In this post we will talk about universal banking and cover mostly on Sales & Trading.

Market Risk

Market risk is the risk that the desk’s portfolio will rise or fall in value due to changes in market prices. The desk can reduce the risk by hedging their risk exposures. As market risk is not static, the desk need to rebalance their portfolio on an ongoing basis.

The greeks, VaR and stress testing are the common parameters used to measure market risk.

Greeks

Delta

Delta measures the change in asset’s value due to changes in the underlying asset’s price.

Example of Interest Rate Risk DV01 (1bps shift up):

Tenor	DV01
O/N	$7,500
1M	$(3,500)
2M	$9,000
3M	$22,500
6M	$50,000
9M	$40,000
1Y	$25,000
2Y	$(50,000)
Total	$100,000

Example of Fx Exposures:

Currency	FX Delta	Spot Rate
AUD	(1,000,000)	0.7822
CAD	3,500,000	1.2293
EUR	800,000	1.0967
GBP	380,000	1.5483
JPY	(200,600, 000)	121.62

If GBP strengthens from 1.5483 to 1.55:

\[\begin{aligned} \text{FX PnL} &= \#380,000 \times (1.55 - 1.5483)\\ &= $646 \end{aligned}\]

Example CDS Spread:

Tenor	CS01	CDS Spreads
1Y	(1,000)	66
2Y	500	67
3Y	2,500	70
5Y	6,000	73

If Microsoft 5y CDS spread widened by 2bps:

\[\begin{aligned} \text{Credit PnL} &= \text{\$6,000} \times (75 - 73)\\ &= \text{\$12,000} \end{aligned}\]

Theta

Theta or time decay measures the change in value of the portfolio due to changes in time. Theta can result in the optionality (nonlinearity) of the portfolio and the NPV of future cashflows. For example, when time progresses by one day, the discounting will decrement by a day causing the NPV to increase just by the passage of time.

VaR

VaR determines how much regulatory capital a bank needs to set aside for market risk exposures. It tells senior management what maximum losses they can expect to incur within a confidence level within a holding period. For example, a $100 mio VaR using a confidence interval of 99% mean that the desk will not lose more $100 mio 99% of the time. A trading desk will typically be assigned a VaR limit. There are three primary methods to calculate VaR:

• Variance and covariance
• Historic simulation
• Monte Carlo simulation

Although VaR tells you how often the maximum losses will be exceeded (like 5% of the time), it does not tell you how much one could lose if market moves beyond that confidence level. Through Fundamental Review of the Trading Book (FRTB), the expected shortfall (ES) model will replace VaR.

Stress Testing

Stress testing involve shock the pricing inputs (stressed scenario) and quantifying the PnL impact. It serves as an indicator of how much capital the bank needs to hold to withstand losses during periods of significant market volatility.

Trading

A bank has separate desks to cover each line of business:

• FX
• Rates
• Credit

For example, the FX desk will only be responsible for pricing client trades and taking positions in FX market. The FX desk can be further divided into linear/vanilla and non-inear/exotic products.

Generation of Trades

Trades can come from clients via sales, electronically from exchanges via market making or even as a result of risk management. In the case of Sales and Trading, sales will inform trading to execute trades for the clients.

Flow vs Structure

Stuctured trades are more complex and less liquid than flow trades. They are typically harder to book, risk management, and a wider margin compared to high volume, simple cookie cutter flow trades. The distinguishing factor is that flow trades are high volume with low margin (market making) while structure trades are low volume with high margin.

Market makers are obligated to provide a two-way market and serve as providers of liquidity. The bid-ask spread serves as a compensation to MM for providing liquidity.

As long as the order flow is random, there is no systematic impact on the price. The risk is when orders are from informed investors. This result in MM hesistation to make a market just before a market-moving event such as economic data releases.

Flow trading has economics of scale. The more order flow, the higher the probability of offsetting transactions.

