through the investment bank’s trading desk, the buy-side analyst’s firm pays a trading commission, which acts as payment for the research services.
Digging Into the Role of the Trading Desk
Traders sitting in their living rooms in their pajamas may be the image conjured by the term active trader. But it turns out, a vast majority of the millions of orders to buy and sell stocks and bonds each day don’t come from the keyboards of ambitious day traders, but the massive trading operations of the world’s largest investment banking operations.
Most major investment banks maintain trading desks. These trading desks are responsible for buying and selling securities. The trading operations of investment banks are typically involved in buying and selling everything from stock to bonds, futures contracts (contracts that allow buyers to take delivery of an asset at a certain time in the future at a preset price), commodities (claims on real assets ranging from energy to agricultural products), and foreign exchange contracts.
Why investment banks are into trading
Investment banks’ trading operations are designed to serve several purposes. At the source, the trading operations are made to handle the demands of customers of the firm who need to purchase or unload large amounts of stock or other investments.
The trading desks of investment banks can assist customers, including pension plans and mutual funds, to build large positions in a financial asset or unload it.
Many investment banks get involved in trading to generate money from a variety of sources, including the following:
Trading financing: Many investment banking operations lend lines of credit to other financial institutions, usually on a short-term basis. These loans can be used by the investment bank’s clients who want to place trades.
Trade facilitation: Companies that use big investment banks usually aren’t buying or selling 100 shares of a stock. Hundreds of thousands of shares may be bought or sold by these mega players. There are so many moving parts that having an investment bank can help in the transactions, including offering insurance services where a client can be protected if there’s an unforeseen drop in portfolio values. Investment banking operations often serve the role of market maker (a position where they buy and sell securities). As a market maker, investment banks stand ready to buy or sell lots of stock just to make sure there’s adequate trading in a security.
Creating securities to be traded: Investment banks are routinely cooking up new securities, typically those that have value based on other investment like stocks, for investors to trade. These invented securities are called derivatives, because they derive their value based on another asset.
How investment banks turn pennies into billions
Next time you log onto your online brokerage account to buy a stock, don’t think there’s a human on the other end selling to you. More likely than not, you’re buying the stock from a computer that trades in and out of stocks millions of times a day.
Wall Street has been taken over by an army of computers that buy and sell stocks as easily as you may shoot down aliens in a video game. Some sources estimate that 70 percent or more of the trading on the major stock market exchanges is being done by computer programs. These programs, often referred to as algorithmic trading, program trading, or automated trading, are a big area of interest for many investment banking operations.
Computerized trading can be used for a number of reasons, including the following:
Serving needs of clients: Sometimes computers are employed to serve the customers of investment banks, helping them sell large positions of stock. Selling for big customers takes a bit of finesse — if all the stock is dumped at one time, the stock price can be pushed lower and cause the seller to reduce his or her own proceeds. Investment bankers have systems in place to help them sell more gradually to avoid these problems.
Part of market-making responsibilities: Computerized trading may also be part of investment banks’ role as market makers. Investment banks certainly trade to try to make a profit, looking for chances to buy and sell stocks for a gain. But in some cases investment banks can also serve a secondary role. When making a market, investment banks aren’t necessarily trading to make a profit (although they probably don’t complain when they do). They’re the buyer of last resort, standing on the market looking to buy and sell when there are people looking to sell and buy. They’re providing liquidity.
The type of analysis used in trading operations
Many large investors that work with investment banks aren’t very transparent about the trading they’re doing — and that’s no mistake. One of the greatest downsides of trading is that when other investors get wind of the strategy and start to copy it, the strategy doesn’t work anymore.
Imagine that an investment bank’s client figured out that stocks tend to soar on the first trading day of January. Talk about an easy way to make money. The client would simply buy stocks on December 31 and sell them on January 1, or whatever the first day of trading is. But if the secret got out, other traders would buy stocks on December 31, too, which would spoil it for everyone. Why? The stock prices would be pushed up on December 31, essentially eliminating the January 1 pop.
Due to the value of keeping trading secrets quiet, you don’t often hear what investment bankers’ clients have been doing until the strategy blows up on them. But investors can see that typically trading strategies fall into several categories, including
Cross-market arbitrage: Arbitrage is a fancy word used to describe a situation when assets are temporarily mispriced relative to each other. These cross-market arbitrage strategies can get pretty complicated, because computers are programmed to find unexplained relative differences in price between stocks, bonds, exchange rates, and currency prices. The computers can locate mispriced assets and theoretically make risk-free trades.
Event arbitrage: Some trading operations try to anticipate and place bets ahead of major market-moving events. Events that may move stocks include a company being included in the popular Standard & Poor’s 500 stock market index, which is usually a boon for the stock. Another example may be a company being ripe to be bought or a small biotech firm getting approval to market a new blockbuster drug.
High-frequency technical trading: Another area of trading that some investment firms are turning to is a type of high-frequency trading where they take advantage of different trading speeds. It’s becoming increasingly common for large trading operations to develop light-speed networks that will let them place that buy or sell order just a millisecond or less before competitors, giving them an edge.
