Chapter 2 Excerpt - The Origination Process

Banks are the ultimate financial intermediaries. The large so-called “bulge bracket” firms do business in every country of the world, borrow and lend in every currency, buy and sell every product, and stand ready to modify any risk at any time for any client as long as they can weigh it, measure it, and (most importantly) charge a fee for it. A well-run bank will enjoy several advantages over other market participants, most notably access to plentiful low-cost capital, a desire and an ability to warehouse risk, and a tremendous analytical and experiential resource base.

The ability to borrow cheaply is a tremendous tactical advantage in an environment where almost every transaction is financed. The cost of capital is, after all, a cost. The higher the interest rate charged on the funds necessary to hold a position, the higher the required profit margin and the more favorable the risk-reward ratio needed to justify the transaction. The entity that can borrow at the cheapest rate can be more aggressive with its pricing while still maintaining a similar (or larger) profit margin. A bank’s competition for a deal may ultimately intend to borrow money from the bank to finance the proposed transaction, the added fees for which will, by definition, make those funds comparatively expensive.

Banks service customers, though a particular firm’s interpretation of serving customers can range from sincere attempts to provide a value-added service to, in some cases, predatory behavior. The very best traders at banks have an ability to be both trader and salesman, and understand that they have a significant personal interest in fostering the growth of their market by providing good but lucrative service and aggressively acting to expand their client base. Perhaps the best example is Mike Milken at Drexel Burnham Lambert, who first pointed out that high-yield bonds were systematically, fundamentally cheap relative to their default potential, then created a reason to use junk bonds as low-cost financing for the wave of leveraged buyouts and corporate takeovers that characterized the 1980s. Other notable examples are Lewis Ranieri, who almost single-handedly created the market for mortgage-backed securities at Salomon Brothers, and Marc Rich, the driving force behind the development of the spot oil market.[5]

Banks do face some notable challenges, particularly in the current environment of increased oversight and regulation following the 2008-9 bailouts.[6] Complying with new regulations will have both real and implied costs in terms of time, effort, and additional procedures around disclosure, reporting, and compliance. This uncertainty has led to a substantial talent drain as top producers move to merchants and hedge funds for a freer operational environment and, in most cases, more lucrative compensation structures.

The banking business is almost incomprehensibly interconnected, as hundreds of large global institutions execute millions of trades daily, forming a complex web of payments that must be exchanged at the close of business. One large firm unable to settle their accounts could tip several others into default, each in turn would damage others, and so on throughout the system. This phenomenon, called Herstatt Risk[7] or cascading default risk, is one of the real underlying dangers in the financial system, and is the reason why bank regulators are so quick to step in and stabilize a failing institution. Unless the exchange of payments is secured, a sizable bank simply cannot be allowed to shut down operations.

Banks are not the only financial intermediaries, though they are by far the largest and the most prominent in the market. Insurance companies (and their shadowy brethren re-insurance companies) operate along the same principles, but with a much more specific, actuarial mindset. Actuarial firms will write a policy[8] on anything that they can contractually define and statistically model. In exchange for providing coverage, the insurer will be paid an up-front premium. The skill lies in pricing the premium high enough to cover the probability of the contract being triggered and paid out, with some margin built in for safety. The more unusual the product requested and the more complicated the modeling and valuation necessary, the larger the premium.

What insurers covet is large, un-serviced demand for products or services that either complement their current business mix, or that can be offered to a large cross-section of clients to achieve a level of risk-mitigating diversification. It is very dangerous to sell a $1B notional policy to a single entity, to which literally anything can happen. It is very good business to sell a thousand $1M policies to people scattered all over the globe. The total diversified portfolio will inevitably have some defaults or incidents where the contract is paid out, but if the product is priced correctly the premium taken in should cover those costs, and more.

Financial Institution Structure

Figure 2.3 Financial institution organizational chart.

