On August 5th, NHC launched the risk salon program allowing students or professionals to be prepared for job hunting in risk management industry. We were honoured to have Dmitri Rubisov, Managing Director, Structured Products from BMO Capital Market giving an overview of trading activities at financial institutions.
Other panel speakers included Catherine Zhang, Associate Director at Scotia Capital and Nicholas Wang, Vice President, CAD Rates Trading from BMO Capital Markets.
Dmitri started the class with introducing the history of investment banking and relevant trading businesses of banks. Trading is part of investment banking. Historically, retail banks in USA could not have investment banking until 1999. Canadian retail banks could have investment banking, but they were small until most of them had major acquisitions of investment companies during 1985-1995. The structure of trading units is different in different banks; for instance, BMO has three lines of business, FICC (fixed income, currencies and commodities), Equities (trading stocks, equity options, convertible bonds, preferred share, ETF and equity swaps) and Structured Products. The panellists discussed why it is more and more popular in different banks to combine FICC under one umbrella. Nicholas suggested that it’s probably because sales people covering FICC activities face the same clients. Dmitri added that also those trading activities are also similar because the most liquid instruments in FICC are forwards. Catherine added on the topic that Scotia does not have structured products as a separate line of business, but other desks trade structure products as well.
After the crisis of 2007-2008 and new regulations, especially in the USA, banks cannot have proprietary trading. The two allowed activities are providing services for clients and market making. In the first case the profit is coming from the client’s fees, in the second from the bid-ask spread. Therefore, after trading with clients, bank traders are always hedging their portfolio to minimize risks. Most of options traded for clients are European style rather than American options because clients do not want to pay for the option to exercise earlier. Speaking of the difference between spread trading and basis trading, Nicholas explained that spread trading is based on different products (for example LIBOR curve and a corporate curve), whereas basis trading usually associated with the same or similar curves.
After that, Dmitri explained the structure of limit letters and authority letters that prescribes what type of products (financial instruments and underliers) and in what currency every line of business and every desk may trade. Limit letters also provide limits on notionals and risk exposures, as well as some secondary limits. Traders are not supposed to breach limits, especially primary limits such as VaR limits, credit exposure limit and stress test limit. Traders, anticipating that they cannot eliminate a primary breach before the end of the day, must obtain an authorization from head of trading and chief risk officer. Failure to do so is not tolerated.
The panellists also discussed different trading strategies. For example, in listed option trading, the bank offers bulk trades to the clients and the price of such a trade includes a fee. To hedge this exposure, traders should buy or sell the underlying stock other and listed options on the same stock with different strikes and/or maturities. In convertible bond trading, while offering the convertible bonds to hedge funds or pensions funds, convertible desk of the bank can buy the old bond from the fund, hedge it and unwind the position over a long period of time to make profits.
Lastly, Dmitri spent some time on structured products, one of the most complex trade types in the market. Many structured products are notes and GIC based on the performance of equity indices, stocks and interest rates and their hybrids. When interest rates were higher, it was popular to sell principle-protected notes (PPN) to investors. For example, the investor pays $100 today and receives $100 back plus 80% return of the S&P index. This note is made by a zero coupon bond plus a call option. The price of this note is less than $100 because of the time value of money. Katherine mentioned that given the low interest rate environment now, it is hard to make PPN attractive to investors. Notes issued now usually offer a higher upside potential, but do not fully protect the investment. The downside protection could be 70%, which means that as long as the underlying asset does not drop by more than 30%, the investors will get the whole principal back. If the underlier goes further down, the investors participates in this downside.
Nicholas explained why banks make bigger profit in the high volatility environment when the bid/ask spread is wider. After financial crisis in 2008, the volatilities were initially very high, but then became significantly lower. This trend affected the banks profit. Today, the volatility is getting higher again but is still not as high as they were. As volatilities increase, banks are able to offer varieties of products to better satisfy needs of the clients.