How do traders operate within banks? Is it really how we think? Let’s see it together.
Do banks trade? If yes, how do they do it?
Banks continue to trade after 2008, when the Lehman Brothers crisis prompted regulators to tighten their grip on high-risk speculative trading activities, effectively limiting the bank operations from matching their own trader large sums to make risky trading operations.
The trading that is done now is very different from what we can currently conceive, i.e. a search for market directionality at all costs with operations that seek profit by means of technical tools aimed at guessing the right direction of a given market. In fact, banks try to trade by means of absolutely different methodologies from those that are normally conceived by a retail trader, who would also find it difficult to profit consistently given the large difference between the liquidity of a bank and that of a private trader. Let’s take a look at how banks operate and what type of trading they do.
The difference between a retail trader and a bank trader
We must point out that the first major difference between a retail trader and a bank trader already lies in the hardware infrastructure that a bank has at its disposal. The bank has an infrastructure that is in no way comparable to that of a retail trader, starting from the direct connection with the market up to the hardware used to trade.
Let’s consider the fact that speed is everything in the banking sector, consequently the computers used by banks have hardware components that are difficult for a retail trader to access. The connection to the market is undoubtedly much more powerful, which allows banks to carry out operations at a very high speed, with a minimum latency and with huge volumes of money.
Just think of HFT, i.e. High Frequency Trading, the trading carried out by banks to send huge volumes at high speed within the market in order to profit on micro-oscillations in the price of an instrument. Consider that over 90% of these orders, due to the competitiveness between institutions, are not even executed as All-or-None orders, i.e. they must be executed for the entire amount placed on the market, otherwise they are directly deleted.
Market Making and Delta Hedging
Most of a bank’s activity lies in what is defined as “market making”, i.e. that type of trading which envisages the existence of a counterparty who pays a commission for the order accepted by the bank, this the latter will have to take an opposite position to hedge the exposure by choosing a financial instrument that has a correlation as close as possible to -1 to better hedge.
For example, let’s imagine that we are an investment fund that wants to buy a large amount of a stock that we will call "Pear". We will call a bank that gives us a price for those shares and we buy 1000 Pera shares. The bank therefore has a "short" position, meaning it has sold short these shares and now finds itself having to manage the risk of this 1000 share position. Having collected the commissions for the operation, it is time to look for an instrument that negatively replicates Pera’s performance in order to hedge the risk of the position for an equivalent value of 1,000 Pera shares.
In this case, the bank trader who took this position will be called “trader sell side”, there are also buy side traders.
Still in the field of market making, we have Delta Hedging , which has the same functioning as the classic market making only that the use of options is envisaged and the recalculation of the position to be assumed to cover the risk based on that which is referred to as the “delta” of an option.
Most of banking trading is just that related to market making. They are still present in the trading desks many physical operators who have the task of negotiating with the various counterparties directly orally, or in any case with direct contact also through what is called the Squawk Box.
Risk containment as a goal
As we can see, banks invest heavily in the pursuit of profit with a very high risk containment. They prefer to maintain a very low risk profile rather than seek profit maximization through risk management aimed at necessarily generating returns at all costs, a profile that is certainly more suitable for trading.
At the same time, as explained with the example already illustrated, the counterparties of banks are almost always hedge funds, investment funds and other financial institutions capitalization that not only negotiate classic financial instruments, but also in what is defined as over-the-counter market, the unregulated market where banks build a financial product by structuring it according to the needs of the counterparties.
An example is the market of CDS (Credit Default Swap), or that of CDOs, markets to which only institutional investors authorized to trade have access these highly sophisticated and complex products both in terms of composition and in terms of negotiation.
Before 2008, banks had what were called proprietary trading desks, where the most talented traders could use the bank’s funds at will in order to speculate on the financial markets. This gave birth to a real trader’s market where the banks paid these market superstars their weight in gold, a dream that ended precisely with the 2008 crisis which prompted a redimensioning of the sector’s risk banking and the "expulsion" of these traders from banks.
These traders now work in hedge funds, family offices, prop trading firms, becoming the counterparts of the market makers, their now former building colleagues.
Original article published on Money.it Italy 2023-04-09 15:43:00. Original title: Banche: perché (e come) fanno trading sui mercati finanziari?
