CSC Volume 2 Chapter 15: Working with the Institutional Client PDF

Working with the Institutional Client 27 CHAPTER OVERVIEW In this chapter, you will learn about the process of working with institutional clients, starting with an overview of the institutional marketplace and followed by an examination of the buy side and sell side of the market. You will learn about the structure, functions, and operations of buy-side and sell-side firms. We will also discuss various aspects of institutional trading, including revenue sources, clearing and settlement, and suitability requirements. You will also learn about the roles and responsibilities of the various participants in the institutional marketplace, along with the investment styles, guidelines, and restrictions they follow. Finally, you will learn about algorithmic trading, high frequency trading, and dark pools. LEARNING OBJECTIVES CONTENT AREAS 1 | Distinguish between the sell side and buy The Sell Side and the Buy Side of the Market side within the context of the institutional marketplace. 2 | List the responsibilities of the buy-side The Responsibilities of a Buy-Side Portfolio portfolio manager and the buy-side trader. Manager and Trader 3 | Describe the roles and activities of a sell-side The Organizational Structure of a Sell-Side back, middle, and front office relevant to Trading Firm equity sales and trading. 4 | Describe the sell-side revenue sources on the The Revenue Sources for Sell-Side Trading equity and fixed-income trading desks. Firms 5 | Explain the institutional settlement process. Institutional Clearing and Settlement 6 | Describe the roles and responsibilities within Roles and Responsibilities in the Institutional an institutional investment dealer. Market 7 | Contrast the different buy-side investment Investment Styles, Guidelines, and management styles. Restrictions 8 | Define algorithmic trading, high frequency Algorithmic Trading trading, and dark pools. © CANADIAN SECURITIES INSTITUTE 27 2 CANADIAN SECURITIES COURSE VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. agency traders market makers algorithmic trading order flow analyst origination axe sheets price spread buy side prime brokerage clearing proprietary traders coverage traders research associate dark pools responsible designated trader direct electronic access sell side high frequency trading settlement institutional clients soft-dollar arrangement institutional salesperson straight-through processing institutional trader trade-matching elements investment bankers Universal Market Integrity Rules liability traders © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 3 INTRODUCTION Investment dealers serve two types of clients: retail and institutional. This course—the Canadian Securities Course— is one of the educational requirements for licensing for registrants who operate on the retail side of the business and on the institutional side. Although most content in the course is relevant to both retail and institutional registrants, this chapter covers some areas of general knowledge that are specific to institutional representatives and their clients. Retail clients outnumber institutional clients. However, institutional clients generally hold much larger accounts, have considerable experience and knowledge, and play an influential role in the financial markets. In this chapter, we discuss the sell side and the buy side of the market. We examine the roles and responsibilities of the different types of investment dealer employees who play a key role in working with institutional clients. We also look at the various styles they use in serving the investment needs of institutional clients and the guidelines and restrictions they follow. Finally, we look at some trends that are currently affecting the institutional landscape. THE SELL SIDE AND THE BUY SIDE OF THE MARKET 1 | Distinguish between the sell side and buy side within the context of the institutional marketplace. The investment industry generally consists of the sell side and the buy side. The term sell side refers to dealers in the business of selling securities and other services to investors, whereas buy side refers to investors, both institutional and retail. Sell-side dealers deal in the following products and services: Trading, investing ideas, and research Investment advice Trade execution Corporate finance (to issuers) Securities (both new and existing issues) Securities professionals tend to use the term buy side to describe institutional clients such as mutual funds and pension funds, but they often use it in reference to retail investors as well. In other words, we typically think of the buy side as investing organizations and individual investors who are the customers of sell-side firms. In reality, however, dealers and investors constantly play the role of both buyer and seller of securities in the secondary capital markets. THE SELL SIDE Investment dealers on the sell side are the focus of this chapter, but they are not the only type of sell-side firm. Other examples include mutual fund dealers and exempt market dealers. There are different types of firms within the investment dealer category. The major distinction among them is the breadth of capital markets activities they are normally involved in, as well as the range and type of services they offer investors. Investment dealers generally fall into one of three types: full services dealers, investment banking boutiques, and self-directed dealers. © CANADIAN SECURITIES INSTITUTE 27 4 CANADIAN SECURITIES COURSE VOLUME 2 Full-service dealers Full-service dealers are involved in almost every aspect of the securities markets, including debt and equity security underwriting, distribution and secondary market trading, mergers and acquisitions (M & A) advisory, fundamental research and technical analysis, over-the-counter (OTC) derivatives sales and trading, commodities and futures trading, and economic analysis and forecasting. They offer these services on a national or international scale and cater to both retail and institutional investors. Investment banking Investment banking boutiques focus on a combination of debt and equity security boutiques underwriting, sales and secondary market trading, and M & A advisory services. Investment banking boutiques usually offer fundamental equity research services, but they tend to focus only on the industry sectors and specific companies they underwrite. They are not generally involved in OTC derivatives trading, nor do they engage in commodity or foreign exchange trading. One major distinction between full-service dealers and investment banking boutiques is that the latter group offers their services only to institutional investors. They generally do not cater to retail investors. Self-directed dealers Self-directed or discount dealers focus primarily on offering secondary equity trading services to retail investors with small-to-medium-sized accounts who prefer to manage and trade their own equity portfolio. Their service offering involves fast, user-friendly equity trading through both internet- and telephone-based communication platforms. They generally do not provide advice to the investor. Because they offer only trade execution, self-directed dealers compete with full-service dealers on the basis of cost to trade—hence, the term discount dealer. Accordingly, they are positioned opposite to full-service dealers on the investment dealer spectrum. They are structured as either an independent entity or an affiliate of a full-service dealer. THE BUY SIDE The primary suppliers of capital in the marketplace are retail, institutional, and foreign investors. Users of capital are typically businesses and governments. However, individuals also use capital through consumer financing products, such as home mortgages, car loans, and credit cards. The various companies and organizations that connect and move capital between the suppliers and users of capital are the financial intermediaries. In well-developed capital markets such as Canada’s, these intermediaries are referred to as the buy side. Also known as institutional clients, they are concerned with asset management and are typically engaged in buying and holding securities on behalf of their clients. INSTITUTIONAL CLIENTS An institutional client is a legal entity that represents the collective financial interests of a large group. The group’s financial interests are the objectives that serve their members’ goals. As such, institutional clients have a fiduciary responsibility for the millions of dollars of their members’ assets. Examples of group members can be shareholders, pensioners, or employees. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 5 EXAMPLE The member groups of institutional clients might have any of the following goals, among others: Hedging out currency exposure in a $100 million bond fund portfolio Growing pension assets faster than inflation over a particular period Raising $400 million in a stock offering for a corporation Minimizing tracking error in an exchange-traded fund Institutional clients are also distinguished by the size of their accounts, which allow for lower fees and commissions compared to the fees paid by retail clients. Because of their size, institutions dominate the financial landscape. A few examples of institutional clients are listed and described below. Note: The Canadian Investment Regulatory Organization (CIRO) provides a definition for the term “Institutional Customer”. However, not all the entities listed below fit within this definition. Corporate treasuries A corporate treasury department is responsible for managing a firm’s financial assets in support of its business activities. Duties range from general management of company finances to decisions on funding and risk management. A corporate treasury department engages in activities that may require the services of a dealer. Activities may include hedging the currency risk of a foreign subsidiary or accessing the most inexpensive capital possible by selling equity or debt in a domestic or foreign market. Insurance companies Insurance companies accept premiums from policyholders to fund potential payoffs for contingent losses suffered by any of the policyholders. A contingent loss is a loss that might occur as a result of a foreseeable but unpredictable event. Examples include physical damage to property or possessions, personal injury or loss of life, or legal claims made by others against the customer. The process by which the insurance company chooses the risks to insure and the suitable amount of premium to be paid is called underwriting. The premiums are then reinvested into the insurance company’s own portfolio of financial and real assets. Investment horizons tend to be long term. Some insurance company activities require the help of a dealer. Such activities include buying and selling equities and bonds, providing a supply of newly issued securities, supplying the market research to support trading activity, and hedging the interest rate risks of its bond portfolios. Pension funds A pension fund is a pool of assets managed with the goal of supplying its beneficiaries with income during their retirement years. A pension fund could represent the interests of either public or private sector employees. An example of a public sector pension fund is the Ontario Teachers’ Pension Plan. Pension funds, like insurance companies, have a long investment horizon. If the fund is managed directly by the public or private sector employees, dealers help pension plans by buying and selling equities and bonds, and by supplying the market research to support that activity. Otherwise, dealers assist indirectly by supporting the investment managers hired by the pension funds to manage their assets. © CANADIAN SECURITIES INSTITUTE 27 6 CANADIAN SECURITIES COURSE VOLUME 2 Mutual funds As we discussed in an earlier chapter, a mutual fund is a pool of assets managed for the benefit of its unitholders. The fund can assume any number of objectives and operate in any number of markets. Dealers help mutual funds by buying and selling equities and bonds on their behalf. They can provide a supply of newly issued securities, supply the market research to support trading activity, or hedge out currency or pricing risks in their portfolios. Hedge funds Like a mutual fund, a hedge fund is a pool of assets managed for the benefit of its unitholders. Unlike a mutual fund, however, a hedge fund is not regulated at all in terms of investment activity, as we discussed in an earlier chapter. Dealers assist hedge funds by buying and selling equities, bonds, or derivatives on their behalf. They also assist them by supplying the market research to support that activity or hedging out pricing risks in their portfolios. Endowments An endowment is a pool of assets created from gifts and donations for the purpose of creating income to help an organization achieve its specific goals. The organization may be a charity, university, or hospital, and its aims are not for profit. For example, the goal might be to fund annual scholarships, buy medical supplies for foreign relief workers, or finance educational media. The endowment owns the assets. Typically, an endowment requires the principal to remain intact in perpetuity. Endowments, especially in the case of larger funds, are free to use whatever investment strategy the custodians of the fund see fit. As with hedge funds, dealers assist endowments by helping the managers in charge of their portfolios to buy and sell equities, bonds, or derivatives on their behalf. They might also supply the market research to support trading activity, provide a supply of newly issued securities, or hedge out pricing risks. Trusts A trust is a pool of assets similar to an endowment. Unlike an endowment, however, a trust is created by a settlor (a person or organization) for the good of another party, known as the beneficiary. The trust terms can spell out specific aims for the use of the assets, although none are required. A trustee who manages the trust’s assets has a fiduciary duty to the beneficiaries. Reasons for creating a trust include tax planning, asset protection, and estate planning. Trusts that are big enough to be considered an institutional account are usually managed as charitable or family trusts of high-net-worth individuals. The investment horizon of a trust is long, typically the life span of the beneficiary. Dealers help trusts by buying and selling equities and bonds on their behalf, providing a supply of newly issued securities, supplying the market research to support trading activity, or hedging out pricing risks in their portfolios. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 7 Investment An institutional investment management firm focuses on managing investments for management firms institutional clients. The firm targets investment mandates from institutional investors, such as defined-benefit pension plans, endowments, large family trusts, and corporate treasuries. Investment management firms may also offer management services to high-net-worth clients who are classified as accredited investors. Institutional investment managers offer their services through different channels tailored to the needs of different investors. These channels may include pooled investment funds, segregated accounts, and limited partnerships. Dealers assist investment management firms by buying and selling equities and bonds on their behalf, providing a supply of newly issued securities, supplying the market research to support trading activity, or hedging out currency or pricing risks in their portfolios. Investment dealers An investment dealer is a firm that trades securities for its own account or on behalf of its customers. Investment dealers represent the sell side of the market but can also at times be an institutional client of another investment dealer. DIRECT ELECTRONIC ACCESS Prior to the prevalence of electronic trading, institutional investment managers placed their security transaction orders with registered investment dealers. Portfolio managers would communicate security transaction orders, (usually verbally), to the institutional sales staff at the various investment dealers with which their firm had a relationship. In essence, these equity trades created a link in a chain of relationships between the institutional investment manager, the investment dealer, and, finally, the particular stock exchange. Facilitated by advancements in electronic trading technology, investment dealers now provide direct electronic access (DEA) to their institutional buy-side clients. This change has been driven by clients for quicker and cheaper access to trading opportunities. Under a DEA arrangement, the institutional investment management firm uses the dealer’s participating organization number to send orders directly to a marketplace without involving the dealer’s trader. In effect, the dealer is sponsoring the buy-side firm’s access to the marketplace. DIRECT ELECTRONIC ACCESS RISKS AND REGULATION On midday of May 6, 2010, the Dow Jones Industrial Average dropped approximately 1,000 points (9%) before rebounding to recoup those losses within minutes. That was the largest intra-day point decline in market history. Although the reasons for this volatility were complex, the so-called flash crash highlighted potential challenges associated with high-speed trading. Of particular concern are sophisticated strategies used by some DEA clients such as algorithmic trading (discussed later in this chapter). Industry experts worry that incidents like the flash crash could diminish investor confidence in the markets. They could also increase systemic risk; a dealer might become unable to meet its financial obligations resulting from a DEA trade. In other words, a weak link in one part of the system could have a profound effect on the integrity of the entire system. In Canada, regulators have designed a framework that allows for the benefits of electronic trading while protecting the quality and integrity of Canadian marketplaces. © CANADIAN SECURITIES INSTITUTE 27 8 CANADIAN SECURITIES COURSE VOLUME 2 Before access can be granted to a client, the investment dealer must accept responsibility for compliance with regulatory requirements relating to the client’s DEA trading activity. Investment dealers must establish appropriate standards and controls prior to offering DEA to a client, including the following requirements of clients: Sufficient financial resources to meet their trading obligations Knowledge of the order entry systems provided Knowledge of and ability to comply with all applicable marketplace and regulatory requirements Appropriate systems and procedures to monitor all DEA trading To ensure that these standards are met, investment dealers require their DEA clients to sign a written agreement specifying that they will comply with marketplace requirements and with the risk and credit limits set by the dealer, among other things. A key part of the rules regarding DEA trading is that all orders must go through appropriate and consistent pre-trade dealer risk and compliance controls before being routed to a marketplace for execution. These compliance filters are designed to prevent the following types of orders: Those that do not comply with applicable marketplace and regulatory requirements Those that exceed pre-determined thresholds Those involving securities that the DEA client is not authorized to trade In addition to pre-trade compliance controls, the dealer is required to conduct regular post-trade monitoring to ensure compliance with requirements. BUY SIDE VERSUS SELL SIDE FIRMS Can you identify which entities are on the buy side and which are on the sell side of the market? Complete the online learning activity to assess your knowledge. THE RESPONSIBILITIES OF A BUY-SIDE PORTFOLIO MANAGER AND TRADER 2 | List the responsibilities of the