Sales & Trading

Contents

1 What is Sales & Trading?
- 1.1 Sales
- 1.2 Trading
2 Why Sales and Trading?
3 Sales and Trading Salaries and Exit Opportunities
4 The Trading Floor
5 Introduction to Trading Products
6 Risk and the Credit Valuation Adjustment (CVA)
- 6.1 Trading Risk – Market Risk and (Trading) Credit Risk
- 6.2 Introduction to Credit Valuation Adjustment (CVA)
7 Related Reading for Sales & Trading

What is Sales & Trading?

S&T is where a bank makes markets for clients through the buying and selling of securities. Similar to other segments of the bank, S&T is where a bank acts as an intermediary and provides liquidity by connecting buyers and sellers while taking on a profit from the difference in price (the spread).

This dynamic is best illustrated through equity sales (although equity sales itself is fading as market making evolves) – a bank receives a call that someone wants to sell a block of shares, gives a quote and tries to offload to a party looking to buy at a higher price. Of course, the exact trading block that the potential buyer demands will likely differ, causing the bank to hold inventory – the bank can take a view here to hold as the market moves or try to offload quickly.

The idea of balancing the book and capturing the difference/bid-ask spread is similar and manifests itself through stocks, bonds, interest rate derivatives, FX derivatives and physical commodities.

Sales

The salesperson markets the product to the client. Although the trading floor is on the public side of the wall, the private side investment banker (coverage banker or relationship manager, although sometimes this is covered by the corporate banker as secondary coverage due to the relationship dynamic involving bank credit being extended) introduces the sales to the client. Traders do not see the client.

Canadian banks usually have enough flow as is, as there are only six major banks and thousands of clients who require hedging foreign exchange, interest rates, commodities, and share price fluctuations.

Coverage is usually split between corporates, financials and governments. Financials are usually the most sophisticated, while governments usually are responsible for the largest volumes per deal. There are a lot more corporates than there are financials or governments.

In sales, performance is measured by the aggregate Present Value of trades they book.

Sales may book trades for flow even if profit is tiny, so that the relationship with the client is maintained and they are in the running for a large bid when the time comes.

All things considered, sales is still very much a relationship business and clients appreciate 1) credit support; 2) pricing and 3) idea generation, with preference varying between clients. The more a client needs credit, the more

Sales guys book a PV of a trade, but traders take positions and can get the highest possible compensation.

Trading

Traders subscribe to a variety of methods, with some successful traders swearing by technical analysis and mapping out thousands of charts and Bollinger bands. Some of the best (on Bay Street) and most famous traders (anyone on Wikipedia who has not gone to jail for rogue trading and blowing up the book) trade heavily on feel or gut feeling (which sometimes is just having a better sense for the most common technical indicators of momentum and support & resistance). Obviously, we are not able to elaborate on the thought process here. These traders will look at the markets, come to a conclusion and enter into a massive position.

Trading is the most meritocratic business in the bank, and the traders who have not been dismissed post-crisis continue to be compensated accordingly. The idea is that a very good salesperson leaving the bank is detrimental but client retention continues to factor in the credit relationship and capital access. When an excellent trader leaves, that money vanishes. A salesperson’s all-in compensation will be a smaller fraction of his PV versus a trader’s PnL.

Traders tend to have a very technical mindset outside of their assigned product and enjoy solving puzzles. On the trading floor, banter about true probabilities on sports betting, large swings in the poker bankroll and arbitrage positions on mispriced securities. Some of these mispriced securities are illiquid and trade in large lots, so it can be astounding when traders purchase them with their personal accounts (PA)

Why Sales and Trading?

Better hours, but more stimulating work and a need to be on top of macroeconomics and global affairs – arguably makes you more knowledgeable
Meritocracy – Hard to argue with PnL
Market Sensitivity – Good for your personal trading account

Sales and Trading Salaries and Exit Opportunities

Base salaries are the same across capital markets with $70-90,000 base for sales and trading analysts, $95-125,000 for associates and so on. Bonuses are ~50% of base salaries. Promotion is much faster once you hit associate (once every year if you kill your numbers), relative to other capital markets careers. Past Vice President, your bonus is extremely variable, contingent on your profit and loss. Top traders make more than top bankers.

As mentioned previously, performance is measured different depending on whether you are in sales or in trading, and performance is linked to compensation. Normally you are hired into an entry level rotational program, where you rotate until you land on a desk supporting the sales side or the trading side.