Vanilla vs Exotic

Sometimes used synonymously with Flow vs Structure. Vanilla trades are standard trades without any complex structures while exotic trades have embedded complexities usually done with options.

OTC vs Securitized

Over-the-counter trade are individualized trade between the bank and the client. A securitized trade (for example a structured note), is packaged into one bundle that can be sold to many customers.

Role of Traders

Traders are expected to manage their risk but ultimately the risk management department will hold the control. Traders can only trade with clients that have gone through the onboarding process. Traders are also expected for estimating and explaining their daily PnL but the officia PnL are done by product controllers with official valuation models and market data. Often the trader’s estimation and official value are rarely the same.

Traders get their funding from Treasury and are expected to bear the cost of funding via FTP. Similarly, if the trading desk has excess cash, the desk can lend to the Treasury at cost of funding as well.

Types of Trading Activity

Market Making

Market makers are obliged to quote a two-way price. The compensation for taking the risk is the bid/ask spread. For example, if the market maker is net long in his book, he/she will skew the price downwards. This will cause the spread to widen. For large trades that will move the market, the trader will be informed of the size and quote a wider spread. At the same time, the trader will get quotes from other market makers to flatten the book.

Sales Trading

Sales traders price and execute trades on behalf of clients and not supposed to be trading under own account and unhedged. Sales trader use their view of the market plus understanding client’s trade flows to generate a quote which tends to be wide.

Proprietary Trading

Propritary trading execute trades in the bank’s own account and actively taking risk. Trades are usually longer term (more than 1D) and also do arbitraging.

In Sep 2021, the Volcker Rule (part of the Dodd-Frank Reform) took effect that limit amount and type of prop trading an investment can take. For example, simple products like loans, government bonds, FX, and commodities are still allowed to be traded under the bank’s own trading book as compared to the banking book which is assumed to be held to maturity.

Treasury

Banks have a centralized Treasury which is essential an internal bank. The key role is for funding trader positions. Treasury will borrow funds from certain desks like sales related to note issuance, and lend to desk require short-term funding. Treasury has its own funding curve (Funds Transfer Pricing (FTP)) and charges or credits the desk according.

Sales

Sales teams are especially prominent and important for sell-side institutions. Sales Desk is typically located together with trading on the trading floor. A sales desk will have a client list that the desk covers. They will monitor the maturity diaries of their clients so that they can actively contact them when the trade expire and require rolling.

For smaller clients, credit lines are managed by relationship manager. For larger clients, credit lines are managed via Credit Risk Management.

The goal of Sales is to build a relationship with the client and allowing the trading desk to capture as much as the trading flow as appropriate.

The basic steps for a smooth trade execution:

• Confirm client is authorzied to trade (have done onboarding and KYC)
• Gather info about flow such as size of trade, reason for trade, etc and relay to trader
• Lining up different legs of a trade and come up with quote
• Provide quote to client
• Confirm to Trader client order
• Providing post-trade follow up

Apart from trade execution, Sales are expected to gather market intelligence (market color) fro the cilent. Sometimes this information value is more valuable than making profit from bid-ask spread in a competitive market.

Sales can also help client develop trades by offering trade ideas and taking ideas from Research and make it client specific. This will increase the probability of being included in the trade execution. This is known as the “Iterative Trade Development”.

An “Axe” is the inclination a trader toward a certain direction such as to buy or sell. Sales will share this information to client to see whether there would be a match or just to give a sense of the liquidity in the market.

Example: Fannie Mae Callable Debt

Fannie Mae’s debt is similar to US government as it is a GSE chartered by US Congress but have slightly higher yield due to credit risk. Fannie Mae obtains funding to finance its mortgage purchases, repackaging them and sell it to investors. Ideally, Fannie Mae would want to obtain a funding level similar to the US government.

Assume the yield for a 3Y non-callable (bullet) Treasury bond is 1.5%. Fannie Mae is looking to fund at T+20bps (1.7%) while there is demand from investors to buy at 2% yield.

