Trading Book
Trading Book is a company's book that shows and accounts for shares that are acquired or sold by a given entity[1]. It is a collection of financial instruments owned by a brokerage house or a bank. It includes all securities that the institution regularly buys and sells on the stock market. These securities are accounted for in a different way than those in the banking book, which are meant to be held by the institution until they mature and are not usually affected by market activity. Trading books can vary in size, from several thousand dollars to tens of millions, depending on the size of the institution[2].
Process
The trading book of a financial institution includes assets designated for active trading. They can be:
- currency Exchange
- debt
- derivatives
- goods
- other financial agreements
The portfolio may be sold for many reasons. For example, they can be bought or sold:
- to benefit from short-term price fluctuations
- to meet the company's needs
- to use them to protect against various forms of risk
- to facilitate commercial activities for clients
Banks, due to regulatory purposes, divide their activities into trade and banking. Registration in the profit and loss account (P & L) takes place whenever there is fluctuations in the portfolio. In contrast to assets in the banking book, they have to be valued on the market[3].
Genesis
The purpose of the commercial book was to store market-related assets (bonds, derivatives, etc.), not traditional banking operations. The trading book is an asset that is to be highly liquid and easy to trade. The development of banking operations in the early 1990s contributed to the growth of the trade book. The legislators decided to allow banks to use value-at-risk models to calculate the capital charges for the trading book. Considering how many banks may be tempted to leverage, it gave the institutions the incentive to allocate as many assets to trading as possible in the trading book instead of in the banking book[4].
History
In 2008, especially at the time before the credit crisis, many banks placed large amounts of assets reminiscent of banking books in commercial books in order to benefit from lower capital requirements. Thus, the great history of the crisis has become the way in which banks have accumulated everything in their trading books. After the disaster, the main conclusion drawn by the regulatory authorities was the conclusion that the supervision of the trading book was conducted very casually, which allowed the banks to abusively deal with this matter, which had adverse effects. Nowadays, the review of commercial books is conducted very thoroughly, and regulators are trying to avoid repetition of the situation from the past[5].
Examples of Trading Book
- Long/Short Equity Trading: This type of trading book consists of two parts: long equity and short equity. The long equity portion consists of long positions in stocks, usually held for investment purposes. The short equity portion consists of short positions in stocks, usually held to hedge against potential losses.
- Fixed Income Trading: A fixed income trading book consists of different types of debt instruments, such as bonds, notes, debentures, and other debt securities. The purpose of this book is to manage the risk associated with the underlying debt instruments.
- Currency Trading: Currency trading books consist of different currency pairs, such as the U.S. dollar versus the Euro, the British pound versus the U.S. dollar, and the Japanese yen versus the U.S. dollar. These books are managed to take advantage of fluctuations in currency values and to hedge against foreign exchange risk.
- Commodity Trading: Commodity trading books consist of different types of commodities, such as gold, oil, and wheat. These books are managed to take advantage of price fluctuations in the underlying commodities and to hedge against the risk of physical delivery of the commodities.
- Derivatives Trading: Derivatives trading books consist of a variety of financial instruments, such as forwards, futures, options, and swaps. These books are managed to take advantage of fluctuations in the underlying financial instruments and to hedge against risks associated with these instruments.
Advantages of Trading Book
Trading Book is an important part of a company’s overall portfolio since it provides a record of all trading activities and investments made. Here are the advantages of having a Trading Book:
- It records the company’s trading activities and investments, enabling managers to view their performance quickly and easily.
- It helps detection and prevention of fraud since it tracks all transactions.
- It assists in making sound decisions since it keeps an accurate record of the company’s trading activities and investments.
- It helps to ensure compliance with the regulations and guidelines of the financial industry.
- It helps to monitor the progress of the company’s investments and trading.
- It enables the company to assess the performance of its investments in terms of risk, return, and liquidity.
- It helps to identify potential opportunities for investments.
Limitations of Trading Book
The Trading Book contains a range of limitations, including:
- It does not provide a full view of a company’s positions in the market, as it only includes the trades that have been executed.
- It does not account for open positions, as they are not considered to be "trades".
- It is also not able to provide an accurate assessment of the risk associated with a particular trade, as it does not take into account the various market factors that influence the performance of a particular security.
- The Trading Book also does not include any information on the actual cash flow associated with a given trade, which can be an important factor in assessing the overall performance of the trade.
- It is also unable to provide an accurate assessment of the liquidity of a particular security, as it does not take into account the number of buyers and sellers in the market.
- Introduction: In addition to Trading Book, there are other approaches used for managing and accounting for trading securities.
- Portfolio Rebalancing: This is the process of making changes to a portfolio in order to adjust the asset allocation and risk profile of the portfolio in line with the investor's goals and preferences.
- Risk Management: This approach involves identifying, assessing and managing potential risks associated with trading securities. Risk management strategies can include hedging, diversification and stop-loss strategies.
- Market Making: This is the process of buying and selling securities in order to facilitate liquidity in the markets, and to provide a two-way price for investors. Market makers will provide both buying and selling prices for a security and will try to benefit from the spread between the two.
- Arbitrage: This is the process of taking advantage of price differences in different markets or between different securities. Arbitrage can be used to make a risk-free profit by taking advantage of price discrepancies.
- Algorithmic Trading: This is the use of computer algorithms to execute trading strategies. Algorithmic trading can be used to take advantage of market inefficiencies and to make trading decisions faster and more efficiently.
In summary, Trading Book is just one approach among many used to account for, manage and trade securities. Other approaches include portfolio rebalancing, risk management, market making, arbitrage and algorithmic trading.
Footnotes
| Trading Book — recommended articles |
| Banking book — Quoted investments — Trading capital — Capped Index — Collateral management — Blind Pool — Floor trader — Margin level — Cross margining |
References
- Basel Committee on Banking Supervision (2013), Fundamental review of the trading book: A revised market risk framework, "Consultative Document";
- Laurent J., Sestier M., Thomas S. (2016), Trading book and credit risk: How fundamental is the Basel review?, "Journal of Banking & Finance", vol.73;
- Nilsson B. (2019), Fundamental review of the trading book, "Lund University School of Economics and Managements";
Author: Filip Piszczek