Organization Description

Banks generally have the largest and most evolved trading infrastructure of any market participant. Supporting the wide variety of products and services that their clients demand requires a degree of subject matter expertise and specialization and a resource depth impossible for a leaner merchant or hedge fund to support. The trading group will commonly be subdivided into the front office (white), middle office (light gray), and back office (dark gray).[9]

The front office is the commercial function of the firm, and will encompass the entire trading and origination desks and personnel that work closely with them, including dedicated on-desk analysts, members of the structuring group, and senior fundamental and quantitative analysts.

The middle office is engaged in the primary business of the firm, but may not have much direct contact with the trading desk and its management. Middle office functions include the risk group (though it is technically outside of the trading reporting chain), the portion of the analytics groups that does not report directly to trading, and the operations group that handles the scheduling and delivery of physical transactions.

The back office handles purely administrative functions, and is composed of the credit group, the legal group, the contract administrators, and the compliance group.

The support for the front-line traders and originators does not come without a significant cost. A well-supported revenue producer can be responsible for the costs of 5 to 10 support staff that are covered directly by his profit-and-loss (P&L). Taking into consideration the cost-per-unit of labor in New York, London, or Tokyo, it is not surprising that bank traders have some of the largest performance goals in the industry.

Customer-Facing/Deal-Flow Traders

A customer-facing or deal-flow trader is responsible for servicing a group of external counterparties, either directly or via an internal middleman called an originator. The process of showing pricing to external entities is called market making, and is the core responsibility of most traders at financial institutions. The product, term, and volume are determined by the customer’s request for a quote, but the ultimate transaction price depends on the negotiation process, which starts with the bid to buy and/or offer to sell (also called the bid-offer spread) the trader feels comfortable showing. If a transaction is consummated, the trader will either attempt to back-fill the equivalent product from the market at a better price and realize a small profit, or take the other side of the transaction and keep the exposure, buying when the customer wants to sell and selling when the customer needs to buy. One of the primary businesses of any large bank is warehousing risk, taking the other side of a never-ending stream of customer transactions and aggregating and managing the risk inherent in the resulting position.

The Origination Process

Figure 2.4 Flowchart of the origination process.

Originators speak with their clients frequently, exchanging market information, inquiring about the clients’ current needs and inevitably proposing bank-provided solutions. If the client has business to do, the originator will approach the trading desk with the client’s bid to buy or offer to sell. Clients can also ask for the market on a product, requesting the bank’s bid to buy or offer to sell without giving away their transactional intent. If the client’s interest is complicated, like a Request for Proposal (RFP) on a long-term deal or a transaction with significant optionality, it will first be routed through the structuring group for analysis and risk decomposition before being sent to the trading desk for pricing of the component products. Complex transactions will be covered in greater depth in Chapter 15.

When asked for a market by an originator, the trader will first ask the details of the transaction and the requesting client. The originator will brief the trader about the client’s level of interest (“just shopping around,” “looking to transact now,” etc.), previous behavior (“this is the third time they’ve called looking for this, and they’ve always been looking to buy”), and any other errata that the trader might find useful (“They want to get this done this morning. I think they’re talking to two other people, max. We’re close but need to be more aggressive to get this done.”). Just as the trader is responsible for knowing the market, the originator is expected to be aware of what is going on in the deal space at all times.

Once the trader understands the client’s needs, she will consult the market and examine her current inventory. If the client’s order compliments the trader’s current interests (the client wants to sell and the trader is already buying, or vice versa), it is said to “fit the book,” and the trader will execute the transaction and keep the position. This eliminates the need to go to the market and saves execution costs for the trader, as she is buying on the bid or selling on the offer. If the client and the trader both want to buy or sell, they are said to be going the same way in the product, the trader will have to fill the order and attempt to back-fill out of the market at a profit. It is rarely acceptable for a trader at a bank to say she has no interest, or lacks the capacity to execute the business or the sophistication to price the component risks.