Sales is looking at how Fannie Mae is able to issue debt at 2%. Fannie Mae can buy a call options on the debt and the investor is compensated by the selling the call by bumping up the yield. Normally there is a lockout period for which the debt cannot be called. For example, a 3NC1 is a 3Y debt that cannot be called in the first year.

However, Fannie Mae is not interested in buying a call options and would just like to fund at 1.7%. What the bank can do is act as the middleman and swap the cashflows. It will fund Fannie Mae at 1.7%, and buy the call options from clients at 30bps (assuming the options is valued at 35bps and pocket 5bps), thus giving the investors a yield of 2%. Contractually, the broker-dealer has the right to call the note in Fannie Mae’s name and reissue a 2Y (assuming 2Y left) note at prevailing market rate while still receive 1.7% from Fannie Mae.

Divisions of Investment Bank

Following the repeal of Glass-Stegall, commerical and investment banks are able to merge. The reason why this might make sense is because of the potential of overlap in the services and for the bank to act as an intermediary. For example, corporations might buy interest rate options (such as caps) to hedge against interest rates rising, while retail clients might sell interest rate options to improve the yield (yield pickup) of a structured note.

A typical investment bank is divided into 3 broad divisons:

• Asset and Wealth Management
• Corporate and Investment Banking (IBD)
• Retail Banking

Asset and Wealth Management

Refers to the professional management of financial investments on behalf of (U)HNW (Ultra High Net Worth) individuals or institutions.

Asset managment primiarly focuses on managing financial assets such as bonds, stocks, real estate and other investment products. Asset managers pooled funds from multiple clients to create portfolios of diversified investments.

Wealth management on the harder hand focus more on financial planning and personalized service. This may include tax, retirement and estate planning.

Asset and Wealth Management is attractive from the perspective of investment banks because it generates relatively stable income that is less cyclical and less balance sheet intensive (from borrowing).

There are certain regulations like MiFID II that prevents asset managers from paying commissions to incentivize distributors.

Corporate and Investment Banking (CIB)

CIB combines traditional corporate banking activities with investment banking and focuses on providing services to corporate and institutional clients. Institutional clients include governments, asset managers, pension and hedge funds.

CIB is subdivided into:

• Investment Bank
• Commerical Bank
• Transaction Bank

Investment Bank

Investment banking caters to large corporation and financial institutions. Financial institutions comprised of:

• Governments
• Asset Managers
• Pension Funds
• Hedge Funds

Investment Bank is further divided into:

• Global Market (FICC & Equities)
• Corporate Finance (IBD)
• Corporate Risk Management

Global Market (FICC & Equities)

Global Market is a combination of divisions that serve large corporation and financial institutions clients with the trading of financial assets, derivatives, and structured products. Financial assets includes:

• Stocks
• Bonds (G10 Rates)
• Currencies
• Credit Products (Investment-Grade Bonds, EM Bonds, Exotic/Structured Debts)
• Commodities
• Equities

Also known as FICC (Fixed Income, Currencies and Commodities) & Equities, Global Market can be further broken down into Sales, Trading, Structuring and Research. Global Market is part of Wholesale but excluding IBD.

The following are some of the common divisions of Global Markets:

• Sales
• Market Making
• Hedging Risk
• Proprietary Trading
• Quants
• Structuring
• Treasury
• Research
• Client Services
• Credit Risk Managment
• Market Risk Management
• Product Control
• Operations
• Legal
• Collateral Management

The above divisions can be categorized under Front-Office vs Back-Office. Front-Office faces the customer/market while Back-Office supports the Front-Office.

Furthermore, the functions of an investment bank can be divided into Producer and Controller functions. Producer functions concern generating revenue for the bank while Controller functions provide control and ensure things are done correctly.

