Paying for Speed: Are Traders Wasting Money?

For a price, high-speed traders can plug into a stock market’s backbone. Unfair advantage or fair exchange?
Paying for Speed: Are Traders Wasting Money?

The essentials

  • Traders can pay for fast access to a stock exchange’s trading and information systems, using the increased speed to their advantage.
  • Researchers have discovered that these “colocation” services benefit not just the traders and the exchange – market liquidity increases as well.
  • With a colocation arrangement, super-fast traders are less likely to be “picked off” by other firms and are therefore able to increase their liquidity by posting tighter bid-offer spreads.
  • On the flip side, colocation adds costs for all market players. 

Do a Google search of “colocation” and you’ll get some interesting hits. Colocation: The Root of All High-Frequency Trading Evil reads one headline. High-Frequency Trading Grows, Shrouded in Secrecy reads another.

The reports cast a dark shadow over the practice of colocation, which refers to trading firms being allowed to rent space on a stock exchange’s computer servers to access trading information milliseconds before competing investors. Such services are offered by most large stock exchanges, including those in Canada.

It’s easy to assume that those who subscribe to colocation services — the fastest trading firms — have an unfair advantage that skews stock market activities.

Not so fast. Research by Ryan Riordan of Smith School of Business, Jonathan Brogaard of University of Washington, and Björn Hagströmer and Lars Nordén of Stockholm University paints a contrarian picture.

Super Fast Traders Boost Liquidity

Following Riordan’s previous research that found no detrimental link between high-frequency trading and market stability, the new study suggests that colocation actually improves liquidity for the overall market — even for firms without colocation arrangements. The research finds that after the speed upgrade, the quoted spread tightens and the realized spread component falls. The impact on prices remains constant.

“Everyone blames these super-fast traders, making it seem like they’re getting this unfair access,” says Riordan. “But these guys who are supplying liquidity, they are almost forced to upgrade.”

He says that once fast traders upgraded their speeds, “we saw this increase in liquidity.”

Riordan and his colleagues studied an optional speed upgrade at the NASDAQ OMX Stockholm equity market that occurred in September 2012. The Swedish stock exchange offered trading firms an upgrade to a 10 gigabit connection that cut the time it takes from order submission to order confirmation by more than 20 percent. Subscribers paid an extra fee for the speed boost.

Thirty large-cap firms of the leading Swedish equity index were studied as fast traders concentrated their activity in these stocks.

“People thought these guys were getting faster to pick off the lower guys. It turned out these guys were getting faster to avoid being picked off by other super-fast traders”

The study found that higher trading speed positively affects two areas: adverse selection and inventory management. When a firm is very fast, it is less likely to be adversely selected or “picked off” by other firms, explains Riordan, and is able to increase its liquidity by posting tighter bid-offer spreads.

“People thought these guys were getting faster to pick off the lower guys,” says Riordan. “It turned out these guys were getting faster to avoid being picked off by other super-fast traders.”

Fast traders’ latency advantage (latency is defined as time that elapses from the moment a signal is sent to its receipt) also leads to lower costs of holding inventory, meaning fast traders can manage their inventory with greater efficiency and a stronger ability to predict incoming market orders. It’s this reduction in inventory fees that the authors attribute to the biggest driver of liquidity improvement.

The downside of colocation services is that they result in higher costs for everyone. “This is rent extraction by the exchanges,” says Riordan. “They’re extracting profit from them. . . Cost comes out of everyone, and it makes liquidity more expensive.”

Colocation Fees Tax Everyone

Riordan speculates that market players would be better off without colocation services. “It would level the playing field,” he says. “They would still be the fastest but they wouldn’t have to spend all of this money paying for these access fees. These colocation fees are almost like a tax on everyone in the market.”

The study has important implications for fast traders and slower trading firms.

For one thing, as market makers’ latency is dependent on information coming from within one exchange, they stand to benefit the most from colocation services.

Conversely, short-term informed traders that may employ automated strategies to trade on news stories or cross-market arbitrage opportunities rely on information originating from outside of the stock exchange, the researchers note.

As a result, they say, it might be a good idea for these traders to avoid collocating. Instead, a better strategy for them is to place servers at geographical locations between their information source and the exchange.

Anna Sharratt

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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