buy-side portfolio manager and the buy-side trader. Most medium-to-large buy-side firms divide portfolio management duties into two primary occupational roles: portfolio manager and trader. However, this division of duties may not apply to some small firms, where the portfolio manager often performs both roles. In this section, we look at the typical roles and responsibilities of the two positions. THE BUY-SIDE PORTFOLIO MANAGER The portfolio manager typically has the following responsibilities: Create the investment mandate, investment goals, and investment guidelines and restrictions for each portfolio, either independently or in conjunction with the fund sponsor Develop and execute the portfolio strategy for each portfolio Provide pertinent and timely information to the head of fixed-income and equity markets © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 9 Supervise all portfolio management staff, including traders, assistant portfolio managers, and any associated administrative personnel Provide information to assist the firm’s marketing and client servicing personnel, including the following details: The outlook for the markets The positioning of the portfolios relative to the market outlook Report of the periodic performance of the portfolios, including a detailed performance attribution analysis explaining the various sources of relative performance compared to the specific benchmark index Represent the firm at marketing meetings with prospective clients and at quarterly or annual meetings with existing clients, as well as industry conferences and interviews with the financial press, as required Essentially, the portfolio manager is responsible for all aspects of the effective and prudent regulatory compliant management of the portfolios and is therefore ultimately responsible for their performance. THE BUY-SIDE TRADER The major responsibilities of the buy-side trader are as follows: Provide the most effective execution of the portfolio manager’s desired trades Remain informed at all times of the portfolio manager’s detailed investment strategy Inform the portfolio manager about market conditions and trends Explain how market conditions can affect the portfolio manager’s investment strategy Be aware of trade opportunities that will further the portfolio manager’s objectives, either from reviewing sell- side trader’s axe sheets or through regular conversations with sell-side sales representatives Maintain good, professional relationships with sales and trading staff of dealers with whom the firm does business DID YOU KNOW? The term axe sheet refers to a list of products that a trader wishes to sell or buy as quickly as possible. The buy-side trader’s primary goal is to execute the portfolio manager’s trades at the best prices available in the market at the time of the trade. In this way, the trader contributes favourably to the portfolio’s performance. To accomplish best execution, the trader is constantly in contact with investment dealer counterparties. By this means, the trader gets to know the overall market conditions and the liquidity of the sectors and securities that the portfolio manager is most involved in. As such, the trader often serves as the portfolio manager’s “ear to the market.” CRITERIA FOR SELECTING A SELL-SIDE BROKER Buy-side portfolio managers and traders aim to obtain the best price for their order from a broker. In volatile or less liquid markets, traders often shop the order around and contact several brokers from their broker list in an attempt to get the best price. In stable and liquid markets, traders are often more confident that they are receiving a competitive bid or ask price, and thus may not feel the need to shop the order around. The portfolio manager or trader typically deals with multiple sell-side firms that meet the following criteria: A strong existing relationship with a trader or sales representative Speed and efficiency of trade execution © CANADIAN SECURITIES INSTITUTE 27 10 CANADIAN SECURITIES COURSE VOLUME 2 Block trading capability Availability of the desired product High quality research Access to industry experts, such as economists Frequently updated daily market commentary This set of requirements is often supplemented by the growing field of knowledge commonly referred to as transaction cost analysis (TCA). In evaluating a sell-side firm, TCA takes into account both explicit costs, such as brokerage fees and commissions, and implicit costs, such as bid/ask spreads and market impact. Trading professionals on each side work together to establish mutually beneficial relationships. Provided that all other evaluation factors are the same or reasonably close, buy-side professionals tend to turn to known and trusted traders and sales representatives on the sell side to place orders. THE ORGANIZATIONAL STRUCTURE OF A SELL-SIDE TRADING FIRM 3 | Describe the roles and activities of a sell-side back, middle, and front office relevant to equity sales and trading. The investment dealer industry has evolved over the years, and the departmental structure of the sell side varies from one firm to the next. However, the nature of the business has remained the same. One of the primary roles of the sell-side dealer is to provide secondary markets for securities held by institutional investors. Most full-service dealers offer clients a wide range of resources, including the following services: Traditional corporate and government finance underwriting Merger and acquisition advice Secondary trading Merchant banking Research Financial engineering Securities services, such as prime brokerage In contrast, some smaller or more focused dealers specialize in particular segments of the capital markets. ORGANIZATIONAL STRUCTURE OF AN INVESTMENT DEALER An investment dealer is generally divided into three main areas, or offices: back, middle, and front. The responsibilities of each office are listed below. BACK OFFICE The back office of a dealer normally consists of the following functions: Operations Information technology © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 11 MIDDLE OFFICE The middle office of a dealer normally consists of the following functions: Risk management Legal and compliance Corporate treasury The heart of the middle office is compliance and risk management. It essentially performs a control function to ensure that there is no collusion between the front and back office. This role is consistent with the separation of duties principle. FRONT OFFICE The front office of a dealer normally consists of the following functions: Sales and trading Corporate finance Government finance Mergers and acquisitions or divestitures Corporate banking Merchant banking Securities services Research In the United States, the investment dealer’s functions may include wealth management and asset management. In Canada, on the other hand, investment banking is typically a division of a full-service investment dealer, which can also have separate wealth management and self-directed brokerage divisions. Investment banking may also be a stand-alone boutique service. Depending on the size of the firm, the following types of securities can be sold and traded: Equities Fixed income Foreign exchange Commodities Related structured products Figure 27.1 provides a partial illustration of the organizational structure of a typical sell-side dealer. © CANADIAN SECURITIES INSTITUTE 27 12 CANADIAN SECURITIES COURSE VOLUME 2 Figure 27.1 | Organizational Structure of a Sell-Side Dealer CEO Legal and Prime Trading Research Compliance Brokerage Firewall Equity Fixed Income Proprietary (reports directly Trading Trading Trading to CEO) Market Sales Trading Making Agency Program Structured Futures and Trading Trading Finance Options EQUITY SALES AND TRADING DEPARTMENT The front office area of the equity sales and trading department of an investment dealer performs various functions. Many of these functions are standard regardless of the dealer’s size; however, some are dependent on the specific areas of the equity markets in which they participate. The particular function also depends on the range of equity- related products and services the dealer offers to institutional investor clients. The primary activities of the equity sales and trading department include the following functions: Equity trading services Program trading Structured finance Futures and options EQUITY TRADING SERVICES Equity trading services are provided by the following staff members of a trading department: Institutional equity sales staff members act as relationship managers between the institutional client and the dealer. Agency traders act on behalf of institutional clients. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 13 Liability traders manage the dealer’s trading capital. Market makers specialize in providing a constant two-sided market for securities under their responsibility. Each of these roles is described in detail later in the chapter. PROGRAM TRADING Program trading is a type of equity trading done by institutional investors that involves the use of computers to generate and execute complicated simultaneous stock market, and often derivative, orders. Program trading can take many forms. Normally, it involves the sale or purchase of a particular group (or basket) of stocks that comprise an index, and the simultaneous purchase or sale of a derivative product that is based on that index. The purpose of these simultaneous transactions is to take advantage of temporary price discrepancies between the stocks that make up a stock index and those that make up the derivative. STRUCTURED FINANCE Equity structured finance essentially involves the creation of derivatives, or structured products, that offer a unique combination of risk and reward. Structured finance is sought by institutional investors, and often uses many of the capital market principles involved in program trading. FUTURES AND OPTIONS An increasingly wide array of both listed and OTC options and futures for equities are available around the globe. Indeed, use of derivatives is so pervasive that many institutional equity investors no longer purchase cash equities. They instead obtain their desired exposure to equity markets solely through investment in equity derivatives. Equity futures and options expertise helps a dealer serve institutional investors who use equity derivatives to execute their equity investment strategies. This expertise also complements a dealer’s agency (and liability) trading efforts, as well as its structured finance operations. PRIME BROKERAGE Prime brokerage is a bundling of equity trading-related services used primarily by hedge funds. The investment dealer’s prime brokerage unit provides the following services: Equity pre-trade compliance testing Security lending (for settlement of equity short sales) Margin and portfolio financing Security settlement Portfolio accounting Capital introductions (sourcing of funds for hedge fund clients) These prime brokerage services enable a hedge fund to become almost a turnkey operation. Many of the hedge fund’s administrative functions (outside of investor marketing and servicing, as well as its equity trading) are performed by the prime broker on a fee-for-service basis. SECURITIES LENDING Most secondary market making or trading is focused on the ability of the dealer’s institutional sales and trading staff. However, the role of the dealer’s security lending operations is also critical to its overall success in the secondary market. © CANADIAN SECURITIES INSTITUTE 27 14 CANADIAN SECURITIES COURSE VOLUME 2 Because hedge funds rely on borrowed securities to operate successfully, securities lending is a vitally important aspect of prime brokerage. The primary role of a dealer’s security lending operation is to ensure that the dealer’s sales and trading staff are able to competitively quote two-way markets on a continuous basis, in the various securities they trade in. Specifically, this means that the security lending staff is able to economically borrow sufficient amounts of securities that the trading staff has sold (short) to their clients or competing dealers. RESEARCH Although research is not formally a part of the equity sales and trading department, it does form a large component of its success. Traditionally, along with order execution and reporting, dealer research (often called sell-side research) has been a key element of the service that dealers offer to their buy-side institutional clients. Buy-side clients clearly value having timely analyst insight into industry trends and company-specific trading ideas. Access to top analysts when needed is important to clients, as is the access that analysts provide the client (money manager) to key personnel of the companies being covered. Clients also greatly value the ability of the research department to customize the research to the client’s needs, as required. Analysts may serve both internal corporate finance needs and the needs of buy-side clients. For that reason, a number of regulatory initiatives have been introduced that are designed to eliminate or minimize possible conflicts of interest. In Canada, CIRO rules address the need to separate research and research reports from influence by the firm’s corporate finance division by means of a firewall. DID YOU KNOW? A firewall is an information barrier implemented to isolate persons who make decisions and separate them from those who are privy to undisclosed, material information that may influence those decisions. THE REVENUE SOURCES FOR SELL-SIDE TRADING FIRMS 4 | Describe the sell-side revenue sources on the equity and fixed-income trading desks. Although sell-side trading firms have a number of potential revenue sources, their important obligation to their clients must not be forgotten. The Universal Market Integrity Rules (UMIR) are a common set of equity trading rules designed to ensure fairness and maintain investor confidence. These rules create the framework for the integrity of trading activity on marketplaces. BEST EXECUTION Best execution requirements, as set out under UMIR, provide that “a Participant shall diligently pursue the execution of each client order on the most advantageous execution terms reasonably available under the circumstances.” The Canadian Securities Administrators has suggested that commonly agreed-upon key elements of best execution include price, speed and certainty of execution, and total transaction cost. UMIR also indicates that best execution refers to the entire period during which the order is handled, not merely the precise moment that it is executed. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 15 REVENUE SOURCES OF A SELL-SIDE EQUITY TRADING DESK The main dealer equity-focused business opportunities are as follows: Equity underwriting and M & A advisory services Breadth and capabilities: Secondary equity market making Agency trading Prime brokerage Equity bull markets tend to increase revenues for dealers as a result of an increase in the following activities: Equity initial public offering and secondary re-offering underwriting M & A advisory business Overall secondary trading activity The increase in secondary market trading activity occurs as institutional client activity increases, which results from fresh investor capital flowing into the clients’ equity portfolios. Naturally, a bearish equity market has the opposite effect on dealer revenue streams. Sell-side equity firms’ revenue streams are grouped into the following four general categories: Trading revenue from spreads earned from principal trading Commissions from both agency and principal trading Fees Interest TRADING REVENUE FROM SPREADS Secondary equity market trading is structured around the provision of continuous simultaneous bid and ask prices for individual equities. The difference between these two prices is commonly referred to as the equity’s bid-ask spread, or price spread. In general, a particular equity’s liquidity is determined by the size of its bid-ask price spread. The smaller the price spread is, the more liquid the equity will be. Liquidity also depends on how many shares of the equity are offered and bid for at these two market prices respectively. In a principal trade, the investment dealer’s own capital (principal) is involved in, and therefore exposed to, the risk in the equity trade. Aside from earning a commission, the main reason investment dealers are willing to put their capital at risk in a principal trade is to generate revenue on spreads by trading existing long or short positions. Another reason is to be seen as the go-to dealer for a particular stock. The price spread represents the maximum potential profit opportunity for the dealer’s principal traders. For example, when acting as principal to a trade with an institutional client who wishes to sell shares, the dealer’s trader attempts to buy the equity from its client. If successful, the principal trader immediately lays off its long position in the secondary equity market at the ask price currently available in the market. If executed properly, the principal trader earns a profit between the purchase and sale price. The trader does so by minimizing the amount of the dealer’s capital at risk to equity market moves, during the short time between the originating trade and the completion of its offsetting trade. © CANADIAN SECURITIES INSTITUTE 27 16 CANADIAN SECURITIES COURSE VOLUME 2 The potential revenue from a principal trade is primarily a function of the following two factors: The trading skills of the firm’s equity traders The total amount of equity trades shown to the dealer’s traders by its institutional investor clients (commonly referred to as client order flow) DID YOU KNOW? An investment dealer’s potential trades are commonly referred to as client order flow. Increasing order flow is one of the main goals of a dealer’s institutional equity sales staff. Of course, the greater the amount of trade opportunities shown to the dealer, the greater opportunity to earn trading revenues. COMMISSIONS When the dealer acts in the capacity of an agent in a client’s equity trade, the dealer’s compensation for facilitating the trade is in the form of a commission. The commission amount is added to each transaction confirmation. It is paid to the dealer at the time the equity trade is settled. By industry convention, equity trades normally settle at T+1, which is one business day after the date the trade occurs. The dealer has a pre-established commission schedule that it negotiates with each institutional client. This commission schedule is set on a per-share basis. It normally decreases in size as the equity trade size increases. FEES The dealer earns fee revenue when it performs equity underwriting. It also earns revenue when it provides merger and acquisition services or related advisory services. These fees are negotiated in advance on a per-deal or transaction basis. INTEREST Interest income is a function of the amount and type of margin account balances it offers to its institutional clients. Many of the larger dealers offer prime brokerage services to their institutional equity investor clients, such as equity hedge funds. Because most hedge funds use some amount of leverage in their investment strategies, they usually obtain these borrowed funds from their prime broker and pay interest daily. This interest income is often supplemented by security lending fees, which are also paid by the prime broker’s hedge fund clients. REVENUE SOURCES OF A SELL-SIDE FIXED-INCOME TRADING DESK All revenue of the sell-side fixed-income desk derives from trading activity in the trader’s inventory. The three areas of operation that work interdependently to bring in revenue are as follows: Trading Sales Origination The methods that each area of operation uses are described below. TRADING REVENUE Trading revenue is generated by moment-to-moment market movements and their effect on the net value of a trader’s inventory. Almost all firms track the change in value of a trader’s inventory at, or very close to, the end of the trading day. The net change in value from yesterday’s closing position to today’s becomes the trading revenue for the day. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 17 The largest effect on trading revenue stems from the constantly changing price of each security in a trader’s position. The bond market is an OTC market, without a central trading place or exchange for transaction at the best prices in the marketplace. The trader must therefore gain an understanding of market value by observing trade flow and keeping abreast of other financial markets. At any given moment, the trader’s inventory is valued by using the observed or estimated bid-side price in the OTC market for long positions and the offer-side price for short positions. Some firms use a mid-market price for both long and short positions. This tactic is not as conservative as full bid or offer pricing. It reflects that positions change gradually over time and are not usually flattened all at once. Traders of liquid securities, such as the Government of Canada bonds, may price client transactions based primarily on current pricing. Traders of less liquid securities, such as high yield, junk, or distressed debt, may price them based on the historical price. There is often only a very limited connection between the current market for liquid securities and the illiquid securities of a high yield trader. In addition to the effects of valuing the trader’s inventory using current market prices, traders also have funding, cost of carry, and coupon effects on their daily profit and loss statement (P&L). The following activities affect traders’ daily P&L statements: They are often charged a cost for the capital they use. They earn the coupon on long positions and pay the coupon on short positions. They earn or incur costs from repurchase or reverse repurchase agreements (repos and reverse repos). DID YOU KNOW? A repurchase agreement is a contract in which the seller of securities agrees to repurchase the securities from the buyer at an agreed price. For the other party to the transaction (the buyer), the contract is considered a reverse repurchase agreement. SALES REVENUE Sales revenue is generated through transactions with clients. It is a function of how well the sales representative can meet the client’s information and product needs, how liquid the security is, and how keen the client is to execute the trade. Profit derives from the difference between the trader’s price for a security and the price at which the client is willing to accept and execute the trade. Sales representatives must bring in as many trade enquiries as possible from the client base to provide a constant flow of trade. They also work with the trader to market products to clients that the trader particularly wishes to sell from or buy into his or her inventory. A sales representative who knows a client well can provide information that allows the firm to sell bonds higher or buy bonds lower than the trader’s initial price. This added value is often tracked by firms and may feature in the sales representative’s annual bonus or incentive payment. ORIGINATION REVENUE Origination, which is also called debt capital markets (DCM) or underwriting, is the process of bringing new debt issues to market. The dealer works with a government or corporation that is issuing the debt to market the new debt issue. The dealer then buys a portion of the debt from the issuing company at a small discount from the new issue offer price and sells it to clients at the new issue offer price. The difference between the price the dealer pays the issuer and the price it receives from the buyer represents a profit for the dealer. In most firms, this profit is tracked by the DCM or debt origination desk. © CANADIAN SECURITIES INSTITUTE 27 18 CANADIAN SECURITIES COURSE VOLUME 2 SOFT-DOLLAR ARRANGEMENTS In a soft-dollar arrangement, an institutional client purchases goods or services through commission dollars, rather than through an invoice. For example, an institutional client may pay for investment research performed by a dealer by agreeing to channel some trading business through the dealer in an amount equal to the amount charged for the service. Soft-dollar arrangements can only be used for order execution and research services. Institutional clients must disclose the arrangement to their clients and make sure it is used to benefit their clients. Soft-dollar commissions are more prevalent in equity transactions than in fixed-income transactions. For dealers, compensation for fixed-income transactions is derived primarily from the spread, rather than charged as a commission. As a result, fixed-income transactions typically do not generate large soft-dollar commissions. INSTITUTIONAL CLEARING AND SETTLEMENT 5 | Explain the institutional settlement process. Clearing is the process of confirming and matching security trade details; settlement is the moment of irrevocable exchange of cash and securities. When an institutional firm makes trades, it notes them in its internal records and updates the portfolio as of the trade date. The process has become highly automated through the straight-through processing (STP) system. However, before we discuss the automated process, we will explain the clearing and settlement process itself so that you understand the complexities involved. THE SETTLEMENT PROCESS The typical institutional trade involves at least the following three parties: The investment manager acts on behalf of underlying client accounts and decides what securities to buy or sell, and how to allocate assets among the accounts. The dealer executes the trades. The custodian (or custodians) holds the institutional investor’s assets. After the institutional investor places an order with a dealer, the investor receives in return a trade execution notice. The investor must then provide the dealer and custodian with certain details to facilitate the settlement of the trade. These trade and account details are known as trade-matching elements. For an institutional equity trade to clear, for example, 26 different elements must be confirmed. These elements can be grouped into two categories: security identification and order and trade information. The dealer, in turn, must issue a customer trade confirmation with the required trade information to the custodian. Once all the trading details have been confirmed, the next step is matching, in which the relevant parties match and verify these elements. Matching also requires that the custodian holding the institutional investor’s assets confirm the trade. The trade is ready for the clearing and settlement process through the facilities of the clearing agency. After matching is complete and the custodian has confirmed the trade, the following three steps are taken: 1. The manager advises the dealer and custodian how the securities traded are to be allocated among the underlying institutional client accounts of the manager. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 19 2. The dealer reports and confirms the trade details to the manager and clearing agency. The categories of trade details that must be confirmed for the matching, clearing, and settlement purposes are similar to the information required from the institutional manager. 3. The custodian verifies the trade details and settlement instructions against available securities or funds held for the institutional investor. After trade details are agreed to by both sides, the manager instructs the custodian to release funds or securities to the dealer through the facilities of the clearing agency. DID YOU KNOW? Matching requires that both sides of the trade agree to the terms, and that the custodian verifies the availability of the required funds and securities. CHALLENGES WITH INSTITUTIONAL TRADE PROCESSING Institutional trades are much more complicated than retail trades because they involve larger amounts of money and securities, more parties, and more processing steps between the initiation of the order and final settlement. Errors and delays can occur in the clearing and settlement process for various reasons. Inadequate technology Problems can occur because the technology is lacking in automated processing capability, real-time functionality, and standard interfaces between trade parties and the custodian. Many messages sent by investment managers and dealers are sent manually by telephone or fax. Also, the recipient of these messages must manually re-key the information, which increases the likelihood of error. Timing of activities Problems can occur during different steps in the trade process, when notices of execution or allocation are missing or late. Data integrity and Incorrect data is the leading cause of most failed trades. For an institutional trade to be accounting issues processed and settled by T+1 (one business day after the trade), all trade details and data elements must be agreed upon by all relevant parties involved in post-trade processing. STRAIGHT-THROUGH PROCESSING An important component of the overall organization of many buy-side firms is the electronic STP system, through which trades are executed. This system is increasingly becoming a buy-side best practice. The STP system is a continuous, real-time investment management database that tracks all security transactions and investments and links the various operating departments of the firm. The system ensures compliance with various regulations, investment guidelines, and restrictions pertaining to each portfolio that a proposed trade involves. It transmits instantaneous electronic communication of executed trades to the dealer, the custodian (for settlement), and the portfolio manager who instigated the trade. The STP system is designed to prevent human errors associated with security trading, settlement, and recordkeeping