In terms of PnL, as trades are booked in the trading books by traders, it is the trader duty to monitor risk and providing an estimate of the PnL. Controllers on the other hand, have the job of providing official PnL.

The basic process from front to back can be summarized:

• Booking of Trades
• Trade and Book Management
• Risk Management and Valuation
• Settlement
• General Control Processes

Corporate Finance (IBD)

Also known as Investment Banking Division (IBD). They deal with transactions that are not traded in the financial market (focuses on cashflows rather than market prices) and focuses more on the liability side of the balance sheet.

IBD can be further divided into:

Investment Banking

• Mergers and Acquisition (M&A)
• High-Yield Loans

Capital Markets Group

• Equity Capital Markets (ECM) (Issuance of Equity)
• Debt Capital Markets (DCM) (Issuance of Debt)

Corporate Risk Management (CRM)

THe division is typically led by a risk managment function that involves risk managers and analysts that works closely with senior management to ensure that risks are managed appropriately and adhere to regulation.

The types of risks are:

• Interest Rate Risk
• Exchange Rate Risk
• Credit Risk
• Liquidity Risk

Commerical Bank

Commerical banking focuses on relationship lending. Long-term loan relationship between clients and bank are built. In contrast, investment banking focuses on transaction lending where the prize the ability to price a deal, having deep derivative, structuring and advisory expertise. Commerical banks take down large loans which stay on their balance sheet, while investment banks tries to hedge the risk if possible.

Commerical banking act as intermediary between lenders and savers and use their balance sheet to conduct financial transformation. Examples of financial transformations:

Size Transformation

For exampling splitting up large financial instruments into smaller instruments of bundling smaller instruments into bigger ones.

Maturity Transformation

Borrowing money short term and lend it out longer term

Credit Transformation

Examples are securitization or tranching.

Liquidity Transformation

Funding illiquid assets with liquid liabilities.

Risk Transformation

Mitigate risk by diversification or pooling.

Transaction Bank

The Transaction Bank division focuses on providing a range of services that facilitate financial transactions and cash management for corporate and government clients and financial institutions.

Key services include:

• Cash Managment
• Payments and Collections
• Trade Finance (Letter of Credit, etc)
• Trasury Services
• Custody Services
• Clearing and SEttlement

Retail Banking

Provides retail customers standardize banking (taking deposits) and financial services such as mortgage loans, personal loans, and debit/credit card.

Buy-Side vs Sell-Side

Buy-side refers to market participants that trade on behalf of clients while sell-side issue, sell, or trade securities.

Examples of Buy-Side:

• Investment Managers
• Pension Funds
• Hedge Funds

Examples of Sell-Side:

• Investment Banks
• Brokers-Dealers

Broker-Dealer is a sell-side market participant that trades with clients. When trades are executed on behalf of clients, they are acting as a broker. When acting as the other side of a trade, it is acting as a dealer. Inter-dealer brokers (IDBs) act as agents in the dealer community and gives dealers anonymity so no information about their heding is conveyed to other dealer to prevent front running.

Risk and Valuation

Traders are supposed to manage their own risk and knowing their PnL (Flash PnL), but the official valuation and PnL are done by controllers. Things like what kind of products can be traded, the official valuation methodology, market data, and trading limits are set by control functions.

Product Control

Product control is the face of finance to the Sales & Trading desks. The provide financial control via:

• Providing a PnL statement and Balance Sheet
• Providing PnL attribution (drivers of PnL) and insight into the results
• The analysis of internal charges allocated to the desk and assitance in minimizing them
• Supporting the desks in executing their business strategy
• Evaluating and integrating new products
• Assistance with setting up of new books

The role for Product Control is to take the financial report from financial reporting and provide an explanation and rationalization of the business results in the legal entity.

Treasury

Treasury is responsible for maintaining the appropriate levels of liquidity. In Basel III, the BIS introduced:

Liquidity Coverage Ratio (LCR)

LCR requires banks to hold unencumbered HQLA that is liquid enough to be liquidited almost immediately to meet their liquidity needs for a 30 calendar day period given a liquidity stress scenario.

