U.S. Treasury Securities

The Trading Floor

Most trading floors are designed to be efficient to handle the complexity and speed required by today’s global financial markets. Large trading floors execute hundreds of thousands of trades and billions of dollars worth of transactions; they comprise thousands of clients and counter-parties, operating in major financial centers throughout the world and across many asset classes.

Most large banks and dealers have a number of trading floors across the major financial centers. New York, London, and Tokyo are popular with clients in the Americas, Europe, and Asia, respectively. Many banks and dealers have satellite centers in other major financial hubs as well: in the Americas, Chicago, Charlotte, San Francisco, and Toronto; in Europe, Frankfurt, Paris, Zurich, Stockholm and Milan; and in Asia, Singapore, Hong Kong, Shanghai and Sydney.

Most modern trading floors are located in large rooms with raised floors and open floor plans. Raised floors are needed to “wire-up” the trading floor with desktop computers, printers, servers, market data, news, trading systems, turrets, phone systems, networks, and a number of other electronic items. Open floor plans allow for “line of sight” communication between traders, institutional salespeople, and support staff. Speed of communication on the trading floor is critical for providing efficient service to clients, particularly in fast-moving, volatile markets.

Trading Floor

Sales and Trading

“Sales” and “Trading” are the heart and soul of the trading floor. The relationship between these two areas of the dealing room is key to the success and profitability of a trading operation.

“Sales” comprises relationship executives who deal with the firm’s institutional clients. They are advocates for the client; they keep clients informed with news and research, make trading recommendations, and execute successful trades. In general, a relationship executive tries to keep the client happy so that he or she continues to do business with the firm.

“Traders” are “product focused”, which means that they specialize in specific asset classes. It is not uncommon for a trader to sub-specialize within a specific sector of the asset class. For example, a trader on the “Government Desk” (trading in U.S. Treasury securities) may specialize in 2-5 year Treasury Notes whereas his colleague may trade in only 7-10 year Notes. As market makers, buying and selling securities throughout the day, the goal of traders is to turn a profit for the firm.

A Representative Trade

Let us use the following example to better how a trade on the floor works:

Pemberley Capital employs an institutional investor named Darcy, who is looking to buy securities. He has reviewed his portfolio, done research, and performed analysis, and has decided that $25 million of the 5-year will be better than the 7- or 10-year, given his expected returns and investment horizon. Now he is ready to buy.

First, Darcy places calls to dealers. Though he trades with many, he knows that certain dealers are more skilled in certain asset classes. He may also narrow his list to those dealers he knows to be particularly strong in U.S. Treasuries. Like any buyer, he is shopping for the best price and wants to enlist the dealer he believes can help him most.

Darcy calls Bingley, an institutional salesperson he’s known for years; Bingley works for Netherfield Park, an eminent bank. Bingley quickly understands that Darcy wants to buy $25 million of the 5-year Note and tells him he’ll try to get the deal done at the lowest price. It is in Bingley’s interest to effectively advocate for Darcy because his compensation is contingent on filling his client’s order. Bingley will either get a direct commission on the trade or a sales credit that will be used to determine his year-end bonus.

As we alluded to before, there are many desks on the floor that specialize in specific asset classes. Government, Mortgage-Backed Securities (MBS), Corporate Bonds, Money Markets, Foreign Exchange, Futures and Options, Interest Rate Derivatives, and Credit Derivatives are just some of the desks typically present on a capital markets trading floor. Large dealers may have other floors — equity trading floors for stocks and commodity trading floors for energy, precious metals, and agricultural commodities.

Traders at each of these desks make markets (bid for and offer securities) in their respective asset specialties. Unlike people on sales desks, traders’ compensation reflects their trading profits. Therefore traders are always looking to buy for less and sell for more.

Back to our example: Bingley, working on behalf of his client Darcy, shouts out to Elizabeth, the 5-year trader on Netherfield Park’s Government Desk. “Offer me twenty-five on the current five-year!” (Most trades are made in millions; here it is implied). Elizabeth replies “10″. The offer price is actually 101-10, or 101 and 10/32 of a percent of face value. The 101 is the “handle” and is usually implied because it is shown on many of the market data screens and is where the 5-year Treasury has been trading recently.