Exit opportunities for sales or trading professionals are good. Sales or trading professionals can lateral easily into asset managers and lucrative hedge funds. Some traders start their own hedge fund. Internal moves into investment banking is also an option.

The Trading Floor

The image of a trading floor with streaming quotations, red and green arrows, charts, the sound of bells and yelling over the phone is what the layman thinks of when he hears “investment bank”. Sales and trading has seen shrinking headcount since the financial crisis, although with the appeal of Dodd-Frank, this trend may start to reverse (although not in its entirety).

The culture continues to be extremely entrepreneurial and fast paced, with compensation being tied to a very clear profit and loss number. The trading floor continues to be where interns grab coffee and food for everyone on the desk and traders keep eyes on their screen for the entire day. Every desk has a few screens and a Bloomberg terminal and the markets rule from a 7AM start to when markets close, where most people will clear out for drinks.

The average trading floor denizen is more quantitative and has a better market comprehension than an equivalent investment banker. It is easier to get a sales and trading interview but the screen is better because it is more difficult to manufacture a response to “where do you see the markets going in 6 months and why? 12 months?” than “walk me through a DCF”. Overall, you will find that the trading floor is intellectually curious and has an aptitude for problem solving.

Introduction to Trading Products

There are a variety of products that investment banks offer as solutions for corporates, financials and governments as they look to hedge or speculate (for corporates and governments, speculation is rare, except for under very large organizations with sophisticated treasury functions – usually recruited from the trading floors of investment banks). As a rule of thumb, hedging is never “free”, so there needs to be a reason to enter into a trade.

At an extremely simplified level, the investment bank takes the opposite side of what the counterparty wants and negates the exposure with another counterparty, taking a spread in between. In reality, there is no immediate counterparty with an opposite need for large, client specific demands, so the investment bank books the present value of the trade and looks to manage the risk through trading. Depending on the creditworthiness of the counterparty, investment banks will include a credit valuation adjustment (CVA) in the cost of the trade.

Both banks and their counterparties will have risk limits that map out a maximum total exposure with a single entity. The trading floor is always looking to be nimble with putting together as big of a trade as possible, so there is a constant conflict between the floor and their risk management teams in determining how much market line is available.

Interest Rates and Bonds

Companies and governments are exposed to interest rate risk when they have floating exposure (and fixed exposure when it matures, because over a long-term horizon, all debt is floating rate debt if you intend to refinance). If the reference rate (usually LIBOR) rises, companies must pay more interest. As companies have a certain amount of sales and pre-leverage costs, companies may need to lock in an interest rate to have more precision pertaining to their profit. For certain projects, a higher interest rate can make it uneconomic, so a hedge is necessary.

There is also issuance risk. If an issuer knows that they will issue debt at a certain time, they do not know what rate they will get to ultimately issue at. The issuer can enter into a bond forward agreement for nearer term issues or a forward starting swap for potential issuers further in the horizon to lock in a rate.

For larger corporates who can hedge relatively cheaply, they will look to be opportunistic with debt issuances – by issuing in a different currency or at a floating rate and swapping it to fixed for a lower all-in cost. Sophisticated counterparties who have a greater ability to take risk may have their treasuries take views and choose to have unhedged floating exposure to save on interest and possibly lower rate volatility.

Commercial Paper & Money Markets

Commercial paper (CP) is a short-term fixed-income instrument with a tenor no longer than one year and sells at a discount to face value instead one that pays interest on a fixed amount of principal such as a bond or a loan. So for instance, $100 of commercial paper that matures in 6 months may be sold at $99.

For many firms, commercial paper is a major source of funding the everyday inflows and outflows of cash from the normal course of business. As such, it is ideally very cheap and liquid. On the investor side, commercial paper is an attractive short duration fixed income instrument (versus a savings account or cash) for insurers, custodial firms (State Street, BNY Mellon), governments and money market mutual funds.

Ever since the financial crisis, commercial paper has shrunk materially and has largely been utilised by very creditworthy companies that are investment grade, and much more in the A range or above. This is not to say that commercial paper cannot be accessed by less creditworthy companies, but pricing is not competitive compared to other borrowing options.

However, commercial paper for companies that do not have attractive pricing can be credit enhanced via a letter of credit from a highly-rated bank or via securing assets against the CP for Asset Backed Commercial Paper. Credit ratings for short-term debt are issued by the ratings agencies (Moody’s, S&P, DBRS) but do not fall under the ABCD scales.

