What Does a Trader at an Investment Bank Do, Anyway?
Contrary to the common image of proprietary trading as fast-paced, high-frequency trading, investment banks typically use long-short portfolios with a 1-3 month horizon. This strategy reduces volatility and aligns with the bank’s overall risk tolerance.
Have you ever wondered what a trader actually does at an investment bank? The job often conjures images of high-stakes decisions, fast action, and intense market moves. In reality, the day-to-day responsibilities are complex, structured, and have evolved significantly with advancements in technology. This article dives into what a trader’s role at an investment bank truly entails, the skills needed to succeed, and how the industry’s shifts have reshaped this career path.
So, What Does a Trader at an Investment Bank Really Do?
A trader’s time is generally divided into two main functions:
Market-Making (90% of time): The bulk of the role, focused on helping clients execute trades and providing liquidity.
Proprietary Trading (10% of time): Using the bank’s own funds to generate profit and balance potential losses from market-making.
Each of these roles requires a unique skill set, and understanding them can shed light on what traders do each day.
1. Market-Making: The Core of the Job
A. What Is Market-Making?
Market-making lies at the heart of a trader’s job at an investment bank. Essentially, market-makers are responsible for providing liquidity by standing ready to buy or sell financial instruments for clients, allowing them to enter or exit positions quickly.
B. Two Types of Market-Making: Agency vs. Risk Business
Market-making splits into two primary types: Agency Market-Making and Risk Market-Making.
Agency Business (80% of Market-Making): In agency trades, the bank acts on behalf of the client, executing orders without taking on direct risk. For this, the bank charges a small commission, which typically averages around 5 basis points (0.05%).
Example Scenario:
Imagine a client, such as a hedge fund, wants to purchase $10 million in Apple stock. In an agency transaction, the trader executes this order on the client’s behalf, earning the bank a commission while avoiding any price risk from holding the stock.
Risk Business (20% of Market-Making): In risk market-making, the bank might commit its own capital to facilitate a trade, taking on temporary risk. Here, the trader might short-sell or hold positions that could vary in price, affecting the bank’s profits or losses.
Example Scenario:
Suppose a client wants to buy $10 million in Apple stock, but the bank doesn’t currently hold that amount. In this case, the bank might sell the shares to the client and then cover the position in the open market. If Apple’s price drops before the position is covered, the bank profits; if it rises, the bank may incur a loss.
A trader’s performance in risk market-making is often measured by a retention ratio, which reflects how effectively they manage to keep the commission earned after covering any losses. A high retention ratio (e.g., 75%) indicates good risk management.
C. Managing Algorithms and Automation
With around 72% of market-making now automated, today’s traders spend much of their time overseeing algorithms. A decade ago, traders executed most trades manually, but now, advanced systems handle the majority of transactions, especially in agency trading. Traders focus on monitoring these systems, adjusting them as needed, and stepping in only if issues arise.
Pro Tip: Aspiring traders should consider building skills in programming and algorithmic trading, as knowing how to interpret and adjust trading systems is highly valued in today’s tech-driven trading environment.
2. Proprietary Trading: The Bank’s Own Bets
Proprietary trading may only account for about 10% of a trader’s time, but it’s essential for balancing risk within the bank. In proprietary trading, the bank allocates capital for traders to make independent investment decisions, aiming to earn profit that can counterbalance potential losses from risk market-making.
Why Is Proprietary Trading Important?
Proprietary trading enables traders to create a “positive selection portfolio.” Unlike the “negative selection portfolio,” which comprises positions taken on during market-making, proprietary trading allows traders to pursue positions they believe will be profitable. The idea is to generate enough return to offset any losses from holding temporary risk positions.
Contrary to the common image of proprietary trading as fast-paced, high-frequency trading, investment banks typically use long-short portfolios with a 1-3 month horizon. This strategy reduces volatility and aligns with the bank’s overall risk tolerance.
The Changing Landscape: Declining Commissions and Increased Automation
Over the past decade, the industry has faced a significant decline in commission rates. Ten years ago, the average commission on agency transactions was around 25 basis points (0.25%). Today, that figure has dropped to about 5 basis points (0.05%), affecting revenues and trader bonuses.
What This Means for Traders
Reduced Earnings: As commission revenue decreases, traders’ bonuses and the capital available for proprietary trading have also dropped by roughly 80%.
More Automation: To remain competitive and reduce costs, investment banks rely increasingly on automated systems, leaving traders to focus on managing and troubleshooting these algorithms rather than executing trades manually.
Key Skills for Aspiring Investment Bank Traders
The changing industry landscape has reshaped the skills needed to succeed as a trader. Here are the essential skills for anyone aiming to thrive in this field:
Algorithmic and Data Management Skills: Proficiency in programming and algorithmic trading is crucial for today’s traders.
Risk Management Expertise: Balancing risk in both agency and risk market-making scenarios is a core part of the job.
Analytical Skills: Strong quantitative skills are essential for evaluating financial data and market trends.
Adaptability and Problem-Solving: With automation handling many tasks, traders must be able to troubleshoot and adapt to new systems.
Market Knowledge: A deep understanding of the financial markets and an ability to make calculated decisions remain invaluable.