by Joe Pimbley, Columnist & Featured Contributor
[message type=”custom” width=”100%” start_color=”#F0F0F0 ” end_color=”#F0F0F0 ” border=”#BBBBBB” color=”#333333″]Editor’s Note: This is the next in a new Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt. [/message]
[su_dropcap style=”flat”]T[/su_dropcap]HERE EXIST NEARLY 200 distinct currencies in the world. When a manufacturer in, say, France sells its products to a customer in the U.S., the manufacturer will permit the customer to make payment in U.S. dollars (“USD” or $). But in many cases the French company has direct need only for its own currency, the Euro (“EUR” or €), rather than the USD. The company’s expenses will be primarily if not entirely in EUR. Its lenders and shareholders likely expect payment in EUR.
Thus, the French firm will sell its USD to a bank for EUR. While one might consider “foreign exchange” to be the exchange of one currency for another, it is just as reasonable to employ the mental picture of “buying” one currency while “selling” the other. The manufacturer buys the amount of EUR that its unwanted USD will purchase. The market price of EUR in terms of USD will vary from day to day – just as the value of IBM stock will vary from day to day.
Foreign exchange is one of the most “natural” banking products since an intermediary, such as a bank, can aggregate the needs for USD, EUR, and other currencies across many corporate and individual clients. The role of “money changers” is thousands of years old, in fact. The bank that sells EUR to the French manufacturer for USD will also have clients that need to buy USD. See figure 3-3. The bank earns profit, for example, by selling EUR to one client at a slightly higher price than it buys from another client. As long as the bank maintains a large, diversified, balanced book, minimizes “failed trades” of its clients, and conducts only “customer business” rather than “proprietary trading,” the risk to the bank of the foreign exchange business is negligible.
Figure 3-3 Bank provides foreign exchange for multiple clients
Trading and Market Making
The discussion of foreign exchange above is a good example of “market making.” Just as manufacturers are “natural clients” of foreign exchange providers when they sell their products in other countries and receive unwanted currency, there are natural clients for other exchange services. Investors in bonds such as pension funds and insurance companies need “dealers” (also known as “market makers”) who will sell them bonds or buy from them the bonds these investors already own. Thus, many banks are dealers in corporate, municipal, or sovereign bonds.
As with foreign exchange, the bank’s goal in bond dealing is to have a wide universe of clients so that its purchase of a bond from one client will soon be offset by the sale of that bond to another client. As long as the average sale price is somewhat larger than the average purchase price, the bank earns profit. There is risk in this activity to the bank when it acts as “principal” – which means in this context that the bank will buy a bond and hold it temporarily before finding another client to whom it will sell the bond.
A bank may also act as a “broker” by simply taking one client’s order to purchase a bond and then finding a seller of that same bond from its client base. There is no risk to the broker since the bond purchase and sale occur simultaneously if and when both buyer and seller “line up” for the trade. The broker stands in the middle of this trade and earns a fee.
When acting as principal, the bank buys and sells bonds among different clients at different times and prices. This activity is also called “trading.” As stated above, the goal of this “normal” trading is not to maintain a position in a bond longer than necessary. But a separate bank activity of “proprietary trading” – or “prop trading” – does have the goal of earning profit by taking larger risk to anticipate market movements. Prop trading does not have or need external clients. For example, a trader may believe that the market price of a Quest Diagnostics Incorporated (ticker symbol DGX) bond is too low. Her reasoning may be based on intuition, a math model, comparison to another bond, or something else. She buys the bond today with the hope that she will sell the bond within the week at a gain.
Prop trading clearly exposes the bank to risk of loss. The observation that a business segment has risk does not of necessity mean that it is “bad” or “wrong.” Yet there is a view among some government, regulatory, and financial professionals that prop trading poses risk without benefit to clients and that the risk falls on the country’s taxpayers if one assumes that the government (i.e., the taxpayers) will bear losses of the bank. We write these sentences to note the existence of the debate but do not explore the arguments on either side here.
Many banks have trading and market making activities beyond foreign exchange and bonds. Commodities such as oil, platinum, and agricultural products, equities, interest rates, and numerous futures and derivative instruments all lend themselves to the same business model of dealer, broker, and prop trading roles. It would be daunting for any individual to try to learn the relevant and minute details (which include legal documentation, operational processes, regulatory compliance, risk management and reporting, accounting, funding, hedging, and audits) of each activity. The big picture concept is straightforward, though. On the trading floor, it’s “buy low, sell high, and swear a lot.”
As opposed to its popular reputation, true investment banking is fairly simple and low-risk. The confusion is due in part to the vaguely misleading phrase “investment banking.” Also, the financial industry applies the imprecise label of “investment bank” to firms with many high-risk activities other than “investment banking!”
An investment banker works with a private company, a municipal entity, or another project or entity to issue debt or equity. If IBM wishes to sell new bonds to the public, for example, this company engages an investment bank. The bank will advise IBM on the maturity of this debt, the currency, the amount, and other features. What the investment bank really brings to the table, though, is its access to investors. A good bank has a large global client base of potential buyers of the IBM bonds. Further, in the majority of such transactions, the investment bank makes a commitment to the issuer to buy its bonds which the bank then sells to its investor clients.
In the ideal scenario, the investment bank has no risk in this transaction. The goal is to identify the investors prior to committing to purchasing the bonds so that the bank will sell all the bonds. But many transactions are not ideal! There is a possibility the bank will not be able to sell all of what it purchases from the debt issuer. Further, the investment bank has a moral obligation of sorts to make a market in the new securities. That is, if bond investors wish to sell the bonds back soon after purchase, the bank will buy the bonds at what it perceives to be the market price. Thus, due to both the uncertainty of the initial sale and the possibility of receiving more bonds through market making, the bank may end up with IBM bonds it does not wish to own.
Most debt and equity issuances are reasonably close to the ideal scenario. That is, the bank sells all its bonds. We’ve thus far omitted from this discussion for simplicity the role of a “syndicate” of investment banks. To reduce the risk that the selected investment bank will find itself unable to sell a large bond or stock issuance, this bank will generally invite other banks, including competitors, to join the effort. The lead bank manages the process and is able to spread its risk and profits by allocating bonds or stocks to other syndicate members.
Our single example in this discussion describes the U.S. industrial company IBM selling bonds. Investment banking is broader, of course, because the concept applies to bonds, loans, equities, and more esoteric instruments. The issuers of such securities may also be municipal entities such as cities and states, non-profit entities such as colleges and museums, and “structured” entities such as asset-backed security (ABS) trusts.
 See, for example, R. De Roover, Money, Banking and Credit in Mediaeval Bruges – Italian Merchant Bankers, Lombards and Money Changers – A Study in the Origins of Banking, Read Books, 2008.