But Bingley wants to get a better price for his client. He asks Elizabeth, “Can you do 9 and 3/4? It’s for Darcy at Pemberley.” The price Bingley is negotiating with the trading desk is 101 and (9 3/4)/32 percent, which is (1/4)/32 (mathematically equivalent to 1/128) of one percent better than the original 101-10 quote.  Elizabeth knows that Darcy is a good and regular client and shouts back, “I’m good at 9 3/4 for Darcy” (with the implication that this price is acceptable, given that the market does not move significantly over the following few seconds).

Bingley has had Darcy on the line (on mute) this whole time. Now he tells him that the market is at 10 but the trading desk is willing to do it at 9 3/4. “Are we done?” Darcy, happy with the price, agrees: “Done.” Bingley shouts to Elizabeth: “We’ve sold 25 at 9 3/4 to Pemberley.” Elizabeth answers: “Done at 9 3/4 for 25.” Bingley confirms the trade with Darcy, thanks him, and hangs up.

Now that the trade is “done,” Darcy, Bingley, and Elizabeth enter (or “book”) the trade into their respective systems. They then forward the details of the trade to their individual back-office operations to have it officially confirmed and settled.

Competitive Dynamics

Elizabeth, the trader, must be extremely agile and flexible. Elizabeth wants to sell at the highest price possible to maximize her profitability as a market maker. She has assumed the risk of purchasing an inventory of 5-year Treasury Notes (using the firm’s capital) and the lower she sells for, the less profit she makes (and if the price drops enough, she loses money). In contrast, Darcy, the client and buyer, wants the lowest price he can get. Bingley, the salesperson, just wants the trade done. If it doesn’t happen, he doesn’t get a commission or sales credit and risks damaging his long-term relationship with Darcy. Naturally, this setup creates tension—Elizabeth wants mores, Darcy wants less, and Bingley wants a compromise—and this tension is what makes the trading floor very efficient and very stressful for those on it.

If Elizabeth asks for too much or takes too long to respond, Darcy might do the trade with the dealer he likely has on a second line, or perhaps the one he has on a third. Darcy is a good client, so she must decide whether to grant him a slight discount to encourage him to do future business with the firm. The financial markets are constantly moving; while negotiating this trade, Elizabeth has to have her eyes and ears on the market and the news to make sure her price is where it ought to be. And if the market is volatile, she might be handling many trade inquiries simultaneously (across the trading floor or electronically through the firm’s Internet portal and e-commerce networks (ECNs)). Elizabeth’s is a complicated, nerve-racking job because there are razor-thin profit margins, millions of dollars on the line, and decisions must be made as quickly as possible.

Intra-company (sales desk versus trading desk) and inter-company (dealer versus other dealers) competitive dynamics drive speed and efficiency on the trading floor.

Middle Office

The Middle Office is primarily responsible for two areas: credit and risk. Over-the-counter trades in assets like U.S. Treasury securities are negotiated between two counter-parties. Each firm establishes a “credit limit” as to how much exposure they are willing to undertake with each client. This is somewhat analogous to the way banks allocate credit to consumers. Depending on who you are and your credit history, the firm will grant you a specific credit line and limit.

The middle office is also frequently involved in calculating the firm’s overall risk. Most trading floors allocate capital and risk limits to each of the trading desks, a process that must be carried out in real-time because of the trades and positional changes that occur throughout the day.

Back Office

The back office comes in after the trade is executed. Its members must confirm with the back office of the counter-party the specifics of the trade: buy or sell, security, amount, price, delivery instructions, payment instructions, account, and so forth, eliminating any ambiguity. If there are any discrepancies, the back offices sort them out. They must also settle the trade, which involves the actual transfer of the security (typically an electronic book entry) and monies, and record the trade in the firm’s accounting system. It also supports the trading desk in calculating what the firm owns as well as profit and loss (P&L). These responsibilities make back offices very busy places.

Most trades of U.S. Treasury securities are settled within one business day (T+1, or trade date plus one business day). In North America, same—day settlement is not unheard of.

Accounting

The accounting department keeps the official “books” (records) for the firm. This often includes accounting for the future, especially when dealing with securities in the capital markets. In our example, the 5-year Note pays interest twice a year on scheduled dates. Accounting must be aware of when and how much of this interest the firm will receive from the U.S. Treasury.