Co-location
Also written Colocation
A stock exchange facility, offered to trading members for a fee, to place their computer servers in the same premises as the exchange's servers so their orders reach the exchange faster.
In plain language
On an electronic exchange, orders at the same price are filled in the order they arrive. For most investors a few thousandths of a second make no difference. For a high-frequency trader, they are the whole business.
Co-location is the exchange renting space right next to its own servers. A broker whose computer sits there has the shortest possible cable to the exchange, so its orders arrive before those of a broker whose computer is in another building or another city.
How it works
Latency (section 4.5.1). Latency is the lapse of time from the moment a signal is sent to its receipt — in trading, the time between a trader placing an order and the exchange receiving it. One of the most important factors is the distance the signal travels, which depends on the length of the data cable. Traders whose servers sit right next to the exchange's servers enjoy much lower latency.
Who uses it. High-frequency trading — a subset of algorithmic trading used mainly by large investment banks, hedge funds and sophisticated institutions — "typically involves use of co-location facilities provided by exchanges in order to reduce their latency". HFT concentrates on very short-term opportunities that disappear within milliseconds.
Who pays. Exchanges offer co-location to their members for a fee, and it is an important source of revenue for the exchanges.
A related route for institutions — Direct Market Access (permitted by SEBI since 2008). DMA lets an institutional client send orders straight to the exchange's order book, bypassing the broker's server, to cut the time lost in the first stages of order routing. Co-location shortens the cable; DMA removes a hop.
A worked example
Illustrative timings and prices. A stock's best offer is 2,000 shares at Rs 500.05. Good news arrives and two brokers' algorithms both send buy orders for 2,000 shares at Rs 500.05 in the same instant.
| Broker A | Broker B | |
|---|---|---|
| Server location | Co-located at the exchange | Office in another city |
| Time to reach the exchange | 0.2 milliseconds | 5 milliseconds |
| Result | Filled — 2,000 shares at Rs 500.05 | Arrives to find the offer gone; the next offer is Rs 500.50 |
Orders at the same price rank by time, so A wins the whole lot. If the price settles at Rs 500.50, A's position is worth:
(Rs 500.50 − Rs 500.05) × 2,000 = Rs 900
Rs 900 is nothing on a single trade. HFT fires huge numbers of orders a second and repeats this thousands of times a day, which is why a few milliseconds are worth paying the exchange for.
Why NISM asks about it
Chapter 4 (Secondary Markets), section 4.5.1 on trading systems, covers algorithmic trading, high-frequency trading and co-location together, with Direct Market Access described just before the block and bulk deal section; the definition also appears in the workbook glossary. Questions ask what co-location reduces (latency), who uses it (HFT), and who provides it (the exchange, to its members, for a fee).
Common exam traps
- Co-location reduces latency. It does not give anyone information others do not have.
- It is provided by the exchange to its members, for a fee — a revenue source for exchanges.
- Co-location and DMA are different. Co-location moves the member's server next to the exchange; DMA lets an institutional client bypass the broker's server.
- HFT is a subset of algorithmic trading, not the other way round.
- Latency is about distance and cable length in the workbook's explanation — the physical location of the server is the point.
Where this is taught
- Series IV · Chapter 6: Trading Mechanism in Exchange Traded IRDintroduced here
- Series I · Chapter 6: Trading Mechanism in Exchange Traded Currency Derivativesintroduced here
- Series VII · Chapter 3: Introduction to Securities Broking Operationsintroduced here
- Series XII · Chapter 4: Secondary Marketsintroduced here
Related terms
- Algorithmic tradingAny order generated by automated execution logic rather than typed in by a person — software that pushes buy and sell orders into the exchange once its parameters are met.
- Direct Market AccessA facility, introduced by SEBI in 2008 for institutional investors, that lets a client send orders straight into the exchange trading system through the broker's infrastructure without manual intervention by the broker.
- High Frequency TradingA type of algorithmic trading that is latency sensitive, marked by a high daily portfolio turnover and a high order-to-trade ratio — many orders placed and cancelled for every one that actually trades.
- Circuit breakerA pre-set percentage move in a stock or index that triggers an automatic halt or limit in trading, giving the market time to assess instead of trading on panic.
- Trader WorkstationThe terminal through which a trading member logs in to the exchange's trading system to enter orders and view its own orders, trades and market information.
- Block dealA single large trade of at least Rs 25 crore, executed in a special exchange window within 3 per cent of a reference price, settled by delivery and disclosed after market hours.