activities. It ensures that only security transactions that meet all applicable regulations and investment guidelines and restrictions are permitted to be executed. The real-time nature of the STP system, coupled with the robustness of its pre-trade compliance module, enables this objective. © CANADIAN SECURITIES INSTITUTE 27 20 CANADIAN SECURITIES COURSE VOLUME 2 ROLES AND RESPONSIBILITIES IN THE INSTITUTIONAL MARKET 6 | Describe the roles and responsibilities within an institutional investment dealer. Most, though not all, institutional clients are sophisticated investors who make their own investment decisions. The decision-making process requires that they evaluate the suitability of the products and services in which they transact. The ability of those clients to make an independent investment decision can vary from product to product. The dealer must therefore determine whether they are sufficiently informed to make a suitability judgment. The dealer must have reasonable grounds to conclude that the client is capable of making an independent investment decision and independently evaluating the investment risk. Only then will the dealer’s suitability obligation be fulfilled for that transaction. DIVE DEEPER For more information on the suitability of institutional customers see Rule 3403, Institutional client suitability determination requirements, located in CIRO’s Investment Dealer and Partially Consolidated Rules. The needs of institutional clients vary from trading services to security issuance to market research. The products they buy and sell include equities, fixed income, and derivatives. Dealers are organized with various key positions in place to fill those needs. Research associate Also known as the associate analyst, the research associate is the entry-level position for other jobs in the equity and fixed-income markets. The research associate, who reports to a senior analyst, mainly builds financial or pricing models, conducts industry or company research, and helps write reports and commentary. To hold this position, you are typically required to have a minimum level of designations, including MBA, CFA, or CA. It is possible to be hired without these qualifications, but only in the more technical fields, such as chemistry or mining, where a master’s degree in the field is more appropriate. Analyst Also known as the sell-side or research analyst, this person is considered an expert in respect to a specific company or sector. Analysts provide other front office staff with ongoing coverage in their area of specialty. For example, investment bankers look to the equity analyst for a financial forecast on companies they cover. Institutional clients may look to the derivatives analyst for market knowledge and trading ideas. Analyst ranks are often filled from within, usually from the trading desk or associate ranks. To hold this position, your education requirements would be similar to those for a research associate or associate analysts, as noted above. However, relevant work experience is considered very important. Institutional sales The institutional salesperson’s main job is to be a relationship manager, serving as the liaison between the dealer and the client. Education requirements for those in the equity and fixed-income arenas are typically less rigid compared to the research associate role, mostly because salespeople tend to be generalists. To hold this position, you are typically required to have an MBA or CFA designation. In this role, you would speak to all types of clients about a wide range of products and subjects, and to a wide range of analysts. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 21 Institutional trader As an institutional trader, you might execute orders on behalf of clients (as an agency trader) or on behalf of the dealer (as a liability trader). You might also provide a constant, two-sided market for securities as a market maker. To hold this position, you are typically required to have a bachelor’s degree, preferably in finance, economics, or business. In addition, the Trader Training Course (TTC) offered by CSI is a CIRO proficiency requirement to qualify as an equity trader on the TSX, TSX Venture Exchange or alternative trading systems. Investment banker An investment banker is responsible for building the following three areas of the dealer’s business: Corporate finance: raising debt and equity capital for corporations Public finance: raising capital for governments and their agencies M & A services: providing advice on mergers, buy-outs, asset sales, corporate restructurings, valuations, and fairness opinions Positions in the investment banking department are stratified over the following three areas of responsibility: Analysts and associates: responsible for analytical work Vice-presidents and associate directors: responsible for day-to-day management Managing directors: responsible for the strategic direction of the business Senior investment banking staff members also take on more responsibility for maintaining corporate relationships and have more client interaction. To enter the ranks as a new employee, you are typically required to have an undergraduate economics or business degree. An MBA or LLB designation would be an asset. Of all these positions, institutional salespersons and the institutional traders work most closely with institutional clients. We will discuss these two key positions in detail over the sections that follow. THE ROLE OF THE INSTITUTIONAL SALESPERSON Institutional salespersons and traders share the need for observation and analysis. The difference is in the purpose. The salesperson, as the client relationship manager, is the conduit between the client and the dealer. In this dynamic position, you provide insight on market movements, promote the dealer’s analysts, take management teams for presentations to clients, take clients to site visits, and generally entertain clients. A good salesperson is an effective pipeline in managing the flow of information, research, analysis, and products to clients who are interested in the sectors that the firm covers or specializes in. In an institutional sales role, you would require proficiency in various key areas of the dealer. Building and As an institutional salesperson, you are often in competition with salespersons of maintaining strong competing dealers. Maintaining strong client relationships through the following means relationships with is therefore a key negotiation strategy that requires the following tasks: your clients Initiate contact with preferred clients Provide market commentary Provide access to the dealer’s economists, analysts, and other resources Negotiate better bids and offers with the trader on behalf of the client © CANADIAN SECURITIES INSTITUTE 27 22 CANADIAN SECURITIES COURSE VOLUME 2 Providing access to A critical skill you require as an institutional salesperson is a good understanding of the good research and client’s needs. However, not every client is immediately receptive to new investment investment banking ideas. A good research group can help you build strong relationships by providing services investment ideas and opportunities for discussion. And an effective investment banking group helps the sell-side firm secure more deals, which provides buy-side clients with good opportunities to invest in new issues. Developing your As a salesperson, you must gain a certain level of expertise about the products you sell knowledge of your and the companies, businesses, and sectors that affect the market for those products. firm’s products and the For example, if you sell credit derivatives, you should be intimately familiar with credit market factors that market spreads, monetary conditions, and business condition risks. affect their pricing Access to good information and familiarity with your firm’s products and services helps build your confidence as a salesperson when speaking to your institutional clients about their investment needs. DID YOU KNOW? The institutional salesperson must negotiate on two sides: with clients (to win business) and with traders (to get bids and offers that clients find attractive). In negotiating with the trader, a key strategy is to convince the trader that the client will go to a competing dealer if the offer is not satisfactory. Accounts among institutional salespeople are typically divided according to several key factors. By geographic area Dealers segregate accounts by geographical area for ease of travel by salespersons to visit their clients. By account type Dealers categorize accounts into two types: fundamental and hedge or arbitrage. Fundamental accounts belong to long-only money managers. To get the managers’ business, the salesperson must emphasize the dealer’s intellectual resources and ability to generate money-making ideas. Hedge or arbitrage accounts are more like trading accounts and tend to be more interested in money-making ideas. By relationships Some dealers allocate accounts to those salespersons with whom the client has the best relationship. THE ROLE OF THE INSTITUTIONAL TRADER Investment firms have the following three types of traders serving institutional accounts: Agency traders Liability traders Market makers AGENCY TRADERS Agency traders (also called coverage traders) execute large trades, called block trades, for institutional clients. They do not trade the dealer’s capital, and they trade only when acting on behalf of clients. Agency traders do not merely take orders; they must manage institutional orders with minimal market impact and act as the client’s eyes and ears for relevant market intelligence. