The Front Office Manual

The Definitive Guide to Trading, Structuring and Sales

A. Sutherland, J. Court

• Éditeur: Palgrave Macmillan
• Année: 2013
• ISBN:
  9781137030696
• Sujet: Business
• Sous-sujet: Finance

The Front Office Manual is unique, providing clear and direct explanations of tools and techniques relevant to front office work. From how to build a yield curve, to how a swap works, to what exactly 'product control' is supposed to do, this book is essential reading for anyone who works (or wants to work) on the 'sell side'.

1

The Structure of an Investment Bank

1.1 Introduction

Most people think of banks as institutions which take deposits from customers and lend money. This book isn’t about these banks – it’s about investment banks. While some of the larger investment banks may take deposits and lend money (through their consumer divisions) the primary aim of investment banking is something completely different.

Investment banks are special kinds of businesses, which do a number of unique things:

• Core investment banking is the business of helping companies issue stocks or bonds to raise money. This traditional role revolves around a small number of large deals, each producing considerable profit for the bank.

• Sales and trading is the business of buying and selling investment products to other professionals in the marketplace. (The definition of these ‘investment products’, and how they are managed, will take up much of this book.)

• Analysis and research goes along with sales – most banks provide market analysis (of a supposedly neutral type) to encourage clients to trade with them.

• Other functions may include wealth management services (wealthy individuals are good sales and trading clients as well), investment advisory services, or any number of services aimed at helping institutional customers do business with them.

This book primarily will look at the sales and trading functions, and the tasks performed by departments that support sales and trading.

While investment banks all have subtly different organizations, the basic structure is similar throughout the industry.

Core functions within a bank are broken down (roughly) into two types.

1. Front-office functions face the customer, or the market, and revolve around creating business – of a profitable sort, hopefully.

2. Back-office functions are supporting the business, and providing the backbone needed to make everything work.

On another level, we can divide the functions into production versus control:

• Producer functions are those which revolve around producing a profit for the bank.

• Controller functions revolve around making sure the producers do the right thing, keeping risks in line and making sure regulations are followed.

We can lay out the major types of role in a simple chart as shown in Figure 1.1.

We’ll look at each of these functions during the course of this chapter. In brief, however, here are some summaries:

Figure 1.1 Divisions of an investment bank

• Sales and relationship management. Sales people are the ones in touch with individual clients – often corporations, hedge funds, investment and pension funds, or other financial institutions. Their role is to encourage trading with the bank – they send in requests to the trading desk, arrange deals and even book trades.

• Investment banking. This is the ‘traditional’ banking department, in charge of closing deals to issue new stocks, bonds or arrange loans to customers.

• Trading. The trading desk is at the heart of any investment bank. Divided into departments, usually by asset class, traders perform a multitude of functions on a daily basis:

• Making markets. Often the desk is obligated to offer prices to buy and sell investment products, such as those arranged by investment bankers.

• Hedging risk. Traders go to the market to enter into positions such that the bank’s risk is minimized, within certain limits.

• Proprietary trading. More popular in less risk-averse times, ‘prop’ trading is essentially taking speculative positions with the bank’s money.

• Supporting sales. Traders need to offer customers of the sales team prices on whatever products they want (often a stressful requirement).

• Quants. A ‘quant’ within the front office is a mathematician, working to ensure the trading processes and models are appropriate for the products being sold. This usually, but not always, involves derivatives trading.

• Structuring. A structurer is someone who builds more complex trades out of simpler building blocks supplied by the trading desk, for sale to customers.

• Treasury. Overseeing the balance sheet of the bank, Treasury is often involved in trading as well: buying and selling in the short-term money market, and funding the activities of the whole organization.

• Research. A largely self-contained department, research provides investment ideas and opinions to institutional clients.

• Client services. This department supports client requests for help in making or receiving payments, reports, valuations – anything a client of the bank may wish to know.

• Credit Risk Management. This control function ensures that traders don’t over-extend credit lines to vulnerable customers, and monitors the collateral that customers are keeping with the bank. This may also include credit value adjustment (CVA), which provides credit ‘insurance’ of a sort to allow trading with risky customers.

• Market risk management. The Market Risk department ensures that trading positions stay within pre-set limits, and that the bank is not taking undue overall risk.

• Product Control. Product Control will provide an independent accounting function to the trading desk – reporting official profit and loss (P&L), and ensuring that traders trade only allowed products.

• Operations. – will do the actual work of making payments, receiving confirmation of trades, and other inter-bank functions.

• Legal. The Legal department supports the entire business – much like Operations – providing advice, documentation and support for each aspect of the bank’s work.

• Collateral Management. Closely aligned with Credit Risk Management, Collateral Management is involved in ensuring counterparties have adequate collateral with the bank to support their trades.

