Professional traders at investment bank have 2 main roles.

Market Making: Traders at investment banks dedicate most of their time to client engagement, specifically with institutional clients like hedge funds and pension funds. They are responsible for making markets in various asset classes, including stocks, currencies, commodities, and bonds, to facilitate transactions for these clients.

Proprietary Trading: In the past, traders at investment banks would allocate a significant portion of their time to proprietary trading, using the bank’s own capital to generate profits. The essence of proprietary trading lies in transactions that are separate from client-related activities.

Dual Trading Accounts: Before regulatory changes, each trader at an investment bank typically managed two separate accounts: one for market making and another for proprietary trading.

Regulatory Shift: The landscape changed with the implementation of the Volcker Rule, which became fully effective on April 1, 2014, requiring banks to be compliant by July 21, 2015. This rule effectively eliminated the proprietary trading accounts at investment banks.

Current Exceptions: Despite the restrictions imposed by the Volcker Rule, investment banks are still permitted to engage in market making, hedging activities, agency transactions, and the trading of government securities like bonds.

Agency business

Market Facilitators — For an Investment Bank Trader, the core operation is Market Making. This can be divided into two distinct types:

Type 1: Agency Business (No risk exposure to the client)

Type 2: Risk Business (Involves risk to the client)

Agency Operations

A fee is levied on all activities related to market making, usually at a rate of 3 basis points or 0.03%.

Around 80% of all market-making activities are categorized as agency operations.

Illustration: Purchasing $10,000,000 of Tesla shares at $105.00 each results in acquiring 95,238 TSLA shares. The commission for the bank would be $10,000,000 x 0.0003, which equals $3,000.

Note: One percent is equivalent to 100 basis points, and one basis point equals 0.01%.

Keep in mind: For the bank, this type of operation carries no risk. Nowadays, all agency operations are processed through a computer algorithm that carries out the client’s directives.

Risk Business

In the realm of Market Making, the risk business usually accounts for approximately 20% of the total activity.

Example: Purchasing Tesla stock worth $10,000,000 at a rate of $105.00 per share results in acquiring 95,238 TSLA shares.

The bank’s commission for this transaction is calculated as $10,000,000 multiplied by 0.0003, which equals $3,000.

Risk Exposure: After the purchase, the trader is “short” $10,000,000 in TSLA stock at $105.00 per share. To neutralize this position, they must buy the shares back in the market. If the repurchase price is higher than $105.00, the trader incurs a loss; if it’s lower, they make a profit.

Profit Calculation: The trader’s profit or loss is determined by adding the commission earned to the gains or losses realized when closing the position.

Example of a Loss: If the trader repurchases all 95,238 TSLA shares at $105.25, they incur a loss of $0.25 per share, totaling $23,800. However, the bank has earned a $3,000 commission. Therefore, the net profit for the bank from this transaction is $3,000 – $23,800, resulting in a negative retention of -$20,800.

Example of a Profit: If the trader repurchases all 95,238 TSLA shares at $104.80, they make a profit of $0.20 per share, totaling $19,047. Adding the bank’s $3,000 commission, the net profit for the bank is $19,047 + $3,000, resulting in a positive retention of $22,047.

Assessing Market Makers

The performance of a Market Maker is evaluated based on the “Percentage of Commission Retained.” In a favorable scenario, the trader’s “Retention Ratio” is 100%, while it stands at -100% in an unfavorable case.

Over the course of a year, involving tens of thousands of trades, a 70% Retention rate is generally considered standard.

Nowadays, most risk factors are integrated into the same algorithms that traders use for executing client transactions. This is because traders are constantly updating prices for clients every 15-30 minutes and managing multiple positions simultaneously.

In the traditional investment banking model, before the implementation of the Volcker Rule, these positions were labeled by the bank as “Negative Selection Portfolios.”

A “Negative Selection Portfolio” implies that the trader is not particularly interested in holding these positions and has no specific outlook on them. The primary goal is to facilitate customer transactions, balancing the commission earned with gains or losses incurred when closing out the position.

In practical terms, this means that most of a professional trader’s time at an investment bank is not actually spent on taking and managing desired positions. Instead, the focus is on executing orders through algorithmic management.

Additionally, traders work on unwinding “Negative Selection Portfolios,” meaning they are exiting positions they neither want to hold nor have a particular view on.

Before the Volcker Rule, professional traders managed two types of accounts: Market Making and Proprietary Trading. Now, they are limited to just one type of account, as proprietary trading activities have been significantly restricted. This shift is a key reason why many top traders have exited the investment banking industry.

Proprietary Trading accounts were substantial, managed as Long-Short Portfolios with a time horizon of 1-3 months under typical market volatility. Only in extremely volatile conditions did we shift to shorter-term trading strategies, such as daily or weekly trades.

Other aspects of our business, like Agency and Risk Market Making, generated steady cash flow. This income covered the fixed operational costs, including the base salaries of all traders among other expenses.

Investment bank traders have always been entitled to a base salary. This base salary, along with all operational costs, is funded by the combined total of commissions earned and the profits or losses generated from managing risk positions.

References

Explore MacroVar Guide on Professional trading