explains Stewart Orrell, director of global financial services for Equinix, a global data center operator and colocation services provider that grew out of the technology boom in Silicon Valley in the 1990s. "In the financial markets and especially in times of fragmentation, they want to connect to different end points, whether it is different asset classes, service providers or network providers," he says. "They want access to exchange traffic in a very efficient and very low-latency way as well."

And buy-side firms no longer have to confront the challenge of building and maintaining their own data centers in order to achieve this low-latency connectivity. By using third-party colocation offerings, buy-side firms now can rent space inside a data center to be close to the action. For smaller investment firms -- and hedge funds usually boast fewer than a dozen traders -- this is a game-changing option.

"The proximity play is very attractive to hedge fund clients as well as those interested in microsecond access," says Bill Ruvo, global business manager, real-time solutions, at Thomson Reuters, which offers low-latency market data solutions. "Technology plays a very key role by normalizing content into usable protocols."

And just as all politics is local, so too are a few asset classes. In today's market there are a bevy of data centers in the New York/New Jersey metropolitan area that cater to cash equities, just like the old days of the New York Stock Exchange. Meanwhile, there is a ring of data centers in Chicago that are focused primarily on matching engines and colocation services for commodities and futures options, which are largely traded in the Windy City.

A number of data center firms -- including Equinix, Savvis and Telx -- are located in the Cermak Building on 350 East Cermak Road in Chicago to be "close to the data centers and the matching engines for BATS and ICE on the futures side," says Jeffrey Otten, global head of sales for Selerity, a provider of low-latency event news. And these clusters of asset class-specific data centers are not unique to the U.S. markets, he notes. Similar clusters of data centers that focus on specific asset classes reside in London outside the London Stock Exchange and in Frankfurt near the Frankfurt Stock Exchange, according to Otten.

In All Fairness

While colocation enables the buy side to forgo costly data center construction, it also is helping a larger swath of hedge funds operate and thrive on a more level playing field. In the past, technology and access to liquidity were market differentiators -- now, as technology, stable networks and high-speed Internet access have become commodities, smaller investment houses are renting space to be close to the markets and compete with the big boys.

"We are finding a lot of smaller firms, such as prop shops with fewer than 12 employees, that are very competitive with trade execution and full throughput of their trading systems relative to the much bigger tech-driven banks and larger prop shops," says Otten. "They are able to compete with the same strategies that years ago only the big boys with lots of tech spend could deploy."

While there are plenty of firms using medium- or low-latency trading strategies, a selection of hedge funds rely on ultra-low-latency strategies that demand colocation tactics, according to Frank Piasecki, president and cofounder of Activ Financial. "It's more a measure of strategies in the investable world and the interaction they have with liquidity," he says. "If they're in cash equities, they're going to need a far more robust set of services and colocation options. Their interests will vary around that."

While colocation providers on Wall Street have not broken the speed of light in terms of connectivity and latency, they are coming close. And the closer hedge fund servers get to the exchanges' servers, the faster the deal. One colo service provider who requested anonymity recalled a client's visit to the server farm; the client noted that a competitor's server was closer to the exchange's server than his own company's box. "Why are they six inches closer?" the client demanded.

The Strategy Calls the Shots

"There are so many colo offerings, and the subtleties of these can have a big impact on cost," notes Activ's Piasecki. "The industry is responding and can deliver various levels of performance using cool capabilities, but it depends on your knowledge of your own applications and the trading strategies required."

Thomson Reuters' Ruvo points to a hedge fund that is using colocation to manage its applications and data as well as to connect to a market while shaving seconds off its trade executions. "We took a buy side firm's trading and market data platform from a deployed, in-house scenario to a hosted scenario," he says, declining to name the firm. "The customer normalized its market data feed to our site, as well as hosting its applications within our data center." Ruvo adds that the hedge fund was able to choose services based upon the latency sensitivity of each particular trading application.

Although nearly every firm on Wall Street uses high-frequency trading methods when executing a trade, not every trade needs to be executed in milliseconds and therefore does not require a colocation capacity. It all comes down to the particular strategies of the hedge funds, according to the experts.

"We're seeing an increased demand for access to low-latency services, for information in multiple asset classes, and funds are moving to proximity centers that offer them access to multiple markets," says Ruvo. "The challenge they have is a fragmented colocation strategy. It is expensive and complex in terms of data design, management and support. If it is mismanaged it can be inefficient."

The past three years have seen an upheaval in the global financial landscape, with capital markets shuddering from various credit crises, near debt collapses, and a wave of proposed and in some cases stalled exchange mergers. What will the next year or two look like in the colocation space? And what does the recent wave of exchange consolidation mean for colocation and the buy side?

While Ruvo doesn't think that every buy-side firm will have to colocate in order to trade competitively, he expects the numbers to grow. "In terms of the exchanges, this is a wait-and-see kind of game," he says. "This has a material effect on where customers are going to locate their trading applications."

And speed will be the name of the game. Phil Albinus is the former editor-in-chief of Advanced Trading. He has nearly two decades of journalism experience and has been covering financial technology and regulation for nine years. Before joining Advanced Trading, he served as editor of Waters, a monthly trade journal ... View Full Bio

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