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HOW DO BANK DERIVATIVES TRADING OPERATIONS WORK? In many textbooks, when you read about derivatives, the authors commence their discussion of the derivatives markets with a focus upon the listed exchanges, most often the Chicago exchanges. However, the development of the over-the-counter (OTC) derivatives markets is more interesting from the perspective of the derivatives dealer for their comprehensiveness and innovation. Listed markets deal only in plain vanilla options with rigidly defined contract specifications and a limited number of maturities. The OTC markets are characterized literally by an infinite variety of maturities, contract specifications and exotic modifications. Understanding the OTC markets implies an ability to fathom quickly the nuances of the listed markets. The reverse is not necessarily true. This article will provide a general overview of the different ways to organize a dealing room operation and the ways in which the dealing room interacts with clients, counterparties and other interested actors in the global capital markets.ORGANIZATION Commercial banks and investment banks make up the foundation of the OTC derivatives market. Their derivatives desk makes markets to customers, develops new products, trade with one another in order to lay off risks and form the apparatus for much of the industry's self-regulation. There are, of course, external regulators including the US Office of the Comptroller of the Currency, the US Federal Reserve Board and the Canadian Office of the Superintendent of Financial Institutions. However, the derivatives markets are so complex and their evolution is so lightning-quick that regulators often have a difficult time keeping pace. More often than not, large losses that might incur the curiosity of the regulator are attributable to new cutting-edge products, the behavioural characteristics of which are different in actual practice than they may have been thought to be beforehand. These institutions engage in operations in up to five main asset classes:
Readers may be familiar with the first four asset classes, easily relating them to transactions commonly seen in the media or in textbooks. The last asset class is the most interesting one for it holds the future of banking. Historically, commercial and corporate banking has been the practice of assessing the creditworthiness of other entities to whom the institution lends money in one form or another. Credit derivatives enable the institution to lay off that exposure to the risk of default or downgrade in a client's credit rating on other parties. In the future, banks will resemble funds holding carefully managed portfolios of credit exposure, tailored through the global credit markets. There will be greater international diversification. The distinction between funds and banks will be one of historical happenstance more than anything else. Organization of a bank's dealing room operations can proceed along two lines:
ORGANIZATION BY ASSET CLASS In this case, the bank sections its dealing room into five separate, vertically integrated groups determined by asset class. Let's consider the case of the foreign exchange group, for ease of argument. In the vertically integrated foreign exchange group, the cash trader (i.e. the spot trader) will sit next to the derivatives traders. This improves the flow of information among dealers specializing in the same underlying market. It putatively reduces transaction costs for the derivatives dealers since the forward and options traders are all part of one consolidated revenue pool. The spot trader has an incentive to treat the options trader well, in order to get as much information about the indirect implications of options market flows for the spot market. Most importantly (and this is the key point), the spot trader knows that if the options trader does well on the year, the available bonus pool for everyone is only going to be bigger. Organizing along asset class lines also means that marketing is integrated for cash and derivatives products as far as the customer is concerned. Marketing teams are directed to sell all of the products in the asset class. They sell options to their clients and then they sell spot and forwards to these clients in the dynamic management of these exposures. There are two problems with this approach to organization. Difficulties arise when customers expect horizontally integrated products. For example, the manager of a domestic money market fund might want to take advantage of his view on the Canadian dollar exchange rate against the US dollar. Technically, he cannot take explicit foreign exchange positions. However, he can buy a structured note that guarantees his principal while simultaneously allowing him to take advantage of his view if it is correct. There are also management issues that come into play in dealing rooms organized by asset class. Because of their highly technical and specialized nature, derivative products themselves might be considered a separate type of asset. If the bank chooses its asset class line managers from the ranks of the cash trader or generalist salesperson, it is unfair to the manager and it is an impediment to business. It is unfair to expect any individual to expect someone to be responsible for products outside of their comprehension. As