Net Stable Funding Ratio (NSFR)

NSFR on the other hand, is for a longer term (1Y). The idea is to use more stable sources of funding on an ongoing basis thathas a time horizon of 1 year.

Treasury is able to penalize desks by charging desks who are funding themselves inefficiently and rewarding desks that overfund their assets (these excess funds can in turn be used by Treasury to provide funding to other business).

Structuring

Structures group simple combinations of products together that the bank already sells and put in a form attractive to clients. The structuring desk will come up with a term sheet that includeds details about the structured note.

Quants

Quants are primarily responsible for the valuation and risk modelling.

Research

Generate report to sales and trading and customers about the market.

Business Manager (COO)

A business manager or COO assist the business in executing the desk strategy. COO will coordinate all support functions into the delivery of business’s products and services such as managing and coordinating the different trading desks to ensure smooth running and ensuring compliance with regulation. They also work to facilitate new business to ensure projects are understood and delivered on time.

COO also monitor KPIs to measure how the desk is performing operationally. These KPIs may include:

• Late trades and trades amendments
• Accuracy of T+0 Flash
• PnL and Risk Report signoffs
• Desk trading within their product and risk mandate

Control Functions

A control structure is required to manage following risk:

• Market Risk
• Settlement Risk
• Operational Risk
• Reputational Risk

Capital Requirements

Basel III require banks to hold 6% of Tier I capital (shareholders’ equity) of Risk Wieghted Assets (RWA), and hold enough (HQLA) to cover the next 30 days of net cash outflows.

Reserve Requirements

Amount of client deposits to be retained and not lent out.

Financial Disclosure and Reporting Rrequirements

Independence of financial auditing process.

Anti-Money Laundering and Anti-Terrorism

Needs to be done during onboarding.

Large Exposure Reporting

Reporting of large exposure from a single client against default risk.

CVA

The CVA desk will stand between the trading desk and the client and charge a fee for underwriting credit risk. Essentially, CVA is insurance against default. With a CVA desk, other trading desk can just use risk-free rates in valuation model and the cost of CVA will be added on top of it.

Operations

Operations oversee the trade lifecycle. They are primarily responsible for confirming and settling transactions by the business. They ensure the following activities occurr:

• Trades are captured by the bank’s system
• Trades within the system are agreed with counterparties (confirmation)
• Cash flows or securities exchanges are settled (cleared)
• Trades that failed to settle are identified and managed
• Trade life cycle events are executed correctly (for example fixings)

This ranges from manual confirmation, trade matching, fixing of rates, trade novations, managing expiration, cancellation and trade amendments.

Settlement

Settlement means making payments. This involves moving real cash or ownership of physical commodities. Banks would have Standard Settlement Instructions (SSIs) for counterparties and send cash to their nominated accounts.

Finance

Banks are required to disclose their finances via regulatory reporting such as annual financial statements. In addition, some reports such as annual statements need to be externally audited and follow financial reporting standard.

Daily trial balance are produced to ensure all redit and debit entries across sub-ledgers are zero. Finance will also create a balance sheet and a PnL statement.

The role of financial reporting would cover:

• Management reporting to the board of the legal entity
• Audited financial statements and filing as part of the Companies Act
• Regulatory reporting

Management Reporting

Also known as perfoormance reporting. The reporting is to provide insight to the bank’s management into the bank’s performacnce. The management team ensures that the performance data (PnL and balance sheet) is accurae and transparency into the drivers of a business’s performance (with the help of product controllers).

IAS 39 Financial Instruments (Recognition and Measurement)

Fully replaced by IFRS 9 in 2018.

Under IAS 39, it is only when the entity has entered into a contract would the financial asset or liaibility be recoginized and entered into the balance sheet.

