COMMENTARY: Co-Location Levels the Playing Field

In the wake of the NY Attorney General's probe into co-location, exchange proximity actually levels the playing field and adds more "fairness" to the capital markets.

Hard work, dedication and skill. These are the key ingredients of any competition, be it on an athletics field, a football match, exam room or concert hall.What is, or should be, true for all of these arenas is that there is a “level playing field.” The judges in a singing competition must be impartial. The distance that each runner sprints must be the same.

It is an important distinction – the competitors should be encouraged to perform at their best, but thevenue must be fair. And so it is, that with both amusement and frustration I regularly enter into discussions with those who consider the advent of latency as a competitive advantage to be unfair when in fact, it is the opposite.

[Goldman Sachs to SEC: These controls, please.]

The venue must be fair, while the competitors must be given the chance to perform -within the rules. My grandmother can’t trade electronically at sub-microsecond speeds, but neither does she have the advantages of a PhD in quantitative finance or any experience in floor trading. While she can’t do it herself, it’s reasonable to expect that she can use the services of experts who operate competitively, within anequitable venue.

Arguing that low-latency trading is a new phenomenon ignores all the technological advances in history. Fast ships carried news around the world for financial gain for hundreds of years, followed by telegraph wires, state-of-the-art phone systems and, more recently, computers. You will not meetmany meek and mild floor traders, since they need bellowing voices to traverse the noisy trading floors during market bursts. Beyond pure physical presence, the card throwing and hand signals, were there to reduce trading latency and execution accuracy. First electronic trading and then co-location were ways of improving the performance and fairness of the venues.

A History of “Unfair” Advantages

Some have postulated that co-location gives an unfair advantage to electronic traders by allowing them to move their computers closer to the exchange. This is in fact much more fair than the alternatives. Before co-location there was simply “location.” If you could afford real-estate close to the exchange, you were closer to the information and events and it took less time to get a message to the trading floor. Floor traders needed to jostle for position. When the industry went electronic, traders acquired real-estate that was as close as physically possible to the electronic exchange to reduce latency.

Before co-location it was virtually impossible to guarantee that customers were accessing the exchange in the prescribed manner, or to successfully audit customer equipment. Even within the co-lo, it used to be common practice to rent space in the datacentre as close as possible to the “matching engine” which runs the auction.

The reality is that whenever there is unpredictable behaviour in the exchange, there is an opportunity for clever people to work out how to take advantage of it. But with advances in technology and practice, we can actually reduce the unevenness toprovide a more fair and equitable venue for all.

Many exchanges around the world have improved the system, by ensuring that the cables between the racks in the datacenter are the same length. This eliminates the need to jostle for limited positions closest to the exchange infrastructure as one rack in the datacentre is as good as any other. More exchanges should undertake this exercise.

At a recent talk at the STAC Summit in London, a representative from Eurex described a scenario of uneven load across its order gateways. These gateways are the computers which accept orders and validate them before forwarding them to the appropriate matching engine. An uneven load means that some of the gateways are more heavily loaded than others, which results in some customers having their orders delayed compared to others.Eurex was made aware of this problem by their customers, who used the timing and time-stamping infrastructure provided by Eurex to measure performance.

In a Perfect World

Every exchange in the world has elements of unfairness and opaqueness toa greater or lesser degree because of the combination of technology, design and policy. They may not be perfect, but by being more open and providing tools such as Eurex have, the market takes a step towards a level playing field.If Usain Bolt was told he would have to run an extra 10 meters compared with everyone else, he’d complain pretty loudly. Openness is a key to fairness.

The solution is that trading venues should be designed such that orders are handled in a simple, first in, first served, basis. This is easier said than done because network infrastructures, which are the “on ramps” to markets, are notoriously difficult to measure and tune.

Network switches provide one of the biggest inconsistencies within the exchange. Different loads and different network media result in different latencies.Market data provided via a heavily loaded switch will have a more variable latency than one which is lightly loaded. The onus should be on the venue to ensure that all participants in the market, including the participants involved in the order, are notified of the order at “exactly” the same time.From a technical point of view there is no reason why fairnesscant be ensured in a co-location environmentto within, say, 10 nanoseconds.

A substantial advantage can be obtained by firms willing to pay for a more favourable venue, and the venues need to be motivated to avoid this.The simple truth is that a controlled, low-latency environment, like a co-location facility, that is available to all on the same terms, is the only way to provide a level playing field.

Dr. David Snowdon is founder and co-CTO of Metamako, a latency efficiency company. Snowden has focused on reducing the latency in financial networking systems, first at a small hedge fund, and then working on extremely low latency network devices and software.