What is Trading and what is so wrong with it?
The evolution of InterBank Markets
Banks, like all businesses, exist to make money. Originally, they used to earn this money by using the interest margin between the taking in of deposits, and the lending out of cash. By taking deposits from the general public, in the form of current accounts and savings, they lose money by paying out interest. However, they then use these deposits to lend out money, mostly to the public or other businesses. The money, therefore, that banks earn is the margin between the interest they pay out, and the interest they receive on loans.
This meant that as they would lend out their money, many banks would often have a net shortage of funds. On the other hand, other banks that receive a lot of deposits will have a net surplus of funds.
Before bankers became more sophisticated, they would simply have an overdraft or surplus at an account at the Bank of England. As time went on, however, they began to move money between themselves. Banks with surpluses would lend funds to banks with an overdraft. This started the practice of interbank borrowing and lending, the interbank (or wholesale) market.
Very quickly banks realised that they could extend this activity to managing risk. When banks have a lot of fixed rate loans to their customers there is a risk that if interest rates go up the bank will lose money (as many of their deposits have variable rate interest payments). This is because whilst the amount of money coming in will be the same (as it is fixed rate), the amount of money going out will rise with the interest rate. To minimise this risk banks find a counter party, normally another bank, who believe the opposite; that the interest rate will fall. This counterparty agrees to take the risk off their hands in the form of a contract (an interest rate hedge contract) for a premium. Similarly, banks used to manage currency rate change risks by buying exchange rate hedging contracts.
Treasury departments of banks have the responsibility of managing these interbank activities. This means they must make sure that the bank has enough cash, and get rid of any surplus. They also have to manage the interest and currency rate risks; usually this is done by entering into contracts in the interbank markets.
Banks have always written these contracts between themselves but there was also always the option of using intermediaries – these intermediaries are called dealer brokers. Dealer Brokers are the middlemen who know a lot about the market. This means that if a bank comes to them with assets they need to sell or risks they need to hedge, they can then sell those assets on to another bank for a profit. As the dealers know more about the market than the banks, they get away with this and so earn money off the margin. When dealers bought these assets, they never meant to keep hold of them, they simply trade them with banks for a quick buy/sell profit. This is called proprietary trading and the intent of the activity is fundamentally different to the intent of the banks who are trying to solve a Treasury Management problem.
The trading concept is best understood with a physical commodity. After oil has been found in the Middle East, it is often sent on a ship to refineries in Europe. A dealer broker might enter into a contract to buy the oil on a ship and commit to sell it to a refinery in Hamburg that the dealer knows needs more oil. Then he finds out that a different refinery in Frankfurt also needs oil. The dealer then buys the shipment of oil from the Hamburg refinery, for a higher price than he sold it before selling the shipment to the Frankfurt company for a larger profit. In this way one shipment of oil can be bought and sold (traded) multiple times as it travels from the source to a European refinery. In this situation, the oil traders are proprietary trading hoping to make a turn. The refineries are like the banks in that they have a fundamental problem that needs solving, namely of buying oil to be turned into petrol, aviation fuel etc.
In the context of financial markets dealer brokers do exactly the same thing but the things they buy and sell are financial contracts including loans, deposits, hedges, options and other derivatives. The footnote at the bottom of this article gives a breakdown of a trade in terms of key processes.
If the dealer believes the price of an asset is going to fall they short sell the goods. This means that they sell assets that they have not even got because they expect they can buy it at a lower price afterwards. They can then buy back those assets for much less when the prices fall.
Short selling and other trading techniques work only when the markets are “liquid”; i.e. the dealer broker is confident that even if his prediction is wrong, he can buy the goods in the market somewhere (albeit at higher fair price).
Dealer brokers now dominate financial markets, dealing in financial instruments. These can be anything from shares to bonds to derivatives, as long as these instruments are liquid the dealer broker is successful. As long as the market remains liquid, the trader can cover their obligations, even if they have to buy instruments at damaging prices. However if the market is not liquid traders are more cautious as they cannot take as big risks. For example, shares or bonds of small companies are generally illiquid because there are so few of them and a relatively small pool of investors interested in the asset class. In contrast larger companies have lots of shares and lots of investors interested in owning them, so can be very liquid. This means that it’s easy to sell shares quickly if a trader loses faith in such a company.
The key risks for dealer brokers are:
- Judging the direction of markets incorrectly and so losing money by buying high and being forced to sell low, and more importantly;
- Being stuck with illiquid assets which they cannot sell to turn into cash and so are unable to fulfil other obligations they have undertaken.
Relationship between Dealer Brokers and Banks
Nowadays, there are far fewer independent dealer brokers around, mostly because large commercial banks such as Barclays, Citigroup, Deutsche Bank, HSBC etc. bought out independent dealer brokers and/or setup their own trading operations. This worked well for banks in a number of ways;
- The large commercial banks had a large amount of natural “deal-flow” because they had lots of banking risks to hedge and deposit and lending surpluses to manage. This meant that a lot of the fixed costs of being in the markets (such as IT systems, trading skills and market information services) were already being incurred.
- They had a lot of money that could be used to fund proprietary trading activities (e.g. retail deposits) which meant they could take bigger bets/ bigger risks than independent dealer brokers.
- The move from managing their own risks to proprietary trading was very smooth. What was the difference to buying a derivative to manage a risk and then buying a different derivative solution that was available at a better price a few days after the first one was contracted and which could be afforded by closing out the first deal. The former was risk management, the latter was proprietary trading but from a trading room perspective a trader is just buying and selling contracts and the situations are very hard to distinguish. This is described in more detail in Banking Commission – Part 1.
In the financial crash, around 2008/2009 the regulatory authorities in countries with big banks all hated having to try and bail out banks that combined dealer brokers and large retail/ commercial banks. They felt obliged to rescue the retail/ commercial banking operations in order to save the economies of the countries that they operated in. They had no desire to bail out traders, who had often earned extremely large salaries and bonuses, but they were not able to let one side of business go to the wall while saving the retail banks. This was because the two operations were highly interconnected; for example in terms of legal entities and IT systems and infrastructure.
As a result, the authorities and politicians all over Europe have started to introduce regulations and laws to create separation between Trading activities and banking. It is just the start of long process that has a long way still to go.
Footnote – Structure of a Trade?
A trade in the financial markets has a basic structure as illustrated in the diagram below:
The four steps are;
There is a lot of IT and operations to underpin the above processes with lots of vendors selling software solutions