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 23 In the role of an agency trader, you must be aware of client intentions at all times. You must watch for news or events that might affect client orders and come up with trading ideas to generate commissions. You must also pay attention to many information sources, including print media, Internet sources, blogs, real-time news services, and industry contacts. All this information is necessary to get an overall sense of the markets and to instantly analyze unexpected events that could move them. Filling orders with minimal market impact means that agency traders must make transactions with the lowest possible cost to the institutional client. If improperly executed, institutional orders could add tens of thousands of dollars in extra costs for the client. EXAMPLE As an agency equity trader, you might choose to fill an order all at once. However, if the market for the stock is too small or if prices might be more favourable later in the day, you might break up the order into pieces. As an agency derivatives trader, getting a good fill means finding a counterparty that is both credit worthy and willing to price the derivative favourably for the client. Agency traders also need to develop and maintain good relationships with their clients. Although they do not have as much contact with clients as salespeople, agency traders must establish a comfort level with clients so that their clients know their assets are being well served on the frontlines of the markets. One way to establish a level of comfort is to come up with the occasional trading idea. Each institutional client has a commission allocation by which business is divided among dealers. Other than the regular business allocated to a specific dealer, each institution has some leeway to pay out extra commissions to each dealer. It is part of the agency trader’s responsibility to capture some of this discretionary business for the dealer. LIABILITY TRADERS Liability traders (also known as proprietary traders or prop traders) are responsible for managing the dealer’s trading capital to encourage market flows. They also facilitate the client orders that go into the market, while aiming to lose as little trading capital as possible. Liability traders can be seen as setting the direction for agency traders, who have more formal client responsibilities. Liability traders have lighter responsibilities, or none at all, often completing orders that could not be filled entirely by the agency trader on the stock exchange. Liability traders are assigned specific sectors of the market. EXAMPLE On the equity desk at a large sell-side firm, Tom covers gold stocks while Chris covers telecom stocks. On the fixed-trading desk, Gina covers asset-backed securities while Igor covers high-yield issues. On the derivatives desk, Helen covers fixed-to-floating interest rate swaps while Ann trades floating-to-fixed swaps. The liability trader walks a fine line daily between market share and profitability. Although a firm wants to be seen as the go-to dealer with respect to a particular market sector, doing so may tie up a large proportion of trading capital. Liability traders must still be intimately familiar with their sectors. They must understand how clients are exposed, or will be exposed, to those sectors, and how fundamentals drive the ebb and flow of the market. Sometimes, in order to ensure a well-functioning secondary market and for the dealer to be seen as the go-to firm, liability trades are executed that end up costing the firm trading capital. The commitment to making a market for a particular security, however, may help secure future agency business from institutional clients, or even underwriting business from the issuer of the security for their next round of financing. When choosing an investment bank, issuers of new securities consider the ability of a firm to make secondary markets for their securities. Accordingly, most investment banks make substantial investments in personnel and technology to compete effectively in the secondary markets. © CANADIAN SECURITIES INSTITUTE 27 24 CANADIAN SECURITIES COURSE VOLUME 2 Liability traders can use the dealer’s trading capital reactively, by making trades based on a reaction to some event or request that has occurred. Or, they can act proactively, by taking the initiative to enter a trade in the absence of a triggering event or request. EXAMPLE The dealer where you are a liability trader has a client who wants to sell 100,000 shares of XYZ stock. The market on XYZ stock is $10 bid, $10.10 ask. As the dealer’s liability trader, you react to the client’s request and make a market and buy the 100,000 shares at $10.10. Because the liability desk is not in the business of holding stocks for the long term, you try to offload the stock that day. Hopefully, market conditions will improve so that you can sell into it. If conditions do not improve, and you sell into the market at $10 bid and $10.10 ask, your firm will lose $10,000 on the sale of XYZ at $10. This is an example of a reactive trade. Another example of a reactive trade occurs when a derivatives dealer is approached to be the counterparty on a contract. If you, as the liability trader, can find a second counterparty or make another trade to offset your exposure, the trade will occur at an agreeable price. Working capital proactively, on the other hand, might mean making a market in a security that is deemed favourable by one of the dealer’s analysts. By accumulating inventory and accentuating demand through analyst reports, you will put the firm in the position to fill orders by the time institutional accounts are solicited by the firm’s salespeople. Another proactive example occurs when the dealer becomes active in a particular stock or sector to create underwriting or investment banking deals. Underwriting and investment banking is a high-margin business. If the dealer is seen to be the top market maker in that space, it can more effectively pitch to be a leading underwriter on the next new issue. Liability traders have a significant amount of flexibility in the strategies they employ. In fact, liability traders use many of the same investment strategies as hedge fund managers, many of whom were liability traders at a dealer before leaving to join or start up a new hedge fund on the buy side. Most buy-side institutional investment firms, except hedge funds, are limited to long-only strategies. Liability traders, on the other hand, are able to use short sales, leverage, and derivative products as trading tools. Generally, liability trading strategies can be broken down into the following categories, based on the tools used: Relative value Event-driven Directional You can read more about the major trading strategies in the context of hedge funds in Chapter 20. All of these strategies are employed by liability traders. MARKET MAKERS Institutional market makers specialize in executing orders for pension funds, mutual funds, investment management companies, and other institutional clients. Market makers perform a valuable function for the exchange by improving liquidity and increasing trading volume. The primary role and responsibility of equity market makers is to provide a constant, two-sided (bid/ask) market for equities under their responsibility. They do so at an agreed-upon spread, and in compliance with all equity exchange rules and regulations. Market makers must perform this task in a manner that meets the revenue targets set by the dealer, and in accordance with risk and compliance standards. A dealer participant that is approved by the exchange as a market maker is assigned a stock (or stocks) of responsibility (SOR). The SOR is based on various criteria, such as size and quality of the market being offered and market-making performance on the participant’s existing SOR. The TSX and Canadian Securities Exchange both reserve the right to determine which competing market-making dealer will be awarded the responsibility. The dealer then assigns an individual responsible designated trader (RDT) to carry out market-making duties on the stock. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 25 The RDTs, who are generally more senior and experienced traders, must follow strict guidelines established by the exchange in trading their SORs. For example, RDTs at the TSX must comply with the following requirements: Maintain a two-sided market at an agreed-upon spread goal Make sure that trading in their own accounts is reasonable and consistent with just and equitable principles of trading Assist others in the execution of their orders with respect to their SOR RDTs trade using the dealer’s capital and carry inventories of their SOR to ensure a liquid, two-way market. They receive advantages in exchange for the responsibilities assumed and the restrictions imposed on their trading. They are entitled to preferential trading fee treatment, and to a smaller margin than that given to the general public for similar positions. The risk to the dealer is that the institutional market maker, who is responsible for executing large block trades, will not perform well enough to earn the target revenue for a given period. ROLES AND RESPONSIBILITIES Can you describe the different roles and responsibilities of participants in the institutional marketplace? Complete the online learning activity to assess your knowledge. INVESTMENT STYLES, GUIDELINES, AND RESTRICTIONS 7 | Contrast the different buy-side investment management styles. To be successful as a sell-side salesperson, you must have a clear understanding of the investment objectives of each portfolio. As well, you need to be familiar with the following key aspects of the buy-side portfolio manager’s investment management parameters: The portfolio manager’s investment management style The investment guidelines and restrictions for each portfolio The salesperson must have a good understanding of all the above aspects to service the portfolio manager appropriately and effectively. The salesperson’s intent is to have a profitable, long-term business relationship with the institutional client. INVESTMENT STYLES Two major styles of portfolio management that investors employ are fixed-income and equity styles. In both cases, passive or active management