Colocation — Illusion of knowledge !!

What the “experts” won’t tell you …

A recent video posted on a website about retail traders being affected by colocation issue got some eyeballs. It talked about many things. In addition to how the retail traders might have been affected by the colo trading, this person spent a large time almost directing what the Agencies should be doing and who all should be arrested. It is more than obvious that he wants these people behind bars for something altogether different but is using what-aboutery in colocation trading to push his agenda.

I’ve no mandate to defend his obvious targets. However, I have been associated with growth of technology in Indian capital markets, and I feel this is as good a time as any other to debunk the blatant lies being peddled in the name of technology.

There are two problems being talked about -

1. Co-location offers differentiated speed to access markets and that hurts people which are on slow speeds.

2. In this video the anchor described a potential method by which HFT does black marketing and profiteering in the exchange.

The gentleman has painted both colo and HFT per se as villains.

Let us first discuss how online retail trading works. A person opens the portal of his on-line trading platform. He places the order and when it gets executed, he gets a notification. He chooses the price he wants to purchase at. He can also choose to trade at best available price at that point in the exchange.

Now if this person happens to be in Mumbai, the order will be placed from Mumbai and if this person is in Delhi, the order will be placed from Delhi. NSE is in Mumbai and hence there will be an extremely small difference in time when the retail trader at Mumbai sees the price vs. when the guy in Delhi sees the price. Can it be said that retail trader in Delhi was cheated by retail trader in Mumbai because he got the price information late? Another retail investor uses his phone to log into his internet trading account, at a speed of 2 Mbps. This is obviously slower than the investor who has logged in on his PC with a 30 Mbps broadband internet connection. Can it be said that the PC based trader is cheating the mobile based trader?

This is as absurd as it sounds. Most retail traders are investors and invest for long term growth in the share price. A micro second extra in execution of trade is not something that affects them.

Differences in time of market data and order sending have been inherent and around since the first day of stock exchanges going electronic. The system closer to the exchange will get information fraction of seconds before the person sitting far from the exchange.

Now let us imagine an institutional desk of a broker executing large institutional or HNI trades through sophisticated algorithmic execution systems. Compare this with manual punching of orders by others who want to buy a basket. Who will execute the trades faster? Can the other be said to have been cheated?

Not only this, globally; and this is true of NSE as well, the speed of connection is a choice exercised by the broker. Different connection speeds are available according to how much they were ready to pay as per a rate card. Have you heard a retail investor ever asking his broker as to what kind of connection speed has he chosen?

The fact is that differential latency and connection speed is a norm. Colocation is a system to allow a distinct class of traders to get extremely low latency with the end goal also of improving liquidity, reducing impact cost and increasing efficiency of price discovery. This, again, is not new and has been adopted by best of the exchanges globally for last couple of decades.

Why speed matters for some? The answer lies deeper in a category of market functioning that is often called Arbitrage. Arbitragers look for price differences and inefficiencies (imperfections) between pricing of related products and profit from these price differences. Let’s see how this works between, say, NSE and BSE at a very simple level. Let’s say that stock of INFOSYS trades at 1870 at NSE and 1871 at BSE. This is inefficiency of price discovery. The opportunity to buy from NSE at 1870 and sell at 1871 at BSE gives a profit of Rs. 1. This opportunity is limited by how many shares of INFOSYS are available at these prices in their respective exchanges. This trading is a very valuable function of stock markets as it brings the prices of two related products close together. In this way, the price in one of the exchanges can’t be manipulated. Now this is where speed really matters. The person who sees this opportunity first will go and execute this trades on both ends and make a small profit. This trade also doesn’t hurt anyone as the prices are set by completely different investors at the two markets and traders who want to buy or sell at those prices. Prices are decided by forces of demand and supply. Arbitrage just gets the price closer for a small profit. It doesn’t create net demand or supply. These arbitrage companies or HFT companies only compete with each other for the same small pie of price inefficiency and try to get the fastest system. That’s why all of them are in colocation.

Now let us consider the holy time before 2010, when colocation did not exist in India. At that time also the arbitrageurs existed. Now, to get the fastest access, the arbitrage companies started setting up offices near the exchanges. (Remember the price of office space in south Mumbai). In fact BSE gave a complete floor to the brokers to setup their trading servers. In a way, this was the first crude co-location in the country and not the one offered by NSE in 2010. This has been going since the 1990s when electronic trading started. Exchanges saw this mad rush as an opportunity where they formalized the space for these arbitrageurs to setup servers close to the exchange (or right next to it.) Not just NSE, BSE also setup colocation. BSE worked with a third party vendor (Netmagic) to manage the colocation services and NSE managed the co-location itself. In-fact colocation made the access uniform and equitable for all colocated brokers instead of differentiating. After colocation, clearly the brokers who were worried about speed could easily co-locate in the exchange premises. Colocation by itself is a good thing and not the evil it is being projected into. It is something which has been prevalent in the all the exchanges all over the world, much before Indian equity markets started offering colocation services.

When a so-called expert uses arguments like “Believe me, I know it” and/or “Take my word for it”; it ,more often than not, is due to his inability to articulate but in the case of this anchor, it is clearly due to his inability to put a coherent argument explaining his case, or should we say cause. The biggest enemy of knowledge is illusion of knowledge. He jumps from retail trading to mutual funds. Then he puts up a wild argument about share price of INFOSYS varying between 2500 and 2000 in matter of seconds. He also confuses information about INFOSYS prices available at BSE being made available in NSE to be able to rig prices. He also confuses HFT with black marketing. I’ll try to make sense of some of his points but they are absolutely incoherent, to say the least.

Mutual funds are different from retail traders. Mutual funds often use big brokers who use complex algorithms for executing mutual fund trades and most of such brokers are themselves colocated. So mutual funds themselves use co-located systems and thus any loss to them by virtue of not being co-located is just plain rumor mongering.

What he is describing in this video is not HFT, but black marketing. Traders are largely of 2 types — One who takes bets of large price movements and second who take bets of small price movements. In any market, there are fewer opportunities when the size of price movement is large. HFTs, typically, place many small bets based on small price differences. Speculators place fewer bets but on large price movement. It is hilarious that he has confused HFT with big price movements. Here-in lies the first flaw of his INFOSYS example that market moves in short time are same as the price band of the mutual fund. This makes no sense by any degree of imagination. Second more bizzare flaw is alleging that algorithms are able to identify price band of mutual fund selling. Exchange data does not contain information about the counter-party, so there is no way to differentiate mutual fund from a retail trader or another algorithm or another mutual fund. And if two mutual funds are taking opposite directions, which they often do, there is no price band in reality. The example of Cinema ticket black-marketing is even more incredulous. He is assuming that shares are a limited commodity and can’t be sold by anyone else at a fair price. Unlike the cinema tickets which may be only available with the black marketeer, shares can be purchased from anyone. There is no limited supply of INFOSYS shares.

Unlike cinema tickets — which are perishable limited commodities, shares of large companies are comparatively un-limited and impossible to corner. So price rigging by black marketing is impossible using co-location or small nano-second advantages.

Don’t believe me ? Read what Nithin Kamath has to say about HFT. Nithin is the promoter and founder of Zreodha — India’s largest retail broker by far.

“In the NSE colo issue, retail traders wouldn’t’ have been affected. If anything, colo helps reduce the impact cost”

It is obvious that a couple of select individuals including this person in the video are spreading all kinds of rumours about functioning of market systems. These are the people who are doing more damage to markets than anybody else.

EDIT : This article has generated some extreme reactions. Please read about them in detail here.