It’s worth noting that all of these departments (with a few exceptions) do most of their work via computer systems. Each department will have its own IT department to develop systems to do the work, support the systems, and extend them to enter new markets or to do new roles.

1.2 Front office versus back office

Traditionally, banks are set up with distinct front office and back office divides. The structure enables control of activities, and ensures that P&L (as well as risks to the bank) are ratified by more than one area.

As trades are placed on the book, the trader will monitor risk and generate estimate of P&L, but crucially, separate functions have responsibility for controlling and producing official measures.

This means that Product Control will have the job of saying how much money the trading desk has actually made. Risk controllers will have the job of saying how much (overall) the traders can trade of any one asset. Operations has the job of actually moving the money in and out of the bank. Segregation of duties, in theory, allows the bank to function in a well-ordered fashion. (When we read about rogue traders, many of the situations occur when the segregation between front and back office breaks down or is deliberately circumvented.)

Over the years, some banks have introduced a so-called middle office. This consists of departments, once considered to be more back office in their nature, which have moved closer to the front office – often sharing desks on the trading floor. Examples include (for instance) Client Service Teams (client facing operations departments), or Product Control. The definition of ‘middle office’ is different in different organizations.

1.3 The basic front to back process

The basic business process for banking can be rationalized into a series of sub-processes.

• The generation of trades and client management

• Trade and book management

• Risk management and valuation

• Settlement and mitigation of settlement risk

• General control processes

1.4 The generation of trades

Within large investment banks there are likely to be a series of legal entities, each with different benefits and restrictions. For example there may be a US broker dealer entity, and a series of banking entities. In very few banks does all business flow through a single legal entity.

Within all these entities, however, a few will be key to the trading process, and trades will flow in through a number of channels.

• Trades can come from exchanges. Some banks will make markets (in bonds, stocks, or derivatives) on exchanges, and trades will flow in electronically. For instance, if a bank has helped a client company issue stock, it is required to buy and sell the stock on an exchange (i.e. be a market maker) for a period of time after issuance.

• Trades can come from individual clients via the sales channels. Sales people will call the trading desk, or execute trades on electronic systems on behalf of clients.

• Trades can be the result of risk management on the inter-bank market. Banks are constantly buying and selling to each other in an effort to reduce their own risk, or boost profits.

The trading process can be very different depending on where the business is derived. If the bank is a member of an exchange, or has e-Commerce pricing platforms, the trades generated have a reasonably high degree of automation. Setting up on an exchange or setting up and onboarding clients to an eChannel may be initially expensive, but once done, the trading activity is largely rule based and requires manual intervention in exceptional cases only (like when a trade is for a large amount).

Dealing with financial institutions and major corporate entities as well as central banks is often by voice, usually with either a dedicated sales desk or a market maker directly. For captive business (i.e. long-standing customers), relationship managers will handle a lot of the business – cross selling products, arranging credit lines, and making introductions to specialist sales teams.

1.5 Structure versus flow

Trades can be divided into two broad types: structured trades and flow business. In general, structured trades are:

• More complex, consisting of a combination of two or more components combined into a single trade.

• More low volume. Structured trades are not only complex to assemble, but also complex to book, risk-manage, and most importantly, complex to sell.

• More high-margin. Structured trades generate more profit per-trade than simple, flow trades.

In contrast, flow business (such as trading stocks, bonds or currencies) generates little profit per-trade, but each trade is cheap to manage, and volume can become enormous.

In the aftermath of the 2007 banking crisis, structured trades have taken a bit of a beating. It was, after all, structured credit deals which started much of the drama leading to the collapse of Lehman Brothers. Appetite for highly structured products has tapered off a bit, and many banks have refocused on flow trading as a profit centre.

What types of structured trades exist?

The most popular form of structure is the so-called structured note. A structured note is nothing more than a bond, which can be bought and sold like any other investment. Notes are often listed (nominally) on a minor stock exchange somewhere. Unlike a bond, however, rather than paying a fixed rate of interest, a structured note will usually return to the holder some amount based on an embedded derivative trade. So for example, if the embedded derivative is a call option on XYZ corporation – the note-holder will make money if the stock price of XYZ rises before the note expires.

Notes are popular, mainly because it is impractical (and sometimes illegal) to sell derivatives to individual investors. Wealth management companies like to sell notes to their customers – the customer gets returns which are uncorrelated to, say, the stock market, and the wealth manager gets a hefty commission.

Along with structured notes, structured deposits are popular in Asia, where the note structure is not as legally convenient. A structured deposit can be sold by a bank, like a standard deposit, and it can offer the same returns as a structured note.

Structured one-off deals with clients represent another type of complexity. These are trades specifically crafted to help individual clients. Examples might include, say, a client of the bank who issues a bond in a foreign country (say, the United States). If the client is ba...