difficult as this tenet is to accept for many people, having non-derivatives specialists in charge of derivatives operations of any sort is like asking a bus driver to fly commercial aircraft. It is terrifying for the manager who will have to explain any loss or other problem to his superiors (or to answer their general questions) without any remotely sophisticated comprehension of what is going on. It also does not make sense from a business point of view. The derivatives desks organized by asset class typically take much less risk, win fewer deals, manage their risk as effectively or make as much money as derivatives desks led by well-trained, experienced leaders. Having said that, many managers who should not be responsible for derivatives operations hang on to them tenaciously because of the cachet of being perceived as sophisticated and cutting-edge. ORGANIZING BY FUNCTION The other type of organization is by function. Cash traders and salespeople work together, dealing with clients who want cash products exclusively. They are also separated by asset class. Cash foreign exchange people will not enter into transactions in cash bonds. Derivatives traders and salespeople handle the sophisticated accounts, across all five asset classes (while usually specializing in one or two of these asset classes). What are the advantages of doing things this way? Clients get seamless service across products. Instead of talking to five different contacts at a bank for their various needs, they talk to one person. Instead of having five different kinds of confirmation contract, they have one. It is easy for the bank to structure products that encompass more than one asset class. Think of a cross-currency swap (an exchange of cash flows denominated in different currencies) with an embedded currency option to hedge against fluctuations in the cross-currency swap exchange rate. At the bank organized by function, the customer talks to one salesperson, gets one integrated price and receives one easy-to-read confirmation after dealing. Hedging can be problematic. Because the bank has organized its dealing room along functional lines, the cash trader has no interest or desire to see the derivatives desk do well. He does not have to provide a competitive or even a market price for the internal transactions with the derivatives desk. This can make customer transactions uneconomic, putting the derivatives desk out of business. The derivatives desk, for its part, can hide information about flows from the cash side, impeding their ability to trade and sell competitively. The dealing room can become an adversarial environment. TRADING VERSUS SALES AS THE ENGINE OF DEALING ROOM PROFITABILITY One important distinction between dealing rooms is the business model that they employ. This business model is linked inextricably to their method of organization. If the dealing room is organized by asset class, then typically the source of their profits comes from proprietary trading. Cash markets for most instruments are commoditized in most cases, depending on market conditions, etc. That is to say, the bid/offer spread that the bank can hope to earn from transacting business with a customer is very small. There are many participants in the cash market. It is very competitive. Winning in a commoditized market often means being very aggressive in terms of the bid/offer price an institution shows its counterparties in an attempt to get the dominant amount of flow. More people asking for prices means more spread and a statistically greater likelihood of retaining that spread. How do you make your money? Volume. In the case where the dealing room is organized by function, the engine of profitability is the customer transaction on the derivative products. The bid/offer spread for these instruments is directly proportional to the complexity of the product. Plain vanilla derivatives like currency options are more like commoditized cash markets while highly structured products command hefty spreads (in part because of the difficulty in hedging them). How do you make your money? By executing a small number of lucrative deals that help the client make more money than they pay in spread. Institutions that have a spotty track record in terms of recommending products that make money for their clients will find that they cannot afford to charge hefty spreads. They rely on the strength of institutional and personal relationships. Sophisticated investors, who do not mind paying for information if it is consistently good, will prefer to deal with functionally-oriented banks. This means that institutions organized by asset class are not the ones from whom we would expect the consistency of well planned market strategies. Those recommendations come from organizations that live and breathe by a relatively low number of deals. WHAT DOES THIS MEAN FOR SOMEONE LOOKING FOR A JOB? You cannot be too careful in picking the institution for which you work. Your first choice may decide your prospects of career growth. If you choose a bank organized by asset class, it may exclude you from ever working for a functionally oriented bank. The other thing is that people will pay higher salaries and bonuses for individuals who can give high-quality advice on sophisticated cutting edge products on a consistent basis. Relationship managers are much easier to come by. |