Role of Investment Bankers in Derivatives Market

The derivatives department is a highly specialized department in the modern-day investment bank. This is because, in terms of size, the derivatives department easily dwarfs all other departments in the investment bank.

For instance, the worldwide market for derivative contracts is said to be valued at $79 trillion! This is definitely a notional value since it is more than all the money present in the world. This notional value is generally used to calculate the actual value, which changes hands. Even though that amount is much smaller than $79 trillion, it is still the biggest market in the world. Needless to say, investment banks all over the world have interests related to this market.

In this article, we will explain how investment bankers utilize their other businesses to generate more business for themselves in the derivatives department.

1. Advisors to Clients: Investment bankers play the role of advisor to many companies. Sometimes they advise companies about how they must restructure their finances to avoid bankruptcy. At other times, they advise their clients about mergers and acquisitions. In each of these cases, investment banks often have access to the books of these firms. When they have access to these books, they can conduct a risk analysis. By doing so, they can identify risks that need to be hedged. This is where the derivatives department of the investment bank comes in. This department pitches various products which can help solve the clients need while simultaneously generating business for the firm.

2. Creating Structured Products: A lot of the times, the needs of the investment banks’ clients are unique. In such situations, simple derivative products such as futures and swaps cannot solve their problem. This is where the investment bank steps in.

   The investment banking team has a team of specialized people called “quants.” These people are able to understand the risks which accrue when several investment banking products are clubbed together to create a new financial product. These types of products are often called structured products. They have been at the center of many debates, particularly after they were blamed for the downfall of the financial markets in 2008.

   Securitized products such as mortgage-backed loans, collateralized debt obligations, etc. all fall under the category of structured products.

3. Marketing of Structured Products: Investment banks are often tasked with the humungous tasks of finding counterparties for their newly created structured products. This task can be difficult since the newly created products are considered to be very risky, and there are a limited number of buyers for these risky products. This is where the expertise of the investment bank comes in. They often use various techniques such as tranching, credit guarantees, and so on to enhance the credit of these securities and make them more palatable to institutional investors.

4. Market Making: Investment bankers act as market makers for many derivative products which they sell to their clients in the over the counter market. This means that if the investor wants to liquidate their position before maturity, they can do so by selling it to the investment bank.

   The trading desk of the investment bank provides continuous buy-sell quotes. Needless to say that there is a bid-ask spread present in all quotes so that the investment banker is somewhat compensated for the risk that they undertake. This market-making takes up a lot of capital from the trading desk of the investment bank. However, it is important since it provides an exit route to the investors.

   Investment bankers also gain from this transaction. This is because firstly, they earn an origination fee when the securities are created and then earn a bid-ask spread when they make the market. Investment banks have deep networks and hence are able to sell out these securities to other counterparties and hence unlock their capital.

5. Acts as Intermediaries: In many cases, investment banks are unable to find counterparties to the products that they have created. In such cases, they are often forced to hold the position on their books. This can be very risky since derivatives are highly leveraged as well as volatile.

   Hence, the financials of the investment bank can be severely impacted in the event of a downturn. Investment bankers hire special risk analysts to manage the risks that they undertake during this trading.

   These risks analysts use complex mathematical techniques to understand the quantum of risks as well as the financial impact it may have. In many cases, if the investment bank finds the risk to be too much, it takes it off its books by buying other derivatives products that might be sold on the exchange.

The bottom line is that trading and selling of derivatives has become an important business of investment banks. In fact, this is what investment banks are now largely known for. This line of business has also brought a lot of disrepute to investment banking as too many scandals have emerged within a short period of time.

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