Firms can choose to apply trade date or settlement date accounting.

The asset can be decregonized if the contractual rights to the cashflow of the financial assets have expired, or the asset is transffered.

Example: Repo

During a repo, the security is passed from Party A to B. Under IAS 39, the agreement is viewed as a secured financing transation rather than an outright sale. Party ! continues to recognize the bonds on its balance sheet and recognizes a corresponding finacial liability for the money borrowed.

Under IAS 39, all financial assets and liabilities are intiailly measured at fair value except those not classified under Fair Value Through PnL (FVTPL).

IAS 39 separates financial assets into following 4 categories:

1. Fair Value through PnL

Most of bank’s financial assets will be classified under fair value through PnL. This is commonly known as MTM accounting. IAS 39 permits bank to account under FVTPL if the securities are classified as held for trading or the bank elect the fair value option.

Securities that are classified as held for trading if:

• liquidate in the near term
• it is a derivative

IAS 39 provides an option to elect the “Fair Value Option” (FVO) if an embedded derivative exists which has a significant impact on the cashflow. For example, a bank provides a fixed rate loan to a client and hedge the interest-rate risk by using a interest-rate swap. Because the IRS is a derivative, it wil be measured at fair value and changes recorded in PnL. This would cause a mismatch with the loan so bank can elect the loan to be measured at fair value as well. When the FVO is elected, changes in the loan’s fair value offset changes in the fair value of the derivative hedge resulting in a flat PnL.

2. Held to Maturity

Held to maturity is rarely used by trading desks and in IFRS9, held to maturity will no longer be an option for banks to choose.

3. Loans and Receivables

IAS 39 defines loans and receivables as not derivatives and having fixed or determinable payments. The financial assets under this category is accounted for on an amortized cost basis.

4. Available-for-Sale (AFS)

Assets that don’t fall into above 3 cateogories. Changes in fair value will be reflected in OCI and flow back through PnL only when the asset is derecognized (liquidated or matured). Not often used in Sales & Trading but more frequently used by non-trading.

Under IFRS 9, AFS will no longer exist and replace by “Fair Value through OCI”.

IFRS 9 (Financial Instruments)

IFRS 9 will eventually fully replace IAS 39 for reporting periods commencing after 1 Jan 2018. Financial assets are now classified under 3 categories and no longer includes the available for sale and held to maturity categories:

1. Amortized cost

This category is used if:

• The financial asset is held whose objective it is to collect the contractual cash flows
• Cashflows on specific dates which are solely payments of principal and interest

2. Fair value through OCI

Asset is measured at fair value, with changes recorded in OCI.

This category is used if:

• The financial asset is held whose objective it is to collect the contractual cash flows and selling it
• Cashflows on specific dates which are solely payments of principal and interest

3. Fair value through PnL

Any financial assets not under amortized cost or fair value through OCI is under this category.

Tax

Tax resides in finance department and reports to the CFO. The main purpose is to ensure that the firm applies the most appropriate tax treatment to its business activites. These activies include:

• Establish Transfer Pricing Agreements (TPA)
• Gives opinion on the tax treatment for new products
• Assisting the adoption of new or changes to tax laws
• Filing tax returns

TPA

TPA is needed when the revenues/cost for a business are not recorded in the location in which they were earned/incurred. PnL needs to be split between locations especially when a single book spans multiple countries.

Collateral Management

Collateral are mostly required for derivative and OTC trades. Often the type and amount of collateral are negotiable and the ISDA Credit Support Annex (CSA) is used as a template. Collateral Management will start with valuing the client’s liabilites to the bank and initial margin posted. Positions are marked to market and variation margin is calculated against the CSA. Any interests earn from collateral has to be returned to the clients.

See Also

References

Sutherland A., Court J. (2013) The Front Office Manual

Tata F. (2020) Corporate and Investment Banking: Preparing for a Career in Sales, Trading, and Research in Global Markets