Location of the Pricing, Location of the Risk

The trader or originator will need to capture a margin as compensation for facilitating the customer transaction and (possibly) warehousing the resulting risk. Some firms will have the trader add margin into the price they show the client/originator and keep it in their book to pay them for the execution risk, leaving the originator as a salaried service provider. Other firms will expect the trader to price the product with no margin (or a very small one) built in, allowing the originator to set the final price and giving them P&L responsibility. It is critically important to coordinate this activity, because if both the trader and originator add margin to the transaction it will quickly become prohibitively expensive relative to any competing offers.

Once the trade has been booked the P&L responsibility can reside with the trader, be owned by the originator, or be shared in a strategic portfolio. There is no inherently better or worse structure; each has strengths and weaknesses. The trader-owned deal P&L tends to lead to fewer, higher quality transactions (as traders will only take what they feel they can handle), more proactive hedging, and better controls on the resultant positions. Originators with transactional authority tend to close more deals and do a wider range of business, but are often less precise stewards of the resulting portfolio. Shared ownership can be productive, as long as the roles and responsibilities are clearly defined.

How Traders Make the Market

Making a market involves quoting both a bid to buy and an offer to sell. Traders make markets for two reasons: proactively to provide liquidity and facilitate transactions, or reactively in response to a specific customer or originator request. Merchants and hedge funds tend to be liquidity providers and transaction facilitators, with most of the customer-related business gravitating toward bank traders.[10]

For an extremely illiquid product, the bid-offer spread the trader quotes may be the only visible indication of value to other participants, and if sufficiently “tight” and reliable may be used as an established source for the industry’s mark-to-market accounting. The willingness to both buy and sell provides liquidity, irrespective of the market maker’s view of the overall trend. A market maker generates profits by buying on the bid and selling on the offer as many times as possible with as little elapsed time between transactions as possible. Market makers prosper with a large base of frequently transacting clients and a low volatility, liquid market that is not yet completely efficient.

Traders will generally take their current inventory into account when making markets. If a trader owns a large volume of a particular company’s stock, for example, he might prefer to be a less aggressive buyer and a more aggressive seller. Sophisticated customers will survey the market, contacting numerous firms in the hope of finding a trader who is motivated by inclination or inventory to show a good price.

In a perfect world, a market maker would face an infinitely long line of alternate buyers and sellers, each transacting in similar sizes at the quoted bid or offer, paying away the spread in return for the convenience and liquidity provided. More commonly, the market maker is buffeted back and forth as waves of sellers and buyers alternately besiege its product, forcing rapid adjustments in price to try to balance the market. Much like an odds-maker, a dedicated market maker’s goal is to find the equilibrium level where the selling and buying interests are approximately equal, minimizing short-term volatility and allowing it to get back to collecting tolls in peace and quiet.

The disaster scenarios for market makers are serious crashes or price explosions, where there can be no balance, only stampeding buyers or sellers. Market makers with access to more than one product or the latitude to trade in other instruments will become adept at hedging an unbalanced book with whatever semi-correlated products they can get their hands on in an emergency. Non-bank market making firms are not deeply capitalized, as a rule, and are certainly not in the business of maintaining large long or short speculative positions. When the whole world runs for the exits at the same time leaving the market maker holding the position, its losses can be violent and career ending. The less scrupulous will widen the bid-offer spread to untradeable levels, or in some cases refuse to make a price at all. Traders refer to earning money in tiny increments day in and day out only to go broke in a flash as “picking up pennies in front of a bulldozer.”

In the trading pits and on exchange floors, a single individual or firm might be responsible for making markets in one security or a small handful of interrelated products, either by pride of place or official exchange designation. This made sense when the market maker was expected to physically process, analyze, and execute on the real-time order flow from within a screaming mob of traders in an open-outcry pit. With the transition to electronic trading platforms, traders can now sit in front of a half-dozen screens calmly clicking away at hundreds of bid-offer pairs without breaking a sweat. Customized software allows traders to formulaically adjust prices, linking their posted bid-offer spreads to a benchmark, moving them up or down or widening them out on autopilot as the referent price changes.

