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Now let's move on to other activities of
the investment bank and we'll start with trading.
Well, as I mentioned before,
trading is an important feature to provide liquidity in
this huge pool that is the liquid market that serves as [inaudible] ,
triple quoted [inaudible] if you will for the people who participate in
that because they basically have the opportunity to
get out of some of these transactions if they liked to.
Clearly, trading is provided not only and sometimes not primarily by investment banks,
there are some other companies and people who engage in that.
First of all, in some cases,
the trading department of the investment bank is key.
Well, first of all, this is when we talk about
specific instruments for example,
when the investment bank created something and
starts to make market in there then clearly takes time for
other people to realize what it is to ensure
that they also can participate actively and that the investment bank does that.
Not only that, we can talk about
some special areas like for example flow trading.
Well, let's say that you talk about trading Treasury bonds and although there are
really small commissions on that because they're basically perceived
as risk less but most often some of
these orders they used to at least go to
sort of few biggest investment banks because they
operated with large amounts of money and
they had some experience and therefore sometimes,
these traders could easily make
small fractions of commission but then because of the volume,
the overall revenue will be quite nice.
I mentioned before that there is
some conflict of interest between
the underwriting department which is sort of key at an investment bank
and the trading department that used to be a little bit subordinate but now is
gaining more and more power because
the universe of instruments is growing and oftentimes,
the volumes and the profits from this activity also can sometimes exceed
that of the investment banking major activity, underwriting and consulting.
The people who stay the fees for underwriting and for consulting well,
we just keep collecting money and you guys keep blowing it.
Indeed sometimes traders at investment banks take
higher risks and sometimes they result into really huge losses.
But that in fact,
cannot prevent this activity trading from growing.
Now that is not all.
Now I would like to add some other specific issues of trading and I would like to analyze
one that you might have heard
about that has a special name that's called When-Issued trading.
4:30
Only these people participated in the auction.
Then here comes the another dealer and finally here is the client.
The securities they go through primary dealer to the dealer and then to the client.
Now, the terms and conditions of the auction,
they are not known in advance but given the overall feeling of the demand,
all these participants I mean primary dealers and secondary dealers or just dealers,
they have a good idea of what the terms would be.
Oftentimes, the dealer can sell the issue to the client
basically to sell short because it
sells it before the issue actually has been implemented.
Now here as you can see the dealer takes the risk because the only way through which
a dealer can obtain these security is through
primary dealers well in reality this is not one primary dealer.
There is stiff competition between them so if
everything goes okay then there is not that much risk.
And the volumes of this short selling was quite high.
However, we have to realize that here,
we have a potential monopoly situation or at least oligopoly.
What if let's imagine that there's only one dealer?
Then these dealer would have had
the monopoly power and could raise the price and in this case,
these dealers, they do not have any other option to get these securities.
They would go bust.
Now that's exactly what happened in 1991 when there was
a famous scandal associated with the very well-known investment bank
Salomon Brothers that was one of the major primary dealers that engaged in
illegal activity that was sort of placing some bids at
this auction that were not competitive but they were sort of link with Salomon Brothers.
Without going deeper in this issue,
we have to say that not only did that result in the infamous retirement of the bosses
at Salomon Brothers but also forced
the system to be changed when many more potential.
Well formally those were just dealers but now they were really admitted and allowed to
participate in this auction in order to make sure that there
is not the issue of this monopoly power or this oligopoly power.
I still remember when I was
the first year student at UCLA business school that was in 1992 and we had
the representatives of these large companies to arrive at our campus and to
hold some parties to start to look for potential interns over the summer.
One of the very first was the guy who came from Salomon and although he
was clearly not responsible for that but when the party
went on then people would come close to him and say,
well how come that you screwed up so badly?
And he was in the position to apologize
not for what he had done but for what his colleagues had done.
So that was quite an impression.
Therefore it shows that sometimes unless you see the potential holes in this and
the areas in which you can
abuse the situation then that obviously adversely affect efficiency.
Now, a couple of more things about trading that have become of interest lately.
You might have heard about this term high frequency trading.
This is basically trading with
the heavy use of modern technology without going deeper than that.
That is the area that deserves a special course.
But for now, I have to say
that the main idea of participating in trading by investment banks
is because they are financial wholesalers so they deal with
huge amounts of money and therefore they can afford to charge
very low transaction commission and that is why they
can outdo some other smaller dealers or market makers.
By the same token,
companies that are involved in the high frequency trading,
sometimes they can afford to charge extremely small commission and they
take small risks but because of the huge volume and because they do that extremely fast,
then they can eat up a certain of market share and sometimes they can have
volumes of trading that is not so small compared to those of investment banks.
Basically right now, there is another area in which investment banks should
compete with some of newcomers to this market and that always around technology.
The idea of technology here also is very important if we take
a broader look because as we discuss in some more detail in our next course,
the majority of ways of valuation right now for advanced instruments,
they involve some maybe ideologically or philosophically.
It's not that complex but in order to do that you need
some advanced hardware and software and on
top of that you have to have certain strategies and ideas behind that.
Therefore the ability to invent and market certain new financial instruments
is closely linked with the technological ability
of the markets and that should not be ignored at all.
Now, I would like to
stop here and I would like to wrap up this trading idea.
So for us, the importance of the fact that investment banks they engage in trading,
it just supports the idea that not only do they care about the feeling of
this big pool but they also care about efficient trading within that,
as the provider and supporter of liquidity.
Because they do realize that it is
this liquidity that allows the people to actively participate in
this public securities market and that is
the important thing that really is key for the investors to come,
buy, sell and basically,
feed the investment banking business in some way.
Konstantin KontorDirector and Professor of Finance and Strategy
