Investment Banking Overview
1.0 What is Trading?
Trading is the act of selling assets to clients and making a profit. The investment bank is able to buy/sell/create these instruments to the client. Which is sometimes only available to the bank directly due to its established reputation and resources and sell them to clients with a fee which provides an income.
2.0 Types of Trading
There are a few different methods of trading that are generally practised today:
- Market Making
- Proprietary Trading
Market Making is the most common one and involves providing the client (portfolio manager) access to financial instruments. The role of a trader is to buy/sell financial instruments on behalf of the client. This provides liquidity for the client and the market.
Proprietary trading is essentially asset management using the bank's own money. There is regulation which outlaws this in certain countries.
3.0 Risk Management
When you buy/sell an asset it can rise or fall in value so what you own or what you owe can will change in value accordingly. To protect yourself from this you can buy another financial instrument which falls in value as the asset rises and rises in value as the asset falls. The hedging instrument can change depending on what asset you have bought and it is at the discretion of the trader to determine what the 'best' hedging instrument would be.
4.0 Investment Banking Division
The purpose of an investment bank is to raise funds for a company this is either through the sale of shares or the sale of debt. The sale of shares is handled by Equity Capital Markets (ECM) and the sale of debt is handled by the Debt Capital Markets division (DCM).
4.1 Equity Capital Markets
The amount of shares that need to be issued is allocated and issued and then handed over to the Traders to sell to the market once the details have been decided.
4.2 Debt Capital Markets
The syndication of debt results in the sale of bonds. Once the term structure and other details of the debt has been decided it is passed to the trader to sell to the market.
5.0 Sales
The job of a sales trader can vary, generally, they align with a trading desk. They manage client relationships and try to sell a Traders inventory and promote the sale of new financial products.
6.0 Trading
The main aspects consist of managing the risk of the inventory, monitor revenue, manage clients and need to do so in a heavily regulated environment. To simplify the key players can be seen in the following diagram.
A trading desk handles an asset class and is responsible for selling the asset to client. Where the client would be a portfolio manager. They aim to generate revenue streams from portfolio managers and create new products that funds may wish to purchase that is related to that asset class.
7.0 Quantitative Research
When a trader sells a financial instrument it will be at the market rate. When you sell a car you will sell it for what people are willing to pay you for it on the market. The buyer isn't going to measure the content of rubber, metal, glass etc. and try to value the individual components and then come up with a price. The role of Quantitative Research is to make sure that the valuation of the asset is within range of what they believe the price to be. By creating an accurate model of the instrument they should be able to provide an accurate model price of the asset.
Their role is also to develop risk models which should give an idea to the trader how the price of what they're trading will change over time and modelling as accurately as possible how much risk the trader has. This will enable the trader to make a more informed choice on how to hedge their risk.
8.0 Product Control
The role is mainly accounting in nature, they are in charge of daily PNL and its explanation to the trading desk. Specifically, the attribution of what created specific PNL the cause of PNL by risk type (which will vary by instrument). They monitor risk on certain products to ensure that it stays within limits. Aspects of this job are linked to Market Risk since there is analysis for value at risk as well as stress tests.
9.0 Technology
The level of automation on a trading desk is dictated by the liquidity and the connectivity of the instruments being traded. Technology will provide connectivity to execution venues and certain parts of the job such as quoting prices to the market can be automated so that the trader can provide pricing for a large volume of trades.
However, in markets where there are no real electronic exchanges such as fixed income a majority of the trades will happen "Over The Counter" (OTC) via the phone or other venues e.g. Bloomberg. The technology will just provide real-time pricing and risk data so that the trader is able to manage their assets and risk effectively.
Since trading is essentially matching Client orders with instruments on the exchange the entire process can be automated with highly liquid instruments such as equities. The trader's job is to essentially ensure that the orders are being executed correctly and ensure that the algorithm is operating within the risk limits.
10.0 Compliance
The main aim of the compliance department is to ensure that the bank is following the latest legislation and laws.
11.0 Real World
11.1 Market Volatility
Assets rise and fall in value, some more than others. In periods where assets are rising and falling in value a lot a portfolio manager is more likely to buy/sell assets that they already own. This means that the bank will trade more and earn more fees as well as profit making opportunities This is why volatility provides more profit to traders, because the clients will buy/sell more during this period which increases revenue.
11.2 Modern Trading
Generally, in this day and age the role of a trader is to manage Risk and "manage" client relationships. The bank you trade for to a large extent will already have an established client base and trading desks will need to manage the existing flow. Which boils down to doing what the client asks you to and making sure you don't ask for a ridiculous fee for providing the sale.
Banks are manoeuvring for position trying to get more and more people to use them as their main broker. Trading these days has become a revenue game since the dawn of dodd-frank and the volcker rule preventing prop trading means that you can't really exploit inefficiencies in the market as much as you used to. A loose interpretation of "Risk Management" is what provides profit making opportunities.
A successful trader will trade a specific asset class and they will be judged by the volume of that asset class that is sold and whether the volume sold was profitable.