Depending on the characteristics of the product, making the market can be a more or less complex proposition. An equity specialist on the floor of the exchange will buy and sell the same shares all day long, adjusting the price to balance the order flow on his books and hopefully emerging at the end of the day with a small profit. A pit trader on a commodity exchange has a slightly more complicated job, showing different prices for different discrete delivery months which will lead to a net position composed of longs and shorts scattered across the curve, which will require constant balancing. A bank trader will be expected to transact across the curve in a variety of products in a multitude of sizes, leading to a complex aggregation of positions with directional risk and several varieties of spread risk. This misshapen risk will, at times, have a mind of its own, and its care and feeding is called running the book.

Running the Book

Running the book at a bank is less about high-volume toll taking and turnover, more about absorbing large and/or non-standard pieces of business on request. The name of the game is warehousing risk, and the result is a large, misshapen mass of positions aggregated from a stream of buys and sells of various products, sizes, and maturities. The skill lies in buying at or near the bid and selling at or near the offer to capture margin whenever possible and managing the net position to ensure that the book is set up for the overall up or down trend of the market. Running a large book is like steering a supertanker. It is impossible to make quick adjustments to the course, so it is critical for the trader to know where the current is heading and be tolerant of a certain amount of drift. A big book trader with a steady stream of flow business will never be flat and will always be attempting to reconfigure the net position to match its view of the market and its anticipated direction.

Some risk-seeking firms elevate market making to an art form, particularly those that believe they have a clear edge in their marketplace. Banks and large merchants occupy the market-making role in developing over-the-counter markets with no organized specialist system to provide structure, trading pit to gather in, or screen-based exchange to monitor. If a firm can successfully price the deals, aggregate the risk, and manage the resultant position, not only will it have hopefully booked profit on each transaction, but will also have collected an incredibly valuable data set of the interests of a cross-section of market participants. Clients tend to move in herds, either through groupthink or common fundamental impulses, and a bank or merchant that understands the migratory pattern can profit tremendously.

At a bank the trader is a team player. The originator is paid to bring in deals and close business, and the trader exists to facilitate the transactions, book the margin, and maintain the inherent value in the deals. Depending on the balance of power within the firm and the relative levels of swagger, either the trader will work for the originator or vice versa, regardless of how the boxes line up on the organization chart. If working in an environment where the trader has pricing power - and therefore veto power - over the originator’s deals, there will be a great deal of pressure brought to bear if the trader’s conservatism impedes business.

Footnotes

[5] It would be irresponsible to not point out that self-inflicted legal trouble ultimately toppled Milken from his perch atop the bond market and drove Rich to seek asylum in Switzerland under indictment for tax evasion and trading with the enemy after allegedly dealing with Iran during the hostage crisis. In recognizing their contributions to the development of their respective markets, I am not endorsing the totality of their subsequent actions.

[6] While some of the regulatory challenges have abated in the past four years, the rise of technology has had transformative effects on most large financial institutions. The bank model is shifting away from human flow traders and market makers and toward platform-based algorithmic execution systems. While there is still substantial room for human intermediation in “high-touch” and non-standard products, the current business model is to replace a floor full of expensive traders with a room full of expensive servers on a floor full of expensive quantitative strategists and programmers. The ultimate success or failure of this strategic shift will not be known for years, but regardless of where the human/machine balance lands, the markets have become significantly more quantitative and current and future traders will have to adapt to the newly required skill set. For an introduction to the basics of data science and programming, please see Appendix B.

[7] Named for a German bank that, in 1974, failed to make the standard exchange of payments to counterparties at the market close.

[8] Writing an insurance policy is conceptually very similar to selling a derivative contract called an option, which we will explore in depth in Chapter 10.

[9] The distinctions between front, middle, and back office are not set in stone, and are often interpreted differently across the industry.

[10] One of the many results of the evolving regulatory environment for banks has been a transition away from the traditional practice of showing two-sided markets in favor of producing a customer-requested bid or offer and the firm’s estimate of the current mid-point of the market, allowing the customer to have a sense of the firm’s potential margin on the transaction.

Copyright © 2020 Joel Rubano

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