Usually, a commercial paper program will be backstopped by an undrawn line of credit from a syndicate of corporate banks. If liquidity dries up when commercial paper matures – that is, the company is unable to roll it over – then they will have access to capital from their banks provided this is a temporary funding problem.

Foreign Exchange

Corporates have substantial FX exposure even if they do not operate internationally as purchases of goods and machinery will often be imported from other countries. For companies who operate internationally, there has to be some thinking around how to repatriate foreign income without being subject to earnings volatility. This is where an investment bank can find ways to add value and a variety of FX solutions can be prescribed, including FX options, forwards, swaps and structured solutions.

A lot of FX business is flow (which is transacted at spot), which is not profitable for the bank, but is vital for maintaining client relationships so that the bank is favored when bidding on a large, esoteric transaction. When the effects of FX are isolated from other drivers of revenue changes, an investment bank can layer in more value-added bespoke solutions, to the benefit of both the bank and the client.

Equities

Corporates have equity risk when they have executive compensation by the way of stock options or units, with cash flow risk when they are cash settled. Whether to counter the effects of earnings or cash flow dilution, an investment bank can offer a variety of calls and option combinations or total return swaps to hedge this risk.

Corporates may also want to hedge the risk of dilutive securities such as convertible bonds or convertible preferred shares. Should the company want to avoid dilution, it will have to settle in cash rather than physically – a jump in the stock price may make this expensive. Equity swaps or options can help to lock in a future payment.

Financials who want to take a view on how the market will react over a certain time horizon can enter into a contract to swap out their equity exposure for cash or vice versa. This can be replicated with any index or security, although as with all other solutions, the less vanilla the product, the greater the cost.

Commodities

Commodity hedging is particularly important in Canada due to it’s wealth of natural resources and attractive business environment for miners. For resource extraction companies in less well-positioned areas of their underlying commodity cost curve, hedging is essential to ensure that return hurdles are met.

Banks have excellent commodity hedging capabilities and can offer derivative solutions for the underlying, a benchmark or a refining margin. From a lending perspective, banks may also demand hedging (and provide the hedging solution to the same client) to ensure there are no threats to debt service.

As noted above, FX is being automated, while commodities are one of the only trading products where banks are not the best positioned. In most cases, the banks have the smartest talent and the most information. In the opaque world of commodities, physical commodity trading houses (Vitol, Glencore, Trafigura, Mercuria, Noble, Louis Dreyfus, ADM, Cargill) have the best access to data and real assets (logistics and storage, which would be extremely punitive to bank balance sheets).

Oil Trading Houses

Supermajors – BP, Shell, Total (Exxon, the largest supermajor, noticeably does not have a large physical commodity trading operation)

Independents – Mercuria, Trafigura, Glencore, Vitol

Brokers – Goldman Sachs (J. Aron), Morgan Stanley (attempted sale to Russian SOE Rosneft), JPM (since sold to Mercuria), Barclays, Citi (Phibro, previously of Salomon Brothers, now separate)

Risk and the Credit Valuation Adjustment (CVA)

Trading Risk – Market Risk and (Trading) Credit Risk

As touched upon above, banks are market makers or intermediaries – they try to take a counterparty on one side and a counterparty on another while capturing a spread in between, removing themselves from risk. However, in reality the book is never perfectly balanced as there are never two parties that require the opposite ends of the exact same trade, and especially not in a competitive market such as global markets. The less offsets the bank has for trades, the more directional risk it is taking.

As such, all trades must be individually monitored and each transaction needs approval from a risk management overseer. Trades carry two key risks – right way risk and wrong way risk.

Right way risk is credit risk when the trade goes well for the bank. For example, if a small oil refinery conducts a trade with a bank to purchase oil for $60 per barrel and the price of oil falls to $30, the bank is the winner on the trade but now has the risk of its counterparty defaulting on its obligations.

Wrong way risk is the opposite – for instance, the price of oil rises to $90 per barrel. Now the refiner is up on the trade as it is buying oil for $60 when it could be buying in the market for $90. The bank does not have default risk in this scenario, but is on the hook for selling oil for $60 when it costs $90 on the open market.

Introduction to Credit Valuation Adjustment (CVA)

Banking is a highly regulated industry and banks have many safeguards against failure. Just like with loans, capital has to be set aside for trades – the riskier the counterparty, the more capital reserved for the transaction.

To account for credit risk, a CVA adjustment has to be built into the pricing to ensure that the bank is compensated adequately for the uncertainty. The higher the CVA charge. Banks only book “profit” on charges beyond the CVA.