approaches can be used. FIXED-INCOME STYLES As we learned earlier in the course, passive bond management minimizes the effects of interest rate risk on a bond portfolio. With this style, no attempt is made to predict the direction or magnitude of interest rates. Three passive bond management approaches include the buy-and-hold strategy, indexing, and immunization. © CANADIAN SECURITIES INSTITUTE 27 26 CANADIAN SECURITIES COURSE VOLUME 2 Buy-and-hold With a buy-and-hold strategy, the manager purchases bonds with available funds and holds each bond to its maturity, thereby avoiding the interest rate risk on an early sale. Indexing Indexing is a method of creating a portfolio that mirrors the performance of a bond index. The typical approach is to create a portfolio that samples the index constituents and produces an effective substitute that mimics the overall index performance. Immunization Immunization can be viewed as a means of protecting the bond portfolio from interest rate risk by purchasing bonds that provide a defined return at a specific time and is therefore immune to outside influences. An example of a security immune to outside influences is strip bonds. With active bond management, the portfolio manager tries to profit from interest rate risk by predicting the direction or magnitude of rate changes. With this approach, the conservative view of bonds no longer applies. By anticipating changes in interest rates and the size of spreads between high-and low-grade corporate bonds, the manager can create strategies to profit from them. Two active bond management styles include interest rate anticipation and bond swaps. Interest rate With this strategy, the manager moves funds from one end of the yield curve to the anticipation other in anticipation of interest rate changes. If rates are expected to fall, extending the duration of the portfolio will be profitable. Conversely, if rates rise, the portfolio will benefit from a shift to a shorter portfolio duration. Bond swaps Bond swaps normally involve the purchase of one bond and the simultaneous sale of another related or unrelated bond. The motivation for a fixed-income swap is to potentially profit from the portfolio manager’s analytic skills. Correct analysis should indicate the proper value for the yield spread between the two fixed-income securities. EQUITY STYLES As we discussed in an earlier chapter, passive equity portfolio management is consistent with the view that the markets are efficient. If so, equity prices should always reflect all relevant information concerning expected return and risk. The passive portfolio manager concentrates on designing the portfolio necessary to meet particular needs and maintaining that structure through periodic rebalancing. Passive equity approaches include the buy-and-hold strategy and indexing. Buy-and-hold A buy-and-hold approach is a strategy whereby stocks are purchased and held for a long time, until they need to be sold. Portfolio turnover using a buy-and-hold strategy is low. Indexing Indexing in the equity market mimics the performance of a specific market by replicating a stock index. The manager holds each stock within the fund portfolio in exact proportion to its weighting within the index. Alternatively, a subset of the benchmark can be held to faithfully mimic the index. Portfolio turnover is low, occurring only when the underlying stocks in the index change. © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 27 Passive portfolio management is a common approach, but it is not the norm. The majority of funds are actively managed to some degree. Active strategies are based on sector rotation, market timing, value, growth, or market capitalization. Sector rotation Sector rotation is a top-down attempt to pick the best sectors by identifying specific sectors that will offer expected superior performance. Timing is crucial. Sector rotation tends to be aggressive. This strategy is the antithesis of the buy-and-hold approach. Market timing Timing the general ups and downs of the market is premised on forecasts of protracted increases or decreases in the market. In practice, however, none of the many approaches to market timing has emerged as the basis for a stable, successful, and replicable strategy. Value As a bottom-up value-oriented portfolio manager, you would look for undervalued securities, with little focus on overall economic and market conditions. You should be prepared to wait many years to recognize a stock’s full value. This somewhat passive style results in a relatively low portfolio turnover. Growth As a bottom-up growth-oriented portfolio manager, you would choose stocks with superior earnings growth rates, compared to the market in general. A growth-oriented management approach results in a higher portfolio turnover, compared to a value- oriented style. Market capitalization The so-called size effect means that smaller firms generate consistently higher returns on a risk-adjusted basis than larger firms. This trait has spawned a style that focuses on the size of issuing companies as measured by market capitalization. However, this strategy may not compensate for the higher transaction costs and illiquidity. Nevertheless, smaller firms offer an advantage through diversification because returns to small cap stocks are less than perfectly correlated with the rest of the market. TYPICAL INVESTMENT GUIDELINES AND RESTRICTIONS FOR EQUITY MANDATES There are unique investment guidelines and restrictions for the management of each equity portfolio or mandate. A prudent buy-side equity portfolio manager generally abides by these guidelines and shares them with the sell-side equity sales staff for a more productive relationship. Sell-side equity salespersons use the guidelines to tailor their coverage of the buy-side portfolio manager, who is responsible for the underlying equity portfolio. This information informs the sell-side salesperson about which sectors and individual equity issuers the portfolio manager is trading. It also highlights the type of information and research that the portfolio manager values. The liability trader plays a similar role to a portfolio manager for the dealer. The dealer’s senior management determines the liability trader’s investment mandate. Therefore, the liability trader must abide by the firm’s investment guidelines and restrictions. Table 27.1 provides a sample list of investment guidelines for a Canadian equity fund and the typical restrictions that may apply. © CANADIAN SECURITIES INSTITUTE 27 28 CANADIAN SECURITIES COURSE VOLUME 2 Table 27.1 | Guidelines and Restrictions for a Canadian Equity Fund Investment Guideline Typical Parameter or Restriction Permitted Common equities traded on TSX, NYSE, or NASDAQ equity exchanges investments Money market securities with less than one year maturity from an approved list of issuers, including the following security types: Treasury bills issued by the Government of Canada Certificates of deposit issued by Canadian Schedule I banks Commercial paper issued by an approved, high credit, Canadian public corporation Diversification In respect to a single issuer’s permitted portfolio weighting’s market cap percentage in an equity index, the following parameter applies: Minimum: 0% (not invested in this issuer) Maximum: 1.5 times the issuer’s percentage weighting in the equity index In respect to an equity exchange index, the following parameter applies: No more than 20% of the equity portfolio can be invested in equities that are not in the S&P/TSX 60 Index In respect to market capitalization, the following parameter applies: No more than 25% of the equity portfolio can be invested in permitted issuers with a market capitalization of less than $250 million at time of purchase Note: Ontario Securities Commission regulations, applicable to mutual funds, state that no single issuer can represent more than a 10% weighting in the market value of the equity portfolio. Non-permitted In respect to type of securities, the following investments are not permitted: investments Preferred stock Convertible bonds Options and warrants Any fixed-income security maturing beyond one year Derivatives, both listed and OTC In respect to type of Industry, the following investments are not permitted: Tobacco manufacturers Alcohol distilleries Gambling venues Weapons manufacturers Short sales Not permitted Leverage Not permitted © CANADIAN SECURITIES INSTITUTE CHAPTER 27 WORKING WITH THE INSTITUTIONAL CLIENT 27 29 Table 27.1 | Guidelines and Restrictions for a Canadian Equity Fund Investment Guideline Typical Parameter or Restriction Permitted purchase Canadian dollar currencies U.S. dollar Foreign currency Required, but only with forward rate agreements with Canadian Schedule I banks hedging ALGORITHMIC TRADING 8 | Define algorithmic trading, high frequency trading, and dark pools. Algorithmic trading involves the use of sophisticated mathematical algorithms to execute equity trades over electronic trading systems. This form of trading has grown exponentially during the past decade. Most algorithmic trading involves a large number of individual trades initiated and conducted with little human interaction. Strategies typically are developed in advance. Trades are then automatically triggered when particular market values have been reached for certain parameters. Algorithmic trading is used extensively by buy-side institutional investors to aid in the execution of large block trading. The goal of algorithmic trading is to optimize the execution of individual large trades by reducing market impact. It involves ‘chopping up’ large market orders into smaller orders. The smaller orders are then routed to several trading platforms, including dark pools (which are explained below). This method of trading attempts to disguise the true size and extent of the total order and therefore reduce the price movement that would generally occur if the

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